MBFJF - Sumitomo Mitsui Financial: Taking Profits Risk Reward Profile Less Attractive

2023-09-14 09:55:37 ET

Summary

• Sumitomo Mitsui Financial Group's shares offer a low 3.4% dividend yield and a slowing earnings growth profile.
• The potential exit of Japan from ultra-low interest rate policies could negatively impact banks, with falling loan growth and increasing credit costs.
• The bank's medium-term plan focuses on wealth management and foreign currency deposits to cater to Japan's aging demographics, but the outlook for growth appears limited.

Investment thesis

Sumitomo Mitsui Financial Group (SMFG) shares currently offer a relatively low 3.4% dividend yield and a slowing earnings growth profile. With Japan looking more likely to exit ultra-low interest rate policies, we believe this will be negative for banks, with falling loan growth and increasing credit costs. Taking these issues into account, we downgrade our rating from buy to neutral.

Quick primer

Sumitomo Mitsui Financial Group is a Japanese commercial and retail bank with a primarily conservative domestic focus. Its 'megabank' peers are Mitsubishi UFJ Financial Group ( MUFG ) and Mizuho Financial Group ( MFG ). Its investment banking division is called SMBC Nikko Securities.

Key financials with consensus forecasts

Net business profit per business division - FY3/2023

(Retail is the domestic consumer business, Wholesale is domestic wholesale, Global is international trade finance and Global Markets is investment banking).

Updating our view after 12 months

We are updating our buy rating from October 2022, where we felt that the dividend yield was attractive and negative newsflow in regard to the investment banking business was priced in.

SMFG's shares benefitted from post-pandemic recovery demand for loans, transaction fee growth, and falling credit costs YoY in FY3/2023. With the Bank of Japan looking more likely to scrap its ultra-low interest rate policy by loosening its grip on 10-year JGBs in July 2023 , this has acted as a tailwind for the Japanese banking sector with the prospect of improving loan spreads and increasing net interest income.

The bank announced a new medium-term plan in May 2023 ( page 22 ), with the core earnings drivers being wealth management and foreign currency deposits. A core recurring theme is Japan's aging demographics, where more individuals facing 100-year lifespans will require more sophisticated financial products to generate income.

Japan's export-driven economy has benefitted from a weak Japanese yen. However, Q2 2023 GDP growth was revised down to 4.8% from 6.0%, as households and companies cut back on domestic spending. We want to assess the outlook for the bank if interest rates are increased, and whether aging demographics will be a positive for the business.

Entering unchartered territory with potential interest rate hike

With Japan's economy having been reliant on ultra-low interest rates for over two decades, we believe any change will result in downside risk from the perspective of a country's psychology that has been used to a deflationary environment. Whilst cash-rich companies and individuals may feel somewhat richer, we see the initial problems coming from 'zombie' corporates who have been allowed to exist under extremely helpful credit conditions - they will be vulnerable, and potential negative headlines about insolvencies and layoffs will be negative for sentiment. Current price hikes are tightening purse strings, and there were signs of this in household spending falling 5.0% YoY in July 2023 (although these monthly statistics can be volatile).

Japan's core inflation was 3.2% in August 2023 , which remains on the lower end of the range for developed economies. It is highly unlikely that interest rates will be raised to a similar level to the US, Europe, and the UK. However, market dynamics will change to make it harder to generate earnings, as both consumption and business investment activity will likely fall with a rate hike. We believe this will result in banks needing to raise loan provisions as well as experiencing stunted loan growth demand. Japanese companies are already seeing asset impairments on overseas acquisitions from rising interest rates and a resultant slowing economy; this risk could spread to become a domestic problem.

Impact of an aging population

A mature domestic market poses problems for a conservative stay-at-home player such as SMFG. The biggest risk is the declining demand for home mortgages and the opportunity to develop high customer LTV (lifetime value). The growing focus on providing wealth management services as well as foreign currency deposit facilities (with relatively higher interest rates) is expected to be in high demand, driving net fee income.

Japan has a sizable population of High Net Worth Individuals ( over 3 million ) and we believe many of them already have access to multiple financial services. The aging demographic is having a massive impact on business succession planning which is driving business for corporate advisory firms such as M&A Capital Partners (MNACF), as well as for estate planning services such as Aoyama Zaisan Networks (FUZAF) - Japan has the highest tax band rate in the world for inheritance at 55% .

Whilst it is reasonable to assume that Japanese people in/or approaching retirement will seek more risk to gain higher returns for their cash, we believe that the majority of SMFG's customers will not be HNWIs and will be relatively risk-averse . Increasing assets under management will therefore be challenging, given the relatively low level of financial literacy and risk appetite. There is also significant competition from domestic peers as well as overseas firms seeking capital. Currently, we do not get the impression that SMFG has a competitive wealth management offering that will drive its domestic retail business ahead of its peers.

Valuation

On consensus forecasts (please see the Key financials table above), the shares offer an FY3/2024 3.4% dividend yield and PER 11.4x which is not that attractive. The current prospective ROE of 6.7% is still on the low side, and market expectations are of relatively slow loan growth into FY3/2025 and FY3/2026 indicating limited growth prospects. With net income growth dropping back down to low single digits YoY in the medium term, the shares do not look compelling. With slowing growth, we believe valuations are no longer attractive and downgrade to a neutral rating.

Thesis catalysts

There were no positive surprises in Q1 FY3/2024 results, and we are not expecting any major changes QoQ. Whilst the company will likely announce a share buyback program soon (postponed from May 2023) which is positive, we believe this is expected and not a surprise.

Risks of The Thesis

The company could embark on major efforts at overseas business expansion to boost growth prospects. Although current measures are based on partnerships, there could be future acquisitive growth. Major domestic demand for wealth management services could arise as Japan enters a normalizing interest rate environment.

Conclusion

SMFG's shares have performed well over the last 12 months, but we believe the outlook points to slowing growth. The company's medium-term plan highlights its core challenge of a mature domestic market, but current initiatives in the form of growing wealth management and foreign currency deposit services would appear to have limited impact. With the dividend yield on offer at only 3.4%, we downgrade our rating from buy to neutral.

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