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Extra Charge Dents HSBC Profit

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HSBC Holdings Plc’s earnings per share for the third quarter were 13 cents, trailing the prior-year period’s earnings of 28 cents. The company’s net profit came in at $2.8 billion, waning 48.9% from $5.5 billion in the comparable quarter last year.

Results for the reported quarter included $800 million of additional provision related to the current US anti-money laundering (AML), Bank Secrecy Act (BSA) and Office of Foreign Assets Control (OFAC) investigations. The company also made UK customer redress provisions of $353 million, primarily regarding Payment Protection Insurance.

Further, results were adversely impacted by the loss in the Other segment. Yet, strong performances by all other divisions were a positive for the quarter.

The core results were negatively impacted by higher operating expenses. Nevertheless, improved top line and growth in total operating income were the positives.

HSBC made significant progress in executing the strategy to reshape itself and improve its returns. Since the beginning of 2012, the company announced the divestiture or closure of 24 of its non-core/unprofitable operations across the globe.

Performance in Detail

Underlying profit before tax was $5.0 billion, surging significantly from $2.2 billion in the prior-year period. The increase was driven by revenue growth in Global Banking and Markets and Commercial Banking segments. Moreover, lower loan impairment charges compared with the third quarter of 2011 was a reason for rise in profit before tax.

Total revenue (on an underlying basis) stood at $16.1 billion, climbing 20% from $13.4 billion in the year-ago quarter. Favorable movement on non-qualifying hedges accounted for $1.4 billion increase in revenue. Further, improvement was driven by growth in revenues from Global Banking and Markets, Retail Banking and Wealth Management as well as Commercial Banking operations.

Total operating income declined 14.2% from the year-ago period to $18.4 billion. The decrease was primarily attributable to reduced net interest income and fee income. These were partially offset by rise in net trading income, dividend income and other operating income.

Total operating expenses were $10.3 billion escalating 16% from $8.9 billion in the prior-year quarter. Expenses in the reported quarter included aforesaid additional provisions. Excluding these, expenses were marginally higher than the third quarter of 2011. Further, the company recorded $3.1 billion of sustainable annualized cost savings, including $0.5 billion in the reported quarter.

The underlying cost efficiency ratio improved to 63.7% from 65.8% in the year-ago quarter, as a result of revenue growth and strict cost control. The improvement in efficiency ratio indicates enhanced profitability.

Performance by Business Line

Retail Banking and Wealth Management: The segment reported $1.5 billion in pre-tax profit, significantly up from $224 million in the prior-year quarter. The impressive rise was primarily due to lower loan impairment charges and strong revenue growth.

Commercial Banking: The segment continued to show improvements. Pre-tax profit of $2.2 billion was up 15.0% from the year-ago period. Segment revenue continued to bolster, partially offset by increase in loan impairment charges.

Global Banking and Markets: Pre-tax profit for the segment was $2.2 billion, significantly higher than the year-ago period. Segment results improved on the back of higher revenues, which were partly offset by rise in loan impairment charges.

Global Private Banking: Pre-tax profit for the segment was $252 million, up 1.6% from the corresponding quarter last year. The slight rise was driven by lower operating expenses, partly mitigated by decline in revenues and increase in loan impairment charges and other credit risk provisions.

Other: The segment recorded a pre-tax loss of $2.8 billion in the reported quarter compared with pre-tax profit of $3.7 billion in the prior-year quarter. The main reason behind this was heightened adverse fair value movements arising from the effect of changes in credit spread on the fair value of the company’s long-term debt.

Profitability and Capital Ratios

Profitability ratios continued to deteriorate during the third quarter. Annualized return on equity fell to 5.8% from 13.2% in the prior-year period. Moreover, pre-tax return on risk-weighted assets (annualized) fell to 1.2% from 2.4% in the third quarter of 2011.

HSBC continued to generate capital from its retained profits. The company’s core tier 1 ratio as of September 30, 2012 improved to 11.7% compared with 10.1% as of September 30, 2011. Total capital ratio also augmented from 14.1% recorded at the end of the prior-year quarter to 15.6% as of September 30, 2012.

Peer Performance

Barclays PLC (BCS - Free Report) reported net operating income of £6,047 million ($9,551 million) for third quarter 2012, down 3.8% from net operating income of £6,238 million ($9,853 million) reported in the prior quarter. Huge statutory losses were the primary reason behind the poor financial performance, which was partly offset by lower operating expenses. Yet, performances of few segments – Wealth and Investment Management, Europe Retail Banking Business and Investment Bank – were credible. Further, capital ratios were strong in the quarter.

Our Viewpoint

Currently, the harsh impact of the deepening Euro-zone crisis is our primary concern. Moreover, HSBC is suffering from weak revenue growth in its mature markets, attributable to the ongoing low interest rates and regulatory restrictions. Nevertheless, the company is poised to benefit from its extensive global network, strong capital position, business re-engineering efforts and strong asset growth.

Further, HSBC’s cost containment measures will help it greatly to deal with the economic pressures. However, we expect high inflation in some key Asian markets, sluggish loan growth, insufficient core operating performance and high wage inflation to restrict the company’s growth, at least in the near term.

HSBC currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Also, considering the fundamentals, we maintain a ‘Neutral’ recommendation on the stock.

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