The Market Still Isn't Giving Itochu Full Credit For Its Self-Improvement

Japanese trading company Itochu (OTCPK:ITOCY) has a tough act to follow - its own meaningful improvement over the past five years. The company was more willing than most of its Japanese trading peers to deemphasize commodity/resource businesses, and it moved fairly quickly here, building up non-resource businesses like its food, “machinery”, and finance operations. Those moves have led to better ROE and cash flow margin performance versus its peers, and Itochu shares have done well relative to peers like Mitsui (OTCPK:MITSY), Mitsubishi (OTCPK:MSBHY), Marubeni (OTCPK:MARUY), and Sumitomo (OTCPK:SSUMY) over that time.

Itochu’s execution has not been flawless, though, and investors are right to worry about the risk of another sizable poor investment (like CITIC (OTCPK:CTPCY)), not to mention the risk of lower long-term returns as Itochu has de-risked its business. I believe its underlying business mix, and the investment priorities that have been demonstrated over the last couple of years, argue for a higher price today, but the upcoming announcement of the company’s next three-year plan could be a significant share mover.

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The Market Still Isn't Giving Itochu Full Credit For Its Self-Improvement

Seeking Alpha: Itochu May Pause, But Has A Good Long-Term Model

Japan's third-largest trading company, Itochu (OTCPK:ITOCY), has not done that well since I last wrote about the company. A 1% gain in the Tokyo-listed shares and a 4% gain in the ADRs is better than the performance of the Nikkei 225 (down about 6%), but not at all impressive relative to the other trading companies (Mitsui (OTCPK:MITSY) has done much better, Sumitomo (OTCPK:SSUMY) and Mitsubishi (OTCPK:MSBHY) a little better, and Marubeni (OTCPK:MARUY) worse). Some of this could be driven by a slower move toward share repurchases or steeper-than-average expected decline in FY 2015 ROE, with Itochu's rivals closing a bit of the gap in terms of returns on equity and capital.

Capital may be chasing those self-improvement stories, but I think Itochu is still the better play for the long term. Management has deliberately moved away from more volatile resource businesses and is looking for its focus on consumer-related products to generate above-average returns for the long-term. These giant unwieldy conglomerates are not going to suit every investor, but Itochu still looks undervalued below $29 to $32 per ADR.

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Itochu May Pause, But Has A Good Long-Term Model

Seeking Alpha: The Market Doubts Itochu Will Continue To Outpace Its Rivals

Sell-side analysts can be a stubborn lot. Even when a less-favored company outperforms, it's not uncommon to see follow-up reports declaring that its outperformance can't continue. When looking at the large Japanese trading companies, Itochu's (OTCPK:ITOCY) outperformance certainly stands out - the shares are up more than 50% in Japan while rivals Mitsui (OTCPK:MITSY), Marubeni (OTCPK:MARUY), Sumitomo (OTCPK:SSUMY), and Mitsubishi (MSHBY) are up around 20% to 30%.

Itochu's strong performance doesn't strike me as a fluke. Management has consciously and deliberately sought to create a balanced collection of assets, with operations in food and machinery offsetting the volatility to the commodities operations. With management looking to build its non-resource operations at a 2-to-1 ratio with the resource operations, I believe this will continue to benefit the company's stability and full-cycle returns without overly curtailing the company's upside to higher commodity prices. Investors must note the significant impact of currency on these shares (8001.T shares are up 55% over the past year, while ITOCY is up about 22%), but I believe Itochu's superior returns, shareholder-focused management, and balanced business could merit another 15% to 20% in gains from here.

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The Market Doubts Itochu Will Continue To Outpace Its Rivals