Thursday, 30 January 2014

Oh the banks! (1)

And HSBC Holdings PLC


Run on Northern Rock, 14 September 2007, courtesy Wikipedia
Everyone in the land was shocked by the collapse of three of Britain's largest banks in late 2008. And every investor in the stock market either saw the value of his bank shares crash by as much as 98% or thanked his lucky stars that he had the foresight or luck not to be invested in them. At one point, shares in RBS, HBOS, LLoyds and Barclays had all lost more than 90% from their previous highs.
Peak support for the banking system amounted to 1.16 trillion pounds (79.4% of 2008 national income), of which 133 billion was in cash according to the National Audit Office. Today, the taxpayer is still 115 billion pounds cash out of pocket.  
Subsequently our banks have been heavily fined for miss-selling payment protection insurance to their customers, rigging interest rates, money laundering for drug cartels and breaking the sanctions on Iran.  
Memories of dramatic events can influence our behaviour for generations. The German fear of inflation harks back to almost 3 years of hyperinflation in the early 1920s. One dollar was then worth 4.2 trillion German marks. It is understandable that British investors are wary of the banks. Indeed both RBS and Lloyds offer little for the investor; they pay no dividend and the shares held by the government, via UK Financial Investments Ltd, overhang the market. RBS continues to surprise observers with its ability to lose vast sums of money, this year to the tune of 8 billion pounds.
However, the banking sector is too large to ignore and investors will recall that the banks will be among the first entities to benefit from a sustained recovery in their markets. Four large banks listed on the London stock exchange, HSBC, Barclays, Santander and Standard Chartered, are worth a look.
Comparing the banks is a useful exercise.
1. Valuation
Standard Chartered
Share price
Share price/net assets
5 yr PE ratio (1)
Net dividend yield
 Return on Equity (2)
2. Balance sheet
CoreTier 1 capital/assets
Cash/total assets
Loans/ deposits
NPL coverage (3)
3. Other
Efficiency (4)
Long-term credit rating
Market capitalization
122bn pounds
43bn pounds
60bn pounds
31bn pounds
(1) Average earnings per share 2008-12. (2) Most recent period of EPS/NAVPS. (3) Provisions/non-performing loans %. (4) Cost/revenue.
While banks, by the nature of their business, can be quantitatively analysed to exhaustion, investors will note:
1. Lessons from the financial crisis include,
·         Banks can report profits when they are on the verge of bankruptcy. Unlike trading companies, bank Income statements only indicate, broadly, how the business is going. In February 2008, RBS reported a 10 billion pounds profit for 2007, when in reality it was bust.
·         As banks are highly leveraged, any analysis must start with the bank's balance sheet, though even the Chairman or the Regulator might not understand what the trillion or half trillion in derivative assets mean. For investors too this is an opaque account. While liquidity, reserves, provisions and capital ratios are all useful indicators, none is definitive. The CEO of the Financial Services Authority informed the public that Northern Rock was solvent two days before it ceased trading.
·         Credit ratings, vitally important for banks, can turn on a sixpence. The Cooperative Bank lost six notches in its credit rating in one day last year, and then promptly defaulted on its obligations.
2. Political risk can only be assessed by reviewing the geographic location of assets and income.
3. Bankers are adept at bypassing rules that they find inconvenient. Off balance sheet items and the valuation of assets, especially derivatives, are a cause of serious risks. It is worth scrutinising management's record.
4. Some banking businesses are more volatile than others are. And volatility in combination with highly leveraged balance sheets means more risk.
5. Some bankers will do anything to earn a big bonus. They risk all on acquisitions and speculative investments, as RBS, Barclays, HBOS and the Cooperative Bank did. They underestimate risk for investments that offered higher returns (Collaterised Debt Obligations et al). They manipulate earnings per share by not making sufficient provisions for bad loans - a common practice. And, if necessary, they disseminate false hopes to the investing public to successfully make a rights issue as both RBS and HBOS did in 2008. Investors should never forget what they have done in the recent past.

HSBC Holdings PLC

View to Hong Kong from Kowloon, by the author
The Hong Kong and Shanghai Banking Corporation (HSBC) is, with Wells Fargo, the largest bank by assets and market capitalisation outside China. And Hong Kong is still its most profitable market. Of course size is not a guarantee of success. Six of the world's ten largest banks in 2008, led by RBS, had to be rescued by governments or by other institutions during the financial crisis. But size does enable a bank to gain returns to scale from IT, marketing, provide a broad service for multinationals and access new markets.
According to Interbrand, HSBC and JP Morgan are by far the most valuable brands in banking. HSBC is widely spread geographically, though dependent on Asia Pacific for its earnings (data from  HSBC's 2012 Annual Report).
% Business
By Risk Weighted Assets
By Operating Profit
By Gross loans and advances to customers
North America
Rest of Asia Pacific
Hong Kong
 US dollar value
Source: 9 months data from HSBC *Of which 77% is in the UK
The failure of the American unit stands out. HSBC bought Household Finance Corporation, the second largest subprime lender in the US, in 2002. HSBC stopped Household's trading in 2009 while providing $16.3 billion in bad loans and a $10.6 billion write-down on its purchase. The bank immediately followed this with an $18 billion rights issue, which saved it from insolvency.
Today the risk is more obviously political and centred on East Asia. Japan and China dispute ownership of the Senkaku Islands. Japan, along with some other South East Asian nations, disputes China's new Air Defence Zone and its Economic Zone in the South China Sea. The war of words could spread to military confrontation. And there is always the threat of a possible conflict between North and South Korea. Kim Il Un, the new leader of the North, seems to be an unbalanced individual. If measured by gross loans and advances, HSBC has 21% of its balance sheet at risk in this region.
At the March 2009 stock market bottom, HSBC shares were 'only' 63% below the previous high. Since late 2009, the shares have traded in a fairly narrow band.
Graph courtesy Yahoo, click to enlarge
But HSBC has made progress since the rights issue that repaired its balance sheet. Consider:
1. The balance sheet is strengthened. Core Tier 1 capital is up from 9.4% in 2009 to 13.3%, while the equity to asset ratio has increased from 4.7% to 6.4%. And loans to deposits are down to 74% from 77%. However, the one ratio that has deteriorated is Non-performing-loan coverage, which is down from 73% to 41%. This is a concern as gross impaired loans have increased from $28 billion in 2009 to $39 billion in 2012, or from $8 billion to $22 billion after impairment charges.
2. HSBC's net asset value per share has increased by 28% since 2009, yet the share price is no higher now than when the bank reported 2009's result early in 2010. The bank's shares trade on a price that is just 16% more than its net asset value.
3. Earnings per share has more than doubled in this period, bringing the bank's historical PE ratio down to 14.
4. HSBC has increased the dividend by one-third since 2009, so that the shares currently yield 4.7%.
5. Return on equity is up from 5.1% in 2009 to 8.3% in 2012.
My valuation model, which assumes no great political risks, values HSBC shares at about 735p.* This is 17% above the present price of HSBC shares, which some investors might consider a sufficient margin of safety.
*EPS growth 10% per annum, equity per share growth 6%, return on equity 9%, average PE ratio 13.5, dividend payout 60%, all discounted at 10.9% (SLXX 3.9% + 2% operating risk + 5% margin of safety) for 2013 to 2017.
Investors will want to consider:
1.  The risk of a political crisis, perhaps leading to war, in East Asia, and the consequences for a bank that has so much invested in the region.
2. The $22 billion of impaired loans that are not covered by provisions. This represents 12% of net assets and it is equivalent to a full year's pre-tax profits.
2. Directors have overwhelmingly sold shares in the last 12 months. Major sales total 1.5 million pounds at prices ranging between 710p and 726p a share. One director bought 78,000 pounds of shares at 703p.
4. HSBC faces legal action in several US mortgage securitisation cases. The money at risk has not been quantified. As regulators continue to scrutinise the activity of banks in recent years, HSBC might face further large fines and damages.

Thursday, 23 January 2014

What to do when a leopard changes its spots?


4th century BC Greek mosaic of a leopard and Dionysius, courtesy Wikipedia
Companies diverge from their main business for many reasons. Often they are defensive, which does not bode well for their shareholders.
Imperial Chemical Industries (ICI) was once the largest company in the British Empire. In 1984, it became the first British company to report more than 1 billion pounds in profit.
In 1993, under pressure from a corporate raider, ICI divested its thriving pharmaceutical and agrochemical businesses into Zeneca. Zeneca then merged with a Swedish pharmaceutical company to form AstraZeneca. ICI's remaining business was dependent on bulk chemicals. Competitors had moved production to low-cost areas and ICI found itself in a low margin and cyclical business with little prospect of growth.
A year after the divestment, ICI decided to sell its bulk chemical businesses and move to specialty chemical businesses and paints, where margins were higher. It imported a new CEO from Unilever, who between 1997 and 2002 sold and bought more than fifty businesses. These included concerns making flavours and fragrances, paints, electronic chemicals and starches. This strategy came at a high cost. Some analysts argued that ICI paid too much for some of the businesses it bought and received too little for some of the businesses it sold. To pay down the resulting debt, the company sold some of the ventures it had bought. Then because they needed to raise more capital, ICI made a deeply discounted rights issue. Management had lost control. ICI, once known for its technical skills, lost the direction and calculated  risk-taking required to innovate.
ICI's share price dropped from 788p in January 1994 to 220p in January 2005. Shareholders who stayed the course received 670p a share from Akzo Nobel, which acquired ICI in June 2008.
Today another large British company is losing its main thriving business. For years, Vodafone's 45% stake in Verizon Wireless has disguised the poor performance of its other businesses. See The loss of Wireless will have great consequences for the company.
Investors will note that companies are in constant flux. Sometimes this can be sudden and dramatic, as in the case of ICI or Vodafone. More commonly, new management branch out into new businesses that change the nature of the company. At other times, the basic business is disrupted by competition or new technology. Sometimes they reflect the work of excellent management, as has been the case of Unilever.
While a buy and hold strategy has its merits, investors would be wise to monitor their investments regularly.


MITIE slogan, courtesy MITIE 2013 Annual Report
The facilities management company, MITIE, once offered a unique business model for the industry. An acronym for Management Incentive Through Investment Equity, MITIE created a majority interest in many small businesses in its market via partial acquisition or co-financing. Its partners retained management autonomy with the incentive that, after five to ten years, MITIE would buy them out on a multiple of ten times post-tax profits, averaged over the previous  two or three years. Owner managers were encouraged to continue working for MITIE after selling their shares. As a result, MITIE's businesses were part owned by local management, the founders. The entrepreneurial spirit was kept alive. And this was its charm.
Between January 1999 and February 2008 MITIE's share price increased by 428%. Beginning in 2006, MITIE began to buy well-established companies. The first was the security business of Rentokil Initial. This enabled the company to continue its growth, but at the cost of changing its business model. The new companies were large and more complex and required substantial integration. And MITIE breached the entrepreneurial model on which it was founded. Net debt has soared from 11 million pounds in 2008 to 222 million at mid 2013. Management now refer to 'Headline' profits that exclude the considerable costs of its strategy, as if they are of no importance to the shareholder to whom they are reporting. The leopard has changed its spots.
As a result, over the last five years MITIE's share price (in blue) has increased by far less than the FTSE 250 (in green), of which it is a constituent.
Graph courtesy Yahoo, click to enlarge.
While MITIE might have fallen out of favour with investors, the company has prospered with its more conventional business model. Consider:
1. Earnings per share have increased by 9% per annum through the recession - from 2005-7 to 2012-14.
2. While return on equity has declined, the return on new equity is still a healthy 14%.
3. Management seem to have been successful in building up a new healthcare and homecare business, while winding down engineering services where it was not able to make a satisfactory profit.
4. Operating cash flow, net of capital expenditure, for the last five years has covered the dividend by 1.8 times, leaving 119 million pounds available for acquisitions.
5. The record order book at 9.2 billion pounds is 4 1/2 times annual sales, giving an idea of the momentum that this service company has generated. 2014 budgeted sales were 85% covered at the beginning of the year.
At the present price of 329p, MITIE shares are trading on a PE ratio of 30, reflecting 40 million pounds after tax reorganization costs that halved the 'headline' profit, and they yield 3.1%. A profit recovery is expected in 2014, which is supported by better results in the 6 months to September 2013. This would put the share on a prospective PE ratio of 14 (broker forecasts) and a yield of 3.3%. My valuation model values MITIE shares at 335p.* This assumes that reorganization costs will cease and that net operating cash flow is used to pay off debt. Less optimistic assumptions would lower the valuation to 228p a share.**
*Earnings per share growth of 9% on a base eps of 18p (average of 2012-14), an average PE ratio of 21.5, 14% return on equity, equity per share growth of 6%, dividend payout 50% of eps; using a discount rate of 10.8% (3.8% SLXX, 2% operating risk, 5% margin of safety) for the years 2015-2019.
**As above except eps growth of 2% and an average PE ratio of 16.5 for 2015-2019.
There are serious caveats:
The CEO uses the annual reports to sell the company rather than address the problems it faces. It is disappointing that the CEO does not indicate what will be the final cost or the time period of the reorganization she is managing or how she intends to pay off the large loans the company has taken out in recent years. Shareholders should be informed why the units MITIE is exiting from cannot be sold to other operators.
Remuneration benchmarks for the management team do not help. While the annual reports are not specific enough to explain precisely how bonuses are awarded, it seems that they are largely based on 'headline' earnings and the share price. Under this formula, earnings can be bought in by acquiring companies while their cost (amortization and integration) is excluded. 'Headline' earnings also exclude the costs of running down two of MITIE's divisions.
The seasoned investor will also note:
1. Three directors sold shares worth 1.4 million pounds at 290p in September 2013. There were no director purchases.
2. The defined benefit pension scheme is a drag on attributable profits with a charge of 14 million pounds in 2013 following a 16 million pound charge in 2012.
3. Receivables are 87 days sales, illustrating the slow conversion to cash. Fortunately, trade payables match receivables.
4. 97% of revenues are in the UK and 61% of these are in the private sector. While given that the UK is one of the stronger developed economies, this is positive, the company is in a very competitive market. MITIE has withdrawn from engineering services, and energy solutions, once highly touted, is loss making and shrinking. .