Yue Yuen Industrial (Holdings), the world's largest manufacturer of sports and casual shoes, yesterday offered a tepid outlook for the year after shocking analysts this week with its first annual decline in profit since listing on the stock exchange in 1992. The company said a return to 2003 profitability levels this year was unlikely, blaming rising raw materials and labour costs. Analysts, however, said the poor results reflected weak management skills and a lack of pricing power. 'It may take time to go back to the 26 per cent gross margin of 2003,' said Yue Yuen executive director Steve Li I-nan. 'If we can improve it by one percentage point, that would be good.' Investment bank Merrill Lynch, which had arranged a share placement for Yue Yuen's controlling Tsai family in October last year, issued a scathing report yesterday, downgrading the OEM shoe giant to a 'sell'. Under the heading 'Dumbfounded', Merrill Lynch analyst Jeanine Angell described Yue Yuen's fourth-quarter results as 'worse than we ever dared fear'. She expressed astonishment that operating margins could fall to as low as 7 per cent in the fourth quarter from 12.3 per cent for the whole of 2003, even when higher raw materials costs were taken into account. 'To say that Yue Yuen's result was disappointing is clearly an understatement,' she wrote. 'Its fiscal year 2004 result was 40 per cent below our estimate.' Gross margins at Yue Yuen fell to 23.9 per cent for the financial year to September. Net profit for the period dropped 1.59 per cent to US$303.3 million, even as turnover increased 8.39 per cent to US$2.72 billion. 'This level of margin deterioration is hard for us to comprehend,' she wrote. 'Clearly we have overestimated the strength of Yue Yuen's business model.' Ms Angell suggested there were only two possible reasons for the margin squeeze, '[neither] of which are good'. Either management has failed to push through higher prices, or it underestimated the impact of rising materials costs. The Tsai family divestment of 3.1 per cent of Yue Yuen in October has raised corporate governance concerns, with observers saying the deal now reeks of impropriety. 'Looking back, the timing of placement is really dubious,' said one fund manager who attended the Yue Yuen results briefing yesterday. 'The third-quarter results indicated an improvement from the previous quarter, but then the fourth-quarter results come out and surprised everyone.' While Yue Yuen is allowing raw materials costs to eat into profits, major customers such as Nike have reported an improving performance. Kim Eng Securities analyst Mark Po Ka-kit said the problem lay in Yue Yuen's inability to pass on costs. 'Yue Yuen has only a few major customers such as Nike and Reebok. Companies with no pricing power will suffer when costs rise.' Just three brands - Nike, Reebok and Adidas - account for more than 50 per cent of Yue Yuen's sales. Yue Yuen raised its average selling price to US$13.70 in the quarter to June, but had to lower it to US$13.40 the following quarter, Mr Po said. Mr Po projects flat net profit growth for the first quarter of this financial year, while Yue Yuen expects 15 per cent turnover growth for the period. About 40 per cent of Yue Yuen's raw materials are derived from crude oil, prices for which have surged. Raw materials costs as a percentage of Yue Yuen's sales rose to 48.22 per cent in the second half of last year from 45.45 per cent in the same period of 2003. But even if oil prices fall, Yue Yuen's profitability would suffer if other cost factors increased, Mr Po said. Other rising costs include wages in the Pearl River Delta, home to 68 per cent of Yue Yuen's global workforce of 250,000. Yue Yuen investor relations director Terry Ip Ming-chung said the company would boost its workforce in Vietnam - where wages are 25 per cent lower than in the mainland - by 10 per cent to 66,000 this year. The firm's China headcount would grow by just 2 per cent to 174,000 workers. The company also plans to spend US$150 million to add 19 production lines this year, most of which will be in Vietnam. Yue Yuen's share price fell 5.5 per cent yesterday to $20.60.