Trouble in store for sidelined supplier Li & Fung

Li & Fung, a supplier to retailers such as Walmart and Target, faces mounting pressure on margins and head-to-head competition with its big customers.

The large retailers are increasingly working directly with factories and cutting out the Hong Kong-based supply chain manager.

Li & Fung said this week Walmart had ended its call option to buy Direct Sourcing Group, a unit set up in 2010 to serve the world's biggest retailer.

"The most alarming fact for Li & Fung is that the customers would like to source products on their own, and it has to secure business by adding more value-added services," said Gabriel Chan, an analyst with Credit Suisse.

"Margin erosion could be structural, rather than cyclical, meaning the pressure on margins could persist for a prolonged period."

But Chan said the impact of Walmart's latest move on Li & Fung's future earnings should be limited as the unit was still only marginally profitable.

Li & Fung declined to comment on the loss of business from Walmart, but chief executive Bruce Rockowitz said last month that while retailers could technically work directly with factories they would still need middlemen like Li & Fung to manage logistics, provide communication tools and carry out quality checks.

Shares of Li & Fung slid 2.56 per cent yesterday to HK$12.20. The stock has declined more than 15 per cent this year, compared with a 12.5 per cent rise for the Hang Seng Index.

Peter Chu, an analyst with Yuanta Securities, said the ending of the option should be viewed as a "slightly positive" signal because under a new agreement, the business relationship between the two firms had become clearer.

"The new agency agreement will continue for five years with an option for an extension of two years, a positive sign for both parties," Chu said.

HSBC analyst Chris Zee upgraded his rating of Li & Fung to overweight because monetary easing in the United States could bolster a significant revival in the firm's earnings.

Last month, Li & Fung's shares saw their biggest single drop in price since the firm listed on the Hong Kong stock exchange in 1992 - falling 19 per cent - after operating profit fell 22 per cent to US$221 million in the first half of the year.

The outsourcer is targeting a core operating profit of US$1.5 billion next year, but market participants suggest it is unlikely to meet such an aggressive target.

The firm has adopted a strategy of expansion through acquisitions, but investors started to question its growth prospects after a write-back of US$198 million after two acquisitions failed to perform adequately.