Japan's trading houses rethink strategy

With their extensive intelligence networks and broad global footprint, Japan's trading houses historically have been reliable sounding boards on topics ranging from energy supply and diplomacy to the world economy.

It is no coincidence that Prime Minister Shinzo Abe meets regularly with their chief executives, just this month [April]spending two evenings with the heads of Mitsubishi and Marubeni.

Yet the instincts of Japan's sogo shoshafailed them when it came to reading the commodity cycle, with many embarking on a shopping spree for resources assets just as commodity prices were reaching their peaks.

The country's top five trading houses - Mitsubishi Corp, Mitsui & Co, Sumitomo Corp, Itochu Corp and Marubeni - have warned of combined impairment losses exceeding $5bn, mainly on oil and gas assets, for the fiscal year that ended in March.

As of the end of December their combined net interest-bearing debt totalled $177bn - roughly double the level of five years ago.

Analysts say the trading houses now stand at a crossroads.

Japanese traders expect them to step up their shift towards non-resource sectors and efforts to repair stretched balance sheets. But such businesses take time to grow and returns are not always as enticing as were energy assets during the commodities boom.

Marubeni, for example, is struggling to justify the $2.7bn it paid to buy US-based grains merchant Gavilon in 2013. The global packaged foods and Asian fresh produce businesses Itochu bought from Dole Food for $1.7bn in 2013 also have been disappointing.

The companies are now exploring ways to revamp their business models, says Naoto Saito, a senior research analyst at CLSA. "It won't be surprising if an industry shake-up occurs."

The hardest hit so far has been Sumitomo, which last month warned of its first dip into the red in 16 years. It expects a fiscal-year net loss of Y85bn ($714m), estimating impairment losses of Y325bn because of hits from US shale oil projects and a Brazilian iron ore mine.

The company was among the most aggressive in Japan in acquiring resources in the wake of the March 2011 Fukushima nuclear accident, which sparked a surge in imports of oil, coal and liquefied natural gas.

Sumitomo has since admitted that it did not "sufficiently understand" the risks involved with resources assets. "We need to strengthen our risk control and rebuild our strategy," Kuniharu Nakamura, Sumitomo's chief executive, said last month.

Stung by the soured deals, it says it will reduce its investment in resources to 10 per cent of its total Y1.2tn spending budget for the next three years, from roughly 40 per cent in the fiscal year through March 2014. Sumitomo hopes to return to profit this fiscal year, propelled by growth in its auto and other non-resources businesses, and projects net profit of more than Y300 within three years.

But analysts expect the writedowns in the sector to continue this year, and say Mitsui - which generates about two-thirds of its profits from energy and metals - is the most vulnerable.

Nomura estimates sliding crude oil and iron ore prices will knock Y103bn off of Mitsui's full-year net profits. In comparison, it projects a combined impact of Y87bn on the four other trading houses.

All five are expected to give guidance for this year when they announce earnings next month.

Separately, Daiwa Securities warns of a potential impairment loss for Marubeni's investment in the Roy Hill iron ore mine in Australia, and possibly also on Gavilon.

Since peaking at $190 in 2011, iron ore prices have fallen more than 70 per cent to about $50 a tonne. Brent crude hit a six-year low of $46 a barrel in January, though has since rebounded to above $60 a barrel.

To cope, Mitsubishi and its peers plan to sell assets to free up funds for fresh acquisitions, even under tough business conditions. "We need to make exits in order to spend. But we believe there will be no growth unless we make investments," Ken Kobayashi, Mitsubishi chief executive, said at an investor event in February.

The trading houses are also expanding infrastructure, healthcare and food businesses, and looking to put their expertise in controlling supply chains to work overseas.

Shares of Japanese trading companies have long traded below book value, but as corporate governance reform has prompted a shift towards higher shareholder returns, Mitsui last year carried out its first-ever share buyback while Mitsubishi made its first in seven years.

Still, analysts urge bigger changes. "Trading houses are engaged in needless competition now. As the size of overseas investments becomes bigger, they can enjoy the merit of scale by consolidating," said Daiwa analyst Jiro Iokibe.

With their roots in the 19th century, the sogo shosha have worn multiple hats as middlemen, investors and supply chain operators. Adjustments to weather weaker commodity prices could well spur another wardrobe change.

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