1H17 beat by 8% on better market activity
HSB's 1H17 interim profit of HKD9.8bn （+20% HoH, +23% YoY） was ahead ofDB/consensus earnings by 8%, with the beat coming largely from a strongnon-interest income line led by wealth management and trading income as the8bps HoH NIM improvement surprisingly came from an ~18bps drop in depositcosts, with asset yields compressing ~10bps due to loan competition. As thetrading income strength may not be sustainable, and coupled with the recentretreat in 3M Hibor of 77bps after June （avg. 1H17: 90bps）， we expect earningsto be more challenging for the rest of the year. Maintaining Hold.
　　Key highlights of 1H17 results:
　　Net interest income （+5% HoH, +7% YoY） was supported by loan growth（+6% HoH） as the margin improved by 9bps HoH to 1.94%.
　　Non-interest income （+41% HoH, +39% YoY） was the key strength of theresults, largely attributable to better FX and MTM equity investment of thelife insurance business as fees remained resilient （+7% HoH, +15% YoY）。
　　As a result of better market activity, WM income rose 45% HoH, 39% YoY.
　　Asset quality remains benign, with the impaired loan % at 42bps （2H16:46bps） while credit costs increased slightly to 19bps （2H16: 17bps） due toa customer in mainland China. Provision coverage improved to 68% （froma historical low of 47% 1H16）。 Overdue loans fell to 25bps （2H16: 33bps）。
　　Loans （+6% HoH） and deposits （+3% HoH）： Loan growth was strong,supported by domestic lending （+8% HoH） on corporate property （+9%），transport （+43%）， mortgages （+3%） and unsecured personal loans （+19%）。
　　Loans for use outside HK recovered, with 3% HoH growth led by mainlandChina. LDR edged up to 71% （2H16: 69%）， with CASA at 78% （2H16: 77%）。
　　Others – capital: CET1 was 16.2% （2H16: 16.6%）， still strongly capitalised,even after stripping out the 2Q17 dividend, coming in at 15.8%. CTI was30% （2H16: 34%） and annualized RoE was 14.5% （2H16: 12.5%）。
　　Maintaining Hold; key analysts’ briefing takeaways; risks
Although it is viewed as a key beneficiary of the rising rate environment, HSB'sshare price has risen by 18% YTD, but has lagged behind HSI and MSCI HK by6% as its dividend yield of 4% in FY18E failed to excite investors. With thestock already trading at 2.2x P/B, 16x P/E and 14% RoE in FY18E, we view thepremium qualities as already priced into the stock. Also, as highlighted in our2H17 outlook report, the strong interim results should not overshadow thepotential challenges faced by the sector ahead – the recent retreat in rates,competition for new loans, weaker NoII growth through MTM losses as LTrates start to increase and potential negative P/L impact from IFRS9 in thelonger run. As a result of better NoII, we raise our 2017E earnings by 6% whilemaintaining our FY18-19E forecasts unchanged until we get better clarity onthe sustainability of non-interest income growth. We value HSB using a GGM.
　　Upside risk: higher rates leading to significant margin expansion. Downsiderisk: a significant property price drop.
　　Valuation and risks
　　Valuation
　　We value HSB using the Gordon Growth Model （P/B = ROE-g/COE-g） to obtain atarget price-to-book ratio. Our key assumptions are a sustainable ROE of 16%, a costof equity of 8% and a long-term growth rate of 2%. Our long-term growth ratereflects our expectation of a blended （90% Hong Kong and 10% China） long-termROE for Hong Kong and China. This gives us a target price-to-book-value ratio of2.3x and, when applied to the average 2017-18E book value, it yields our 12-monthtarget price. In our GGM target price, the property reserves' valuation amounts toHKD8/share. In view of continued elevated property prices, we believe the MTM ofself-owned premise method increasingly discounts the core operation RoE of thebank. Therefore, we separate it out to more accurately reflect the higher sustainablecore operation RoE of the bank.
　　Risks
　　Key upside risks include: （1） a worse-than-expected economic outlook, which shouldlead the market to assign a premium to HSB's defensiveness, and （2） a significantearnings improvement from rate hikes. Downside risks: （1） worsening investmentsentiment, which would affect HSB's wealth management business, and （2） asignificant property price correction beyond this level, which would be negative forHSB as property valuation losses would hurt its book value and net profit.