Introduction

European bank stocks are still rather weak as the lack of details on how the COVID-19 pandemic will impact the financials weighs on a potential recovery. Additionally, the European regulator has asked all banks to suspend dividends in order to protect the balance sheets while the COVID-19 dust settles. I consider this to be a good move from the regulator as it avoids unnecessary unrest on the financial markets if/when one bank would have had to cut its dividend by a wider margin than others. This also creates opportunities as foregoing one year of dividend payments (assuming the suspension for 2020 doesn’t result in catch-up dividend payments) should go a long way in absorbing the COVID-19 related losses. Societe Generale (OTCPK:SCGLF) (OTCPK:SCGLY) is one of those banks and the generous dividend (2.20 EUR per share in a pre-COVID era) would now represent a 15% dividend yield.

Source: Yahoo Finance

Societe Generale’s US listings are relatively liquid (with average daily volumes around 100,000 shares), but I will refer to the bank’s main listing in this article. SocGen is trading in Paris with GLE as its ticker symbol, and the average daily volume is clearly superior with 8M shares trading per day.

A net loss in Q1, but I expect more COVID-related pain in Q2

I will keep the discussion on SocGen’s Q1 results quite short as this article is mainly meant to determine the consequences of the Q1 results and the COVID-19 outbreak on SocGen’s dividend.

Q1 was a rather disappointing quarter for SocGen as the bank reported a net loss of approximately 326M EUR.

Source: Q1 update

Two reasons for the very disappointing Q1 result jump out: There’s a 820M EUR “cost of risk” provision which is more than three times as high as the provision recorded in Q1 2019 while the net banking income decreased from almost 6.2B EUR to 5.17B EUR.

The net banking income decrease can easily be explained: Whereas the retail banking activities were relatively flat (-1.2% in France, +1.2% for the international division), the main culprit were the global banking and investor solutions activities where the net banking income fell by almost 30% while a gross operating income of 213M EUR in Q1 2019 was converted into a 350M EUR loss in Q1 2020, mainly due to a 98.7% (!) drop in the equity net banking income in Q1.

Source: Q1 update

As you can see on the income statement, the bank recorded just 820M EUR as “cost of risk” (which appears to be a fancier word for impairment charges or loan loss provisions). Granted, that’s a substantial increase compared to the loan loss provisions in the previous few quarters, but I’m wondering if this really is a realistic assumption. Keep in mind that according to the accompanying press release the cost of risk doesn’t just include the COVID-19 impact, but also includes two exceptional fraud files.

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Source: Company press release

Fortunately SocGen also provided some sort of guidance for its loan loss provisions. In its base case scenario, it expects a total cost of around 70 base points for 2020 and 100 base points in a more severe scenario. Note: I interpret the underlying paragraph as 70-100 base points in total cost of risk (including the base cost of risk).

Source: company press release

If SocGen’s assumptions are correct, then the worst should be behind us (regarding the COVID-19 related loan loss provisions). However, keep in mind SocGen provided this update in April and the bank will undoubtedly have more detailed datasets it can use to determine the COVID-19 impact on its financial situation. I’m looking forward to seeing the Q2 results as I think those results, in combination with a more detailed guidance for the cost of risk this year.

In the company presentation, the total cost of risk amounts to 32 base points excluding two fraud charges and COVID-19, and SocGen mentions COVID-19 represents 36% of the cost of risk in Q1.

Source: company presentation

This means that in Q1, 36% of the 65 base points of cost of risk (23.4 base points) is considered to be COVID-19 related. If we would assume the worst-case scenario outlined by SocGen (100 base points of total cost of risk in 2020, which includes the COVID-19 and fraud files), the total loan-loss provisions will be around 5.05B EUR in 2020 (3.5B EUR assuming the cost of risk remains limited to 70 base points). This means that we can reasonably expect SocGen to report a full-year loan loss provision of around 4.3B EUR (the mid point between both scenarios) indicating the average quarterly loan loss provision in Q2-3 will be around 1.1-1.2B EUR.

Once SocGen fine tunes the expectations for its cost of risk when it publishes its Q2 results, I will be able to fine tune the expectations for the remainder of the year.

Source: company press release

What does this mean for the dividend?

This is a tougher calculation, as SocGen’s pre-risk income in Q1 was obviously also impacted by the losses generated on the fair value of its own financial assets. However, we also can reasonably expect a strong performance in Q2 which could perhaps wipe out the bad performance in Q1 and one could wonder what this means for the 2.20 EUR dividend SocGen traditionally pays out?

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I think the best way to approach this issue is to have a look at SocGen’s pre-risk income in FY 2019 as that will provide us with a more reasonable look on how SocGen performs without encountering economic shocks.

Source: annual report 2019

We see the bank recorded a gross operating income of 6.9B EUR in FY 2019 and 7.27B EUR in FY 2018 on a pre-risk basis. This means that even if we would apply a 10% lower banking income (to 6.2B EUR) and using the higher end of the cost of risk with a 5.05B EUR impairment charge, SocGen would still be profitable, reporting a pre-tax income of around 1.1-1.2B EUR and an after-tax income of around 800-900M EUR (for an EPS around 1 EUR per share).

This creates the possibility SocGen will indeed pay an “exceptional dividend” it has been hinting on later this year (if the regulator allows it), but I’m more interested in the longer-term dividend potential of SocGen.

Let’s say the banking income remains at a normalized 6.3B EUR (10% lower than in FY 2019) while the cost of risk increases by 100% compared to the 1.28B EUR recorded in 2019). This would result in a taxable income of around 3.6B EUR (assuming there will be a net expense from other assets as well) and a net income of 2.75B EUR (assuming an average tax rate of 24% (compared to 21.5% in FY 2018 and 23.7% in FY 2019). Roughly 800M EUR will be payable on the subordinated notes and minority interests, resulting in a net income of 2B EUR attributable to the common equity holders.

Given SocGen’s dividend policy to use a payout ratio of 50-5555%, the FY 2021 dividend could be around 1.1B EUR. Divided by 854M shares, this could indicate a dividend of 1.30 EUR per share. And that’s based on a 10% lower banking income and a 100% increase in loan loss provisions compared to FY 2019.

Of course, at this point this is just a theoretical thinking exercise and everything will depend on Societe Generale’s more detailed COVID-19 outlook which will undoubtedly be unveiled the next few months.

Investment thesis

Societe Generale is a tough call right now. I do believe the underlying business is sound, but we shouldn’t forget Societe Generale has a large exposure to the corporate world and even a full quarter after the worldwide outbreak of COVID-19, it’s still too early to tell (or even guesstimate) what the impact on Societe Generale’s loan book will be. I strongly believe the “cost of risk” (the impairment charges) in Q1 will accelerate in the next few quarters and Societe Generale’s main priority should be to keep its balance sheet healthy.

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The bank still handsomely meets the minimum CET1 requirement so I don’t expect any immediate issues but I’m fully on board to keep the dividend within the bank to offset potential losses. It makes no sense to prematurely resume dividend payments until the total impact becomes clear.

SocGen has been paying a 2.20 EUR dividend over the past three years and I don’t think we’ll see that level back anytime soon. But even if SocGen would keep the dividend at half that pace (1.10 EUR per share), the current dividend yield of around 8% could be attractive for investors who believe in a V-shaped recovery.

Source: screenshot interactive brokers

Due to the elevated volatility, the option premiums on writing put options on Societe Generale are quite attractive. As you can see above, writing a P13 for September would result in an incoming option premium of around 0.90 EUR.

While SocGen clearly isn’t out of the woods yet, everything boils down to whether or not its cost of risk assessment of 100 base points is credible, and if there will be an additional fallout in FY 2021. So, 2020 will per definition be a semi-lost or a lost year, but things could be looking up again in 2021 if no new skeletons fall out of the closet. I currently have no position in SocGen but I’m looking to establish a new long position before the Q2 results come out. Depending on the updated guidance, I may expand that position aiming to lock in the dividend for the long haul.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I may write some put options on Societe Generale.



Via SeekingAlpha.com