Summary
- Itochu did not raise its annual profit or dividend forecast in the last earnings report, unlike most of its trading company peers.
- The stock continues to underperform. This could finally reverse if commodity prices weaken but the company is still more expensive than peers based on earnings and book value.
- Competitors have improved their debt levels, return on equity, and dividend growth, removing some justification for Itochu's premium valuation.
- I wouldn't sell here but other trading companies look like better buys at this time.
Core Growth Is Slowing
ITOCHU Corp. (ITOCY) (ITOCF) just issued a disappointing fiscal 3Q 2023 earnings release . Overall profit for the 9 months to date totaled ¥682.2 billion, barely changed from ¥678.9 billion in fiscal 2022. The company did have ¥81 billion less in extraordinary gains this year, meaning core profit has increased. Unfortunately, the company attributes more than 100% of the core growth to foreign exchange effects and the reduction in covid-19 restrictions compared to last year. With the yen now strengthening and most countries essentially past the pandemic, we cannot count on these factors to benefit the company in the year ahead.
Looking at factors outside of forex, we see that the more industrial-focused non-resource businesses (within Energy & Chemicals, Machinery, Metals & Minerals, and General Products & Realty) did significantly outperform vs. 2022. This was largely offset by lower performance in the more consumer-focused businesses (ICT & Financial Services, Food, and the Chinese and Thai JVs CITIC and CP Pokphand). Missing from the above slide is any mention of The 8th Company, the segment which contains convenience store chain FamilyMart. Digging deeper in the slide deck , we see that FamilyMart managed to increase customer traffic and ticket sizes, more than offsetting costs. Despite these improvements, The 8th Company only increased its core profit by ¥3 billion from last year, a small impact on overall ITOCHU results.
On top of the small year-on-year improvements, ITOCHU did not raise its full year profit forecast or its dividend forecast. This is in contrast to the other three trading companies that have already reported, all of which raised both figures.
I mentioned last quarter that ITOCHU stock was " ready to play catch-up " with its trading company peers as the less resource-focused company would not be as negatively impacted by falling commodity prices. Unfortunately, the low growth in the non-resource businesses make me question this thesis. The market seems to agree as the stock continues to underperform.
Additionally, the strong commodity environment over the last couple years has allowed competitors to improve their return on equity, lower debt, and grow dividends more quickly. This takes away some of the justification for ITOCHU's premium valuation.
More On Commodity Price Sensitivity
The argument that ITOCHU is less sensitive to commodity price changes is still a valid one, however. Like other trading companies, ITOCHU provides a sensitivity chart on how changes in commodity prices and exchange rates impact profitability.
If we annualize these 4Q 2023 sensitivities, we can estimate the impact on FY 2024 profits compared to this year, as I recently did in my article on Mitsui ( MITSY ) ( MITSF ). ITOCHU did not provide a coal price sensitivity, but I estimated one based on market price difference between 2022 and 2023 and the change in coal subsidiary profits.
We see that the total price and forex impact on ITOCHU for FY 2024 is only -¥13.8 billion, or less than 2% of the FY 2023 profit forecast of ¥800 billion. For comparison, I calculated an impact of around ¥90 billion on Mitsui next year, which is over 8% of its FY 2023 profit forecast of ¥1080 billion.
If one wants to maintain an allocation to Japanese trading companies, the math suggests that ITOCHU is still the one to own if expecting commodity price deflation or yen strength. Still, the improving picture at the other trading companies makes this argument less compelling.
Valuation
ITOCHU still has a premium valuation compared to the other trading companies. The P/E of 7.34 and P/B of 1.24 are the highest of the group. ITOCHU has long had a better balance sheet than its peers with a significantly lower debt/equity ratio. After the last couple years of strong commodity pricing however, the other trading companies have been able to reduce their debt and now all five have a debt/equity ratio in a narrow range of 0.50 to 0.58. Most peers also now have strong dividend growth and a payout ratio around 25%, although Mitsui now ranks best in class on both metrics.
Looking at relative changes compared to last quarter, we see that ITOCHU ranks lowest on profit forecast growth at zero. This also gives in the lowest improvement in forecasted return on equity. ITOCHU was one of two companies to have negative share price performance in the past quarter. Mitsubishi ( MSBHF ) stock did worse, but the company managed to improve earnings and dividends, making it the most improved in valuation metrics and dividend yield. Marubeni ( MARUY ) ( MARUF ) had strong share price performance, making it least improved on valuation and dividend yield. On an absolute basis, though, Marubeni is still cheap and has the best return on equity.
Capital Management
Itochu continued its trend of record core operating cash flows in the nine month period, although like core profits, this was helped by forex effects. The company has been active in capex and M&A, using ¥437.1 billion of cash on investing YTD.
Core free cash flow, which excludes cash flows from working capital changes, was ¥305 billion YTD. This covers the full year dividend of ¥140 per share or ¥205 billion total, plus YTD buybacks of ¥35 billion and the additional ¥25 billion recently authorized .
Looking ahead, ITOCHU has committed to a payout ratio of 30% by FY 2024 as part of its 3-year Brand New Deal management plan. If there is indeed a small reduction in profits in FY 2024 from this year's ¥800 billion, then I still would expect the dividend to grow to around ¥160, or 14% from this year's levels.
Conclusion
ITOCHU continued to post record core profit with the latest YTD results. Much of this growth was from a weakening yen and covid recovery, not the organic growth I was hoping for from the non-resource businesses. Declining commodity prices and a stronger yen could be a headwind in FY 2024, though not as large of a headwind as its peers will feel due to their higher commodity exposure.
In theory, this economic environment would favor ITOCHU over the other trading companies, but the share price continues to lag the group. The competitors have used the last couple years of strong commodity prices to pay off debt and improve returns on equity and dividend yields. As a result, the former justifications for ITOCHU's premium valuation are no longer as compelling.
If we get an extended period of commodity price deflation or yen strength, ITOCHU could still be the trading company to own. If we don't see that, the stock will continue to lag. Even so, the improvements made by peers in the last couple years have made them less risky to own, even in a weaker commodity price environment. I currently prefer Mitsui and Marubeni, both of which offer higher returns on equity at lower valuations.
For further details see:
Itochu: Not Caught Up Yet