Costs and ROE target cast a shadow on HSBC's results

Despite declaring strong profit growth and a stellar year in global banking and markets, HSBC's share price fell yesterday as investors questioned the higher costs and a reduced return-on-equity target.

HSBC's net profit more than doubled in calendar 2010, but analysts are concerned by a large increase in costs and a lower return-on-equity forecast. Investors dumped the stock on the news, sending the share price almost 5% lower in London trading.

The 2010 earnings, which were released after the close of Hong Kong trading yesterday, showed a strong performance in calendar 2010. Profit before tax grew by $5 billion to $18.4 billion, which resulted in a net profit increase of 112% to $14.2 billion. Drivers of the improved performance were personal financial services, commercial banking and global banking and markets (GBM). Asia drove lending growth in commercial banking and generally performed well, contributing strongly to profits. Hong Kong in particular saw strong revenue growth supported by strong fee-income growth, and HSBC maintained its market leadership position in residential mortgages, credit cards, life insurance and deposits in its home market.

The growth did, however, come at a price. Costs increased by $3 billion during the course of the year on a gross basis, translating into an 8% year-on-year increase. Net of one-off expenses, costs increased 6% year-on-year. The second half of 2010 was weaker than the first half and saw an acceleration in cost growth. Also, increased capital requirements due to Basel III will take a toll on HSBC's return-on-equity, as they will at a number of financial institutions.

Group chairman Douglas Flint, group chief executive Stuart Gulliver, and group finance director Iain Mackay participated in an earnings call after the results were declared yesterday. The call was Gulliver's first after taking over as CEO in January. Analysts focused on both the increase in costs and HSBC's forecast that new capital rules had caused the bank to reduce its return-on-equity target to a range of 12%-15% from 15%-19% earlier.

Gulliver attributed part of the increase in costs to the need to position HSBC for growth, describing around half of the 6% increase as “revenue enhancing”. Specific areas where costs increased were: prime services and equity capital markets within the global banking and markets division; electronic platforms for rates and foreign exchange; staff costs, particularly in Hong Kong, the rest of the Asia-Pacific region and in Latin America; and regulatory and litigation costs in Europe and the US. But Gulliver also conceded that the cost efficiency ratio was outside the forecast range. He termed this “clearly unacceptable” and went on to say that discipline was being stepped up on cost control so that cost efficiency would be back in the target range in two to three years.

Analysts were spooked by the risk-weighted assets (RWA) position, which stood at $1.1 billion on December 31 last year, down just 3% from the previous year. A number of analysts asked for more colour on the RWA, including whether the bank had plans to make any disposals, leading Gulliver to suggest the topic be tackled in more detail on the investor day in May this year.

Analysts also asked for more clarity on the reduced ROE target. HSBC had flagged at its previous earnings call (after the six-month results) that ROE targets were subject to Basel III clarifications, but analysts suggested the new target had been reduced due to more than just higher capital requirements. Gulliver said the adjustment was due to changes in the way tier-1 capital was calculated, combined with environmental changes in things like short-term interest rates, and added that HSBC was being conservative in its estimates.

The bank clearly tried to convey that all was not gloom and doom. In addition to highlighting the improved profitability and reduced loan impairment charges, it also defined other future focus areas. Wealth management is a “huge opportunity for HSBC”, said Gulliver, both in emerging markets and mature markets where the bank is well-established, such as Europe. He added that it is a priority for him personally to ensure that HSBC is positioned to capitalise on the opportunity in wealth management. HSBC’s total compensation-to-revenue ratio last year was 23.3%, which Gulliver termed one of the best in the industry. GBM, which is really Gulliver’s baby as he ran the division for four years before relinquishing charge to Samir Assaf when he was promoted last year, had its second-best year ever.

But HSBC's shareholders were not convinced. The bank's London-listed shares lost 4.8% during yesterday's trading to close at around £6.77 ($10.91).

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