1H13 results - satisfactory, but guidance lacks positive tone

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1 Deutsche Bank Markets Research Rating Hold Asia Hong Kong Banking / Finance Company Reuters Bloomberg Exchange Ticker 0011.HK 11 HK HKG 0011 ADR Ticker HSNGY ISIN US41043C3043 1H13 results - satisfactory, but guidance lacks positive tone Exceptional supported interim earnings growth HSB reported headline earnings of HK$18.5bn, which is 16% above consensus. But core earnings are in line when we strip out better property revaluation gains (HK$1bn) and lower tax expenses due to a deferred tax release (HK$1bn) of IB re-classification. We maintain our Hold rating on the stock as this in-line core result is unlikely going to trigger any upward revision in FY14-15 earnings. Earnings driven by loan growth and flat NIM; asset quality improved Loan growth was better than expected for the bank, up 8% HoH, attributable to trade finance and lending outside of HK. Together, they contributed 70% of HoH loan growth in 1st half. While the bank continued to leverage up (e.g. slower deposit growth) LDR, now reaching near 71% (2H12: 67%), NIM was at best flat HoH to 1.84%. The bright spot of results continued to be asset quality; the NPL ratio further improved by 3bps to 22bps. The annualized credit costs were only 7bps, and it was predominantly on general provisions. Basel III fully loaded ratio stands at 10.3% after deducting the Industrial Bank stake. Guidance lacks positive tone HSB already cited margin pressure heading into interim results, from deposit competition and higher conversions into RMB. While cost of funding has been moving up, the ability to re-price the loans as in 1H13 results is tapering, thus putting pressure on the lending yields in second-half. Domestic loan growth remains weak and will come mainly from lending for use in China. The bank s investment book will not benefit from a rise in long-term bond yields as rates remain stable for the banks own investment book. Valuation looks fair value, lack of re-rating in-sight Currently trading at 2.1x P/B, with a 14.5% 2014E RoE, the stock appears fairly valued. While the IB re-classification removes concerns over sustainability in the current DPS payout, we believe a higher DPS payout through IB stake disposal looks remote in the near term as 1) HSB has no urgency to dispose of its IB stake and 2) unattractive valuation for its IB investment. We value HSB using the Gordon Growth Model. Upside risks: disposal of the entire stake in IB, a reversal in liquidity. Downside risk: significant property price correction. Date Results Price at 5 Aug 2013 (HKD) Price target - 12mth (HKD) week range (HKD) HANG SENG INDEX 22,191 Franco Lam Research Analyst (+852) franco.lam@db.com Price/price relative Tracy Yu Research Analyst (+852) tracy.yu@db.com /11 2/12 8/12 2/13 HANG SENG INDEX (Rebased) Performance (%) 1m 3m 12m Absolute HANG SENG INDEX Source: Deutsche Bank Forecasts And Ratios Year End Dec A 2012A 2013E 2014E 2015E Net profit (HKDm) 16,885 19,426 22,625 15,659 17,113 EPS (HKD) EPS growth (%) PER (x) Price/book (x) Yield (net) (%) ROE (%) Source: Deutsche Bank estimates, company data 1 DB EPS is fully diluted and excludes non-recurring items 2 Multiples and yields calculations use average historical prices for past years and spot prices for current and future years, except P/B which uses the year end close Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013.

2 Model updated:21 July 2013 Running the numbers Asia Hong Kong Reuters: 0011.HK Hold Bloomberg: 11 HK Price (5 Aug 13) HKD Target Price HKD Week range HKD Market Cap (m) HKDm 232,284 USDm 29,947 Company Profile HSB is the second-largest domestic commercial bank in HK by asset and deposit franchise. HSB provides a wide range of banking and related financial services, including personal wealth management, corporate banking, treasury and private banking. HSB established a local incorporation in China in 2007 and currently operates 18 outlets on the mainland. The HSBC Group is its largest strategic shareholder, with a 62% stake. HSB's key competitive advantages include its industry-leading cost efficiency, established brand, and large low-cost deposit base. Fiscal year end 31-Dec E 2014E 2015E Data Per Share EPS (stated) (HKD) EPS FD (stated) (HKD) EPS FD (DB adj.) (HKD) Growth rate - EPS (stated) (%) DPS (HKD) BVPS (stated) (HKD) BVPS (DB adj.) (HKD) Average market cap 218, , , , ,284 Shares in Issue (m) 1,912 1,912 1,912 1,912 1,912 Valuation Ratios & Profitability Measures P/E (stated) P/E FD (stated) P/E FD (DB adj.) P/B (stated) P/B (DB adj.) ROE (adj.) (%) ROA (adj.) (%) Dividend yield(%) Dividend cover(x) Payout ratio (%) Profit & Loss (HKDm) Net interest revenue 15,736 16,946 18,460 19,755 22,395 Non interest income 6,861 7,435 7,594 8,813 9,057 Fees & Commissions 4,836 5,086 5,510 5,891 6,251 Trading Revenue 1,636 2,439 2,048 2,448 2,048 Insurance revenue ,288-1,400-1,200-1,200 Dividend income ,141 1,378 1,663 Other revenue 921 1, Total revenue 22,597 24,381 26,054 28,567 31,452 Total operating costs 7,898 8,389 8,857 9,379 9,904 Pre-provision profit/(loss) 14,699 15,992 17,197 19,188 21,548 Bad debt expense ,496 Operating Profit 14,259 15,606 16,680 18,207 20,052 Goodwill Pre-tax associates 4,032 5, Extraordinary & Other Items 964 1,126 9, Pre-tax profit 19,255 22,113 26,617 18,422 20,133 Tax 2,370 2,687 3,993 2,763 3,020 Minorities Preference dividends Stated net profit 16,885 19,426 22,625 15,659 17,113 DB adj. core earnings 12,504 13,710 14,178 15,476 17,044 Key Balance Sheet Items (HKDm) & Capital Ratios Risk-weighted assets 304, , , , ,638 Interest-earning assets 914,016 1,004,955 1,041,288 1,079,455 1,119,769 Total loans 482, , , , ,250 Total deposits 774, , , , ,634 Stated shareholders equity 79,634 92, , , ,372 Preference share capital na na na na na Tier 1 capital 35,357 41,002 43,812 45,146 47,607 Tier 1 ratio (%) Tangible equity/ total assets (%) Credit Quality Gross NPLs / Total loans (%) Provisions / NPLs (%) Bad debt exp/ Avg loans (%) Growth Rates & Key Ratios Growth in net interest income (%) Growth in fee income (%) Growth in non-interest income (%) Growth in revenues (%) Growth in costs (%) Pre-provision earnings growth (%) Growth in bad debts (%) Growth in RWA (%) Growth in loans (%) Growth in deposits (%) Loan-to-deposits ratio (%) Net int. margin (%) Cost income ratio (%) Cost asset ratio (%) Trading income/ Total Rev (%) Source: Company data, Deutsche Bank estimates Franco Lam franco.lam@db.com Page 2 Deutsche Bank AG/Hong Kong

3 Figure 1: HSB 1H13 results summary P&L Account (HKDm) 1H13 2H12 1H12 HoH (%) YoY (%) Comments Net interest income 8,969 8,660 8, Robust loans growth of 8.1% HoH Non-interest income 4,508 3,361 4, Fee inc growth of 10% HoH and FX gains Total income 13,477 12,021 12, Operating expenses (4,345) (4,312) (4,077) Positive jaws with cost to income falling to 32% Pre-provision profit 9,132 7,709 8, Bad debt charges (198) (137) (249) Annualized credit cost 7bps Operating profit 8,934 7,572 8, Non-recurring items 1,385 3,527 2, HK$1bn from investment property revaluations Exceptional items 8, ,281.4 n/a Dilution gain on reclassification of IB Amortisation n/a n/a Pre-tax profit 18,773 11,454 10, Taxation & minority (305) (1,330) (1,357) Due to tax reversal on reclassification of IB Net profit 18,468 10,124 9, EPS (HKD) DPS (HKD) BVS (HKD) Balance Sheet (HKDm) Advances to customers 579, , , Growth in Trade finance and Loans for use outside HK Deposits from customers (include CDs, SDs) 819, , , Key Ratios (%) bps HoH bps YoY Return on equity Return on assets Net interest margin Cost / Income Better cost efficiency despite growth in loans Loan to deposit ratio (including CDs, SD) Tier 1 capital Total CAR Gross NPL ratio Annualized credit costs Source: Deutsche Bank, Company reports Deutsche Bank AG/Hong Kong Page 3

4 Figure 2: HSB net interest margin 1H12 2H12 1H13 bps HoH bps YoY Net Interest Margin (%) Source: Deutsche Bank, Company reports Margin was flat as the bank saw higher cost of funding heading into interim period Figure 3: Non-interest income break-up 1H12 2H12 1H13 % HoH % YoY Gross Fees & Commissions 2,977 3,321 3, Less: Fees & commissions expenses Net fees & commissions 2,408 2,678 2, FX gains 1, , Rental income n/a n/a Profit from trading n/a n/a Net revenue from insurance activities Dividend income Others ,095* Total Non-interest Income 4,074 3,361 4, Source: Deutsche Bank, Company reports *includes a property gain held by its insurance business Fee and commission income up 10% HoH; Non interest income up 34% HoH Figure 4: Net fee income break-up 1H12 2H12 1H13 % HoH % YoY Securities broking and related Retail investment funds Structured investment products Insurance Agency Account services Private banking service fee Remittances Cards Credit facilities Trade services Others Total Fee Income Total Fee Expense Net fee income Source: Deutsche Bank, Company reports Strong growth revival in securities broking, retail funds segments Figure 5: HSB gross NPL and credit costs % 1H12 2H12 1H13 bps HoH bps YoY Gross NPL ratio Annualized credit costs Source: Deutsche Bank, Company reports Asset quality continued to stay in benign level Page 4 Deutsche Bank AG/Hong Kong

5 Figure 6: Loans & Advances break-up (HKD m) 1H12 2H12 1H13 % HoH % YoY Property development 27,927 29,771 28, Property investments 103, ,675 99, Financial concerns 3,944 3,595 4, Stockbrokers Wholesale and retail trade 15,952 16,445 19, Manufacturing 13,792 15,212 17, Transport, and transport equipment 6,082 5,774 6, Other commercial 25,015 28,440 34, Trade finance and loans for use outside HK drove loan growth to 8% HoH Loans for HOS/PSPS 13,962 13,886 13, Mortgages 115, , , Credit cards 18,392 20,389 20, Other personal 13,814 13,514 14, Trade finance 42,917 47,555 62, Loan for use outside HK 105, , , Total 506, , , Source: Deutsche Bank, Company Reports Valuation and risks We value HSB using the Gordon Growth Model (P/B=ROE-g/COE-g). We assume a ROE of 14.5%, a cost of equity of 8.25%, and a long-term growth rate of 2%. We derive the latter from blended long-term ROE assumptions, factoring in HSB's business mix in China (40%) and Hong Kong (60%). This provides us with a target price-to-book ratio of 2x. Applying this to HSB s FY14E book value, we derive our 12-month target price of HKD115. The terminal growth rate of 2%, lower than peers, is due to its continued deterioration in market share of its core market in HK. Given increasing crossborder activities in HK, we see Chinese banks have better leveraged in and their presence would be a major threat to HSB's deposit franchise. Key upside risks: 1) disposal of the entire stake in IB and 2) a worse-thanexpected economic outlook, which we believe should lead the market to assign a premium to HSB s defensiveness. Downside risks: 1) worsening investment sentiment, which would affect HSB s wealth management business and 2) a significant property price correction beyond this level, which would be negative for HSB as property valuation losses would hurt its book value and net profit. Valuation charts The valuation charts below show HSB is currently trading below its historical mean, which we believe is justified given 1) concern over the huge capital deduction for Industrial bank investments, 2) the low interest rate environment Deutsche Bank AG/Hong Kong Page 5

6 has negatively impacted NIM and profitability and 3) loss of competitiveness in its core market HK. Figure 7: HSB Forward P/B valuation Figure 8: HSB Forward P/E valuation SD 5.5x Mean 3.4x -2SD 1.3x SD 20.6x Source: Deutsche Bank Source: Deutsche Bank Figure 9: HSB Forward PPOP valuation Figure 10: HSB Forward dividend yield valuation SD 18.8x Mean 14.3x SD 6.2x Mean 4.9x SD 9.7x SD 3.6x Source: Deutsche Bank Source: Deutsche Bank Page 6 Deutsche Bank AG/Hong Kong

7 Appendix 1 Important Disclosures Additional information available upon request Disclosure checklist Company Ticker Recent price* Disclosure 0011.HK (HKD) 5 Aug 13 7,14 *Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies Important Disclosures Required by U.S. Regulators Disclosures marked with an asterisk may also be required by at least one jurisdiction in addition to the United States. See Important Disclosures Required by Non-US Regulators and Explanatory Notes. 7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year. 14. Deutsche Bank and/or its affiliate(s) has received non-investment banking related compensation from this company within the past year. Important Disclosures Required by Non-U.S. Regulators Please also refer to disclosures in the Important Disclosures Required by US Regulators and the Explanatory Notes. 7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s) about the subject issuer and the securities of the issuer. In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Franco Lam Deutsche Bank AG/Hong Kong Page 7

8 Historical recommendations and target price: (0011.HK) (as of 8/5/2013) Security Price Previous Recommendations Strong Buy Buy Market Perform Underperform Not Rated Suspended Rating Current Recommendations Buy Hold Sell Not Rated Suspended Rating *New Recommendation Structure as of September 9, Aug 11 Nov 11 Feb 12 May 12 Aug 12 Date Nov 12 Feb 13 May /10/2011: Buy, Target Price Change HKD /03/2013: Hold, Target Price Change HKD /02/2012: Buy, Target Price Change HKD /04/2013: No Recommendation, Target Price Change HKD /07/2012: Buy, Target Price Change HKD /07/2013: Upgrade to Hold, Target Price Change HKD /11/2012: Downgrade to Hold, HKD Equity rating key Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in share price from current price to projected target price plus pro-jected dividend yield ), we recommend that investors buy the stock. Sell: Based on a current 12-month view of total shareholder return, we recommend that investors sell the stock Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Notes: 1. Newly issued research recommendations and target prices always supersede previously published research. 2. Ratings definitions prior to 27 January, 2007 were: Buy: Expected total return (including dividends) of 10% or more over a 12-month period Hold: Expected total return (including dividends) between -10% and 10% over a 12- month period Sell: Expected total return (including dividends) of -10% or worse over a 12-month period Equity rating dispersion and banking relationships % 31 % 38 % 31 % 8 % 28 % Buy Hold Sell Companies Covered Asia-Pacific Universe Cos. w/ Banking Relationship Page 8 Deutsche Bank AG/Hong Kong

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10 David Folkerts-Landau Global Head of Research Marcel Cassard Global Head CB&S Research Ralf Hoffmann & Bernhard Speyer Co-Heads DB Research Guy Ashton Chief Operating Officer Research Richard Smith Associate Director Equity Research Asia-Pacific Fergus Lynch Regional Head Germany Andreas Neubauer Regional Head North America Steve Pollard Regional Head International locations Deutsche Bank AG Deutsche Bank Place Level 16 Corner of Hunter & Phillip Streets Sydney, NSW 2000 Australia Tel: (61) Deutsche Bank AG Große Gallusstraße Frankfurt am Main Germany Tel: (49) Deutsche Bank AG Filiale Hongkong International Commerce Centre, 1 Austin Road West,Kowloon, Hong Kong Tel: (852) Deutsche Securities Inc Nagatacho Sanno Park Tower Chiyoda-ku, Tokyo Japan Tel: (81) Deutsche Bank AG London 1 Great Winchester Street London EC2N 2EQ United Kingdom Tel: (44) Deutsche Bank Securities Inc. 60 Wall Street New York, NY United States of America Tel: (1) Global Disclaimer The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). 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