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We have lowered our long-term recommendation on HSBC Holdings plc to ‘Underperform’ from ‘Neutral’. This is based on the recent penalty imposed on the company for its involvement in money laundering and its credit ratings downgrade by Fitch Ratings. Yet, we expect the company to benefit from its restructuring initiatives, extensive global network, diversified revenue sources and strong capital position.

In December 2012, HSBC reached a settlement with the U.S. law enforcement authorities in the money laundering case. The company agreed to pay a fine of roughly $1.9 billion for its misdeeds and undertake measures to prevent such issues going forward. Although the settlement comes as a relief since it would reduce litigation overhangs and legal costs, it will exhaust the company’s financials to a great extent.

Also, Fitch lowered HSBC’s long-term Issuer Default Ratings (IDR) to reflect its expansion into the high-growth and high-risk markets. The rating agency believes that the advantage the company gains from its diversified operations is mostly mitigated by the cost of maintaining and managing huge business globally. We expect the ratings downgrade to lead to a hike in the already high funding cost of the company.

Further, revenue growth remained restrained in recent years as a continued low interest rate environment pressured revenue generation from several corners. As growth remains muted in HSBC’s mature markets (Europe, UK, and the U.S.), overall improvement in revenue is expected to remain under pressure in the upcoming quarters as well. Moreover, new regulations are expected to restrict fee income growth.

Though management has been working hard on its cost rationalization efforts, rising wage inflation in its faster-growing markets along with strategic investments will not allow HSBC to make the cost line favorable any time soon. We also expect that the re-engineering efforts taken by the company to reduce cost will take some time to remove inefficiencies.

Nevertheless, the situation is not as bad at HSBC as it seems. The company expects the targeted cost savings of up to $3.5 billion to exceed the limit by the end of 2013. Further, the company remains on track with its long-term strategy of slashing its global workforce by 30,000. In 2011, the company had announced its plan to restructure the businesses. Some of the major divestitures completed include the sale of its U.S. credit card business to Capital One Financial Corporation (COF - Analyst Report) and 195 of its branches to First Niagara Bank, N.A. – a wing of First Niagara Financial Group Inc. (FNFG - Snapshot Report).

Additionally, despite the uncertain macro environment, HSBC remains strong with respect to its balance sheet and capital position, which is definitely a competitive advantage over other banks. We anticipate this capital strength to allow HSBC to enhance its profitable market share. Also, owing to its strong capital base, unlike many of its peers, HSBC continued to pay dividends over the last few years, though at a reduced rate.

HSBC currently retains a Zacks #4 Rank, which translates into a short-term Sell rating.

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