Expectations For Societe Generale Have Dropped To A Point Where Outperformance Seems More Likely – Société Générale Société anonyme (OTCMKTS:SCGLY)

There’s long been a line of thought in investing that there’s a price where almost any stock can be attractive, provided the business is a going concern. I don’t quite believe that (I’ve seen stocks languish for a decade or more), but I do believe that Societe Generale (OTCPK:SCGLY) has shored up its capital position and has finally started tackling some of its more significant lingering operational problems.

Even for a bank that generates such low returns, SocGen shares look undervalued, and I believe the expectations bar has been set so low for this bank that the odds favor some level of outperformance. The macro environment is a risk, particularly with the ECB now going back to easing, but it looks to me as though European banks in general, and SocGen in particular, has derated to a point where just “okay” performance would generate some upside.

Repositioned Retail – Finally Some Gain After Years Of Pain?

Investors need only compare SocGen’s results in the French Retail business over the last few years to rivals like BNP Paribas (OTCQX:BNPQY) or Credit Agricole (OTCPK:CRARY) to see a pronounced trend of lackluster performance. Between branch closures and repositioning the business, I believe at least some of that underperformance has been “deliberate”, at least insofar as an active effort on the part of management to reposition the bank for more profitable business down the road.

In particular, management has been pivoting its core Societe Generale brand toward more affluent/mass-affluent customers. Although these customers can be more expensive to service, they tend to be more active “consumers” of other products (like wealth management services), creating cross-selling opportunities, and they tend to be less price-sensitive when it comes to rates and fees. At the same time, the bank has been less interested in competing for volume in the core mortgage business, and I believe that explains at least some of the relative underperformance.

SocGen is also looking to boost its commercial lending operations through Credit du Nord. In particular, SocGen management is targeting professionals and small/medium-sized businesses, and again there are opportunities here to cross-sell more services (treasury services, etc.).

Last and not least, SocGen is not abandoning the larger retail banking market in France, but they are placing more emphasis on the fast-growing Boursorama online bank. The argument here is pretty straightforward – online banking requires meaningfully lower operating expenses, and SocGen would like to shift more of its “non-affluent” retail business to online channels if possible.

This shift has taken longer than I expected (indeed, longer than I think almost anyone expected), and management hasn’t done a great job of staying “on message” as far as the long-term goals and the short-term costs of achieving those goals. I do think, though, that the bank is past the worst of this shift, and although lower rates in the short term will create some headwinds, I believe SocGen could start showing some growth in this business again relatively soon.

International Is An Offset

While SocGen’s French Retail business is a very large part of the mix (about a third of revenue), the similarly-sized International Retail business does offer at least some offset. SocGen’s significant operations in the Czech Republic, Romania, Russia, and Africa do help to mitigate some of the near-term rate pressure from the ECB. Although weak GDP growth in Russia (forecasted at 1% for 2019) is likely to lead to rate cuts, growth in the Czech Republic (up 2.7% in the second quarter) and Romania (up 4.4%) is outpacing the scant growth in the EU (up 0.2%) and SocGen enjoys strong share in these markets.

Capital And Restructuring

SocGen has delivered some much-needed good news on capital in its recent earnings reports. The second quarter report saw a reported CET1 ratio of 12%, about 10bp better than expected and up 30bp qoq excluding the benefit of in-progress disposals. The bank also saw slightly better than 50% uptake of its scrip dividend proposal (investors agreeing to take stock instead of cash). All told, this meaningfully eases the capital pressure on the business and should reduce the need for further big swings or asset sales. That said, an easing posture from the ECB is going to reduce profitability for banks operating in the EU, and capital concerns across the sector could still weigh on SocGen (guilt by association).

Management also has work left to do on restructuring. Management previously outlined just how mixed the results are within the bank’s Global Banking and Investor Solutions operations. Businesses representing 56% of risk-weighted assets generate a combined return on equity of over 14%, while the other 44% of risk-weighted assets generate less than 5% returns. Flow lending has been a particularly weak business, and SocGen is reducing this to a level that will only support other ongoing business relationships. Wealth/Asset Management is also a low-return business, and this could be a tougher business to fix, as I don’t think exiting the operation is an option management wants to pursue.

Lastly, there was word a few days ago (a Bloomberg article) that SocGen was contemplating another round of cost restructuring that would see a EUR 600M reduction in costs from the corporate headquarters. A cost reduction of that magnitude would be meaningful, but I struggle to see how there could be that much “low-hanging fruit” left, and so if this report is true, I’d be concerned about what cost cuts of this magnitude would mean in terms of business disruption.

The Outlook

Earnings expectations for SocGen have continued to slide through 2019; I started off with much lower expectations than the sell-side, so the changes to my model haven’t been nearly as significant. I’m still looking for around EUR 3.2 billion in adjusted net income in 2019 and around 2% growth over the next five years. I’ve become a little more bullish on the longer-term picture (and my long-term growth rate moves up about half a point), as I think the bank’s progress on shoring up its capital position has reduced the risk/need to sell-off other profit-generating businesses. With those assumptions, I believe SocGen is more than 30% undervalued on a long-term core earnings basis.

On the other hand, SocGen’s returns on assets and tangible equity remain very low, and those low returns continue to argue for a low P/TBV-based fair value. The “good news” is that sentiment is so low that even a 0.65x target multiple still drives a fair value more than 30% above today’s price. While I will again note that European banks have derated and currently trade noticeably beyond historical valuation norms, SocGen’s ROTE would have to fall below 4% for today’s price to be “fair” on a long-term historical basis.

The Bottom Line

Even though I still own a small position, I can’t say I really like SocGen. Management has made countless errors over the years and the bank found itself in a position where its back was basically against the wall. Today’s management seems to be rising to the challenge, though, and while I don’t believe SocGen is, or will be, a top-tier European bank, I do believe it is better than what the valuation reflects. This is definitely a tepid buy recommendation, and the market will not be merciful if SocGen stumbles with respect to revenue growth, profits, or capital over the next 12 months, but I think the market is pricing in just too much negativity at this point.

Disclosure: I am/we are long SCGLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.