CRARF - Credit Agricole: Dividend Yield At 10% Means It's A Buy

2023-03-30 09:44:41 ET

Summary

• We outline 5 additional risks to consider. We see limited EU banking exposure toward the US.
• Solid margin of safety with a current dividend yield higher than 10%.
• There are positive MACRO and MICRO reasons to buy the French bank. Our target price is confirmed.

Here at the Lab, we recently did a deep dive into the EU financial banking environment. Our most devoted readers are probably well aware of our latest publications; however, we recommend that our followers check up on our previous articles so that they are well-informed of the EU banking story up to now ( ISP , BNP , UniCredit, and SocGen ). Once again, before analyzing Crédit Agricole's ( OTCPK:CRARF ) latest news, it is important to review our MACRO thesis. From the day of the Silicon Valley Bank crash, some Old Continent financial institutions have burned about a quarter of their value on the stock market in less than three weeks. Paradoxically, looking at the stock price performance, it seems that the crisis is stronger among European banks than among US ones. Speculation (primarily on credit default swaps), Credit Suisse's (CS) panic, and estimated higher cost of risks weighed heavily on the EU banking environment. But is it only this? For a better answer, we need to start analyzing the market concerns. Although very vaguely, there are at least five fears surrounding the EU banking system: 1) derivatives, 2) exposure to the US commercial mortgage market, 3) potential losses deriving from Government bonds (hold to Maturity), 4) Tier 1 securities market " killed " by the Swiss authority decision, 5) deposits and liquidity maintenance.

According to all the coefficients published by the EBA , the European banking system is solid. On average, the primary capital CET 1 is at 14.8% with a liquidity coverage ratio of 162.5%. Bad loans are only 1.8%.

Why are we still positive?

1. According to Deutsche Bank's 2022 financial statements , the bank has derivative contracts outstanding for a notional value of approximately €42.500 trillion. This is a gross value and is in line with US banks. JPMorgan (JPM) held $54.3 trillion, Goldman (GS) $51 trillion, and Citi (C) $46 trillion. Despite the huge numbers, the notional value is not in itself indicative. What matters is the real exposure to counterparty risk. Due to the various reforms (after the Lehman crash), most derivatives require a Central Counterparty that stands between two contracting parties, canceling the risk that one of the two will fail. If you look at Deutsche Bank's (DB) balance sheet, we find that most derivatives use a central counterparty. About €13 trillion remain without them. But even these should be protected by " collateral " guarantees. It is very difficult to understand the actual risks; however, there are at least two factors that mitigate the downside risk. On a quarterly basis, each bank must enter the derivatives at market value. So, if these financial instruments have losses, at year-end numbers, they should have already emerged. The second mitigation is the fact that the derivatives market is no longer what it was in 2008. In the meantime, the legislation has become very stringent and prudent, starting with the greater role of central counterparties;
2. The other concern is the European bank's exposure to the US commercial real estate sector. Will European banks feel the blow? The answer is likely yes. According to DWS , EU banks have exposure to global commercial real estate equal to an average of 6% of total loans, compared to 36% of US regional banks and 16% of large US banks. Once again, EU banks seem (not immune) but more protected;
3. There are Government bonds that are frozen in the EU bank environment balance sheet. These are not written down because they will be " held to maturity ". The problem emerges if the bank is forced to sell them before their expiration. This is what happened to Silicon Valley Bank. However, as already emphasized in the SocGen article, the EU banking sector is more diversified. The higher liquidity coverage ratio also provided an additional margin of safety;

4. When the Swiss authorities decided to write off Credit Suisse's Additional Tier 1 notes without writing off the share value, it came as a shock to the market. There was panic among all holders of AT1 qualifications. As already mentioned, if EU banks decided to issue new shares to replace the AT1 note, this would generate an average loss on earnings per share of approximately 10%. A drama? We don't believe so.

So why do we still like Crédit Agricole?

Since the FY results, the company was not immune to the recent sell-off and this provide an opportunity to re-enter at a reasonable price.

1. Here at the Lab, we have a positive view of Crédit Agricole's Italian exposure. We really deep-dived into the Italian banking market and Banco BPM investment (CASA owns a 9.18% equity stake already proved to be the right one). Details are in Crédit Agricole And Its Italian Optionality Part 1 and Part 2;
2. In the meantime, the ECB increased its key interest rates by 50 basis points, and this will provide additional margin expansion in Crédit Agricole earnings;
3. The bank has an immaterial exposure toward Russia;
4. There is a margin of safety provided by a DPS of €1.05. At today's price, the group is yielding higher than 10%;
5. We much liked the ' Ambitions 2025 ' Plan and the company raised the bar on profitability targeting a ROTE of more than 12%. As a reminder, looking at the EU banking, the estimated ROTE is at 11% and 12% in 2023 and respectively;
6. CET1 ratio is above 11% and the bank has a low cost of risk (Fig 1). Important to note is the solid asset quality demonstrated by a low non-performing loans ratio (Fig 2);
7. In the Q4 comment, the bank confirmed its 2025 financial targets. At this stage, we left our earnings estimates unchanged (this is also due to the fact that ECB's latest rate hike was incorporated in our 12-month visible period). Despite that, Crédit Agricole is trading at a discount versus its historical average on its Tangible Book Value (0.45x versus 0.6x). In addition, at the aggregate level, EU banks are trading at a TBV of 0.8x. Therefore; Crédit Agricole's valuation is not justified and we confirmed our buy rating target at €13 per share ($7 in ADR).

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