Ping An’s HSBC campaign fails the financial test

Boc Hong Kong Holdings

08/09/2022 01:44

(The authors are Reuters Breakingviews columnists.  The
opinions expressed are their own.)
    By Jennifer Hughes and Liam Proud
    HONG KONG/LONDON, Sept 7 (Reuters Breakingviews) - It’s nice
to dream of a better world, but harder to make it happen. That’s
the challenge facing China’s Ping An Insurance  601318.SS ,
 2318.HK . HSBC’s  HSBA.L ,  0005.HK  largest shareholder is
pushing the global bank to spin off its Asian business. To make
the separation worthwhile for investors, though, the carved-out
unit would have to trade at an improbably high valuation.
    It’s easy to see why Ping An, which owns 8% of HSBC, reckons
there’s hidden value in the bank founded in Hong Kong and
Shanghai 157 years ago. Asia accounted for just 44% of the
lender’s $148 billion of tangible equity at the end of June yet
will bring in 61% of its pre-tax profit this year, according to
Visible Alpha consensus estimates. Knock off tax at 20%, and the
Asian business will generate a healthy 16.7% return on tangible
equity (ROTE), double what the rest of the bank produces.
    While investors currently value HSBC at a paltry 0.9 times
its tangible book value, Asian lenders like Singapore’s DBS
 DBSM.SI  and Hong Kong-based Hang Seng Bank  0011.HK  –
controlled by HSBC – trade at roughly twice that multiple. It’s
not clear, though, that spinning off an Asian business would
unlock that value.
    
    THE DREGS
    Ping An hasn’t produced a detailed breakup plan and has only
said publicly that it wants to maximise value. Still, assume
that HSBC split into two parts; call them EastCo and WestCo. The
latter half would be a predominantly European bank with
operations in North America, the Middle East and Latin America.
Stripped of its Asian arm, WestCo would be smaller and less
diversified. That would raise the cost of servicing its $100
billion of wholesale funding by 0.25 to 0.5 percentage points,
HSBC reckons, adding about $375 million to its annual expenses.
    WestCo would also inherit a load of loss-leading corporate
lending relationships. Right now, those clients pay their way by
doing lucrative business in Asia. A German manufacturer, for
example, might get a cheap loan from HSBC in Europe, but use its
trade finance and cash management services in Asia. Without
those group-wide benefits, WestCo would probably have to
jettison unviable clients. 
    This cross-border business generates about $9 billion of
wholesale revenue a year for HSBC. Assume it splits evenly
between the two halves, and WestCo loses a third of its share,
or about $1.5 billion. Apply the group’s adjusted profit margin
of 44%, based on Visible Alpha 2022 consensus estimates, and
that’s a $660 million hit to pre-tax profit.
    These two setbacks to earnings would lower WestCo’s ROTE to
7.5%. Stripped of its Asian business, the bank would also trade
at a lower valuation. Europe-focused lenders like Barclays
 BARC.L  and BNP Paribas  BNPP.PA  are valued at roughly half
their tangible equity, implying a market value for WestCo of
just $41 billion.
    
    FADING JEWEL
    A split could also cost EastCo some business. Only two of
HSBC’s top 20 custody customers in Asia, for example, have their
headquarters in the region. Meanwhile, HSBC currently books a
fifth of the trade-finance-related business that the bank does
with North American and European clients in Asia. Assume that
EastCo, like its western counterpart, would give up about $660
million of annual pre-tax profit.
    The unit would also have to bolster its balance sheet.
Authorities in Hong Kong, where EastCo would almost certainly
have its head office, typically require capital levels higher
than HSBC Asia’s current common equity Tier 1 ratio of 14.4%.
Increasing that to, say, 16% would require an additional $7
billion of capital, taking EastCo’s tangible equity to $72
billion. Combined with the lost pre-tax profit from cross-border
clients, its ROTE would fall to 14.4%, according to
Breakingviews calculations.
    To get there, HSBC Chief Executive Noel Quinn and his team
would have to pull off a time-consuming, risky and complex
restructuring while incurring hefty expenses. Quantifying the
one-off costs is tough without a detailed plan. But the bank
reckons building a standalone IT system for EastCo would cost
several billion dollars, as would reissuing the region’s
loss-absorbing debt. A report by consultant In Toto, which
people familiar with the matter say was commissioned by Ping An,
estimates total one-off costs at almost $4 billion.
    
    HIGH BAR
    To make the whole exercise worthwhile, the breakup would
have to boost HSBC’s $123 billion market value by a substantial
amount – say 30%. If WestCo is worth $41 billion, then EastCo
would need to be worth at least $120 billion. That implies a
multiple of 1.7 times its tangible equity. Long-time market
darling DBS trades at a similar valuation, but $36 billion local
rival BOC Hong Kong  2388.HK  trades at just 0.9 times.
    HSBC’s record merits criticism. The bank’s ROTE has fallen
short of its probable 10% cost of capital for almost a decade
while previous turnaround plans have repeatedly fallen short. A
more ambitious strategy might involve getting rid of the Mexican
and Canadian retail banks, or even hiving off HSBC’s ring-fenced
British unit. Ping An’s dream of an Asia spinoff, however, fails
the financial test.
    Follow @JennHughes13 https://twitter.com/JennHughes13 and
@liamwardproud https://twitter.com/liamwardproud on Twitter

    CONTEXT NEWS
    China’s Ping An Insurance Group on Aug. 24 said it supported
calls to restructure HSBC, which could include a spinoff of its
Asia business, saying it cared about investment returns from its
large stake in the bank but was not an activist investor.
    “It is a significant investment and we’ve invested in it for
seven years,” Jessica Tan, Ping An’s co-chief executive, told
Reuters.

    <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Tangible difference Tangible difference    https://tmsnrt.rs/3Qhwweg
    ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
 (Editing by Peter Thal Larsen and Oliver Taslic)
 ((For previous columns by the authors, Reuters customers can
click on  HUGHES/  and  PROUD/ 
SIGN UP FOR BREAKINGVIEWS EMAIL ALERTS https://bit.ly/BVsubscribe
 | jennifer.hughes@thomsonreuters.com; Reuters Messaging:
jennifer.hughes.thomsonreuters.com@reuters.net
liam.proud@thomsonreuters.com; Reuters Messaging:
liam.ward-proud.thomsonreuters.com@reuters.net))