Home Commercial book Sumitomo Mitsui Financial Group: Embedded Negative Prices, Offering Attractive Yield (SMFG)

Sumitomo Mitsui Financial Group: Embedded Negative Prices, Offering Attractive Yield (SMFG)

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Andrii Dodonov

Investment thesis

Sumitomo Mitsui Financial Group (NYSE: SMFG) has faced significant headwinds over the past 12 months with exposure to Russia and market manipulation within its investment banking arm Nikko Securities. However, with its core business performing stably, we believe that the the prospective dividend yield of 6.2% is attractive. We reiterate our buy rating on equities.

quick primer

Sumitomo Mitsui Financial Group is a Japanese commercial and retail bank with a predominantly conservative domestic orientation. Its “megabank” counterparts are Mitsubishi UFJ Financial Group (MUFG) and Mizuho Financial Group (MFG). Its investment banking division is called SMBC Nikko Securities.

On September 28, 2022, Japan’s FSA issued its fourth administrative action against SMBC Nikko Securities, following the Securities and Exchange Surveillance Commission’s announcement of its recommendation for administrative action against the company. The FSA is considering a partial business suspension order and is also considering administrative action against parent company Sumitomo Mitsui Financial Group. Negative issues cited include a “sales-oriented corporate culture” and “low awareness of legal compliance.”

The watchdog slammed the company for “undermining market fairness” and filed criminal charges against SMBC Nikko Securities for allegedly manipulating the stock prices of Koito Manufacturing (OTCPK:KOTMY), Mos Food Service (8153) and other companies in connection with block trading. The Tokyo District Procuratorate charged the company’s former vice president and other executives with violating the Financial Instruments and Exchanges (Market Manipulation) Law by illegally buying shares.

We would like to update our view from our August 2021 Buy rating, which was based on expectations of improved shareholder returns given SMFG’s well-capitalized balance sheet.

Key financial data, including consensus estimates

Key financial data, including consensus estimates

Key financial data, including consensus estimates (Refinitiv, company)

Breakdown of net corporate profits by business unit (FY3/2022)

Breakdown of net corporate profits by business unit (FY3/2022)

Breakdown of net corporate profits by business unit (FY3/2022) (Company)

Our goals

We would like to update our view from our August 2021 Buy rating, which was based on expectations of improved shareholder returns given SMFG’s well-capitalized balance sheet. Stocks corrected 20% – time to add or sell?

The photo (ignoring Nikko Securities)

Japanese banks have outperformed their global counterparts since the beginning of 2022, the main reasons being 1) the limited contribution of global market activities (such as investment banking) 2) their relatively overcapitalized balance sheets and 3) a prudent management which resulted in predictable credit costs. Essentially, Japanese banks are stable, sluggish businesses, and even when they’re in a cloud with negative reputational issues according to SMFG, equities don’t significantly underperform their peers (chart below, relative performance of shares since the beginning of the year).

Chart
Data by YCharts

SMFG’s FY3/2023 first quarter results showed surprisingly strong performance, albeit from a low year-on-year base, with ordinary earnings growth of 64% year-on-year ( slide 5). Growth was driven by the following factors.

Retail businesses saw the strongest growth in capturing payment fees, driven by the late but materializing cashless market in Japan, for both acquirers and issuers. As consumers and merchants embrace credit and debit cards, e-money and QR code payment, this has become a new revenue driver in what was a predominantly cash-based market.

Wholesale operations have seen steady year-over-year improvements, but with fluctuating foreign exchange markets, money transfer fees have been particularly high. The loan book grew 14% year-on-year as credit appetite resumed, and asset quality saw continued improvement with lower credit costs and non-performing loans falling to 0.92 % quarter-on-quarter vs. 1.08% in FY3/2022.

SMFG suffered a 100 billion yen/$0.7 billion impact on exposure to Russia in fiscal year 3/2022, and we estimate there will still be losses to absorb over the course of fiscal year 3/2023. However, the company’s statement indicates that additional impairment for the aircraft leasing business is $0.46 million, and that additional credit costs, as well as expropriation charges for the local subsidiary, may occur; we believe these will be significantly lower overall year-over-year, with some benefit if insurance claims are received for the aviation sector. Expecting a gradual recovery, SMFG has increased its exposure to aviation with the acquisition of Goshawk, which should provide accretive earnings in the medium to long term.

Recent trading shows that SMFG is operating on a stable and sustainable basis, although global markets are visibly weak, which contributed 25% of the company’s total net profit in fiscal year 3/2022 – we review that afterwards.

Implications for Nikko Securities in the future

After major insider trading cases, the Japanese regulator takes the example of Nikko Securities, the brokerage arm of SMFG. In practice, this is negative for the business as it will prevent participation in lucrative investment banking activities such as IPOs and other equity offerings as key bookrunners, as well as underwriting of corporate bond issues. As a result, Nikko saw its net operating income drop almost 40% year-on-year in the first quarter of FY3/2023.

Despite this negative development, from a share price perspective, we believe this episode has been priced in. There will be ongoing review by the regulator, but we expect SMFG to respond appropriately by ensuring it becomes compliant and showing improvements and changes within its organization. On a positive note, global markets are not the bank’s biggest contributor to earnings, unlike peers such as Mizuho and other investment banks such as Nomura (NMR) and Daiwa (OTCPK:DSEEY).

Unless further negative issues are uncovered at the bank, we believe Nikko Securities present relatively low risk to stocks at this time. Either way, this branch of investment banking is set to become more conservative than before. A lack of momentum can be seen as a negative, but given that Nikko Securities is effectively a relatively new operation created in 2009 (since Citigroup bought the original high-quality brokerage and SMFG broke ranks with a partnership with Daiwa ), its history is relatively short and acted inappropriately in order to catch up with established domestic peers – the risk profile is set to decline, which is a positive.

Evaluation

Based on the consensus forecast (see Key Financial Data table above), the prospective dividend yield is 6.2%, on an ROE of 6.3%. We believe that the negative events that have influenced stock price performance over the past 12 months are no longer a long-term concern. On this basis, we believe that the proposed dividend yield is attractive.

With a relatively robust start to FY3/2023, we believe the JPY220 dividend outlook is not under threat. The 100 billion yen/$0.7 billion share repurchase program scheduled for FY3/2022 has not started yet – we expect it in the first half of FY3/2024 once macroeconomic conditions will begin to stabilize.

Main risks

The upside risk comes from the announcement of an accelerated share buyback program, the restart of the initial program from fiscal year 3/2022 as well as an additional program. If the company maintains its policy of a 40% dividend payout ratio, any rise in the earnings forecast for fiscal year 3/2023 could mean a noticeable increase in dividends year-on-year.

Downside risk comes from Russia – while we believe the losses booked in FY3/2022 are sufficient, there is an overhang from new credit costs and a delay in insurance payouts for aeronautical activity. Any significant increase in the borrowing costs of its overseas loan portfolio could pose problems for its core business of commercial banking.

Conclusion

SMFG has faced significant headwinds over the past 12 months with exposure to Russia and market manipulation within its investment banking arm Nikko Securities. We believe that these problems have already been taken into account and that in the long term they do not present a major risk for the bank. With a stable dividend yield of 6.2%, we believe the stock remains a buy.