Sumitomo Mitsui Financial Group is a strong play on Japan recovery

The Japanese banking sector hasn’t exactly enjoyed the best time of it in recent years, with economic conditions still subdued as the country emerges from decades of deflation. The Bank of Japan’s negative interest rate policy (NIRP) has also become a further problem to earnings.

The outlook may be improving, with manufacturing and consumer activity on the up (household spending in August saw the biggest rise in three years). Long-term Japanese bond yields also look to be breaking to the upside, which should boost net interest margins and sentiment towards a sector which is trading at a depressed valuation.

This bodes well for the mega-banks, including Sumitomo Mitsui Financial Group (SMFG) which is off to a good start in the first quarter of the 2019 financial year, and is almost a third of the way towards its year-end profit target. The bank continues to achieve this, being the lowest-cost operator amongst its peers, while maintaining decent levels of growth.

For the first quarter, the bank made good progress at its fee-based business and on the cost front. Ordinary income (interest + non-interest income) rose 4.8 per cent to ¥1.426 trillion, despite headwinds from the BoJ’s NIRP.

The bank also continues to push through with its “next stage” initiative. Management intends to expand more in Asia, build up a broader international presence and grow the lucrative wealth management and wholesale banking businesses.

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Management’s focus on higher-yielding, though riskier, retail areas  (individuals & SMEs) has reaped rewards, and resulted in the bank attaining a superior interest spread (0.98 per cent) to peers such as Mitsubishi UFJ (0.88 per cent) and Mizuho (0.82 per cent).

The fee business performed, with trusts fees and commissions increasing 7 per cent to ¥255.04 billion.

Lower costs

On the cost side, operating expenses fell 5.5 per cent to ¥428.8 billion. SMFG also has shown stronger cost management than peers, with an overhead ratio of 59.6 per cent (versus 69.6 per cent and 74.6 per cent for Mitsubishi UFJ and Mizuho respectively).

Overall consolidated net business profit rose 3.7 per cent to ¥314.39 billion. Attributable profits of ¥227.08 billion were down slightly on last year (3.7 per cent) but still put the bank well on target to achieve a financial year 2019 target of ¥700 billion.

Overall total loans dipped 1.2 per cent year on year to ¥74.9 trillion. Management, however, continues to focus on improving badet quality by reducing exposure to “volatile” segments such as resources. An improving prognosis for Toshiba (which is undergoing divestments) is another positive with the tech giant one of the largest domestic borrowers.

Improving credit quality is also clear in SMFG’s non-performing loans ratio  falling from 0.96 per cent to 0.72 per cent. Capital-wise SMFG is also in great shape, with a common equity tier 1 (CET1) ratio of 14.7 per cent, up 210 basis points year on year. This is well above internal targets of 10.0 per cent and the regulatory minimum of 6.5 per cent.

Overall, we see SMFG as a strong play on a recovery in the embattled Japanese banking sector, and on the back of rising long-term interest rates, a rebounding economy and the scope for policy changes. A price to book ratio of 0.6 times and a financial year 2019 earnings multiple of 9 times make for a very undemanding valuation in this scenario.

Greg Smith is the head of research at investment research and funds management house Fat Prophets. Interests badociated with Fat Prophets declare a holding in SMFG. For a free trial of Fat Prophets’ daily market commentary please click here.