Itochu - It's Not Easy, But It Might Be A Good Value

By Stephen D. Simpson, CFA | January 03, 2013 AAA

If you're a quant investor who loves to go through a business line by line, trading companies like Itochu (OTC:ITOCY) will either be a dream come true or a living nightmare. Like most trading companies, Itochu operates over 130 branches in over 60 countries, with about 700 subsidiaries and affiliates ... and it's not even the largest of the Japanese trading companies (trailing the likes of Mitsui (OTC:MITSY) and Sumitomo (OTC:SSUMY)).

While these large, far-flung enterprises are generally derided as hulking behemoths (and there's an element of truth to that), I wouldn't sleep on Itochu. The company has not only made a concerted effort to trim away underperforming assets, the company has also devoted increasing efforts and assets to building up its non-resource businesses, particularly those aimed at the Chinese consumer.

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Itochu, in Brief
The fourth-largest Japanese trading company, Itochu has several major business lines.

Energy and metals represent about one-fifth of gross profits and more than a quarter of assets. This segment is largely built around iron ore and coal, with stakes in major mining efforts led by BHP Billiton (NYSE:BHP) and Xstrata (OTC:XSRAY). Itochu is also involved in oil and natural gas, though to a lesser extent than its peers.

Chemicals and forest products represent about 15% of gross profits, and Itochu has become the largest handler of paper pulp in the world. Machinery and IT operations account for about one-fifth of assets and profits, and the company is active in leasing, shipping and owns the third-largest mobile phone retailer in Japan.

The most interesting businesses to me are the textiles and food operations, which make up about 12 and 27% of profits, respectively, and about 7 and 20% of assets. These are also the largest China-facing businesses, as the company not only operates apparel brands, retailers and distribution businesses, but is also involved in multiple food production, processing, distribution and retail operations - including a one-third stake in the Asia-wide convenience store chain FamilyMart. Itochu also recently expanded this business with the $1.7 billion acquisition of two businesses from Dole Food (NYSE:DOLE).

SEE: Biggest Merger and Acquisition Disasters

Resources Are too Big to Ignore
More than 20% of Itochu's gross profits and nearly half of its net profits are tied to resource businesses, so clearly this is a highly significant business to the company's fortunes. As most readers likely know, Japan has a huge industrial economy, but relies heavily on imports for inputs like coal and iron.

By and large, Itochu needs iron ore prices to be above $100/mt to fare well. With prices spiking from about $115 to over $140 in December, that doesn't seem like such a big worry right now, but prices have tested that $100 level more than once in recent memory.

It's also worth noting that there are execution risks to Itochu's resource operations - the company has had difficulties with its Mongolian coal assets, while its consortium in Australia had to sue to move forward with the Wandoan project.

The Bottom Line
Investors have plenty of options for adding exposure to Japan to their portfolio, including several ETFs. The downside with ETFs, though, is that they're largely passive investments. Itochu is a living, breathing company where superior strategic and capital allocation decisions can be expected to lead to better returns. Moreover, with about three-quarters of the company's revenue tied to Japan, it thrives (or not) with Japan. All of that said, the stock of Itochu does trade pretty closely in sync with the iShares Japan ETF (ARCA:EWJ).

SEE: 6 Popular ETF Types For Your Portfolio

Itochu is a difficult company to value, and there are multiple alternative methods. Historically, these shares have traded above book value and buying below book value has been a good move, and the stock is slightly below book value today. Other alternative valuation methods include discounted cash flow (which suggests a fair value in the high $20s on the basis of a free cash flow growth rate in the low single digits) and a return on equity model akin to how banks are valued - with a projection of a mid-teens return on equity pointing to a fair value in in the mid-to-high $20s.

Itochu is a difficult stock to follow, and investors who believe in thoroughly understanding every aspect of a company should likely steer clear. For other investors, though, particularly those looking to add growing exposure to the Chinese consumer with both a good dividend and sound valuation, Itochu is worth more than just a cursory glance.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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