SSUMF - Sumitomo Corporation: Resilient Fundamentals Support Capital Return Upside

Summary

• Sumitomo’s diversified businesses continue to deliver solid earnings through the uncertain macro backdrop.
• While the decline in commodities has weighed on the resource side, the China reopening tailwind should help.
• With management also taking another step toward returning more capital to shareholders, Sumitomo is worth a look.

The major Japanese trading houses like Sumitomo Corp (SSUMY) have held up well over the past year (relative to the TOPIX index) despite the commodity price headwinds in H2. A key reason for the outperformance is their diversification, with strong earnings in the non-resource businesses offsetting any weakness on the resources side. Like its peers, Sumitomo reported a strong quarter, all things considered, with the move to accelerate its capital return via a share buyback program (a first for the company) marking a notable improvement in governance. With the post-COVID China reopening offering a near-term tailwind for the resources business as well, expect a step up in shareholder returns for the next fiscal year. Given the low payout ratio, maintaining dividends at current levels should have a limited impact on balance sheet flexibility and, by extension, the company's ability to reinvest for the long term. For now, the current net profit target remains intact and should adequately support a steady increase to the JPY115/share dividend guidance for FY22. Trading at a ~5x P/E valuation, Sumitomo is worth a look here.

Reaping the Benefits of Diversification

Sumitomo's intact Q3 profitability led to solid cumulative YTD (i.e., fiscal Q1-Q3 2022) profits of JPY464bn. The key driver was the non-resource businesses, led by automobile distribution and leasing operations, while the metal products segment also benefited from resilient steel tube demand. This helped to offset P&L weakness in the commodities business, which suffered from the declining output at the Ambatovy project (a Madagascar industrial operation related to mining and refining nickel and cobalt) due to maintenance and a slowdown in gas trading activity. Elsewhere, infrastructure earnings were also impacted by increased electricity purchasing costs, while the lack of proceeds from real estate sales (skewed towards H1) also weighed on the headline numbers.

With overall profitability resilient, the FY22 headline net income guidance remains unchanged at JPY550bn (+19% YoY). By segment, though, guidance for metal products was raised ~JPY10bn on expectations for continued steel pipe demand and a favorable pricing environment. Similarly, the Q3 strength in Transportation & Construction systems led to a JPY7bn guidance raise on sustained leasing and auto demand resilience against the macro headwinds. On the other hand, the negative impact of electricity prices led to downward revisions across Infrastructure and Media & Digital, while Mineral Resources, Energy, Chemical & Electronics were also guided lower due to disruptions at the Ambatovy project and headwinds at the Bolivian businesses.

China Reopening Tailwind for the Resource Operations

Despite the P&L headwinds for the resource operations in the back half of the fiscal year on declines in key commodities like coal and iron ore, the easing of zero-COVID restrictions in China could drive some upward revisions in the coming months. Expect more of the same from here, as seasonally strong business conditions in China in the spring (which tends to be accompanied by seasonally strong steel demand) are set to be supported by a contraction in Australian coking coal supply as the region enters a rainy season.

Over the mid to long-term, coking coal volumes should also see some added benefit from its Australian coal businesses, as the easing of import restrictions in China looks to be here to stay. Net, the combination of a recovery in resources and continued fundamental strength in the non-resource businesses post-Q3 should keep the earnings growth algorithm supported, in turn supporting stock prices in the near term.

Announcing a First-Ever Buyback

The major surprise coming off the Q3 results was perhaps Sumitomo's share buyback program announcement of up to JPY50bn or 33m shares from February through April. For context, this is equivalent to ~3% of shares outstanding (excluding treasury stock). After the buyback is concluded, management has outlined plans to retire all the repurchased shares by mid-year. So while the FY22 dividend guidance remains unchanged at JPY115/share, the addition of a buyback marks an important shift in the company's capital return philosophy. And with management also targeting a 35% dividend payout ratio post-FY22, all signs point to higher shareholder returns from here.

While the latest buyback announcement is in line with H1 commentary regarding additional shareholder returns, this move is a significant step in Sumitomo improving its governance and boosting ROEs. Even if the resource P&L proves to be more volatile than expected, the steady earnings stream in its non-resource businesses should be more than enough to support the payout. The only concern from here is whether the capital return comes at the expense of growth investments and strengthening its overall financial position. Assuming no material change to the mid-term plan, though, there remains ample buffer, and thus, higher dividends should not impede flexibility or long-term competitiveness.

Resilient Fundamentals Support Capital Return Upside

Having moved into investors' radar following Berkshire's ( BRK.A ) investment in 2020, the Japanese trading houses have continued to outperform the broader market (proxied by the TOPIX index), even through the commodity headwinds in H2 2022. On the back of strong earnings in its non-resource businesses, Sumitomo again delivered a resilient bottom-line result in Q3 and followed up with a surprise buyback announcement. Alongside the prospect of higher earnings over the next fiscal year as China reopens, the focus is now on the shareholder return outlook, with ample upside left relative to the conservative dividend payout ratio. The key near-term catalyst will be progress updates on the current mid-term plan, particularly on projected earnings and investment needs; visibility here will be key to underwriting a sustainably higher shareholder return scenario.

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