2010 performance review

The Group experienced the U.S subprime crisis and European sovereign debt crisis, it seems that the group is recovering from the crisis from the annual report of 2010, the group's earning per share increased over 50% and dividend increased 6%.

However, we are not so optimistic for the group's operating performance. First, the increasing in operating income was major contributed by reducing 47% in loan impairment charges and other credit risk provisions, the group's core business performance is needed to improve, compared to 2009 the net interest income, net fee income and net trading income decreased 3%, 1.75% and 26.9% respectively.

Apart from that, the total operating expense increased 9.6% due to the increase in administrative expenses, employee compensation and benefits, as a result the cost efficient rate reached 55.2%, for improving the operating performance, undoubtedly a comprehensive restructure is needed.

In May 11, group's strategy day, the senior management presented future target of group as below:

1. Maintain the return of equity 12-15%

2. Before 2013 Cut cost 2.5-3.5 billion U.S dollars, cost efficient rate achieved 48-52%

3. Maintain target dividend payout ratio 40-60%

4. Restructure the global business

Traditionally HSBC enjoy a high reputation among the shareholders and clients, with the experienced management team, we believe the group will achieve their target finally what they need is time only.

Even though the group will be still affected by the European sovereign debt crisis, new regulation rules from government, we expect the group will increase the dividend progressively by restructuring the U.S retail banking and credit card business, which is a positive signal to the share price.

Therefore, we give the company a “hold” rating. For the recent low share price, HSBC is suitable for long-term investing .We suggest, “hold” rating 12-months target price is 86.5.

Global economy

U.S is still suffering from the subprime crisis, the unemployment rate is still high and the second quantitative monetary policy is coming to end in June, the U.S real economy is still weak, therefore, HSBC is right to withdraw from the U.S market.

By restructuring the retail banking network in U.S and selling U.S credit card business, we expect that will contribute about 7 billion U.S dollars to income and a 5 billion U.S dollar special year end dividend.

Europe is affected by European sovereign debt crisis. Greece is still in dilemma between the cutting budget deficit and gaining the Euro Group's support.

If the Greek can`t gain the support on time, it may be causing a global financial crisis. Many foreign banks invested in the Greece sovereign debt, there are billions of related debt and derivative products including CDS.

If Greece defaulted on the debt; this is a potential threat to the global financial market. We predict the problem can`t be settled in next year and this crisis will continue affect the share price of HSBC.

Regional Business Performance

Hong Kong sector contributed 30.3% of the group's pretax profit, total 5.56 billion US dollars compared to 2009 up 10.5% yoy.

HSBC is the market leader in mortgages, credit card, life insurance and deposits; the group's 2010 profit is mainly contributed by the increasing sales in insurance, credit card business, mortgage and investment link related product.

The cost efficient rate is only 43.4%, which is the lowest among the group.

The Hong Kong economy is benefited from the economic growth in China, we expect the Hong Kong sector will play more important role to the group, especially for the commercial banking business.

There is an increasing trend; the mainland enterprises use the banking service in Hong Kong, as RMB offshore settlement center, the RMB settlement service and related investment link product will be a great opportunity to the company.

Apart from that, China's Central bank raised the deposit reserve ratio to 21.5 %, which worsened the lending market of Mainland China.

Therefore, with the appreciate expectation in RMB and a better interest rate in Hong Kong, we expect the demand of Hong Kong dollars loan from mainland enterprise will be increasing. HSBC can be directly benefited from that.

Europe sector contributed 22.5% of the group's pretax profit; total 4.13 billion US dollars compared to 2009 reduced 37% yoy, due to client's transaction reduced which led the Global banking and market's profit decreased.

Profit from personal and commercial banking grew, for personal banking, HSBC focus on increasing the number of clients in premier and HSBC advance, which is a high value group to the bank.

As a result the loan amount in personal banking is increased 3% and the mortgage's market share in England increased to 5.2%, the loan amount to SME also increased 19% in England. However, the cost efficient rate is 67.9%, which is the highest among the group, we expect a large cost cut measure is needed.

The rest of Asia Pacific region contributed 31% of the group's pretax profit; total 5.69 billion US dollars compared to 2009 up 36.9% yoy, due to a large grew in China and India business.

In India total pretax is 679 million US dollars compare to 2009 increased 81.55%.

In China, the total pretax profit is 2,565 million U.S dollars, compare to 2009 increased 57.17%, with a higher contribution from Ping An Insurance and Bank of Communications. We expect the grow will keep on, especially for the cards, wealth management, settlement activity and branch network.

Sector Performance

Personal Financial Service

The personal financial service sector contributes pretax profit U.S 3.5 billion, which is 19.1% of the group's pretax profit. HSBC will focus on wealth management business in emerging market, such as China and India, the numbers of Primer and Advance clients, is expected to rise which is high value customer to the group.

Commercial Banking

The Commercial Banking Sector contributed pretax profit U.S 5.95 billion which is 32.4% of the Group's pretax profit. In Asia the loan amount increased 21%, with the demand on RMB settlement service and loan demand from China Enterprises, we expected the Asia's business would play an important role in 2011.

Global Banking and Market

The Global banking and market sector contributed pretax profit U.S 9.2 billion, which is 50% of the group. However, compared to 2009, pretax profit reduced about 9%, the cost efficient raised about 10%. HSBC will focus on the emerging region especially in Latin America and Asia. We expected the global banking and market would be still affected by the global economy and Greece sovereign debt crisis.

Dividend policy

Company maintains high dividend payment policy, committed to reward shareholders by dividend payment. The management planned to pay US$0.09 per Quarter, for the first-3 Quarters of 2011; we expect company will gain total U.S 7-8 billion by selling and restructuring the business in low profit margin area such as Russia, Britain and North America.

After restructuring the business, the dividend per share will be increased by 0.3 to 0.4 HK dollars.

Apart from that, we also predict there will be a extra expense for the new regulation in UK, (if the bank's headquarter local in UK) as the chairman Douglas flint said if the new regulation applied to 2010's business, HSBC will pay extra US 0.6 billion, it is about 3.2% of the 2010 Group's pretax income.

Therefore, we expect only half of the expense will be realized in2011 which is about 0.2-0.3 billion US dollars.

Meanwhile, even though HSBC had core Tier 1 Capital 10.5%, for meeting the requirement of Basel 3 in the core Tier 1 Capital, we expect the company may increase more retain earning and reduce dividend pay. Therefore we expect the dividend per share in fourth quarter is about $1.1 HK dollar.

Industry Comparison

Compared with competitors, the P/E, P/B ratio of HSBC is relative lower than others; it is because the ROE of HSBC is the lowest among the industry.

However, the management planned to achieve 12-15% in ROE with the P/B ratio is only 1.14, which is the lowest in the industry, thus, we believe HSBC has a attractive valuation for long term investment, the intrinsic value will be released after the business restructure.

Valuation

From above graph, HSBC's Price to Book value is 1.14, which is below mean plus one standard deviation. Even though, global banking industry still be affected by the European sovereign debt crisis and weak economy recover in U.S, we believe HSBC can grow with the right strategy.

HSBC withdraw from the low profit margin area (Russia, U.S, England) to emerging market (China, India), with the experienced management team, we expect HSBC can maintain a high dividend payout in 2011.

The company is now suitable for middle-long term investment, forecast book value will be about $69 Hong Kong Dollars. Price to book value will be about 1.25 times, which is mean plus one standard deviation, estimated earning per share is $6.4 Hong Kong dollars, the target price is about $86.5 Hong Kong Dollars, and expected Price to earning ratio is 13.5 times.

According to above prediction, we give HSBC a ” hold” rating with an upside potential about 13% within 12 months.

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