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Itochu's US$5b China bet doubles default risk: Japan Credit

Itochu Corp's US$5 billion purchase of a stake in China's Citic Ltd. has almost doubled the Japanese trading house's default risk amid threats of a rating downgrade.

[TOKYO] Itochu Corp's US$5 billion purchase of a stake in China's Citic Ltd. has almost doubled the Japanese trading house's default risk amid threats of a rating downgrade.

Itochu's credit-default swaps jumped to 79.5 basis points yesterday from 47 in early-December, when reports appeared on talks to invest in the Chinese conglomerate with Thailand's Charoen Pokphand Group. Yen corporate credit-default swaps cost 66.5 basis points on average yesterday, down from a two-month high of 76.5 in mid-December, according to the Markit iTraxx Japan index.

Moody's Investors Service and Standard & Poor's last week placed Itochu on review for a possible downgrade, saying they may lower its rating by one level on the increasing debt load as exposure to the Chinese market rises to a fifth of equity. Details remain scant on how Itochu and its Thai partner will make a return on their 20.6 per cent stake in Citic, built on the base of a Hong Kong unit that has suffered derivatives losses and business disputes on Australian iron ore investments.

"The worsening debt-to-equity ratios, uncertain business investment strategy going forward, and the record outlay for a single investment may cause some negative sentiment," said Hiroki Shibata, an analyst at Standard & Poor's in Tokyo. "We still cannot determine if the companies' synergies and profit projections through this equity investment will be realized." A failure to reap timely return on profit will also raise Itochu's borrowing costs, affecting future deals, he said.

Wagering the equivalent of a quarter of Itochu's capital in the biggest outlay for the 157-year-old company, President Masahiro Okafuji has said the investment is key to accessing Chinese food, water and new energy markets.

Citic Group will sell a 50-50 venture between Itochu and Charoen 20.6 percent of its Hong-Kong listed unit in two stages, at a total cost of HK$80.3 billion (US$10.4 billion). The unit bought US$38 billion of assets from the parent company last year and now commands China's biggest securities firm, trust company, construction equipment manufacturer and real estate operations in 29 cities among other assets.

For Itochu, that will mean an outlay of 600 billion yen (US$5.1 billion) in investments and loans, according to a presentation by the Tokyo-based company. The transaction will make it difficult for Itochu to have positive free cash flow in the next three years, and will push its net debt-to-equity ratio to 1.3 times from about 1 as of Sept 30, it said.

The purchase, which will be its biggest in China, will be financed only through borrowed funds, Itochu said.

"Nothing ventured, nothing gained," Okafuji said in a briefing in Tokyo last week.

Not all agree that the deal will weigh on Itochu's finances. The ability to strike a partnership with such a company as Citic is about as good as you can hope for in China, and Moody's and S&P's concerns may be overstated, said Fumihiko Tsuchida, a credit analyst at Mitsubishi UFJ Morgan Stanley Securities Co.

The deal will help Itochu book about 70 billion yen in additional net income a year, equal to 23 per cent of the trading house's net income forecast for this fiscal year ending March 31, Tsuchida said in a report on Jan 21.

"We can probably expect Itochu also to boost asset sales in order to recycle cash and control further investments to keep net outlay in check," he wrote.

The extra yield on Itochu's 0.785 per cent notes due in 2024 has risen five basis points since early-December to 26 basis points more than sovereign debt. Japan's 10-year government bond yield has dropped 20 basis points during the period to 0.235 percent, while the yen has gained 1.1 per cent to 118.48 per dollar as of 10:51 am in Tokyo.

The investment was announced on the same day Citic said it will write down as much as US$1.8 billion on an investment in an Australian iron ore mine that's over-budget and was subject to a royalties dispute with local tycoon Clive Palmer.

The Hong Kong firm, formerly known as Citic Pacific, had to be bailed out by parent Citic Group after wrong-way currency bets led to a 2008 annual loss of HK$12.7 billion. Hong Kong's security regulator last year sued Citic Ltd. and five former directors for allegedly disclosing false or misleading information over the 2008 losses.

"Concerns could take precedence in the short term considering Citic's volatility from a high weighting for financial services, the large size of the investment, slow cash recovery pace based on Citic's dividend payout ratio of 20 per cent to 30 per cent, and time needed for measures to achieve synergies," Kazuhisa Mori and Shogo Umeda, analysts at JPMorgan Securities Japan Co, said in a Jan 20 report.