Can Societe Generale Ever Be Relevant Again?

| About: Societe Generale (SCGLY)
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I have no doubt at all that many readers will read that article title, snort, say "no", and move on with their day. And that's certainly understandable - while Societe Generale (OTCPK:SCGLY) may not be the European bank most damaged by the Great Recession, credit crunch, and resulting European sovereign debt crisis, they certainly did their best (or worst) to be in the running.

Societe Generale has emerged from this mess as a different bank, though, and the company has gone to great lengths to improve its balance sheet and capital position. Perhaps the question to ask with Societe Generale isn't so much about whether it can be a top-tier bank again (if it ever was), but rather whether it deserves to lag relative to other troubled banks like Citigroup (NYSE:C), Bank of America (NYSE:BAC), and Santander (NYSE:SAN).

The Bank In Brief

Societe Generale is still one of the largest banks in Europe. Not only is this company the third-largest bank in France by assets (trailing Credit Agricole (OTCPK:CRARY) and BNP Paribas (OTCQX:BNPQY)), but it also operates banks with significant market share and assets in Romania (BRD - #2 in assets), the Czech Republic (KB - #3), and Russia (Rosbank - #9).

Unfortunately, the bank is better known for the business decisions and mistakes that very nearly killed it. Societe Generale was a significant player in credit default swaps, and was one of AIG's (NYSE:AIG) largest counterparties at the time of the credit crisis - had the U.S. government allowed AIG to go under, SocGen would likely have been out something on the order of $11 billion and may not have survived (at least not absent virtual re-nationalization).

In addition to its derivatives book, SocGen was a major lender and underwriter to PIIGS countries like Greece, Italy, and Spain. Not only did SocGen pile into sovereign debt underwriting (going from virtually nowhere in 2005 to a top ten eurozone underwriter a year later), but the company held billions of debt from Greece, Italy, Spain, and the like - EUR 2.5 billion in Greek debt alone at the end of 2010, and that was after a couple of years of writedowns and sales.

Making matters even worse, SocGen also operated a sizable Greek bank business (Geneki) that had billions more in exposure to Greece. To add a cherry to the top of this fairly fetid sundae, SocGen started the credit crisis with one of the worst-ever trading scandals, as Jerome Kerviel lost almost EUR 5 billion in a series of fraudulent transactions that the bank was not able to detect or stop.

Has Harsh Medicine Restored Some Semblance Of Health?

Investors who follow the banking sector, particularly the European banking sector, know that SocGen was hardly alone in its Euro-disaster, but there's no question it was badly damaged. The more relevant question now, though, is where the bank stands for the future.

European exposure is still a risk for this bank, but as a European bank that is to be expected. SocGen management was fairly aggressive in responding to the sovereign debt crisis, routinely writing down debt by a larger degree than other European banks and not being shy about seeking out additional capital to shore up the business.

Overall PIIGS exposure now sits at about EUR 2.6 billion, with the bulk (50%+) of that in Italy and no Greek exposure. SocGen has also worked down its non-investment grade U.S. mortgage exposure to less than EUR 2 billion. In fact, the company has cut its legacy asset exposure by about two-thirds and has sold over EUR 16 billion in loans over the last eighteen months or so (at an average discount of 4%).

The company has sold Geneki, sold TCW (a US asset management firm), and sold its 77% stake in Egypt's fourth-largest bank NSGB) to Qatar National Bank for $2 billion. SocGen also launched another Tier 2 capital raise, issuing $1.5 billion in 6.625% subordinated perpetual securities. In short, SocGen has actively deleveraged itself and launched asset disposals to shore up capital. At this point, then, capital and liquidity no longer look like pressing issues. The company's Tier 1 ratio sits above 10% today, more than two points higher than the level at the end of 2010.

With the deleveraging story basically over, now the question is whether SocGen can get back on track with its core operations. Although the bank's operations in central Europe and Russia are still seeing macro pressures, results are getting better. Likewise, in France - while the operating conditions in France are not especially robust for any bank, SocGen has been seeing good loan and deposit growth. The company's investment banking operations are also looking better, with both equity and fixed income results much stronger recently on a sequential basis (up 22% and 42% in the fiscal third quarter).

What Can SocGen Be Now?

The huge destruction of capital at SocGen, and the resulting need to sell loans, assets, and entire operations like NSGB, has clearly dented management's prior ambitions to be a global player. Maybe that's not such a bad thing, though, as it would seem that many of the banks with the grandest global dreams of empire (Bank of America, Citigroup, Santander, and UniCredit, for instance) were hurt the worst by the credit and debt crises.

I believe it's well worth noting that SocGen still has a valuable collection of operating assets. The company has a sizable presence both in France and in Central/Eastern Europe, as well as subsidiaries in parts of North Africa. The company has also built itself into a significant investment banking player within Europe and underwriting is likely to remain a profitable industry in the future.

SocGen's return on equity is still in the dumps (mid-single digits), some of which is due to ongoing deleveraging and writedowns, but also the generally weak state of the European economy and the global interest rate environment. This will not last forever, though, and the long-term earnings power of the bank's assets is such that high single-digit or low teens returns on equity should be probable in a three- to five-year window. Moreover, while there is still ongoing discussion in Europe regarding severely curtailing banks' abilities to engage in "speculative" activities (particularly in France), SocGen has already cut back these activities fairly significantly and should see less incremental impact.

So how will SocGen build value and improve its return on equity? For starters, a steeper yield curve and a healthier economy in France and central Europe would do wonders - make more loans, collect more deposits, and earn a bigger spread between them. Clearly SocGen can't make this happen all on their own, but it seems extraordinarily bearish to say that France will never see better days again.

At the same time, the company can now focus more attention on "right-sizing" the bank's operations and trimming down its expense profile. Part of that, too, should be a gradual decrease in the bank's cost of capital as time goes on - as investors regain confidence in European banks (and SocGen particularly), the firm may be able to swap out expensive capital. Last and not least, the company can start devoting more time, attention, and capital to higher-earning businesses like insurance, wealth/asset management, and business services.

Turning back to the question of value, I do not believe that SocGen needs any further large-scale disposals, writedowns, or capital raises. Moreover, while management has talked about a long-term ROE target in the low teens, I use only a 9% estimate in my excess return model, as well as a higher-than average discount rate. Those inputs suggest a fair value of $10 or more for SocGen shares today.

The Bottom Line

Investors who haven't been following the story may be surprised to learn that SocGen was up almost 80% for the year in 2012 - making it one of the top-performing banks. That should give you some idea as to how sell-side analysts and institutional investors have viewed the company's progress in deleveraging, even despite the ongoing economic malaise in Europe.

I currently hold SocGen shares, largely on the belief that there's still a relative catch-up trade to be had relative to other banks like Santander and Bank of America. What's more, I do believe the market currently underestimates the bank's inherent earning power for the long term - not only do these shares trade well below tangible book value today (about 50% of tangible book), but the implied long-term return on equity is only in the mid-single digits. As I said, I believe these shares are worth about $10 today, with upside into the low-to-mid teens if management's guidance regarding long-term ROEs (10% to 12%) is accurate and prescient.

I fully expect many investors to regard France as a perpetual basket case and large banks like SocGen as impenetrable black boxes with almost all of the risks skewed to the downside (you never hear about rogue traders earning billions for the bank). Likewise, the current rate environment is not especially healthy for any bank. All of that said, and I really do respect the viewpoint that SocGen is more trouble than it's worth, the expectations are still low on this name and I believe that the transition from shoring-up to "back to business" can produce still more value for patient investors.

Disclosure: I am long OTCPK: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.