Societe Generale: Slow progress towards price parity
In the third installation in our series of bank reviews, we take a look at something in our investment wheelhouse. Post-Great Financial Crisis (“GFC”), Société Générale Société anonyme (OTCPK:SCGLF, OTCPK:SCGLY) (“SocGen”) is trading at a significant discount to book value. This is a reflection of a bank that underperformed in the strict regulatory environment subsequently imposed.
Over the past few years, it has made progress in laying the foundations for higher yields. However, with a pandemic-related business slowdown hampering 2020 results, a €3.3 billion loss on the disposal of Russian assets to do the same for 2022 results and a likely global recession in 2023, the bank has yet to convince the market that its transformation is complete.
We believe that if SocGen can hold its own over the next 12 months, starting in 2024, the stock can embark on a journey from its current low levels towards price parity.
SocGen operates a universal banking model, with a national retail banking network in France at its core. It also operates a number of international retail banks, concentrated in Eastern Europe and Africa, and a Global Banking franchise which includes its Markets business. These three areas form pillars of similar size in terms of allocated capital and revenue contribution, although with the majority of its retail banking business we have focused primarily on its vanilla borrowing and lending business. .
Its Q3 2022 Group net income YTD of €858 million represents an annualized RoE of 1.8% while maintaining a CET1 ratio of 13.1%, although these figures include the impact of the impairment of Rosbank. Without this expense, RoE improves to 8.6%, and excluding all credit write-downs (internally referred to as Cost of Risk), its underlying returns are a respectable 11.1%.
Indeed, this dilemma of generating strong profitability, both before and after accounting for impairments, has been a recurring narrative over the past 10 years, as we attempt to demonstrate below.
We observe that until 2015, SocGen managed a portfolio of high yield loans, with robust net interest income and RoE (excluding impairments). However, large volumes of impairments weighed on overall profitability, with overall RoE below 10% and CET1 never exceeding 11% during this period. Overall, he suggested a generally poor quality loan portfolio.
Between 2016 and 2019, while net interest yields stagnated, overall RoE showed signs of stabilizing around 5-7%. We are also seeing a marked improvement in the credit quality of the loan portfolio, as evidenced by the decline in impairments and a rise in the CET1 ratio to just under 13%.
Thanks to this stronger capital position, the bank has recently been able to improve underlying performance, as shown by ex-RoE writedowns returning to double digits in 2021. However, this healthy position has not changed. reflected in the bottom line, with 2020 RoE impacted by pandemic-related volume loss, and 2022 hampered by Rosbank impairment.
With near unanimous consensus that a global recession awaits in 2023, we believe the next 12 months will continue to be a challenging environment for SocGen to release numbers that reflect its improved positioning. We expect RoE for the full year 2023 to return to low single-digits as once again rising credit writedowns erode the revenue gains generated by the interest rate environment. higher interest.
What is different this time around is that we view the impending deterioration in earnings as cyclical and not structural as before, and therefore expect any decline in earnings to be short-lived. We anticipate clear air as we wait out the other side of the recession in early 2024, which will allow SocGen to finally stretch its legs and demonstrate what we believe it is capable of: sustainable RoE of 8.5%. Our view is in line with management’s stated ambition to achieve Ro(T)E of 10% and CET1 of 12% by 2025, although perhaps cautious (as management suggests a tolerance at higher risk in the future).
We stated earlier that a bank earning 10% ROE is fair valued at 1.0 P/B. Following this, we suggest that a historical RoE of 8.5% is accompanied by a fair value equivalent to a P/B of 0.85.
In our view, although clearly undervalued, we believe it is understandable that SocGen’s share price is trading at a P/B of 0.3, reflecting the fact that the bank has not been able to persuade the market that it is capable of generating sustainable, consistent and quality profits.
2023 also does not appear to be an environment conducive to exceptional results, so we believe that a significant rise in the share price will probably begin in 2024 at the earliest. We expect price appreciation once SocGen demonstrates back-to-back quarters of nearly 8.5% RoE, and the stock can be fully rewarded with a P/B of 0.85 once it racks up 2 years of performance at these levels.
We cite Bank of America (BAC) as a relevant example of a successful turnaround story, where for the first half of the past decade it traded below book value, eventually reaching parity in 2016 once which it has telegraphed to the sufficient sustainability of the market in its profits. . We see SocGen being able to replicate this price action in the next 2-3 years.
Adding a safety margin to our calculation, we have conservatively modeled the stock reaching our P/B target by the end of 2026, which equates to a stock price of EUR 85, with EUR 7 additional returns as dividends. With the stock currently trading around $25, we envision total returns nearly triple the initial outlay in four years.
Risks and measuring progress
We find ourselves trusting a bank with a random track record, to prove itself over a substantial period of time in an uncertain environment. The blow from the Russian asset sale was a reminder of the untimely setbacks that banks encounter all too often, and for some skeptical shareholders, such unfortunate events happen more often to some banks than others. We could argue that SocGen’s low share price contains a discount for perceived operational risk, some of which may be unfairly earned simply by being a European bank. Overall, we’re concerned that there won’t be much residual goodwill on the part of investors should another “skeleton in the closet” be discovered that challenges the company’s reputation, culture or profitability. bank, and in such a scenario, our thesis may not hold water.
Additionally, we based our assumption of a recovery from 2024 on the market consensus that a 2023 recession will be “short and shallow”. There is a risk that a more severe and prolonged downturn could occur, which could delay the recovery. However, if SocGen has truly become resilient as we believe, we should not expect a significant erosion of fundamentals.
Ultimately, for our investment thesis to succeed, the most important aspect is for SocGen to prove its credibility in the market. We expect it to show this through resilient quarterly and annual figures, in particular healthy RoE, CET1 and credit provisions.
We also want a more aggressive change in tone towards SocGen’s share buyback program. With stocks trading deep below par, we expect significant reloads over time in recognition of the bank’s undervaluation, the amount of capital the bank can spare and management’s confidence in the positioning. of the company.
On the face of it, it’s easy to argue that a bank trading at 0.3x of the portfolio is undervalued, but SocGen’s path after the financial crisis has made it difficult to get a more appropriate valuation. With a recession looming, we don’t see a significant move towards book value imminent. However, a lot has been done over the past decade to solidify SpcGen’s capital position and clean up its loan book, and we expect the fruits of that hard work to start bearing fruit from 2024.
We believe that with current valuations so cheap, it makes little sense to anticipate further declines in SocGen’s share price or predict sideways movements over the next 12 months. Thus, we advocate a “buy now, buy more later” approach. We are convinced that an investment in Société Générale can now grow by nearly 300% by 2026.
(EURUSD=1 assumed in analysis)