Li & Fung (494.HK) - jrj.com.cnpg.jrj.com.cn/acc/Res/HK_RES/STOCK/2013/2/20/68777330-6cea-4d5e... · Li & Fung (494.HK) – Turning a Corner 20 February 2013 Sun Hung Kai Financial

Li & Fung (494.HK) – Turning a Corner 20 February 2013

Sun Hung Kai Financial Institutional Research 1

Research Idea: Turning a Corner

We rate Li & Fung a Buy with a 12-month price target of HK$14.45. The company is highly exposed to the U.S. consumer. If the Fed is successful in reducing unemployment, consumer spending will recover. If employment fails to recover then it is likely that the Fed will continue to keep bond yields low, making high quality companies with high yields interesting to investors. We consider a market leader with a 4.85% yield and optionality on a U.S. consumer recovery as an attractive investment.

Three reasons to buy:

Margin and Growth Mix Improving – Li & Fung is moving into higher-margin and higher-growth businesses to offset slowing growth in its traditional businesses. The development of the

wholesale brand distribution into China and Asia will drive future growth, as will moves into Russia and Brazil. Currently 30% of sales are from Distribution and 30% are from the new growth segments.

Macro Improvement - Over the past four years the global economy has been adjusting to excess U.S consumption and excess China exports. We expect the U.S. consumer to slowly recover over 2013 on

the back of better jobs and a stronger housing market. We also expect Chinese consumption to pick up as the overall economy improves.

The recent problems at Li & Fung and the capitulation of shareholders gives investors an opportunity to buy one of Asia’s leading companies at close to historic-low valuations. Li & Fung has

a respected management team, good corporate governance and strong competitive advantages. A dividend yield close to 5% for 2013 and a P/E of 14.4X suggest the company is not being appropriately valued.

Catalysts. Improving U.S consumption data. Positive commentary on the

new growth businesses in the March 2013 final results.

Valuation. 2013 P/E of 16.3X and EV/EBITDA of 11.2x are at the bottom of

their historical ranges. Historical P/E has averaged in the mid-20s. Our target multiple is 17X our 2014 earnings of HK$0.85/share.

Risks. U.S. and Chinese consumption fails to recover. LF USA needs further

restructuring. Integration risk for acquisitions.

Figure 1: Earnings Summary

Year end 31 Dec. FY11 FY12E FY13E FY14E

Revenue – US$ m 20,030 20,151 22,125 24,309

Gross margin – % 14.91 14.93 15.30 15.57

EBITDA – US$ m 1,105 1083 1293 1507

EBIT margin – % 4.39 4.00 4.47 4.82

Net profit – USD m 681 617 756 906

Net-profit growth – % 26 -9 23 20

EPS – HK$ 0.66 0.58 0.71 0.85

EPS growth – % 10.70 -13 23 20

P/E – X 15.16 17.35 14.44 12.06

Dividend yield – % 4.52 4.03 4.85 5.80

P/B – X 2.63 2.09 1.96 1.82

ROE – % 17.99 13.48 14.01 15.66

Sources: Bloomberg and Sun Hung Kai Financial

Nicholas Studholme-Wilson

+852 3929-6156

[email protected]

Reports available at: http://www.shkresearch.com http://www.thomsonreuters.com http://www.capitaliq.com http://www.themarkets.com Bloomberg Code: <shkr>

Target Price HK$14.45 12m Rating Buy

(40% upside)

Li & Fung (494.HK) Retail Services 20 February 2013

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Scenario Analysis

Bull HK$17.25: 18X 2014 EPS of HK$0.90

Base HK$14.45: 17X 2014 EPS of HK$0.85

Bear HK$8.10: 11X 2014 EPS of HK$0.81

Key Data

Price – HK$ 10.20

52W high/low – HK$ 20.15-9.93

Mkt cap – HK$84.24bn

(US$10.80bn)

Shares in issue – m 8,359

Free float – % 66%

3M avg. t/o – HK$370m (US$48m)

Major shareholder – %

Fung Holdings

Capital Group

26%

12%


FY12E revenues: US$20.2bn

Trading70%

Logistics2%

Distribution28%



Investment Thesis

Introduction

Li & Fung is a high-quality company that has a long history of good management, sound corporate governance and wealth creation for its shareholders under Victor and William Fung and Bruce Rockowitz. The company has grown both organically and by acquisitions and has established a sourcing and distribution platform to which acquisitions are easily added.

The opening up of Chinese manufacturing to the world has allowed it to be a key protagonist in global labor arbitrage. With government-led labor inflation in China, Li & Fung has migrated to suppliers in lower-cost countries e.g. Vietnam and Bangladesh. While China remains the biggest production base (50%), the company has migrated to lower-cost regions in East and Western China.

The company has underperformed the Hang Seng Index since the end of 2010 over concerns about its aggressive acquisition strategy and the weak macro environment. Acquisitions made from 2005 are key strategic acquisitions, which the company requires to meet its long-term objective to move up the value curve and move into higher-growth regions. However like a snake that has swallowed too large a meal, digesting these acquisitions has taken longer and consumed more energy than expected and has resulted in 2 years of poor operational performance.

The company recently guided down its operating profits for 2012 due to a $200m non-recurring charge for LF USA that includes: an $80m write-down in the value of a number of underperforming brands; a further $80m in restructuring charge; and $40m in other charges such as the destruction of goods by Hurricane Sandy.

Our investment thesis recognizes the current problems with the business, but we consider a number of these issues as cyclical, a number are one-off and some are operational problems that need to be dealt with by a management team that are capable of doing so. We consider long-term growth drivers to be intact – although at a slower rates to that of 2000-2008 – and believe that current valuations are discounting a considerable amount of bad news.

Margin and Growth Mix Improving

Li & Fung has evolved from a local dockside trader into the global supply-chain powerhouse that it is today. The company has driven step-like changes in its business model through key acquisitions, e.g. the purchase of the Inchcape business in 1995, the creation of the U.S. distribution business in 2005, and more recently the acquisition of the Asian distribution business IDS in 2010.

The distribution business is a natural extension of the trading business. The trading business was built on the relationships that Li & Fung had with its suppliers on one side and its customers on the other. The distribution business allows the company to deepen its relationship with its current customers by providing branded products, e.g. Calvin Klein footwear to their traditional customers such as Kohl’s. They can also use their relationships in manufacturing to produce the branded products, thereby capturing a larger portion of the product value.

The company’s current acquisition strategy began in 2005, when it decided to start the Distribution Network to complement the Trading Network. The move into wholesale distribution of brands was consistent with its past strategy of moving up the value chain. While the Distribution Network has a



potentially similar client base to the Trading Network, they are fundamentally very different business models. The Trading Network is an agency business with low and transparent margins, but requires little in the way of assets or working capital. The Distribution Network on the other hand is a principal rather than agency business, i.e. it sells products rather than services and therefore the costs are less obvious, which can lead to better margins. Net margins can be 7%-8% in some principal products against 3% from agency business.

The Distribution Network has been built up through the acquisition of businesses that have licensees and knowledge to supply branded products, which can be produced by the company’s network of suppliers. Currently distribution represents 27.9% of sales but gross margin is 22.9% vs. 8.6% for trading. As the distribution business grows in importance to the company, margins will continue to trend upwards.

However the strategy to grow the Distribution Network by acquisition has had a dramatic impact on the nature of Li & Fung’s assets. Intangible assets have built up rapidly from the acquisitions and inventories have increased from 5 days to 20 days. This buildup of assets, in a traditionally asset-light model, has resulted in a sharp decline in the ratio of sales to assets (asset turnover). Net margins have improved slowly since 2004 (+30 bps) despite an interruption during the financial crisis, but not in sufficient size to offset a decline in asset turn. As a result, return on equity has been negatively impacted by the acquisitions. However we believe that sales synergies can be extracted from the acquisitions to drive improving profitability.

Figure 2: Li & Fung – inventory days, EBITDA margins and ROE breakdown

Sourc Sources: The Company, Bloomberg and Sun Hung Kai Financial

Sources: The Company and Sun Hung Kai Financial

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We believe the decline in return on equity will bottom out in 2012 and start to improve as the business shifts further towards distribution and sales growth recovers in the U.S. Growth in the distribution business will be come primarily from Asia and secondly from Europe, with Russia as the main driver there. Our assumption is that the Asian businesses will grow sales at 30% a year for the next two years, with 20% from organic growth and 10% through acquisitions. We see Europe (including Russia) growing at a similar rate to Asia in 2013 before dropping to 18% in 2014. Sales from distribution will go up from 27.9% to 30% by 2014, which will take gross margin from 14.93% to 15.57% and core operating margin from 4.4% (2011) to 5.08%. The Distribution Network will account for 38% of core operating profit by the end of 2014.

Li & Fung is evolving into a better business that sells higher-value goods into higher-growth markets. This transition has come about through acquisitions that have depressed operating metrics, but it is likely that the worst is over and the company can now reap the rewards of its strategic initiatives.

Management is optimistic about the opportunities for cross-selling within the business to drive revenue growth. However translating management-speak into practice will be difficult. The Trading Network, which makes up 70% of sales, is based on a specific relationship with a customer to deliver a specific product. Customers are protective about their products and would not expect sourcing partners to share products or details with their competitors.

On the other hand cross-selling brands on the Distribution Network is a genuine opportunity, as the product development and design sits with Li & Fung rather than its customers, giving it unrestricted access to their customer base with any of their brand products.

Cross-selling strategies are always hard to implement because it is difficult to align companies and employees interest, when the bulk of employees are remunerated directly from their own business. Li & Fung uses stock options to incentivize employees to act beyond their own product lines, but when the share price goes through a long period of weakness as is the case here, it is a blunt tool. Instead individuals are more likely to be driven by their own P&Ls. However the importance of the new initiative is that it illustrates management’s focus on improving sales synergies and margins. Core operating margin for Distribution in 2011 was 4.82%. Management should be aiming to get them closer to its competitors’ margins of 10%-15%.



Macro Impact

Li & Fung and its customers are highly dependent on discretionary spending in the U.S. (62% of sales) and Europe (18%), which together account for 80% of sales. With consumption deteriorating in Europe and stagnant in the U.S. the company has suffered.

Figure 3: Euro-zone household expenditures

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European consumers have been a disaster in 2012, due to high and deteriorating unemployment, conservative fiscal policy and a negative outlook on future wages. Indication from management suggests that Europe saw a high-teens fall in revenues. Even Germany has seen a retrenchment in spending, but it looks as though it has exited the year on a more positive note, with both consumer and business surveys more positive on the outlook. European business for Li & Fung was down a mid-teens percentage in 2012. Our assumption is that major European economies will stabilize this year and will therefore not drag down sales as they did in 2012.

Figure 4: Li & Fung’s sales vs. U.S. personal consumption

y = 4.5766x - 32085R² = 0.9044

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Sources: The Company, Bloomberg and Sun Hung Kai Financial

The company sales are highly correlated to U.S. personal consumption, which is unlikely to change soon. Emerging market revenues are becoming important to growth, but are not sufficiently large to offset the U.S. macro.



Figure 5: Li & Fung’s sales vs. U.S. personal consumption growth (L); U.S. consumer incomes and spending (R)


Our expectation is that discretionary spending will start to recover, driven by an improving job situation and improving housing market. This should feed into improving consumption, despite the 2% tax increase. Since the crisis U.S. consumers have reduced debt and incomes have already started to improve. If you add to this an improving housing market, the backdrop has become more positive for consumers.

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Valuation

Figure 6: Li & Fung – valuation scenario analysis

Scenario

Target

Price Return Key Assumptions

2013E

EPS

2014E

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P/E (X)

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P/E (X)

2014 Target

P/E (X)

Bull Case 16.14 58%

Sales growth of 13% in 2013

Strong rebound in U.S. consumption

Gross margin improvement in distribution

Opex returns to 2011 levels

0.81 0.90 12.3 11.2 18

Base Case 14.45 42%

Sales Growth of 10% in 2013

LF USA posts 0% organic growth

Gradual recovery in U.S. consumption

Partial recovery in opex

Gross margin improves to 15.57%

0.71 0.85 14.6 11.4 17

Bear Case 8.94 -12%

Sales growth of 5% in 2013

Muted recovery in U.S. consumption

Further impairmant charges from LF USA

0.64 0.81 15.9 12.5 11


Based on our FY13E consensus EPS estimate of HK$0.62/US$0.08 the shares trade at a P/E of 16.45X, at the low end of their historical range of 20X-40X. We believe the stock deserves to trade at a premium to the market and will continue to do so, due to the quality of management, the company’s competitive advantages, its superior 3-5 year growth prospects vs. the market, and a dividend yield of close to 5%. High-quality consumer names have a tendency to trade at a premium to the market and we do not think Li & Fung is any different.

Our 12-month target price of HK$14.45 is based on 17X our FY14 EPS, and forward dividend yield of 4% and FCF yield of 6.4%. Our P/E target is below the historical P/E range of 20X-40X as we don’t believe the company will achieve the sales growth it had prior to 2008. Our base case assumption for 2013 and 2014 is for revenues grow 10% (60% organic, 40% acquired). Our revenues are 4% below consensus in 2013 and 2014, but our margin assumptions are higher as we consider the problems in 2012 to be extraordinary items and that core operating margins recover faster than market expectations, which results in our EPS being 11% ahead of consensus in 2013 and 7% ahead in 2014.

The rate of revenue growth determines the valuation the market is willing to pay for Li & Fung, and we believe that revenues will start to grow again this year. Last year had underlying growth close to our assumption for 2013 but it was offset by 5% price deflation and a collapse in European consumption of -15% to -20%. Management suggested at the recent analyst day that the worst is over for deflation and we believe that European demand is bottoming out. If the U.S. recovery continues we consider 10% revenue growth achievable. However we expect the market to focus on earnings growth as opposed to sales growth, when the benefit of the shift to higher margin businesses is more clearly recognized.

Li & Fung has had a consistent dividend policy that has paid out 80% of net income. It is possible that it may switch to 60% of core operating income, i.e. US$586m or HK$0.55 per share in 2013, which works out to be the same as 80% of net income. Our assumption is that management is a bit more conservative with its dividend policy and pays HK$0.49/share, as raising capital from the markets is becoming harder. We expect the company to generate close to US$900m in FCF in 2013, as it requires little in the way of capex. We therefore consider the company to be in a good position to continue with its current dividend policy.



Figure 7: Li & Fung – P/E vs. revenue growth

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We do acknowledge that it is unlikely that the company will achieve its historic-high multiples again; but we consider the valuation adjustment overdone. The consensus EPS estimate for 2013 of HK$0.62/US$0.08 would imply that management is misleading the market on the one-off nature of the charges and that consumer spending does not improve. Firstly, from our experience with management we regard it as a high-quality team with sound corporate governance. Secondly, data coming out of the U.S. on consumption is already showing signs of improvement. Therefore, extrapolating the current negative trends at the likely lows of the cycle would seem overly cautious and we believe that there is greater probability of risk to the upside.

Figure 8: Li & Fung – P/S, P/E and EV/EBITDA trends

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The growth rate of this business is likely to be slower than it was pre-crisis. However it is still relatively attractive. There is no doubt that we are in a different world post 2007, where there has been a rapid adjustment to over-consumption from the U.S. and over-dependence on exporting from China. We continue to believe that outsourcing of low-value goods will continue, that there will be a greater shift to outsourcing of higher-value goods, and that the company will continue to exploit other growth opportunities such as Asia, Russia and health/beauty products. It would not be unreasonable to assume that the company can grow revenues by 10% p.a. over the medium-term.

It is important to remember that the company is only a $20bn revenue company. This may be regarded as large in Asia but is actually relatively small in a global context. Wal-Mart is likely the biggest client, from which Li & Fung currently derives $1.5bn-$2bn of revenues, but Wal-Mart itself has revenues of $440bn. In other words Li & Fung provides less than 0.5% of its sales. Target has revenues of $70bn and is another large client, likely accounting for $1.3bn-$1.7bn of revenues to Li & Fung, which is 2% of Target’s total sales. There is little reason to believe that the long-term organic growth story is over if Li & Fung can continue to penetrate its main accounts with new products.

Comparisons

Market Cap

(US$bn)

2013

P/E (X)

2014

P/E (X)

2013

EV/EBITDA (X)

2014

EV/EBITDA (X)

2013

P/B (X)

2011

ROE (%)

2013 Op

Margin (%)

Div Yield

(%)

2013-2014 Sales

CAGR (%)

Li & Fung (494 HK) 10.8 16.5 13.4 11.2 9.6 2.0 18.0 3.9 4.8 9.5

Esprit (330 HK) 2.5 na 24.4 18.8 9.9 1.0 5.0 3.7 3.8 (1.8)

Giodarno (709 HK) 1.6 15.9 14.5 9.4 8.7 4.0 28.0 14.9 4.6 13.4

VF Corp (VFC US) 17.4 13.9 12.3 9.7 8.8 2.9 22.0 13.0 2.2 7.7

Ralph Lauren (RL US) 16.1 19.0 16.3 9.7 8.7 4.3 20.0 15.4 0.9 8.9

PVH (PVH US) 9.4 16.0 13.9 8.8 7.5 2.8 13.0 9.8 0.1 11.0 Sources: Bloomberg and Sun Hung Kai Financial



The Risks

The key company specific risk to the company is the integration of acquisitions, highlighted by the problems at its U.S distribution business. LF USA has been through a tumultuous 2012, which ended up with a $200m charge at the end of the year. The real disappointment was that this business was the model to develop the global distribution business, the validity of which has now been questioned by investors.

The problems for LF USA started with high cotton prices in 2010 and leather prices in 2011, which sent gross margins down from 36% at the start of 2010 to 31% in the middle of 2012 and led the company to bring in consultants and restructure the division. Management said the $200m charge was against a number of non-performing brands from the MESH business, which it is discontinuing. Implicit in the profit warning for a 40% decline in core operating profits is a further $150m decline, which is likely connected to the weakness in Europe.

The problems facing LF USA may have their origins in the business being pieced together from acquisitions. These started in 2005 but it was only really from 2007 that acquired revenue has become material. Without exact details of the earn-out periods for acquisitions, we can infer that they are probably structured around 3-4 years. It is always a risk in these deals that people depart the company post earn-out, and since a lot of this business is to do with relationships, the business goes with them. LF USA has not made an acquisition in the past 18 months, which suggests that the company may have become aware of the problem in the middle of 2011, which is 3-4 years after the initial build-out of LF USA.

What is surprising is that 3-4 years should be plenty of time to dilute key personnel risk and broaden relationships. If this is the reason for the problem, then it shows an oversight by management and perhaps why the company felt it needed a new management team. This may be pure conjecture but the time line seems to fit well.

It is also likely that the write-offs and restructuring costs is the worst-case scenario to give Dow Famulak – who took over in December 2012 – a chance to clean up the business and easier year-on-year comparisons in 2013. The new management team’s objective will be to turn a portfolio of assets into a business.

We currently have no reason to doubt management and believe that the charges taken in 2012 are one-off, that LF USA will begin its recovery in 2013. We assume zero growth for the business based on a number of brands being discontinued in 2012. Our expectations are that core operating margin for the group recovers to 4.49% from 2.28% in 2012.

Acquisition Strategy

The company has stated that it will acquire growth in the absence of organic growth. This is a contra-cyclical strategy; i.e. make investments during downturns to increase operational leverage into the upturn. Post crisis there has been little organic growth, which has forced the company to acquire sales.

From 2006 to 2011 Li & Fung acquired US$9bn of sales and US$294m of profits after tax. Total revenues have compounded at 18% and profit at 24%, whereas organic revenues have compounded at 4.7% and organic profits at 10.86%. For the three years to 2011 – a particularly difficult time for those exposed to developed markets – organic revenues compounded at -2% but organic profits grew 12.6%.



This demonstrates that for the past three years management strategy has been about acquiring sales growth whilst reducing operating costs, which is why we have seen margins improve, but asset turns decline.

Figure 9: Li & Fung’s operating profit margins vs. acquisition costs as % of revenue

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It is interesting to note that the last time acquisition costs as a percentage of revenue spiked in 2007, this was followed by a correction in operating margins, then a positive step-function change in margins. The company seems to be going through a similar issue in 2012 and it is our assumption that it emerges from the downturn in a similar way, as management tends to react by cost cutting and restructuring.

We do not have a problem with a rational acquisition strategy to enhance growth. Li & Fung has developed two platforms (Trading and Distribution), to which it can slot in new teams and new licenses it acquires. The acquisitions it makes are not about empire building, but about sharing the cost base for an increased number of products it can potentially offer to clients. Li & Fung has a long history of returns exceeding cost of equity, so while it can continue to do so it makes sense to carry on investing in the business.

However returns have been held back by the acquisition strategy due to intangible assets collecting on the balance sheet and having to provide for contingent liabilities from potential earn outs. On a cash basis returns have held up better.

It is difficult to understand the valuation of the acquisitions unless you look at it from a total earn-out to total cost basis, rather than initial cost. We do not know exact details of the deals but there are a couple of assumptions we can make to give us some insight into the performance expectation of the deals. The first is that the return on investment hurdle rate for an acquisition is 12%. The second is that the earn-out period is four years.

The company is secretive about deals so as not to lose negotiating power in future deals. However the company gave us a glimpse beneath the veil with its acquisition of Brilliant Global last year, which had sales of US$150m and a target of US$300m by 2016 (four- year CAGR of 19%).

With this framework in mind we can then work out what an acquisition needs to grow by to make the 12% hurdle rate and decide whether these targets are reasonable.



If we look at the active deal-making period from 2007 to 2011, we can see that acquisitions made in 2011 required a 15% CAGR to make their hurdle rate, 2010 required 38%, 2009 and 2008 required 22%, and 2007 required 30%.

The standout years were 2010 and 2007, during which what can be considered strategic investments were made. First, in 2007 the sourcing business of Tommy Hilfiger was acquired to lock in a high-profile brand as well as CG Group to take the company into beauty and cosmetics. In 2010, IDS was purchased to take the company into Asia. The company certainly has high expectations for IDS, but it is not unrealistic. We are modeling 30% growth over the next 2 years, which is a little more conservative than the company’s expectations and would mean that it misses its hurdle rate in the short term.

If the company cannot get back to its premium valuation, future ability to acquire growth has been curtailed. But on our assumptions the company has enough cash to pay for acquisitions for 2013 and 2014.

Figure 10: ROI sensitivity to earnings growth at the end of a four-year earn-out

2011 2010 2009 2008 2007

Total Purchase Consideration 1,803,883 2,352,457 522,505 481,533 824,406

Initial PAT (if fully consolidated for 12 months) 126,770 78,974 28,552 25,201 34,692

Initial ROI (PAT/Consideration) 7% 3% 5% 5% 4%

Estimated Future Value of PAT at 15% CAGR over 4 years 221,722 138,125 49,937 44,077 60,676

ROI at year 4 12.29% 6% 10% 9% 7%


ROI at year 4 16% 7% 12% 12% 9%


ROI at year 4 20% 10% 16% 15% 12%


ROI year 4 25% 12% 20% 19% 15%




Company Background

The company was founded in 1906 in Guangzhou by Fung Pak Liu and Li To-Ming to sell Chinese goods, e.g. porcelain to the west. It was one of the few Chinese-owned trading companies in a market dominated by foreign companies. However, few at that time could speak both English and Chinese which allowed Li & Fung a clear competitive advantage. The business was incorporated in Hong Kong in 1937 and when China closed to trade post WW2 the company moved operations to Hong Kong.

The nature of the business remained fairly unchanged until the 1970s when margins for broking goods between the east and west started to get squeezed. The company made a decision at that time that it needed to evolve its business model and move further up the value curve to providing value-added services. The step change that led to the modern company that we see today occurred in 1995 when it purchased Inchcape Buying Services for HK$475m, to nearly triple in size.

Having some knowledge of the history of the company is helpful in understanding that it has deep and long-term relationships in China. It is a product of a constantly evolving business model that seeks to provide higher levels of value to customers, and that acquisitions are a key part of its DNA.

Li & Fung is the global leader in supply-chain management of high volume, time-sensitive goods for leading retailers and brands worldwide via an extensive global network. The company provides one-stop manufacturing services from product design, raw-material sourcing, production management, quality control to delivery to the retailer. It has a global network covering 40 economies, with 300 offices and distribution centers, and 15,000 suppliers. The current business is divided into three units, Trading Networks, Logistics and Distribution Networks.

It has developed a competitive advantage by building a scale advantage, in an industry dominated by smaller companies and internal sourcing departments. This scale provides Li & Fung with purchasing power and shared infrastructure costs, and its experience in the sourcing industry provides it with unique relationships with suppliers and manufacturers in China.

The economic forces that impinge on Li & Fung are a microcosm of what is happening in China as a whole. U.S. consumption growth and production outsourcing have greatly determined the economic fate of the company and China, and more muted consumption patterns in the coming years will certainly affect them both. However, wage growth and increases in per capita wealth in emerging markets are likely to cause a change in global consumption dynamics.

It is with this in mind that the company has started to develop its emerging-markets business, entering both Russia and Asia in the past couple of years. The move into emerging markets does not support the traditional sourcing business model, which leverages the company’s ability to source cheap production. Instead Li & Fung has developed a distribution platform to distribute global brands to the growing consumer class in emerging economies. The distribution business is a key growth driver for the company and its superior margins will lead to a general improvement in overall margins, as it becomes a bigger share of the overall business.

Li & Fung’s 2012E revenue breakdown by division

Trading70%

Logistics2%

Distribution28%




The Trading Network

LF Sourcing: Sales US$10.90bn (2012E)

LF Sourcing is the traditional part of the Li & Fung business. It is an agency business, where products are sourced for department stores, hypermarkets, specialty stores, global brands, and catalog and e-commerce customers e.g. Tommy Hilfiger, Helly Hansen, Roots, J Crew, Target. In addition it provides a sourcing service for its own distribution networks: LF USA, LF Europe and LF Asia. Apparel makes up 70%-75% of the business with the balance from fashion accessories, footwear, home textiles and hard goods. DSG, the business that deals with Wal-Mart, resides in this division, has revenues of $1.5bn-$2bn, and became profitable in 2012. DSG’s profitability in 2013 will help support the division’s margins.

Production continues to be dominated by China (50% of sourced goods), but is starting to move from the south east to the west of the country. Li & Fung is not held to China as labor arbitrage is important to its strategy and therefore utilizes low-cost production in Vietnam and Bangladesh.

The company provides a valuable service to its customers by providing end-to-end solutions for numerous products. Supply chains are becoming more complicated, suppliers more numerous and consumers demand more choice – it is getting harder to source goods. This year the company has picked up 28 net new customers (gained 38 and lost 10).

The worries that investors have had about disaggregation of its business are overdone. Customers such as Wal-Mart are required by their customers to offer an increasing number of different products (SKUs). The average SKU per Wal-Mart store is 150,000. An attempt by Wal-Mart to de-clutter the stores was met by declining same-store sales and as a result had to reverse policy. Other retailers in the U.S. have had a similar experience. Managing and sourcing this magnitude of SKUs is made easier with the help of third-party sourcing agents such as Li & Fung.

Sourcing is not as simple as it sounds, since each sales item (SKU) has different components that need to be separately sourced. Taking a pair of jeans as an example, Li & Fung would source the denim, the rivets zipper, thread and the label, and ensure sizing and delivery were correct. In addition, Li & Fung’s customers have increasing accountability for human-rights violations and the environmental sustainability of production, so it is necessary to have experts audit the manufacturing process to avoid the risk of bad press and reputational damage.

Management continues to believe that it can drive organic growth with existing clients by increasing its share of their business. It expects the top 30 customers, which account for 50% of the division’s revenue, to grow 10% organically. Demand for private-label products is driving this growth. Opportunities remain to expand in new markets under-penetrated by the company, e.g. BRICs, and through new product categories, such as fashion accessories and luxury.

Our expectation for revenue growth in 2013 for LF Sourcing is 6% (3% organic growth and 3% acquisitions).

LF Beauty: Sales US$1.2bn (2012E)

This division sources beauty products for its customers e.g. skincare creams, fragrances and primary and secondary packaging i.e. jars and boxes. Customers include Avon, Chanel, Calvin Klein, Boots, and P&G. As a relatively young business it is still in the growth phase and operating profits are on target to triple from 2010 to 2013.

Li & Fung’s 2012E trading network revenue breakdown

LF Sourcing 57%

Walmart11%

LF Beauty8%

LF Fashion12%

LF Products12%




LF Beauty is expected to be an engine of growth for Li & Fung over the next three years. We expect this division to provide low-hanging fruit for the cross-selling initiative the company is making. We would expect department-store customers to be interested in developing private-label beauty products.

The objective of the division is to service all retail channels globally with product capabilities across all categories in beauty. Li & Fung will make acquisitions to assist this new platform build-out.

Our expectation for revenue growth in 2013 is 20% (15% organic and 5% acquisitions).

LF Fashion: Sales US$1.9bn (2012E)

Unlike the other divisions in the Trading Network, LF Fashion is a principal business not an agency business and is a supplier of fashion products including apparel and accessories. It has in-house design teams and sample-making facilities, but does not manufacture its own products.

The average selling prices of its merchandise are higher than the rest of the company, and unusually for Li & Fung it works closely with customers’ in-house buying departments. LF Fashion’s main regional exposure is Europe, leaving the U.S. as only 23% of sales. The U.S. market will be a key driver of growth, leveraging Li & Fung’s relationships in that market.


LF Products: Sales US$2bn (2012E)

LF Products sources hard-goods products for customers. This is something of a miscellaneous division that has little product focus, supplying home and office furniture, toys and seasonal gifts.

There has been cost restructuring for this business in the past two years, which should benefit the division this year. The main growth driver is going to be acquiring new product categories to the platform, and there is a strong pipeline of potential deals. Despite the lack of focus, this should have better margins than the average Trading Network business as the costs for hard goods are less transparent than for apparel.


Figure 11: Li & Fung’s trading-network sales-growth assumptions

Sales Growth Sales Growth

2013E 2014E

LF Sourcing 6% 5%

LF Beauty 20% 18%

LF Fashion 20% 18%

LF Products 7% 6% Source: Sun Hung Kai Financial



The Distribution Network

The Distribution Network is being developed to create a global wholesaler of brands. It is a natural fit with the Trading Network as a number of customers will be shared between the two businesses, and it fits in with Li & Fung’s objective to become a one-stop shop for large-scale retailers.

LF USA: Sales US$3.3bn (2012E)

LF USA was established in 2005 and is a wholesale distributor of fashion apparel, accessories, and footwear and home products to the top retailers in the U.S. The top 10 customers account for 65% of sales, and the top 30 customers account for 85%.

Top 10 customers are Wal-Mart, Costco, Kmart, TJ Maxx, Sears, Macy, Target, QVC, JC Penney, and Kohl’s. The brand portfolio includes Rachael Zoe, Vena Cava, Nautica, Geoffrey Beane, Ben Sherman, Sketchers, and Dockers.

2012 was a very poor year for the division, which has catalyzed aggressive management action. The problems for the business started with high cotton prices in 2010 and leather prices in 2011, which sent gross margins down from 36% at the start of 2010 to 31% in the middle of 2012 and led the company to bring in consultants and restructure the division. At the interim reporting, management announced restructuring costs of $70m and extended this to $200m at the end of 2012. Management said that the $200m charge was against a number of non-performing brands from the MESH business which it was discontinuing and should be regarded as one-off.

We are not expecting any revenue growth in 2013 from this division due to the discontinuation of a number of brands, which will have a negative drag on sales, but we are not clear as to what extent this will hamper growth. We also assume that management will not make any acquisitions until it feels comfortable it has control of its existing portfolio of brands.

However we consider the long term growth story of the division to be intact, and that the management change for the division should be a positive.

LF Europe: Sales US$1.3bn (2012E)

LF Europe’s platform distributes a range of products, including apparel, hard goods and gifts, to the U.K., Germany, France, and the Netherlands. Despite weak market conditions the division has been experiencing positive growth, driven by character licensing after the acquisition of TV Mania and entry into Russia, a new high-growth market.

Core operating profits grew at high double-digit rates in 2011 and 2012, which the company expects to continue into 2013.

Our expectation for revenue growth in 2013 is 30% (20% organic and 10% acquisitions)

LF Asia Food, Healthcare & Beauty: Sales US$1.1bn (2012E)

This division came from the IDC acquisition in 2010 and is Li & Fung’s first step into creating a platform to distribute brands into Asia. The platform serves China, Taiwan, Hong Kong, Macao, Thailand, Malaysia, Singapore,

Li & Fung’s 2012E Distribution Network revenue breakdown

LF USA52%

LF Europe20%

LF Asia Food & Health

17%

LF Asia Fashion &

Home11%

Sources: Company and Sun Hung Kai Financial



the Philippines; Brunei and Indonesia. The acquisition also gave the company an entry into food distribution, a business it had been looking to enter.

Key customers include: L’Oréal, P&G, Tiger Balm, GSK, Pfizer, and Nestlé.

Growth will come from new-customer wins and increasing penetration in China from 24 cities to 44 cities by the end of 2013. Organic CAGR for 2010-2012 was 32%, and we expect 2013 to be similar.


LF Asia Fashion and Home: Sales US$0.7bn (2012E)

This business was established in 2011 to develop seven business verticals in Asia: Kids, Lifestyle, Footwear, Home, Luxury, Intimates and Licensing. The aim of this division is to bring a broad range of global brands into Asia to service the demands of increasing personal wealth in Asia.

Kids’ brands include Calvin Klein Jeans, Nautica, Benetton, Disney, Marvel, and Ben 10. Lifestyle brands include Nike and Roots. Footwear brands include Chloé, Coach, and Marc Jacobs. Luxury brands include Roberto Cavalli, and a.testoni. The Intimates brand is Jockey and Licensing is for U.S. Polo Association merchandise.

The business has already 3,000 points of sales through franchisees and distributors, which it plans to double over the next three years. The three-year plan is to hit US$1bn of revenues by 2013, which it has achieved a year ahead of target.


Figure 12: Li & Fung’s distribution-network sales-growth assumptions

Sales Growth Sales Growth

2013E 2014E

LF USA 0% 4%

LF Europe 30% 18%

LF Asia Food & Health 30% 25%

LF Asia Fashion & Home 30% 25% Source: Sun Hung Kai Financial

The Logistics Network

Sales US$0.5bn

LF Logistics is the newest and smallest of Li & Fung’s businesses, with expected sales of US$500m in 2012. The business came with the IDC acquisition in 2010 and provides logistic services mainly in Asia, but also has hubs in the U.S. and U.K. The division will be a clear beneficiary of the group’s cross-selling initiative. For example, prior to the acquisition in 2010 by Li & Fung the business had 33 customers. By 2011 this had increased to 110 and by October 2012 it was up to 145.

Our expectation for revenue growth in 2013 and 2014 is 20% p.a. (10% organic and 10% acquisitions).



Appendix: Financial statements and forecasts

Year end 31 December

P&L – US$ m FY10 FY11 FY12E FY13E FY14E

Revenues 15,912,201 20,030,271 20,151,228 22,125,602 24,309,108

Consensus 20,925,000 22,861,000 24,992,000

COGS 17,143,436 18,741,037 20,523,347

Gross profit 2,228,289 3,074,204 3,096,457 3,481,917 3,892,721

Operating Expenses (1,513,151) (2,192,148) (2,553,534) (2,492,022) (2,718,572)

Operating Income 669,318 879,937 806,600 989,895 1,174,149

Profit Before Tax 586,292 772,064 696,167 874,918 1,047,826

Tax (47,525) (90,660) (78,642) (118,083) (141,419)

Net Income 538,767 681,404 617,525 756,835 906,407

EPS (USD) 0.07 0.08 0.07 0.09 0.108

Consensus 0.06 0.08 0.10

DPS (USD) 0.43 0.45 0.40 0.49 0.59

Shares Outstanding (’000s) 7,649,000 8,080,000 8,359,000 8,359,000 8,359,000

Revenue Growth 18.1% 25.9% 0.6% 9.8% 9.9%

EPS Growth 17.4% 10.7% -12.7% 22.6% 19.8%

Gross Margin 13.5% 14.9% 14.9% 15.3% 15.6%

Operating Income Margin 4.2% 4.4% 4.0% 4.5% 4.8%

Net Income Margin 3.4% 3.4% 3.1% 3.4% 3.7%

Balance Sheet– US$ m FY10 FY11 FY12E FY13E FY14E

Cash & Equivalents 968,530 426,240 1,320,786 606,861 234,034

Accounts Receivables 2,079,012 2,004,543 2,094,319 2,299,516 2,552,456

Inventories 768,687 1,035,787 1,074,685 1,192,570 1,310,261

Current Assets 4,177,788 3,951,571 4,972,097 4,633,818 4,684,407

PP&E 313,000 328,576 372,670 413,749 454,580

Total Non-Current Assets 5,316,031 6,968,849 7,176,974 8,282,983 9,064,308

Bank Borrowings - ST 430,848 490,610 697,790 774,396 850,819

Accounts Payables 2,208,404 2,336,991 2,400,943 2,661,710 2,924,386

Current Liabilities 3,317,362 3,664,820 3,792,058 4,206,077 4,621,161

Bank Borrowings - LT 1,256,552 1,256,007 1,255,734 1,255,734 1,255,734

Total Non-Current Liabilities 2,544,379 3,316,994 3,126,089 3,126,089 3,126,089

Shareholders' Equity 3,632,078 3,938,606 5,230,925 5,584,634 6,001,464

A/R Days 42.3 37.3 37.1 36.2 36.4

Inventory Days 14.3 19.4 22.5 22.1 22.3

A/P Days 48.1 48.0 42.9 41.8 41.9

Cash-Conversion Days 8.4 8.6 16.7 16.6 16.7

Debt/Total Capital 29% 32% 27% 27% 26%

Cash Flow Statement– US$ m FY10 FY11 FY12E FY13E FY14E

Operating cash flow 683,163 836,957 930,551 999,481 1,133,508

Investing cash flow (740,465) (990,804) (603,737) (1,183,622) (871,850)

Financing cash flow 4,664,832 (36,037) 567,732 (529,785) (634,485)

Free Cash Flow (FCF) 604,411 723,734 817,551 873,365 994,946

ROA 7.4% 6.7% 5.1% 5.9% 6.6%

ROE 18.6% 18.0% 13.5% 14.0% 15.7%

Sources: Bloomberg, the Company and Sun Hung Kai Financial



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The views about any and all of the subject securities and issuers expressed in this report accurately reflect the personal views of the research analyst(s) primarily responsible for this report; and the analysts are paid in part based on the profitability of Sun Hung Kai Investment Services Limited ("SHKIS") and its affiliates (collectively called "SHKF") which includes revenue from investment banking activities. Research Analyst Conflicts Financial Interests: The research analyst(s) who prepared this report and/or his/her/their associates has/have no financial interests in relation to listed corporation(s) covered in this report. Relevant Relationships: The research analyst(s) who prepared this report and his/her/their associates do not serve as officer(s) of listed corporation(s) covered in this report. SHKF's Financial Interests and Business Relationships SHKF may make a market in, or may, as principal or agent, buy or sell securities (or derivatives thereon) of issuer(s) mentioned in this report. SHKF may have a financial interest in the issuer(s) mentioned in this report, including a long or short position in its/their securities and/or options, futures or other derivative instruments based thereon, or vice versa. Likewise, SHKF, including its officers or employees may serve or have served as an officer, director or in an advisory capacity for any issuer(s) mentioned in this report. SHKF may also, from time to time, solicit, perform or have performed investment banking, underwriting or other services (including acting as adviser, manager, underwriter or lender) within the last 12 months for any issuer(s) referred to in this report. Information about conflicts of interest relevant to this report is available at this SHKF website: http://www.shkresearch.com/rp/disclosureOfInterests.html

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Li & Fung (494.HK) - jrj.com.cnpg.jrj.com.cn/acc/Res/HK_RES/STOCK/2013/2/20/68777330-6cea-4d5e... · Li & Fung (494.HK) – Turning a Corner 20 February 2013 Sun Hung Kai Financial