No Big Beat this time

Itochu Corp. (OTCPK:ITOCY) (OTCPK:ITOCF) made a profit of 820.269 billion yen in fiscal 2022. Although this was a record result and more than double the profit for the fiscal year 2021 it was just in line with the latest forecast of 820 billion yen. This ends a series of big beats and stands in contrast to other Japanese commercial companies who still beat their most recent plans. With these results, the company will continue with its plan to pay out a year-end dividend of ¥67 per share for a total of ¥110 for fiscal 2022.

Itochu continues to have the lowest debt of its peers, although high commodity prices have allowed all five Japanese trading companies to improve their balance sheets. The company increased its equity by 26.6% in fiscal 2022 while reducing its net debt by 12.2%. Japan’s interest rates are expected to remain low, unlike the rest of the world, but Itochu’s financial situation should benefit it relative to its competitors if rates rise.

Itochu’s ADRs have been the worst performing of Japan’s top 5 trading companies since the release of Q3 results in February 2022. Tokyo common stocks were roughly flat over this period, but the weakening of the yen had an impact on dollar ADRs.

Looking ahead, Itochu expects to earn 700 billion yen in fiscal 2023, down 14.7% from last year’s results. It’s not as bad as it sounds, as fiscal year 2022 results saw several extraordinary gains from corporate sales. On a basic basis, earnings from resource-based businesses will decline 4.5% in fiscal 2023, while non-resource businesses will increase 5.6%. Overall, the plan has core earnings up 2.9%, and that’s after a 30 billion yen “buffer” to be more conservative. Without the buffer, the base earnings forecast would be up 7.2%.

I was overly bullish in my last article when I suggested that stocks were ready for a breakout. Equities remained stable in yen terms and were impacted by fears of an economic slowdown in Asia. For long-term owners, Itochu is worth premium P/E and P/B valuations relative to its peers because non-resource businesses provide less cyclical revenue and higher return on equity.

Drivers of FY2023 performance

This earnings release is the first time Itochu has released its FY2023 plan, but I attempted to make a prediction in my last post. It was based on saving extraordinary gains and losses, then adding simple assumptions about commodity prices and the growth of each segment. Overall, I came very close to the company plan, but there are some differences within the segments.

Itochu is not as optimistic as me on the energy and chemical sector. One of the key differences is that there were strong gains in chemicals trading in 2022, which the company expects will be more normal this year. The other difference is a drop in oil production volume held from 37 mboed in 2022 to 33 mboed this year. Itochu diplomatically called this “less production in upstream interests in a business environment with concern for geopolitical risks.” This appears to refer to the company’s interest in Russian oil production in Sakhalin and Eastern Siberia.

I was also overly bullish on the General Products and Realty segment. Specifically, lumber prices are not expected to be as high as in the previous estimate, and pulp prices are also down. Finally, the “Other” segment is lower in the company’s plan because it incorporates the cushion of 30 billion yen.

Most non-resource activity now looks stronger for 2023 than I originally expected. Textiles show a greater rebound from the impacts of Covid-19. ICT and finance are benefiting in IT from 5G and data center projects, while the finance side sees strength in retail-related finance and insurance. The 8th Company is now seeing the operational benefits of taking full control of FamilyMart, including the improvements it has made in product quality and marketing. FamilyMart is also benefiting from the reduced impacts of Covid-19.

Overall, the company’s forecast shows upside potential if commodity prices remain high. If they weaken, the 30 billion yen buffer should lessen the impact on the forecast.

Evaluation

Comparing Itochu to other major trading companies, it has the highest P/E at 7.56 times the FY2023 earnings estimate. It also has the highest price-to-pound ratio at 1.26. While these are “deep value” metrics for a US company, they are premium numbers compared to Itochu’s Japanese peers. These bonuses are justified, however, given the quality of Itochu. Itochu has the lowest debt ratio of the five companies at 0.54 and reduced debt last year. After a long period of highest return on equity, Itochu is now second only to Marubeni (OTCPK:MARUY) (OTCPK:MARUF), although it is still a decent 16.7%. Relatively less reliance on commodity-dependent segments should make Itochu’s stock less volatile than its competitors when commodity markets weaken.

capital management

Itochu quickly deleveraged in fiscal 2022, like all other Japanese trading companies, on the back of strong commodity profits. The debt ratio of 0.54 is down from 0.78 at the start of the year and remains the best of the group. Equity/Total Assets improved to 34.6% from 29.7%. The announced minimum dividend for fiscal year 2023 is ¥130 per share. This is an increase of 18.2% from the total of ¥110 in fiscal 2022. However, sequentially, the first-half 2023 dividend of ¥65 is only 3.2% higher than the second-half 2022 dividend. Itochu now has a forward yield of 3.5% and a payout ratio of 27.3%, close to the stated target of 30% by fiscal year 2024.

Free cash flow by the Japanese definition of operating cash flow less all investing cash flow was 839.8 billion yen in 2022, higher than 639.6 billion yen in fiscal 2021. Rising commodity prices were a barrier to operating cash flow as cash was needed to build working capital at higher prices. The numerous asset sales in fiscal 2022 generated positive investing cash flow.

Free cash flow was more than enough to cover dividend payments of 135 billion yen. The company also carried out stock buybacks of 60 billion yen, repaid debt of 349 billion yen and paid lease debts of 267 billion yen.

Conclusion

Itochu delivered a record performance in fiscal 2022, although earnings were just in line with the latest guidance. Equities have recently underperformed, especially in dollar terms, given the weakness of the yen. The stock is still the most valuable trading company, but it deserves its premium due to its low debt, high return on equity and low relative exposure to commodities. Nevertheless, there could be near-term pressures from the continued weakness of the yen and fears of an economic slowdown. If the stock reverses with the other trading companies on weak commodity prices, Itochu would be a buy due to its higher concentration in less cyclical companies.