Is HSBC Holdings plc A Value Trap Or Value Play?

At first glance, HSBC (LSE: HSBA) (NYSE: HSBC.US) looks like a steal. The bank is currently trading at a forward P/E of 11.2 and offers a dividend yield of 5.5%.

What’s more, City analysts believe that the bank’s earnings will jump by 26% this year. As a result, HSBC is trading at a PEG ratio of 0.4. 

However, while HSBC looks cheap at first glance, there now talk that HSBC is becoming a classic value trap: a stock that is cheap, but could get much cheaper.

Complex business 

HSBC’s size has the become the bank’s own worst enemy over the past decade.

HSBC was built around the mantra ‘bigger is better’. The bank has, in the past, looked to enter as many markets as possible in order to provide a truly global offering. But this strategy has now come back to haunt it. 

Indeed, HSBC has been forced to close 77 businesses and slash 50,000 jobs over the past few years as rising costs and regulatory concerns eat into profits.

And far from generating economies of scale by expanding into these markets, if anything the bank has only succeeded in creating diseconomies of scale. 

Diseconomies of scale are forces that cause HSBC’s costs to rise as the bank grows in scale. The concept is the opposite of economies of scale where costs fall as the business grows. 

Rising costs

It seems as if the bank’s diseconomies of scale are only getting worse.

HSBC cut costs by just under $5bn since it began an ambitious restructuring plan during 2011.

However, over the same period the bank’s cost income ratio — a closely watched measure of efficiency — remained stubbornly high at around 60%. Moreover, HSBC’s cost income ratio has continued to increase over the past twelve months.

HSBC’s full-year 2014 cost income ratio was 67.3% as higher than expected running costs, a wave of litigation, customer redress and higher taxes all weighed on earnings. 

The big question is, will the bank be able to reverse this trend? If HSBC is unable to get costs under control the bank’s dividend payout could come under pressure — the telltale sign of a classic value trap. 

Value trap or value play?

If HSBC’s management fails to get a grip on rising costs, HSBC could become a value trap. Although management isn’t out of options just yet. 

Analysts are increasingly calling for HSBC to break itself up and concentrate on its key markets. If the bank follows this path then it could return to growth and would no longer be at risk of becoming a value trap. 

For example, HSBC’s Hong Kong division remains highly profitable. Around 70% of HSBC’s group profit comes from Hong Kong, where the bank’s cost income ratio sits below 50%.  

So all in all, HSBC looks like a value trap at present. Costs are rising and unless the bank takes drastic action, the dividend could come under pressure. However, if HSBC decides to break itself up, lower costs and concentrate on key business divisions, the bank could unlock growth…

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.