Societe Generale's Ongoing Operating Malaise Still Weighs On The Valuation

I’ve flagged France’s Societe Generale (OTCPK:SCGLY) (“SocGen”) as a potential value trap for some time now, despite its low valuation and my own ownership of some shares, and the shares have borne that out – the local shares are down about 40% over the last year (the ADRs are down about 45%), underperforming French peers like BNP Paribas (OTCQX:BNPQY), Natixis (OTCPK:NTXFF), and Credit Agricole (OTCPK:CRARY), not to mention a host of European peers.

Although SocGen still appears significantly undervalued on many metrics, the fact is that the company’s performance continues to be uninspiringly weak and it’s difficult to see how management will change that in the foreseeable future. While very patient, very long-term-oriented investors may still find some value here, and valuation may well be bottoming out, the company’s ongoing restructuring efforts will continue to create headwinds for revenue and profit growth.

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Societe Generale's Ongoing Operating Malaise Still Weighs On The Valuation

To Get Its Due, Societe Generale Has To Do Better

French multinational bank Societe Generale (OTCPK:SCGLY) continues to test investor patience with its slow turnaround. While the share price has improved over the past couple of years, the company's return on equity and return on tangible equity remain frustratingly low due to persistently high costs, recent challenges in its CIB operations, and foreign operations that until recently weren't carrying their weight.

SocGen is still somewhat undervalued on the basis of what I don't regard as especially ambitious assumptions, and the shares still yield more than 4%. What's more, key markets like France, the Czech Republic, Russia, and Romania are improving, and management is expected to unveil a new strategy for growth in November that will restore some investor enthusiasm.

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To Get Its Due, Societe Generale Has To Do Better

Seeking Alpha: Societe Generale Not Getting Its Due

It's been a disappointing summer and fall for European bank stocks, and despite two solid quarters with double-digit earnings beats, Societe Generale (OTCPK:SCGLY) (GLE.FR) has been unable to beat that trend in European bank stocks. While the shares haven't done as badly as names like Credit Agricole (OTCPK:CRARY) (down about 24%), Banco Bilbao (NYSE:BBVA) (down about 25%), or UniCredit (OTCPK:UNCFF) (down 20%), SocGen is still down about 6% from my last update.

I believe this performance has created a more interesting gap between the bank's current price and long-term potential. The world has certainly changed for large banks, and the higher capital levels that regulators are demanding will make it much harder (if not impossible) to achieve past high-water marks in ROE/ROTE/ROA. What's more, I wouldn't say that Western Europe is quite the picture of economic health yet, and Russia still has the potential to get worse before it gets any better. All of that said, I think SocGen has made underrated progress with its French retail operations, its retail operations outside of France, and with its overall costs and capital allocation. I believe that fair value for the ADRs is around $11.50 to $12.50, making these shares a more interesting consideration particularly when including the dividend.

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Societe Generale Not Getting Its Due

Seeking Alpha: Societe Generale Continues To Grind Forward

The last three months haven't been the easiest stretch for Western European banks, and Societe Generale (OTCPK:SCGLY) is down around 6% over that stretch. BNP Paribas (OTCQX:BNPQY) has been even weaker (down more than 10%), while Credit Agricole (OTCPK:CRARY), UniCredit (OTCPK:UNCFF), Credit Suisse (CS) and many others have done better but are still down over that short stretch.

Not all that much has changed, but banks have moved to a different part of the recovery phase. First quarter results were pretty "meh," including those at Societe Generale. The stories have shifted from significant cost of equity and balance sheet improvements to slower, grind-it-out return on equity improvements. I continue to believe that Societe Generale is undervalued and one of the more attractively-priced large bank stories today, but it's going to take time and the Street still isn't convinced that Societe Generale is going to produce the double-digit ROE on schedule and/or improve its lagging Russian operations.

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Societe Generale Continues To Grind Forward

Seeking Alpha: Can Societe Generale Ever Be Relevant Again?

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 (SCGLY.PK) 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 (C), Bank of America (BAC), and Santander (SAN).

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Can Societe Generale Ever Be Relevant Again?

From Sons of Athens ... to Sons of Anarchy

Thanks Greece.

Virtually every financial system is built upon a certain level of trust and good faith amongst its members, and Greece seems to have taken up the role of "turd in the punchbowl". Greece basically lied their way into the European Union, gorged on cheap debt, wasted it on unproductive assets, and then turned around and held the financial system hostage with a version of "bail us out … or else!".

Of course, anybody wasting their time bashing on the Greeks is overlooking events a little closer to home. Let's see … lying to get favorable loans, using those loans foolishly, and then whining, wheedling, and begging for a bailout. Where have we seen that before?

Oh yeah, that's right. We did that too.

Now we have the S&P lowering Greek debt to "junk" (way to be on the stick ahead of time, guys … oh wait, we've seen that before too!), Greek 2-year notes yielding about 19%, and a lot of people nervously watching Portugal, Spain, and Ireland for signs of weakness.

Think about that for a moment … Greek 2-year notes are yielding almost 19%. That's like credit card rates. On second that, maybe I shouldn't have said that … Capital One (COF) may soon be seeing a flood of applications from Athens at this rate.

The scary part, though, is how long this could last. Latvia went into crisis a little while ago and even massive cuts to government wages, pensions, and spending (and other austerity measures) didn't help much. Greece, then, could be looking at quite a few years of high taxes, a sharply contracted public sector, malaise, and discontent. Not too many countries have the capability to withstand that, and there could be unrest as a result (as seen a few years back in Argentina).

It's almost a given that the "market" won't be much help here, and the rescue package will have to come out fully-funded by other European countries. On top of that, you're probably looking at wage cuts of 20% or higher as part of the package, and I don't think many Greek civil servants will be happy about that. Worse still, after 12 or 18 months of that, it may still not be enough and Greece may opt to default/restructure that debt and send more ripples of chaos through the market. Simply put, we're talking here about a program that would take four or five years … and that's assuming that Portugal and Spain don't fall over and make it even worse.

In the meantime, a lot of banks have gotten smacked already. Several German and French banks have (or had) major exposure to Greece, with names like Commerzbank, Credit Agricole, Societe Generale and BNP Paribas among them. The damage there is probably already done, but I'd be very cautious around any banks heavily exposed to Spain … or frankly almost any European country at this point.  After all, plenty of British banks have loans on the books for vacation homes in Spain, so you can never just assume a bank in Country X is safe.

Sooner or later, this storm will pass. The U.S. economic recovery isn't heavily predicated on Europe at this point, though chaos in the credit market can quickly become a global issue. But that isn't to say that the fallout won't cause some chaos and hairy days. Expect talk to begin about creating a mechanism to boot out European Union countries that can't get their stuff together, and should the Euro actually collapse … well, that's probably a really good day to own gold (and probably dollars as well, because as messed up as we are, we're not that bad).

Here's hoping the sons of Athens figure a way out of this mess before it gets too much worse.

(Disclosure - I own shares of Societe Generale)