Shell‘s (LSE: RDSB) 8.5% dividend yield makes its shares highly tempting. Unfortunately, shrinking earnings is a cause for concern — in the first nine months of 2015, underlying earnings declined by 54%.
The company is not generating enough cash flow to cover its capex and dividend payments, with more than half of its dividend likely to be funded via asset sales and debt in 2015. Meanwhile, the company is making an expensive and risky acquisition of BG Group, which will raise the level of its indebtedness at a time when bond markets are becoming increasingly nervous about the energy sector.
On the upside, its dividend seems secure over the next two to three years, with management making it clear that the dividend is a top priority. Shell plans to balance cash flows through a combination of asset sales and reductions in capital spending, even as the oil price extends recent losses. This should be do-able in the medium term, but there is much greater uncertainty in the longer term.
HSBC (LSE: HSBA) seems cheap, with its shares trading at a forward P/E of 10.0 and carrying a dividend yield of 6.5%. However, investors are concerned about slowing growth in emerging markets, particularly in Asia. HSBC has some 40% of its loans in Asia and generates more than two-thirds of its operating profits there. With growth slowing and investment flowing out of the region, slower loan growth and declining credit quality will likely put pressure on the bank’s top and bottom line.
On top of these cyclical issues, HSBC also faces structural ones. The bank is too diversified and too complex, causing it to lack scale in some markets and bear much higher compliance and regulatory costs than its competitors. Regulators also demand that it holds far more capital than its peers, with a 2.5% capital surcharge applied to its required Common Equity Tier 1 (CET1) capital ratio.
As such, HSBC has a much lower profitability target than many of its peers, with management expecting return on equity (ROE) to be “more than 10%” in the medium term. That is barely above its cost of capital. So, although it is difficult to tell whether the bank is a value trap, or not, it is clear why HSBC deserves lower valuation multiples.
Standard Chartered (LSE: STAN) is in even worse shape. Falling commodity prices and slowing emerging market has been causing loan losses to soar, particularly because the bank has high loan concentrations in specific high-risk countries and cyclical sectors. Loan impairments in the first half of 2015 almost doubled to $1.6 billion, causing underlying earnings to roughly halve to $0.49 per share. And, the worst could be yet to come.
But, there is definitely long-term potential here. Standard Chartered has a proven strategy with retail banking in emerging markets and it could grow its presence in the “under-tapped” wealth management market there.
Much restructuring is still needed though, and investors should not expect any quick rewards. Management is forecasting a return on equity of merely 8% by 2018. This return seems lower than its estimated cost of equity, and we still have to wait three years before the bank even achieves that.
Nevertheless, for those who are willing to take a chance, you could buy its shares at a huge discount. After its rights issue, Standard Chartered will have a net asset value of $16.08 per share, meaning its shares trade at just 0.46 times its book value.