The letters of HSBC (HSBC, Financial) stand for Hong Kong and Shanghai Banking Corporation. The company was founded 157 years ago by a Scottish banker named Thomas Sutherland. It has headquarters in London and Hong Kong, as it has a major U.K. presence following its acquisition of Midland Bank in 1992. Its primary listings are in London (LSE:HSBA, Financial) and Hong Kong (HKSE:00005, Financial), though it also has a listing of American depository receipt on the New York Stock Exchange. You might know it from its airport adverts as “The World’s Local Bank."
In recent years, this company has been consistently beset by controversy, but relatively strong economic performance from its main geographies in mainland China and Hong Kong over the last year has helped achieve a 33% return over the last 12 months.
There has been another catalyst too. Ping An Insurance (Group) Co. of China Ltd (HKSE:02318, Financial), HSBC’s largest shareholder owning 8.3% of the group, has been aggressively pushing HSBC to demerge and split its Eastern and Western operations, claiming this could unlock as much as $35 billion in value for shareholders due to higher valuation multiples.
The push for a breakup
Earlier this month, during its interim results, when it produced better than expected second-quarter earnings, HSBC argued that separating the current structure would be too complex and threaten Hong Kong’s status as a global financial centre. Ping An followed up by accusing HSBC of exaggerating the potential difficulties involved in spinning off its Eastern business.
Ping An believes that a break-up could release HSBC from $8 billion in additional capital requirements imposed on so-called global systemically important banks (G-SIBs), according to a recent article in the Financial Times. The Financial Times also noted that Ping An informed HSBC’s management that almost all its recent revenue growth was dependent on a “phased, shortlived and uncontrollable interest rate hike cycle” and that its “underperformance has not yet been fundamentally addressed and it is in urgent need of radical change." These do seem to be valid points in my opinion.
The tension follows from when Hong Kong investors were annoyed by the U.K. regulator blocking U.K. banks from paying dividends during the global market meltdown immediately following the outbreak of Covid-19 in March 2020. Additionally, HSBC has found itself becoming a political hot potato following U.K. parliamentarians’ criticism of the bank for supporting China’s national security legislation in Hong Kong and the freezing of accounts of pro-democracy activists (HSBC says it was only following local law, which it is indeed required to do).
It might be that Ping An’s calls for the breakup of the bank are as much strategic as they are financial, given the increased U.S. congressional attention over the bank’s corporate governance in Hong Kong. Regardless of the rationale, the break-up does make sense in my view. With the U.K. government being closer to the U.S. than China, HSBC will find it increasingly difficult to please both Chinese and British regulators.
Asia now accounts for around 60% of HSBC's reported pre-tax profits, and as one of the world’s largest financial institutions, both the Asian branch of HSBC and the the U.K. HSBC would have large enough scale in their own rights. The aggregate value of the bank’s customer accounts is split more or less evenly across its Hong Kong, U.K. and rest-of-the-world segments, so each would be significant enough businesses to stand on their own.
The spin-off of the Asian arm of HSBC would have short-term costs. HSBC has compiled a 14-point list of reasons why changing the bank’s structure could harm its corporate performance. It says structural change risks diluting the economics of its international business model, in addition to cost and capital factors that would drive material valuation loss. HSBC cities significant one-off execution costs, higher ongoing running costs and material complexity and execution risks.
HSBC does have an investment banking division, so I find it interesting that it decided to hire Goldman Sachs (GS) and boutique investment bank Robey Warshaw to build the defence against Ping An's activism campaign rather than relying on its own financial and legal experts. In my opinion, this level of outsourced effort could indicate a lack of internal support for the arguments.
In the short term, the fighting over a breakup is going to be costly in terms of management’s time and focus. In the long term, I believe it seems inevitable that HSBC cannot straddle the divide between Hong Kong/China and the U.K./U.S. HSBC is also too large in my opinion, and it suffers from diseconomies of scale. The recent scandals are likely a result of the difficulty of managing such a global empire.
HSBC’s Piotroski F-Score is a strong 7 out of 9. It has a price-earnings ratio of 10 and a dividend yield of 3.5%, so it looks about fairly valued for the banking industry. The banking group is a good way to get exposure to China and Hong Kong’s macro economy.
Part of the reason why I believe a break up would make sense is because HSBC’s Asia-based investors likely won't want to be exposed to the U.K.'s current volatile political environment, with the country's government potentially aiming to increase regulatory scrutiny in the financial sector.
As guru Joel Greenblatt (Trades, Portfolio) wrote in his excellent book "You Can Be a Stock Market Genius," special situations such as demergers provide ample opportunity for making excess returns. The HSBC situation is one to watch closely in the coming weeks and months.