Sumitomo Corp: Time to sell when valuations look cheap
Sumitomo Corp (OTCPK:SSUMF) is currently experiencing an increase in earnings visibility driven by rising natural resource prices. We have calculated that all things being equal, the company’s net income could increase by 20% year-over-year in fiscal year 3/2023, which would translate into a potential dividend yield of 6.5% . However, given our limited expectations for the sustainability of earnings at record highs and management’s attitude to pay stable dividends, we are short on the stock.
Sumitomo Corp is one of Japan’s “top 4” trading houses with relatively low exposure to natural resources. It is known for its stable operations in retail/real estate and services such as supermarket chain Summit, internet service provider JCOM and IT consultancy firm SCSK (OTCPK: SCSKF). However, the recent commodity price spike has significantly skewed its earnings mix in favor of natural resources.
Key financial data
Revision of the composition of the net result for the financial year 3/2022
The spike in commodity prices caused by the Russian invasion of Ukraine had a major influence on Japanese trading companies, including Sumitomo. In this piece, we want to assess the following:
- if possible, quantify the impact on FY 3/2023 net income of increased resource prices, assuming all business, including non-resource business, remains flat year-on-year the other.
- Assess what kind of impact non-resource activities will experience in the face of a macro downturn.
We will take each in turn.
Sumitomo Corp discloses the sensitivity of net profit to price fluctuations in its commodity trading. We took current market prices and calculated the annualized impact on net profit. Assuming all businesses remain stable year-on-year, we estimate net profit for the forward-looking year (FY3/2023) and, using the payout ratio of 30%, we derive a dividend forecast .
Our estimate of net income for the 3/2023 financial year
Our analysis shows that, all things being equal, FY 3/2023 net profit will see a 19.8% year-over-year increase due to the impact of commodity price increases – the consensus forecast do not yet appear to have adjusted to recent price trends. If the company sticks to its mid-term dividend payout rate of 30%, that equates to a significant upside resulting in a prospective dividend yield of 6.5%.
The key question is whether these returns are sustainable. We believe that regardless of what happens to commodity prices in the future, the company’s management will not pay such a high dividend due to its fundamental approach of paying long-term stable returns and to avoid excessive volatility. The risk the company faces is the specter of a negative dividend cut when market conditions begin to normalize, although the timing of such an event is unknown. In conclusion, we believe that shareholders will not directly benefit from the benefits of this period of high commodity prices.
Next, we assess the impact of a global macroeconomic slowdown on its non-resource businesses.
Non-resource activities facing challenges
Sumitomo Corp has limited exposure to Russia itself (mainly car sales) and the CIS (the Commonwealth of Independent States, including Belarus and Ukraine).
Looking at each business division, we believe the overall short-term outlook is stable, helped by its Infrastructure and Media & Digital businesses. However, there are risks that the business will have limited ability to mitigate. We believe the main issues are as follows.
First, COVID-19 has not gone away. While European countries like the UK have completely opened up and even Japan has opened its doors to foreign visitors, China does not seem to have Omicron under control. New cases continue to rise in Vietnam and Southeast Asia overall remains in a fragile state. This raises the issue of semiconductor shortages that will negatively impact the company’s businesses in metal products and transportation and building systems.
Rising commodity prices will have a ripple effect on demand and profitability for Metal Products, which trades steel, non-ferrous metals, specialty metals and tubular products for the energy industry . Rising fuel prices will put pressure on logistics costs, which will affect retail operations as well as automotive demand.
We believe the outlook is one of earnings stability, but material growth will remain difficult to execute.
With the leverage ratio remaining at manageable levels (1.25x in Q3 FY3/2022), there do not appear to be any major credit risks facing the company. There are 325.5 billion JPY/2.8 billion USD of bonds and borrowings due next year which can be covered by its cash and cash equivalents or refinanced.
We will not refer to consensus forecasts as they do not appear to reflect changes in the resource market. If we use our FY 3/2023 net income estimate of JPY 551 billion/USD 4.7 billion (an all-time high), the resulting P/E multiple is 4.6x with a dividend yield of 6.5% (based on a payout ratio of 30%). However, we believe that these estimates are very high.
If we take the midpoint between the current FY3/2022 net profit forecast and our indicative estimate of JPY551 billion/USD4.7 billion, the result of JPY505 billion/USD4.4 billion equates to a PER multiple of 5.1x. This looks like a more realistic valuation and although still very cheap, we believe this is not a positive indication.
We question the sustainability of these revenue levels – historically Sumitomo has had a very inconsistent revenue profile. Second, the stock price tends to fall after the company hits new relative highs in net profit for the year – we believe this is because the market is starting to appreciate the unsustainability of these benefits. From there, we think Sumitomo shares should be sold when P/E multiples are cheap and bought when they are high (or in negative net income territory).
Net Income Levels vs. Year-End Share Price
The major upside risk is if we are at the start of a prolonged cycle of high resource prices. If price increases continue, this will help offset lower end demand, putting the company in a strong position with high earnings visibility.
If management decides to pursue a strict payout policy of 30% in fiscal year 3/2023, we will see a significant year-over-year dividend increase which we believe will be received positively by the market.
The downside risk stems from the fact that the dividend payout for fiscal year 3/2023 is below 30%, which signals a relatively negative message from management to the market regarding shareholder returns.
Business activity being softer than expected in non-resource businesses would also be negative for the earnings outlook.
Sumitomo’s share price rose on its exposure to natural resources. However, we believe this is not a sustainable driver of company earnings and should be viewed as an opportunity to sell the stock. The risk is that the dividend payout in FY 3/2023 will be 30%, offering a potential yield of around 6.5%, but given management’s fundamental objective of paying a stable dividend , we think this scenario is unlikely.