International Finance - HSBC vs BP - Essay Example

1.0 INTRODUCTION The major factor influencing the operations of multinational corporations is the foreign exchange transactions entered into by suchcorporations in respect of their sales, assets and income as well as liabilities. Because of the geographical dispersions of the branches and subsidiary companies of the multinational corporations allover the world, it becomes absolutely essential for those companies to guard themselves against the risks of changes in the foreign currencies, which are highly volatile in nature and directly affect the working, income, growth and share price movements of the multinationals. In our purview of this paper, the financial bases of two multinational giants are to be compared and a selection of the shares of any one of them is to be made for the purpose of investments. The investment analysis is to be made not only on the basis of earnings but also a careful analysis of the effect of changes in foreign exchange on such companies shares is to be evaluated and a decision taken. 2.0 BRIEF PROFILES OF THE CORPORATIONS A.BRITISH PETROLEUM (BP) PLC British petroleum shortly known as BP was formed in 1998 from the merger of British Petroleum and Amoco grew by buying Atlantic Richfield Company. BP has proved reserves of 18.3 billion barrels of oil equivalent including large holdings in Alaska. BP is the largest oil producer in the US and also top refiner processing 2.8 billions barrels of crude oil per day. BP operates 28,500 gas stations worldwide, including 15,900 in the US. With the success of its ‘BP solar international subsidiary’ BP has created BP alternative Energy (hydrogen, solar and wind power generation) with an initial investment of $1.8 billion. British Petroleum (BP) is one of six vertically integrated private sector oil, natural gas and gasoline super-majors in the world. In the year 2006 BP was ranked 4th in the world by the Fortune Global 500 list, for turnover with sales at $268 billion. In the 2006 Forbes global 2000, BP was ranked the eighth largest company in the world. BP’s profits in 2005 amounted to $22.341 billion after providing for replacement cost, profit after interest, tax and minority shareholders’ interest taken into account of $ 19.3 billion. B.HSBC HOLDINGS PLC HSBC Holdings Plc is one of the largest banking groups in the world ranked the fifth largest company and third largest banking company in the world in Forbes Global 2000.The group is named after its founding member the Hongkong and Shanghai Banking Corporation, a bank established to finance British Trade in the Far East in 1865. The Bank is the largest corporation in the world in terms of assets worth 1.74 trillion as of June 30, 2006. The results of the Bank are being reported in United States Dollars as more than 80% of its earnings are from operations outside England. Nearly 22% of its earnings are from Hongkong, where it was headquartered until 1991. HSBC holdings have emerged as a single largest bank in the world operating with 9800 branches in nearly 80 countries. The group has identified itself as a giant in providing consumer and commercial banking services, credit cards, asset management, private banking, securities trading, insurance and leasing. The operations of the bank in the United States include HSBC USA with the purchase in the year 2003 of the consumer lender ‘Household International’ now known as ‘HSBC Finance’. 3.0 INTERNATIOANL FINANCIAL ENVIRONMENT: The main issue faced by multinational corporations in the international financial environment is the valuation of such projects whose cash-flows depend on the exchange rate. Two approaches are used: one based on option-valuation methods and the second based on equilibrium arguments that rely on the international capital asset pricing model. The other factors which need consideration are tax planning and the management of flow of funds within foreign subsidiaries of a given multinational. Two essential and related aspects of this environment are first, the foreign exchange market in which exchange rates are determined and second the international financial system governing exchange rate determination. There is a close connection between interest rates, inflation, and exchange rates. The connection between inflation and foreign exchange is known as purchasing power parity principle. For the information of the investors the modern day accounting disclosures have made it compulsory that the companies should reveal the foreign exchange transactions and the resultant gain or loss to the revenue and how it affects the share holders. While operating on International financial environments, different companies adopt different ways of protecting their interests against risks of changes in foreign exchange rates. For instance HSBC follows the principle of Structural foreign exchange exposures and these exposures are represented by the net asset value of its foreign exchange equity and subordinated debt investments in subsidiary undertakings, branches, joint ventures and associates. Gains or losses on structural foreign exchange exposures are taken to reserves. However BP adopts a system of providing a statement of recognized income and expense on account of foreign exchange transactions for the information of the shareholders by charging the differences due to the foreign exchange fluctuations to the respective revenue accounts. This is in view of its large foreign exchange exposure due to large sales revenue being realized all over the world. 4.0 EXCHANGE RATE RISK MANAGEMENT Another important factor which determines and seriously affects the working result of any multinational company is the exchange rate risks because of the changes in the rates, the company has to face and the protection the company takes against any such changes. Exchange rate risk management is an integral part in every firm’s decision about foreign currency exposure. Measuring and managing exchange rate risks exposure is important for reducing a firm’s vulnerabilities from major exchange rate movements which could adversely affect profit margin and the value of assets. The traditional types of exchange rate risks faced by firms are due to transactions, translation and economic risks. Transaction risk basically is a cash flow risk and deals with the effect of exchange rates movements on transactional exchange exposure related to receivables, payables or repatriation of dividends. Translation risks basically balance sheet risks and are related to the valuation of a foreign subsidiary and in turn to the consolidation of a foreign subsidiary to the parent company’s balance sheet. Economic risks are those which affect the present value of future operating cash flows. Measuring currency risks may prove to be difficult atleast with regard to translation and economic risks. At present a widely used method is value at Risk –VaR. The value at Risk can be calculated in three methods namely historical simulation, variance-co variance model and Monte Carlo simulation technique. By adopting these techniques, company BP charges to its revenue the gains and losses relating to the foreign exchange transactions and thereby eliminate the risks of changes in the foreign exchange rates. For the year 2005 the company has reported the following provisions in the accounts: Currency Translation difference US $ (2502) million Exchange gain on translation of foreign operations Transferred to gain or loss on sale of business and Fixed assets US $ (315) million Actuarial gains relating to pension and other post Retirement benefits US $ 975 million Cash flow hedges US $ (176) million Available for sale investments US $ 262 million Similarly to guard against the foreign exchange fluctuations, HSBC has created the following reserves in its accounts for the year 2005. Property Revaluation Reserve US $ 1092 million Reserve for unrealized gain on effective hedges US $ 315 million Reserve for unrealized gain on available for sale Securities US $ 1294 million Although the figures for both the companies are not comparable, the provisions of such amounts go to prove that the companies have taken adequate measures in respect of their foreign exchange transactions. However the fact remains that company BP because of its existence allover the world and the higher magnitude of its sales volume, the company has made an insignificant loss on account of currency translation difference and cash flow hedging etc which is charged to revenue. 5.0 ANALYSIS FOR INVESTMENT DECISION 5.1 COMPARISAN OF BALANCE SHEETS One of the major considerations in analyzing the financial strength of the companies is to asses the way in which the company’s finance is structured in the sense that the debts and equity of the company should be distributed according to the generally accepted norms. A careful study of the balance sheets of both the companies as given hereunder would reveal the financial strength of the companies concerned: BP HSBC FIGURES AS ON 31 DEC 2005 Assets: (Value in Million US Dollars) Current Assets Cash 12,818.0 255,717.0 Net Receivables 41,114.0 Inventories 19.593.0 Other current Assets 1,598.0 Total current assets 75,123.0 255,717.0 Net Fixed Assets 85,947.0 14,891.0 Other Non current assets 48,294.0 1,136,336.0 Total Assets 209,364.0 1,406,944.0 Liabilities and Shareholders Equity Current Liabilities Accounts Payable 52,380.0 Short term debt 18,015.0 Other current Liabilities 1,602.0 922,993.0 Total Current Liabilities 71,997.0 922,993.0 Long term debt 13,926.0 274,667.0 Other Non-current Liabilities 38,294.0 115,760.0 Total Liabilities 124,217.0 1,313,420.0 Shareholders equity Preferred stock equity Common Stock equity 85,147.0 93,524.0 Total Equity 85,147.0 93,524.0 a. Long term Debt to Equity Ratio: The Ratios in respect of the companies are as below: BP 0.163 HSBC 2.937 From this calculation it becomes evident that HSBC being a bank is financed mostly by long term borrowings. The ratio in the case of a banking company is not abnormal, as every bank deals only in other peoples funds. Similarly in the case of BP also the company has been judiciously carrying out its operations in such a way that a fairly good debt to equity ratio is maintained. On this score both the companies rank equally for any investment proposals. b. Current Ratio This ratio tells the liquidity of the companies in terms of availability of liquid funds to meet any exigencies. The current ratio is arrived as a factor of Total current Assets and Total current Liabilities. The ratios for the companies are: BP 1.04 HSBC 0.27 Here again the current ratio in respect of HSBC is low as compared to that of BP. However being a banking company the lower current ratio does not really matter to consider the liquidity of funds. So also, company BP is maintaining a comfortable current ratio signifying that the company adopts sound financial management principles in respect of managing its current finances. Both the companies qualify for offering their shares suitable for investment. Apart from the consideration of the above ratios for investment in the respective shares of the two companies, the analysis of the balance sheets and the ratios gives a clear understanding of how the companies are financed and the liquidity or otherwise of the companies financial position. By a careful analysis of the figures as depicted by the balance sheets and as evidenced by the ratios calculated both the companies have positioned themselves financially in a comfortable situation. The current ratio of 1.04 for BP signifies an efficient management of its short term assets and liabilities thereby enabling the company to have adequate liquid funds 5.2 COMPARISAN OF ANNUAL INCOME For any investment decision the Income and growth potential of the companies are to be considered without fail. The following income statements of both the companies provide as assessable base of the performance of the companies: BP HSBC FIGURES AS ON 31 DEC 2005 (Value in Million US Dollars) Revenue 245,486.0 93,494.0 Cost of goods sold 188,312.0 Gross Profit 57,174.0 Gross Profit Margin 23.3% Selling & Administration expenses 16,221.0 44,412.0 Depreciation 8,771.0 Operating income 32,182.0 49,082.0 Operating Margin 13.1% 52.5% Non – operating Income (1,792.0) (72.0) Non-operating Expenses 559.0 28,803.0 Income before Taxes 31,421.0 20,207.0 Income Taxes 9,288.0 4,515.0 Net Income after Taxes 22,133.0 15,692.0 Continuing operations 20,252.0 15,495.0 Discontinued Operations 184.0 Total Operations 20.436.0 15,495.0 Total Net Income 19,642.0 15,495.0 Net Profit Margin 8.0% 16.6% The important factors to be considered in respect of the earning capacity of the companies as well as the earnings to the investors in the respective stocks are outlined below: BP HSBC 1. Operating Margin 13.1% 52.5% 2. Net Profit Margin 8.0% 16.6% Although the company BP has an envying market cap than that of HSBC, the Operating Margin as well as Net profit margins of BP is comparatively lower. Hence on this score Company HSBC’s shares are preferable for investment as against the shares of BP. Another important factor for consideration in respect of BP, because of its high sales revenue from the different countries of the world, is that the company’s foreign exchange risks are far more than HSBC. As explained elsewhere in this article the company should have in place sound foreign exchange risk management policies and programs to guard against any possible revenue losses due to sudden changes in foreign exchange rates. 5.3 OTHER KEY FINANCIAL INDICATORS: The other key financial indicators for deciding on the investment of the shares of the companies under consideration are shown below: BP HSBC Current Dividend 2.30 4.55 Dividend Yield 3.39% 5.00% Historic Dividend Growth 11.38% 8.19% % Return from Dividends 22.71% 37.22% Share Price Change Year to date 5.7% 13.00% PE Ratio 10.61 11.84 Earnings per share EPS (current year estimate) 6.40 7.68 Earnings per share EPS (next year’s estimate) 6.87 8.18 Projected EPS growth 11.55% 8.44% Expected return 14.94% 13.44% Price/Sales Ratio 2.25 2.25 60 month Beta 0.60 0.80 5 year Growth rate 29.63 15.32 On a short and medium term consideration of quick earnings and a considerable dividend income, the shares of HSBC can be selected for investment on the basis of current dividend and dividend yield as shown in the above table (4.55 and 5.00% in the case of HSBC and 2.30 and 3.39% for BP). Similarly a comparatively higher PE Ratio, Current year estimate of the EPS and the next year’s estimate of the EPS all provide a favourable indication for investment in HSBC shares. Whereas, in the case of BP, the projected EPS growth, expected return and the long term growth rate figures strongly recommend the purchase of the BP shares (the values are 11.55%, 14.94% and 29.63 for BP as against 8.44%, 13.44% and 15.32 for HSBC). This means that an investment which is considered as a long term one should go with the stock of BP rather than those of HSBC. Moreover the long term beta risk factor is only 0.60 in the case of BP and it is 0.80 for HSBC which indicates that the shares of BP are comparatively better placed in terms of volatility than those of HSBC which is definitely a factor to reckon with for any kind of investment decision. 6.0 CONCLUSION: After a careful consideration of international financial environment in which both the companies are operating and also the foreign exchange rate risks to which they are exposed along with other financial and non financial considerations, the following analysis of factors which are in favour of investment in both the companies are enumerated below: Factors which are in favour of investment in the shares of HSBC: As the profitability of HSBC is high the company has posted an impressive operating and net margins offering quicker and enhanced returns for the investor who wants to place their funds for a short or medium term. when the investor is interested in changing the portfolio after making some decent returns by way of dividends, without really looking for consolidation of asset backing for the investments, then investment in the shares of HSBC would prove profitable and it can be strongly recommended that the shares of HSBC can be bought for a short or medium term of investment to earn reasonable dividend income. Presently the growth potential of the company is very high and the share prices are also at a comparatively low level. Now the consensus recommendation for the shares of HSBC is to ‘buy’, which will definitely prove worthwhile in the short/medium term investments as the returns are posing a really attractive avenue for investment. Another factor which goes against the BP shares is that the revenues of the company depends on the world petroleum prices and any sudden changes in the petroleum prices is likely to have an impact on the share prices as well as growth potential of the company. Although the company BP would have taken adequate safety measures for guarding themselves against the foreign exchange risks, the sales revenue in the case of BP is at a very high figure posing a definite threat to the profitability of the company with the inevitable changes in the foreign exchange rates. Factors which are in favour of investment in the shares of BP: The investment in the shares of BP offer the investor the necessary comfort in terms of asset backing as the company’s projected EPS growth as well as the long term growth potential are impressively better than those of HSBC. Moreover, the analysis of the Balance sheet of the Company reveals that the company is efficiently managing its long term debt against the equity funds. The current ratio of the company is also equally impressive showing that the company maintains adequate liquidity of its funds and as such the company is in a very comfortable financial position from the investor’s point of view. Although the operating margin and net margins are lower as compared to HSBC the company has maintained an impressive growth rate over the past years in comparison to HSBC. The Company because of its stronger financial position would have adequately covered itself against all the risks of changes in the foreign exchange rates by employing suitable Exchange risk measurement and management techniques and thereby would have eliminated the risks of foreign exchange changes. This is quite evident from the fact that the company is able to have a consistently impressive growth rate over the period. Even the company’s historic growth rate is higher than that of HSBC. Hence, it is strongly recommended that the investor can buy the shares of BRITISH PETROLEUM having higher expected returns and projected earnings growth rate coupled with the long term dividend growth rate and a strong intrinsic value of the assets. REFERENCES 1. BARCLAYS share price & Tools viewed 14 December 2006 < http://www.investorrelations.barclays.co.uk/BRC1/jsp/brccontrol?task=articleforgroup&site > 2. Dividend Discount Model viewed 14 December 2006 < http://dividenddiscountmodel.com > 3. http://www.bpplc.com 4. http://www.hsbc.com> 5. 6. Maurice D.Levi Mar 2001 BAIM510 International financial Environment Faculty of Commerce and Business Administration The University of British Columbia 7.Michael Papaioannu Nov 2006 Exchange Rate Risk Measuremetand Management Issues and Approaches for firms IMF Working Paper Read More