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Bank on HSBC for a large and fast-growing yield

INCOME TIP OF THE YEAR: Unusually for a bank, HSBC appears to be generating more capital than it needs, which leaves it with some of the best income characteristics around.
January 2, 2014

Dividend growth is a key factor in successful income investing and high-yielding HSBC (HSBA) looks set to deliver this in spades over the coming years. At a time when most lenders are struggling to meet tougher regulatory capital requirements, HSBC appears to be generating more capital than it knows what to do with. Indeed, with its third-quarter figures, it reported a 10.6 per cent Basel III capital ratio, compared with a regulatory minimum of about 10 per cent. But with prospects for loan growth looking subdued, returning this excess capital to shareholders seems likely - leaving HSBC as one of the best income plays around.

IC TIP: Buy at 656p
Tip style
Income
Risk rating
Medium
Timescale
Long Term
Bull points
  • Impressive dividend prospects
  • Improving credit quality
  • Emerging market exposure
  • Partial UK arm float could release value
Bear points
  • Business misconduct issues have hit sentiment
  • Ongoing margin erosion

HSBC's healthy capital generation reflects such factors as chunky cost savings, restructuring, and falling bad debt charges. Since 2011 it has axed an annulaised $4.5bn (£2.7bn) of fat, with a further $0.4bn of savings achieved in the third quarter of this year alone. Broker Espirito expects another $2bn to 3bn of savings between 2014 and 2016. Selling non-core units has generated cash, too. Just in 2012, over $7bn of gains were booked from selling its US branch network, its US cards business and the Ping An insurance arm, while in October, selling the Panama business netted $1.1bn. A collapsing North American bad debt charge has also helped - this fell $1.6bn in the year to end-September and reflects rapidly improving credit quality at the US consumer finance unit (in run-off). Overall, group impairment charges at end-September fell 28 per cent year on year to $4.7bn.

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Expect more to come, too. Back in the summer Espirito Santo estimated that HSBC would generate $56bn of excess capital (above Basel III capital requirement) by 2015. It also emerged this month that HSBC may be considering a partial float (perhaps 30 per cent) of its UK arm, which could release significant value. Espirito Santo thinks it could add 60p to its current 850p a share sum of the parts valuation for HSBC. It could have other benefits, too. "A carve-out of the UK business would help to deal with the requirement of the incoming Vickers rules, which demand that UK banks ring-fence their domestic retail banking operations," suggests Espirito's banking analyst Shailesh Raikundlia.

HSBC HOLDINGS (HSBA)

ORD PRICE:656pMARKET VALUE:£124bn
TOUCH:656-656.2p12-MONTH HIGH/LOW:773p635p
FWD DIVIDEND YIELD:5.6%FWD PE RATIO:12
NET ASSET VALUE:951¢  

Year to 31 DecPre-tax profit ($bn)Earnings per share (¢)Dividend per share (¢)
201019.073.034.0
201121.992.039.0
201220.674.041.0
2013*25.195.452.0
2014*24.592.160.0
% change-2-3+15

*Investec Securities' forecasts

Normal market size:3,000

Matched bargain trading

Beta:1.33

£1=$1.64

But with economic recovery still fragile, HSBC is unlikely to grow fast enough to absorb this capital. "Net loan growth remains weak," points out analyst Ian Gordon of Investec Securities. And with regulators still fretting about banks already being too big to fail, then blowing cash on big acquisitions isn't likely, either. So returning capital to shareholders is on the cards, leaving analysts anticipating chunky dividend payouts. Based on Investec's estimate that the dividend payout will rise to 66¢ in 2015, which means the shares would yield 6.1 per cent and some analysts - such as those at Espirito Santo - expect even fatter payouts. Its end-2015 estimate, for example, implies a prospective yield of over 7 per cent. That beats anything on offer from other UK banks. True, shares in a few international peers are also fat yielders - those of Spain's Santander (Sp: SAN) offer a 9 per cent or so prospective yield for end-2013, for instance - but the sustainability of their payouts is usually in doubt.

HSBC's trading prospects don't look bad, either. While tapering is likely to continue to be a source of uncertainty for some time, HSBC is heavily exposed to the robust emerging market growth story - Hong Kong and the rest of Asia-Pacific generated 69 per cent of group pre-tax profit in the nine months to end-September. And even the European unit is recovering as impairments slide. It turned end-September 2012’s $884m loss into a $2.7bn profit a year later.

But the lender still faces challenges. Yields on customer lending have fallen with net interest margin down from 2.68 per cent at end-2010 to 2.17 per cent at end-June 2013. HSBC also continues to suffer its share of sentiment-zapping business misconduct issues. Last year it was fined $1.9bn by US authorities for money laundering compliance failings, while a cumulative $2.76bn had been set aside between 2011 and end-June to cover payment protection insurance mis-selling compensation. More provisions for interest rate products mis-selling are also likely - after setting aside $598m in 2012 for this, a further $132m was provided in the first nine months of 2013.