Societe Generale Continues To Clean Up Its Act

By Stephen D. Simpson, CFA | August 07, 2013 AAA

The stocks of U.S. banks like Bank of America (NYSE:BAC) and Citigroup (NYSE:C), not to mention smaller regional players like Zions (Nasdaq: ZION), Regions (NYSE:RF), and Synovus (NYSE:SNV), have enjoyed strong rebounds on the back of the clean-up trade – ongoing improvements in bad debt inflow, credit ratios, and so on.

As bad as things got in the U.S., they were much worse in Europe and Societe Generale (Nasdaq:SCGLY) teetered on the brink of going the way of Lehman Brothers and Washington Mutual. Since going almost to the very edge of the cliff, though, SocGen management has been working hard to clean up the business, shore up its capital, and reposition the company for profitable growth. Although there is still a lot left to be done, and ample doubts as to whether they can do it, a strong second quarter and ongoing improvements are a good sign.

SEE: How To Evaluate The Quality Of EPS

A Significant Beat For The Second Quarter
In a swamp of charges, one-offs, and very items, it's not especially easy to evaluate SocGen's performance. Cutting through to the basics, though, SocGen reported revenue that was 6% better than the average of analyst estimates, operating income that was 28% better, and underlying net profits that were nearly 50% better than expected.

SocGen's non-performing loan (NPL) ratio is still quite high at 4.3%, though, as most U.S. banks are below 2%, with Wells Fargo (NYSE: WFC) being one of the rare exceptions above 3%. Likewise, SocGen's coverage ratio of 78% isn't so good, but the positive side is that the development of non-performing loans is slowing considerably – suggesting that credit will continue to improve.

Doing Well At Home, Not So Well Abroad, And Getting A Lot From Trading
SocGen's underlying profits in its French retail banking were down about 11%, but that was good for a 12% beat, while the underlying pre-provision profit was both positive and about 15% better than expected. Although lending is still sluggish, SocGen delivered segment revenue growth of about 3% at a time when larger rival BNP Paribas (Nasdaq: BNPQY) was down.

SEE: The Evolution Of Banking

The news was more mixed elsewhere. Net banking income in the International Retail operations was up about 2% on a like-for-like basis, missing expectations. SocGen also continues to see weak lending in Romania and Russia, the latter being particularly troubling given the general strength of the Russian banking market. While SocGen may have, on the whole, met its pre-provision profit target in this unit, the ongoing weakness in Russia seriously detracts from the long-term recovery story.

Where SocGen really exceeded expectation this quarter was in its CIB unit, its trading and investment banking operations. Not only were CIB profits up very strongly in a quarter where American banks like Citi, Bank of America, and Goldman Sachs (NYSE: GS) posted year-on-year weakness, the results were almost 40% better than expected. While any and all profits help at this point, banking and trading is a volatile business and generating so much of this quarter's outperformance here does reduce the quality of this beat.

Better, But How Much So?
SocGen management continues to target a return on equity of 10% to 12% over the long term, and actually managed to achieve that this quarter on an adjusted basis. What's more, the company's other ratios (Basel 3 common, Basel 3 leverage, etc.) are in much better shape than even just a couple of quarters ago. All told, SocGen is back on decent footing and arguably in a stronger position than rivals like Santander (NYSE:SAN).

The question is how much more the company can achieve. The bank has streamlined and shed non-core ops, and still holds significant market share in countries like France, Russia, Czech Republic, and Romania. Still, execution is a big question mark – SocGen has done a lot better than expected in France, but Russia continues to be a very disappointing situation with high operating costs and declining loan market share. Moreover, I'm not sure how much additional scope there is for SocGen to beat expectations on lower operating costs.

SEE: Analyzing Operating Margins

The Bottom Line
The good news is that even skepticism suggests SocGen could have more room to run. The bank's current return on tangible equity suggests a fair price-to-tangible book value ratio of 0.85x, or about 20% above today's price – and those returns have been improving. What's more, a long-term target of 9.5% for return on equity (below management's target) likewise suggests the shares are undervalued even on the basis of a 11.5% cost of equity assumption.

As Bank of America (and others) have shown, investors will reward banks that can clean up their act and turn lower credit expenses into higher reported profits. If SocGen can continue to show better credit numbers and get the Russian business moving in the right direction again, the rewards here could still be worthwhile.

Disclosure – At the time of writing, the author owns shares of Societe Generale.

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