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A Harsh Downgrade for HSBC

NEW YORK (TheStreet) -- Credit Suisse analyst Amit Goel sees a good upward trajectory for HSBC's (HSBC) profit before tax over the next few years, but the analyst on Wednesday cut his rating for the stock all the way to "underperform" from "outperform."

HSBC's stock closed at 597.90 pence on the London Stock Exchange Tuesday.

Goel lowered his price target for the shares to 580 pence from 780, while cutting his operating earnings estimates by "11%/12%/14% for 14E/15E/16E."

The stock was down 1% in Wednesday afternoon trading in London, to 594.50 pence, while HSBC's American depositary receipts were down 0.6% in early trading on the New York Stock Exchange, to $49.54. The ADRs closed at $49.83 Tuesday, down 8% this year.

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"Whilst we still see strong capital generation, we no longer expect significant additional capital return in the next 24-36 months," Goel wrote in a detailed research report.

The main reason for the analyst's discouragement is what he calls "UK regulatory inflation," leading to an ultimate Basel III Tier 1 common equity ratio requirement of "10.7-13.2% before any management buffer or sectoral capital requirements." In comparison, major global banks headquartered in the United States are targeting Basel III Tier 1 common equity ratios of 9.5% to 10%.

The ever-rising capital bar for HSBC will make it very difficult to hit the 12% to 15% return on equity target range laid out by the bank's management in 2011. This translates to a return on tangible equity goal of 15% to 19%, according to Credit Suisse.

HSBC has many moving parts, because of the company's multiple efficiency initiatives and exit from certain businesses in an effort to lower its risk-weighted assets (RWA), which is a key element in calculations for capital requirements. The company therefore includes "underlying earnings" figures in its financial statements. Goel in his report made further adjustments, to come up with an estimated profit before tax of $22.833 billion for 2013, which was a decline of 1.3% from $23.131 billion in 2012.

Looking ahead, Goel sees a strong earnings trajectory for the company, with estimated "core" profits before tax increasing by 7.5% this year, followed by increases of 8.0% in 2015 and 10.2% in 2016.

Credit Suisse estimates HSBC's return on tangible equity (ROTE) for 2013 was 11.7%, and that the ROTE for 2014 will be 11.5%, increasing to 11.9% in 2015 and 12.4% in 2016.

These are much lower expectations than investors might have been last May, when I wrote HSBC Makes U.S. Banks Look Fat and Lazy, focusing on the bank's efficiency initiatives. But the weakness in the stock price shows that the market perceived that HSBC would have a tougher road ahead in light of the increased capital requirements.

Goel estimates HSBC's capital return, including higher dividends and share buybacks, will be "stepping up after 2016."

"We estimate total capital requirements have increased by c.30% relative to management's targets presented in May 2011," he wrote.

This chart shows the performance of HSBC's ADRs since the end of 2011:

HSBC Chart data by YCharts

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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