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Li & Fung May Need More Purchases to Meet Earnings Targets

Li & Fung Ltd., the Wal-Mart Stores Inc. supplier that doubled its workforce after at least 11 acquisitions in the past year, may need to make still more deals to meet its earnings targets.

The world’s biggest supplier of toys and clothes to retailers may report first-half profit fell 25 percent to HK$1.6 billion ($205 million) when it announces earnings today, according to the median estimate of seven analysts in a Bloomberg News survey.

The outsourcer has dropped 47 percent this year, wiping out about $11 billion of market value amid the faltering U.S. economy and rising costs. After pledging to focus on “organic growth” in the next three years, Li & Fung may instead need to make more purchases to meet its goal of more than doubling operating profit at its main business to $1.5 billion by 2013, according to Credit Suisse Group’s Gabriel Chan.

“They need to drive growth further by having more acquisitions,” said Chan, who has an “outperform” rating on Li & Fung. “If we assume no further acquisitions, then I think it will be very tough to meet its three-year target.”

Li & Fung fell 16 percent in July and has the second-biggest loss on Hong Kong’s benchmark Hang Seng Index this year. The stock closed unchanged at HK$12 in Hong Kong trading today after earlier gaining as much as 1.7 percent.

Consumer Sentiment

The Hong Kong-based company, which traces its beginnings to 1906, when parent Li & Fung Group was founded, made 65 percent of last year’s HK$124 billion revenue in the U.S., where consumer confidence fell to the lowest level in two years in July, a survey from Thomson Reuters/University of Michigan showed.

Flagging consumer sentiment in the U.S. “makes life hard for all businesses” relying on that market, said Matthew Marsden, an analyst with Samsung Securities Co. in Hong Kong.

Last year’s purchase of Integrated Distribution Services Group Ltd, the company’s biggest in at least the past decade, may help Li & Fung make more sales outside the U.S. IDS distributes goods in Asian nations, including China.

“Our ambition is to both source globally and sell globally,” Deputy Chairman William Fung said in a June interview. “You can’t sell globally unless you are selling to China.”

Li & Fung, whose annual sales grew in all but one of the last 19 years, reported core operating profit, which excludes items such as interest income, taxes and acquisition-related costs, gained 42 percent to HK$5.7 billion in 2010.

Silk and Fireworks

The company started out selling porcelain, silk, jade and fireworks, and now says it supplies companies from Target Corp. and Marks & Spencer Group Plc to Esprit Holdings Ltd. and Paul Smith Ltd. to Avon Products Inc. and Nivea maker Beiersdorf AG.

Rather than tracking down materials or making products themselves, companies such as Liz Claiborne Inc., Inditex SA’s Zara and Toys “R” Us Inc. rely on Li & Fung to do that.

Concerns about faltering global economic growth may prompt more companies to “stop purchasing for themselves and turn to companies like Li & Fung, because of its economies of scale,” said Kenny Tang, Hong Kong-based general manager of AMTD Financial Planning Ltd.

First-half profit may be affected by the costs of building the division to supply Wal-Mart. The division, called the DSG Group, may contribute $2 billion in revenue this year and its chief, Dow Famulak, said in June it has “addressable business” of as much as $100 billion.

Doubling Profit

Li & Fung has used acquisitions to boost growth, spending at least $3 billion on deals from 2006 to 2010, doubling both sales and profit in the five-year period, according to data compiled by Bloomberg.

The company tends to retain the management of businesses it acquires, helping maintain an “entrepreneurial spirit” among its executives, said Marsden, who recommends buying the stock.

“Their strategy is to acquire good people,” said Marsden, adding that Li & Fung needs to continue making purchases.

With some acquisitions, Li & Fung links the price to the performance of the unit after it joins the company. For instance, it agreed to pay as much as 173 million pounds ($281 million) for clothes maker Visage Group Ltd. last year. Of that amount, more than 115 million pounds would be paid over three years if the unit met annual profits-before-tax targets.

Profit Margin

Turmoil in the global markets may help Li & Fung “because acquisition prices may go down,” Tang said. During the financial meltdown of 2008, “its market share actually expanded because smaller rivals were forced to shut down,” he said.

The company receives orders from clients, which are filled through a network of more than 12,000 factories around the world. About half of the products are made in China.

The doubling of its workforce to more than 26,000 people will raise costs and may narrow margins, Tang and Chan said.

Li & Fung had a profit margin of 2.91 percent in the second half of 2010, compared with 3.39 percent in the previous year. Profit margin for the first half of this year may be 2.76 percent, according to the median of five analyst estimates in a Bloomberg News survey.

First-half profit may account for 30 percent of this year’s total, lower than the historical average of 40 percent, because of higher costs, Fung said in June.

Acquisition Fund

Relying on organic growth “clearly” won’t be enough if the company is to meet its earnings target, Tang said. Li & Fung had about $1 billion in its acquisition fund, Chief Executive Officer Bruce Rockowitz said in March.

While Rockowitz has said the U.S. will remain Li & Fung’s biggest market “in my lifetime,” the company aims to make more sales in Asia. The LF Asia division aims to have more than $1 billion sales by 2013, Jason Rabin, the unit president, said in June.

More than half of that will come from China, said William Fung, who takes over as chairman from older brother Victor Fung next year. The brothers rank No. 5 on Forbes’ Hong Kong rich list with an estimated combined wealth of $8.6 billion.

The company will also look to Asia, including Japan and China, for more acquisitions, Rockowitz said in May. The goal is to be “selling to China out of Asia,” he said.

The company may use LF Asia to deliver western brands into Asia, Marsden said.

“Li & Fung has been gearing up for the next stage of growth,” he said.

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