SMFG - Sumitomo Mitsui Financial Group Aims For Streamlined Growth And Remains Undervalued

2023-06-28 08:44:49 ET

Summary

• Sumitomo Mitsui Financial Group has reported a 39.51% YoY increase in Q1 revenues, reaching $13.66bn, despite a 57.25% decline in net income. The bank's strategy focuses on becoming a leaner, streamlined business with a focus on digitalization and geographic expansion across Asia and the US.
• The bank is currently undervalued, with a net present value of $9.28 compared to its current price of $8.40, according to a discounted cash flow valuation. This undervaluation is also supported by Alpha Spread's intrinsic valuation, which calculates a base case fair value of $17.14.
• However, SMFG faces potential risks including shifts in domestic monetary policy, global economic slowdown, and recessionary pressures. Despite these challenges, the bank's transformation into a leaner business and geographic expansion strategy are expected to enable long-term margin expansion and scale accretion.

Sumitomo Mitsui Financial Group ( SMFG ) is a Tokyo, Japan-based multinational megabank with operations across retail, corporate, and investment banking verticals.

As a globally systemic bank, SMFG is prone to the macro trends of the international banking industry. Therefore, SMFG aims to capture growth opportunities and mitigate risk by addressing the expanding role of banking in the economy, the increased digitalization of retail and commercial banking, deregulation across the industry, protectionism and deglobalization, greater financial uncertainty given interest rates and inflationary pressures, and the role of social issues in business.

Through its activities, SMFG has recorded $13.66bn in Q1 revenues - a 39.51% YoY increase - alongside a net income of $300.77mn - a 57.25% decline - summing up to a TTM free cash flow of $13.68bn.

Introduction

Although SMFG presents a diversified strategy, which involves geographic expansion across Asia and the US and judicious capital deployment, the core of SMFG's current corporate strategy is to form a leaner, streamlined business, with more effective operating expenditure, reductions of wasteful verticals, and focus on margin-expanding assets.

The combined accretive effects of this leaner business strategy, strong financial health and capital allocation, and geographic growth potential, alongside a general undervaluation leads me to rate the stock a 'buy'.

Valuation & Financials

General Overview

In the TTM period, SMFG - up 39.30% - has experienced superior price action to both the Financial Select Sector Index (CBOE:SIXM) - up 2.16% - and the broader market, represented by the S&P 500 ( SPY ) - up 12.24%.

I believe that the financial industry has underperformed the general market due to poor balance sheet convexity - since major banks in the US and Europe are fixed maturity asset-heavy - with rising interest rates in Western markets.

However, the more lax monetary policy in Japan, alongside the yen's price movements, which have dually enabled greater attraction to Japanese equities from foreign investors and greater expansion for SMFG, have separated SMFG thus far. Though I do not believe SMFG will continue to overperform at this level, strong fundamentals and the company's ability to adapt to both a weaker yen may yield long-run benefits.

Comparable Companies

As one of the 'three megabanks' with a deep-rooted presence in Japan, SMFG can best be compared to the other two megabanks in Japan, including the largest Japanese bank, Mitsubishi Financial Group ( MUFG ), and the slightly smaller Mizuho Financial Group ( MFG ). To better analyze the company's value relative to other international firms, I also chose to compare SMFG with National Australia Bank (NAB.AX) and Pittsburgh, Pennsylvania-based PNC Bank ( PNC ).

As demonstrated above, although SMFG has experienced best-in-class YoY performance and the second-best quarterly price action, the firm remains undervalued on a multiples basis, both when assessing income-oriented metrics and balance sheet-oriented ones.

For instance, SMFG maintains the second-lowest P/S ratio at 1.25, beaten only by Mizuho, and the second-lowest P/B of 0.62. Moreover, the firm is able to maintain the joint-lowest P/CF of 6.93 alongside National Australia Bank.

While SMFG does maintain a high debt/equity level, it is not out of the ordinary and immediate obligations are well-covered by SMFG's strong quarterly cash flow levels.

Valuation

According to my discounted cash flow valuation, at its base case, the net present value of SMFG is $9.28, meaning at its current price of $8.40, the stock is undervalued by ~10.50%.

My model, calculated over 5 years without perpetual growth built-in, assumes a discount rate of 10%, to account for the increased cost of capital, SMFG's relatively higher beta, and overall high debt levels. Additionally, although the firm's 10Y smoothed out - for the irregularities of the past few years - revenue CAGR is significantly greater, I estimate an average revenue growth rate of 5%, incorporating potential recessionary pressures and divestments from periphery SMFG services in its effort to become a more streamlined organization.

Alpha Spread's intrinsic valuation, which is an average of its in-house discounted cash flow and relative valuation, more than corroborates my thesis on undervaluation, calculating a base case fair value of $17.14, meaning SMFG is undervalued by 51%.

However, Alpha Spread's models fail to holistically capture the risks posed by higher debt levels, potential recessionary pressures, and a relatively volatile yen.

SMFG Fosters Growth With a Leaner Business & Dynamic Capital Reallocation Strategy

At the centre of SMFG's lean operation strategy is an accelerated focus on digital product and service offerings. For SMFG, its Olive brand is the nucleus of the strategy, enabling SMFG's interest-based activities, direct-to-consumer wealth management and payment products, and generally enhancing consumer accessibility and engagement with SMFG products and services. In doing so, the bank aims to reduce labour costs and dependency on labour to interact with consumers.

Additionally, taking advantage of a weaker yen to expand globally, SMFG has aggressively moved into Indonesia, India, Vietnam, and the Philippines, both via direct ventures and partnerships. In doing so, beyond scale expansion, SMFG seeks to augment and specialize its capabilities, for example, providing Islamic finance products in Indonesia. Such efforts have seen material success, with SMFG's India business seeing new loans increase by 50% YoY and Philippine profit increase by 70%, becoming the 5th largest private bank in the country by total assets.

Ultimately, SMFG dedicates itself to the disciplined deployment of the capital generated through streamlined operations and geographic expansion. The firm's financial priorities are threefold, maintaining a policy of opportunistic M&A, margin-centricity when it comes to reinvestment, commitment to a 40% dividend payout ratio, flexible and opportunistic share buybacks, and strong capital ratios, with a return on CET1 assets aimed at >9.5%.

Wall Street Consensus

Analysts echo my positive outlook on SMFG, projecting an average 1Y price increase of 17.04%, to a price of $9.83.

Even at the minimum predicted price, analysts forecast a price increase of 2.29% to $8.59, a positive return with investors netting even more with SMFG's dividend.

This reflects analyst opinion on SMFG's strong operational strategy, as well as favourable macro conditions, with potential currency movements and interest rate movements supporting the firm.

Risks & Challenges

Monetary Policy Shifts in Domestic Markets

While SMFG has proven itself highly capable of navigating interest-related headwinds globally, on a domestic level, the firm has depended on a relaxed monetary policy and a lower cost of capital. To deal with the potential fallout of tighter policy in Japan and major operating markets, SMFG has aimed for greater capital efficiency and a diversified balance sheet, such that it would not excessively be impacted by recessionary or inflationary pressures. However, if SMFG proves incapable of dealing with rising rates, the company may face reduced profitability.

Recessionary Pressures & Global Economic Slowdown

Although the megabank has developed its strategy around risk mitigation to recessionary pressures, the firm may face reduced demand for its products due to global liquidity and income concerns. For instance, with rising interest rates, consumers may reduce their interaction with costlier banking services. As such, SMFG may have to absorb costs or risk increasing consumer churn and reducing scalability.

Conclusion

In the coming years, I expect SMFG's transformation into a leaner business and geographic expansion with a weakened yen will enable long-run margin expansion and scale accretion.

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