Turnaround is still a distant prospect for HSBC investors

Shareholders got a pleasant surprise yesterday, when banking giant HSBC announced first-half profits of US$8.9 billion, up 35 per cent from the same period last year.

After many analysts had predicted no profit growth, or even a decline in earnings, the market was caught wrong-footed by the good news. In London trading, HSBC shares promptly rose 5 per cent following the announcement.

Yet although yesterday's profit increase was welcome, HSBC's long-suffering shareholders will have to wait a good deal longer if they want confirmation that the strategic overhaul initiated by new chairman Stuart Gulliver is starting to pay off.

Back in May Gulliver outlined his plan to lift HSBC's stagnant share price. He promised to slash the bank's ballooning costs and streamline its sprawling 87-country network, disposing of peripheral businesses and instead playing to HSBC's strengths by investing in fast-growing Asian markets where the bank boasts a competitive head-start.

The result, he pledged, would be cost savings of between US$2.5 billion and US$3.5 billion a year, which would reduce the bank's operating expenses to between 48 and 52 per cent of income from last year's level of 55 per cent, and raise HSBC's return on equity from 9.5 per cent last year to between 12 and 15 per cent.

The surgery has already started. On Sunday HSBC announced the US$1 billion sale of 195 of its US branches, disposing of much of the US consumer banking network it acquired with the purchases of Marine Midland Bank and Republic National Bank.

Elsewhere, HSBC has closed its personal banking businesses in Poland and Russia, and is busy cutting jobs. So far, the bank has shed 5,000 staff, mainly in Britain, France, the US and Latin America, where it is consolidating its local headquarters. And there will be many more losses to come. Gulliver is planning to cut a further 25,000 jobs over the next couple of years.

At first glance it might look from yesterday's results as if the restructuring is already working. Not only did HSBC's profits increase in the first half of the year, but the group's return on equity for the six month period came in 12.3 per cent, a sharp in improvement on last year's level.

In reality, however, rather than being the first fruits of Gulliver's grand plan, the rise in HSBC's first half profits was attributable to an altogether more prosaic cause. The increase was driven almost entirely by a drop in bad loan charges, which fell to US$5.3 billion from a thumping US$7.5 billion in the first half of last year as HSBC continued to run down its disastrous consumer lending business in the United States (see the first chart, left).

Elsewhere, HSBC's performance was patchy.

In Europe, its pre-tax profits plunged by 39 per cent, while profits at the bank's global markets unit fell by 12 per cent, thanks to lousy market conditions. Earnings from private banking were flat.

In contrast, HSBC's profits from Asia rose by 16 per cent, and now make up more than half of the bank's total pre-tax earnings.

Worryingly, however, costs in the region rose by a painful 18 per cent, propelled by rapidly escalating salaries. As a result, HSBC's overall costs climbed to 57.5 per cent of income; a far cry from Gulliver's 48 to 52 per cent target range.

And with a structural shortage of qualified banking staff in the region, Gulliver admitted there was little prospect of a let up in cost pressures in the foreseeable future.

Meanwhile, HSBC's net interest margin - essentially the average spread the bank earns between its deposits and loans - narrowed from 2.78 per cent a year ago to just 2.54 per cent in the first half of 2011.

And on closer examination even HSBC's return on capital looks less impressive. Although the first half return of 12.3 per cent appears to be within Gulliver's 12 to 15 per cent target range, that's under Basel II capital standards.

Under the more stringent incoming Basel III standard, Gulliver explained that HSBC would have had to have generated an additional US$2 billion in pre-tax profits over the half in order to meet his target.

In other words, Gulliver and his crew still have their work cut out if they are to succeed in turning HSBC around.

That's reflected in the bank's stock price. Although HSBC's shares have almost doubled in value from their crisis lows, they are no higher today than they were in the depths of the 2003 Sars outbreak. In contrast, over the same period the Hang Seng index has risen 160 per cent.

Shareholders still have a long wait ahead of them.