Li & Fung (OTCPK:LFUGY), or L&F, a global supply chain manager for retailers and brands worldwide, engages in trading, distribution, and logistics services. Its turnover and net income ending FY2011 is $20B and $681M respectively; garments sourcing making up a big part of the business. As of 1H 2012 ended 30 June, the leading contributor of turnover is USA (62%, up from 58% a year ago), followed by Europe (decreased to 18% from 22%) and Asia (remains at 13%). China remains the biggest sourcing location at 56% in 1H 2012.
L&F shares have plunged about 40% over the 1 year period ending 1 Mar 2013. On 11 Jan 2013, L&F issued a profit warning that expected 2012 Core Operating Profit (COP) to decline 40% YOY mainly due to a $200M "ongoing restructuring costs and additional provisions" associated with their US unit, LF USA. Of this, the restructuring costs and provision for termination of loss-making brands each cost $80M and $40M is for other expenses.
The warning shocked the market mainly because the announcement came in less than 2 months after the L&F Analyst Day on 15 Nov 2012, which the management guided an earnings growth in 2012 on a YOY basis. The three-year target to achieve COP of $1.5B now appears far-fetched. Not only has this raised doubt among the analysts and investors on management's guidance credibility, questions were also raised on the effectiveness L&F's M&A strategy in meeting growth target.
As an investor, it is important to understand if the impact on profit growth is merely one-time or a sign of deeper problem within L&F's long-term business model, which is to pursue the "Twin Strategy": organic growth and strategic acquisitions.
Business Model: Organic Growth
The rising of minimum wage in China is a key concern for LF Sourcing, the biggest revenue generator under L&F's Trading (70% turnover and 91% COP contribution as of 1H 2012). . In 2012 alone, minimum wages has increased by an average of 20% in 25 Chinese provinces. The organic growth has been lackluster in recent years but masked by the one-time EPS boost from every accretive acquisition. EPS growth has lagged behind COP growth and with heavy equity and debt financing; the interest expense has also been increasing.
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Notably, after stripping out the $211M annualized COP contributed by the 19 new acquisitions in 2011, the 2011 organic COP actually declined by $54M. While it is difficult to isolate the cross-selling benefit as a result of the M&A, it is clear that excluding it would only reveal a much weaker organic COP.
The management expects double-digit growth for top 30 customers in 2013 within LF Sourcing. In contrast, L&F's main customers including Wal-Mart (WMT) and Target (TGT) are expecting persistent US sales weakness as a result of the US payroll tax hike sealed on 1 Jan. Also, other major customers such as J.C. Penney (JCP) and Marks & Spencers (MKS.L) had their shares tumbled after announcing weaker than expected sales earlier this year. In attempt to achieve further cost reduction by cutting out middleman, Wal-Mart, Fifth & Pacific(FNP), the owner of Kate Spade, children's apparel companies Carter's and Gymboree Corp have cancelled part of their deals with L&F in lately and planned to source more of their products directly in the coming years too.
Furthermore, FOMC minutes released last month indicated that the discussion to end near-zero interest rates policy came earlier than expected, although chances are slim that QE3 will go away in 2013. In terms of European turnover contribution, L&F has seen negative impact due to the sluggish economic condition. In 1H 2012, the absolute dollar sales amount has decreased by 13% on a YOY basis. Seeing no signs of improvement in the near term for European economies, I expect to see flat, if not declining trend in this segment. As heavy as L&F's business is dependent on the US and European markets, it would be extremely difficult to grow organically. Hence L&F is relying heavily on strategic acquisitions.
Business Model: Strategic Acquisitions
The 59 target companies acquired since 2004 had an average PE ratio of 8 compared to L&F's 25. This has enable L&F to leverage on the EPS boosting benefit from the accretive acquisitions. According to the management, the synergies from these deals have enabled more cross-selling, particularly seen in the Logistics Network that realised an 82% YOY COP growth as of 1H 2012. However, that record contribution is only 2% of the overall COP. On the other hand, on average since 2004, the acquired businesses as a whole have not managed to delivered satisfactory return and instead led to the deterioration of ROA:
Another proxy of M&A success, turnover per employee, has declined by 24%, from $892K in 2007 to $676K in 2011.
Benefit of the acquisitions aside, another consideration is whether the strategy is sustainable. L&F has relied heavily on external financing. In 2012 alone, L&F raised $1B via equity and bond placement. Since 2007, adjusting for the 2-1 split in May 2011, L&F's shareholders have experienced a staggering 20% dilution in ownership.
Assuming that L&F has $807M cash on its balance sheet ($307M as of Jun 2012 + $500M from bond issuance in Nov 2012). Accounting for the $3.5M annualized COP contribution from the new acquisition in 1H 2012, and further assuming an optimistic 5% organic COP growth rate and 10% Return of Asset (ROA) for new M&A targets, L&F will need to acquire another $5.2B of assets to meet the 2013 $1.5B COP. Based on the 30% upfront payment methodology indicated in the 1H 2012 presentation, L&F will still need to raise another $750M. See below for the sensitivity analysis of the fund requirements:
ROA \ Organic Growth
Moody's (MCO) has revised L&F's rating outlook to negative earlier this year, expecting Debt/EBITA for 2012 to rise over 3x and EBITA/Interest slipping to 5x-5.5x. The rating agency stated that they will downgrade L&F if it pursues more debt funding such that the ratios stays over 3x and below 6x respectively. Therefore based on the above model that does not even consider working capital needs and coupon payment, unless L&F decides to further dilute its owners or retain earnings for reinvestment, I expect a downgrade by the end of 2013 should the company continue pursuing its growth target. The credit rating downgrade will be devastating for a company like L&F that relies heavily on borrowing to make growth.
Operations & Financials
For some basic insights, I will compare several metrics of L&F to those of PVH (PVH) (owner of Tommy Hilfiger, Calvin Klein) and VF Corp (VFC) (owner of The North Face, Timberland). L&F's ability to generate cash flow from operation from sales and operating margin is less than half of this peer group. EBITDA margin that cancels out the differences in depreciation, takeover histories, tax and capital structures again underscores the weakness in L&F's operating profitability. Although L&F is highly geared, its 5 years EPS growth is only comparable to PVH and VF Corp. Having its market cap plunging almost 40% in 1 year, its EV/EBITDA ratio is still higher than this peer group.
Market Cap ($ bil)
Operating Cash Flow/Sales
5-yr EPS Growth
There is a clear surge in Net Debt/Equity ratio because (1) debt financing, (2) L&F acquires companies by paying 30% upfront and then booking the 70% into "Consideration Payable for Acquisition", which will eventually be performance based, before paying them over time. As of Jun 2012 that payable is $1.8B, or 27% of the total liabilities. When the acquisitions perform worse than expected, L&F simply credits the difference into operating profit as "Gain on Remeasurement of Contingent Consideration Payable", such as the $198M in 1H 2012. This has inflated the operating profit by 106%.
Goodwill/Total Acquisition Value
Furthermore, as of Jun 2012, L&F recorded intangible assets of $6.7B; only 7% of the non-current asset is tangible, or 40% of the total assets. The company has had a long history of acquiring targets with expensive premiums and has over time booked 84% of the acquisition value into goodwill.
As far as the stock is concern, I do not think all negatives have been effectively priced in. Some market participants should soon realize that there will be no imminent turnaround given the bottlenecking "as-is" business model and the thin balance sheet that is susceptible to heavy write-downs. I expect L&F's organic growth to continue be constrained by the weak macroeconomic outlook and customers' effort in skipping middleman. The fact that LF US has been under restructuring since H2 2011 spells the growing integration risks that has been overlooked by the aggressive acquisitions. While the acquired businesses no longer generate sufficient return to compensate for the risk amidst the piling up of goodwill and liabilities, L&F has left itself with no room for error in M&A but several options pointing to further downside: L&F can opt to maintain its aggressive growth target via more M&As with fund from either equity placement that is dilutive, or debt financing that risks rating downgrade. Another option is to overhaul the dividend policy. The management has not shown strong intention in this area because the high 80% payout has been a source of investors' confidence and share price support. With such dire cash needs, it is probably wiser to bite the bullet and reinvest the earnings for growth. L&F can execute combinations of above if it can handle the aftershock of the corporate finance exercises. And there is always a last resort to abandon the growth target.
During the analyst day, the management again avoided question on the cash drain. If management continues burning cash quickly without providing clear explanation, I expect investors to start losing patience and confidence in the company that has missed 7 earnings estimates over the last 11 releases. Admittedly, the barrier to cloning such huge supply chain network is high; but the potential competitors are actually L&F's own customers. Therefore it is my belief that L&F must:
- Re-emphasise on its strength in nimble management of supply-demand changes
- Focus on building up customers' dependency and exiting hurdle
- Move into higher-value activities in the value chain for better margin
- Concentrate on supply chain improvement of high quality acquisitions that can integrate and complement existing network in creating synergies on adequate risk-reward basis.
Until any signs of management's commitment into these, there is no apparent margin-of-safety to warrant L&F as long-term investment.
Additional disclosure: The research was first done on Li & Fung stock listed on Hong Kong Exchange (0494.HK) and this article was finished on March 10. All relevant figures cited can be found directly in L&F's annual/interim reports.