Credit Agricole Appears Undervalued And Has A Good Potential Upside

Aug.12.14 | About: Credit Agricole (CRARY)

Summary

The U.S. market appears overvalued, while France is still relatively cheap: it seems like a good time to invest overseas, especially after the recent price drops.

Of the three major French banking groups, Credit Agricole is the cheapest, and has decent growth prospects.

There are still significant risks with Credit Agricole: pending litigation in the U.S. and in the European Union, exposure to southern European economy, and collateral damages of the Ukraine crisis.

Credit Agricole S.A. (OTCPK:CRARY), which trades as an unsponsored ADR in the US, is a major French banking group. It includes retail banking, investment banking, asset management, insurance, etc. As the name implies, its initial focus was on lending to French farmers at the end of the 19th century. Today though, its scope is much larger and not much remains of its initial mission. By assets, it is the third largest bank in the world. It has a significant global presence, with 5 countries in Africa, 14 countries in Asia and the Middle East, 24 countries in Europe, and 7 in America. It is significantly exposed to southern Europe: the second domestic market of the bank is Italy, with 962 branches and 8521 employees. It is also present in Spain, Portugal, and Greece. The negative impact of this sensitivity to the European periphery was obvious following the financial crisis of 2007-2008 and the economic meltdown of Greece, Portugal, Spain and Italy. The weight of Italy in the group's results is both a strength, and a risk with Italy sliding back into recession last quarter.

Credit Agricole released its first-half results on August 5, 2014. The bank had to write down 708 million euros due to the unwinding of the Portuguese bank Banco Espirito Santo (OTCPK:BKESY), or BES (in which CRARY owned a 14.6% stake). Credit Agricole announced that they would participate in potential lawsuits against BES. Moreover, there remains a strong risk of litigation against the group, both in the U.S. and the European Union. Indeed, in the EU, Credit Agricole refused to settle an anti-trust investigation over Euribor manipulation. In the U.S., Credit Agricole is under investigation for money laundering and violating the embargo on Cuba, Iran, and Sudan. Considering what happened recently to BNP Paribas (OTCQX:BNPQY), slapped with a 8.9 billion USD fine for similar charges, this investigation makes investors nervous, even though Credit Agricole had a much smaller amount of dollar transactions involving the sanctioned countries according to the CEO (after the bank concluded an internal review of these transactions).

CRARY is still up 12.12% YTD, even after a 13.4% drop as of August 8 during these past 3 months (due to bad news specific to the bank and the general drop in European markets resulting from the risk of an escalating war in Ukraine). It may be a good time to establish a position in this stock. Here is why:

First, the bank is undervalued compared to its peers, reflecting the short-term risks associated with it. Credit Agricole trades at a price-to-book ratio of only 0.59 (most recent quarter, data from the Bloomberg website) and a price-to-tangible-book-value of 0.91. This compares favorably to a P/B ratio of 0.76 for BNP Paribas, and of 0.61 for Societe Generale (OTCPK:SCGLY). With regard to these two French big banks, Credit Agricole S.A. appears discounted. For comparison, U.S. banking groups also have higher P/B ratios: for instance 1.61 for Wells Fargo (NYSE:WFC) or 1.01 for JP Morgan Chase (NYSE:JPM). Similarly, the P/E ratio of Credit Agricole, at 11.9 for the trailing twelve months, is pretty low. The dividend yield is fairly decent, at a current 3.35% (0.35 euros per share). The banking group is also well capitalized, with a Tier 1 ratio (Basel 3) of 12.7%, and a core Tier 1 ratio of 9.9% (and rising). At a share price of 7.03 USD (August 8), it seems to me that a lot of bad news is already priced in.

Second, excluding the exceptional items (especially the writing off of its stake in Banco Espirito Santo), the first-half pre-tax net income of Credit Agricole S.A. increased significantly: indeed the income statement shows 1.43 billion euros, and if you add the exceptional items that were subtracted from the net income (mainly BES), it represents a 36% year-on-year increase (and a 9.6% decrease when you remove these exceptional items). The cost of risk was also down 20% year-on-year for the first half of 2014. Another positive aspect is that corporate and investment banking only represent 12.5% of the group's revenues, while retail banking provides 69.1% of these revenues, and asset management and insurance provide 16.6% (these numbers are for the first half of 2014 for Credit Agricole Group which is Credit Agricole S.A. plus the local and regional banks, owned at 25% by Credit Agricole S.A.). In other words, Credit Agricole is more akin to a traditional brick-and-mortar retail bank. Under Jean-Paul Chifflet, the current CEO, the bank has been relatively well managed, compared to the excesses of the past decade when the group expanded aggressively toward southern Europe.

To summarize, my investment thesis is twofold: first, the U.S. market is fairly valued or even overvalued right now. By contrast, the French stock market is still relatively cheap as a whole (see, for instance, this recent article, even though the metrics used by the authors may be somewhat arbitrary). It seems to me that for value-oriented investors, it is time to invest outside the U.S. Second, I like financial services now that the EU is slowly growing again, and of all the French banks, Credit Agricole is the cheapest. There is a significant risk with this bank, which explains the discount: risk of litigation with the U.S. and the EU, and over-exposure to southern Europe. However, this is old news: the risk of litigation has been known for several months, and the total provision of Credit Agricole for unspecified litigation was a healthy 1.2 billion euros at the end of last year. Credit Agricole has already written down a significant part of its assets in southern Europe, especially Portugal and Greece (with Emporiki Bank). There is also a more general risk with Europe, as the escalation of the crisis in Ukraine and the economic sanctions against Russia may negatively impact the continent as a whole. Another contentious point is the ownership structure of the group: Credit Agricole S.A. remains majority owned by its regional retail banks (the caisses mutuelles). Together, they control 55% of the outstanding shares. Many people seem to find this structure unfavorable, because, amongst other things, the regional managers may try to protect or expand their turf and may not act in the best interest of the shareholders or the group as a whole. On the other hand, these same regional managers may curb excess risk taking by the CEO (in particular they do not necessarily welcome an expansion of investment banking). I believe that at the current price CRARY has more potential upside than downside, and that most of the risk is already priced in. For what it's worth, the consensus amongst French analysts is to overweight with a target price 22.52% higher than at the close of the market on August 8.

Disclosure: The author is long CRARY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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