Feb. 4 (Bloomberg) -- The force is weak in them. Even the combined powers of Yoda’s light-saber lip balm, Bob the Builder t-shirts and Jennifer Lopez bras haven’t been enough to lift Li & Fung Ltd.’s sagging earnings.
The world’s biggest supplier of toys and apparel to companies such as Wal-Mart Stores Inc. and Kohl’s Corp. warned investors two years ago that the age of cheap manufacturing in China is over. Li & Fung set a target of $1.5 billion in operating profit by this year, with almost half coming from acquiring, licensing and distributing branded goods.
The strategy’s not working.
Li & Fung is likely to fall short by almost $600 million, according to the average estimate of 15 analysts surveyed by Bloomberg. Operating earnings plunged about 40 percent in 2012 after weaker consumer sentiment and margins hurt a U.S. unit that sells brands under license, the company said Jan. 11. The shares slumped 15 percent the next trading day, and hit a 3 1/2-year low in Hong Kong today.
“Li & Fung is trying to reposition itself, shifting its focus to more brand-management businesses, rather than just being a middleman,” said Gabriel Chan, a Hong Kong-based analyst at Credit Suisse Group. “The company is in the middle of a reform and it’s facing challenges from all fronts.”
In the U.S., where Li & Fung gets about 60 percent of its $20 billion in annual revenue supplying toys and clothes to retail chains, unemployment has hovered near 8 percent as the economy struggles to escape the 2008-2009 recession. Gross domestic product contracted 0.1 percent in the fourth quarter. Revenue from Europe has wilted amid the region’s debt crisis, falling to 18 percent of the total from 29 percent in 2008.
At the same time, manufacturing costs are climbing in China, Li & Fung’s biggest sourcing location. Minimum wages rose an average 20 percent in 25 provinces last year, the country’s labor ministry said on Jan. 25.
Li & Fung shares have plunged about 39 percent over the past year, the worst performer on Hong Kong’s 50-strong benchmark Hang Seng Index. The shares closed 0.6 percent lower at HK$10.66 today. Even after the declines, the stock trades at 22 times estimated earnings, about twice the Index average.
Twelve of 23 analysts tracked by Bloomberg who cover the company recommend investors sell the stock: the most pessimistic view on its prospects since May 2009. Six rate the shares “hold,” with five “buys.”
The company traces its roots to 1906, when parent Li & Fung Group was founded. In recent years, it has acquired rivals and entered into supply agreements to sell American and European retailers consumer goods that are mostly made in Asian countries. Now, some retailers are sourcing directly from suppliers in markets such as Bangladesh, Vietnam or Indonesia that are cheaper than China, Credit Suisse’s Chan said.
“I would say 2010 was the year that the deflationary trend for goods ended,” Li & Fung President Bruce Rockowitz said on an earnings call in 2011. “We’re into a new era of higher prices of sourcing,” he said, laying out the company’s three-year plans to seek higher growth businesses.
Gross margins for the distribution unit could go as high as 25 percent this year, compared with about 8 percent for sourcing, said Charles Yan, a Hong Kong-based analyst at Standard Chartered Plc, who recommends investors buy the stock.
“The company is still a solid business and it has no real competitor globally,” he said.
To bolster distribution, Li & Fung bought companies including TVMania, a supplier of Hello Kitty and Bob the Builder t-shirts, and jewelry and accessories maker Crimzon Rose. Other purchases include youth cosmetics company Added Extras, which sells the Star Wars-branded lip balm.
In the U.S., the company distributes brands in part through its MESH venture with New York-based Star Branding, whose partners include Andy and Tommy Hilfiger. Li & Fung’s U.S. business separately signed licensing agreements to sell Marilyn Monroe apparel at Macy’s and Lulu Guinness accessories in the first half of last year.
Earnings may become more unpredictable as the pace of growth in existing operations slows and the company tries to integrate its acquisitions, according to Bank of America Merrill Lynch analysts. Li & Fung announced 15 takeovers worth $1.6 billion in the past three years, data compiled by Bloomberg show.
Unlike sourcing, where Li & Fung depends on its ability to locate low-cost manufacturers that can meet its clients quality and volume demands, distribution hinges on securing the right brands. Managers also need the skills to manage more of the supply chain, including design and selling to outlets.
The company has shut some U.S. brands with much of the restructuring taking place within MESH, said Barclays Capital Inc. analyst Vineet Sharma, citing a conference call the company had with analysts.
Li & Fung hasn’t said which U.S. brands underperformed, or have been shut, and declined to comment on the performance of the distribution business because of a blackout period ahead of its March earnings announcement.
Some of the brands Li & Fung has “are little known,” said Chan at Credit Suisse. “L&F needs to acquire bigger and more significant brands, but they don’t come cheap.”
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