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Morningstar | Lowering FVE For Li & Fung Amid Looming Trade War; Upping Uncertainty Rating to Very High

While there is no direct impact on Li & Fung’s book of business from the initial list of China imports into the U.S., there is a risk that the subsequent USD 200 billion list of goods that may be subject to a 10% additional tariff could affect Li & Fung’s trading business.  As a result, we revise our fair value estimate for the company down to HKD 2.89 from HKD 3.06 to reflect this heightened risk. We also lift our uncertainty rating on Li & Fung’s cash flow and valuation to very high, given that the company’s thin margins are extremely sensitive to the escalating risks of a full-blown Sino-U.S. trade war.

As we pointed out in a recent report “Escalating U.S.-China Trade War Raises Risks; but our View Remains that Cooler Heads Will Eventually Prevail,” we think negotiation between the two countries is the likely eventual result, as it will allow President Trump to declare some political victory. In the case of Li & Fung, our base case assumes the 10% tariff on $200 billion Chinese goods will go into effect for the near term. Even though the list has largely left apparel (around 70% of Li & Fung’s business) untouched, we see items such as gloves, suitcases, handbags, cameras, and other miscellaneous items on the list. With hard goods like these predominantly manufactured in China and making up around 30% of the company’s trading revenue, we think the company will experience limited top- and bottom-line pressures in the near-term.

The bulk of our fair value estimate adjustment comes from modest downward revisions in revenue and margin assumptions, as we believe only a small portion of Li & Fung’s hard goods are subject to additional tariffs. We anticipate some retailers will bypass Li & Fung and source directly from manufacturers to offset rising costs, but on the other hand, either Li & Fung or the manufacturers it works with could pick up some of the costs to retain customers. We are assuming tariffs will be in place for the next three years and it will take around a year for retailers to find alternative sourcing options. We further believe that U.S. retailers will want to stay diversified once they switched away, and Li & Fung will only be able to win back a portion of the orders lost.

In the less likely case of a full-blown trade war, we think the company will suffer sales and margin declines for an extended period, leading to our revised bear-case fair value of HKD 1.12. The latest sign from President Trump indicates he is “ready” to put duties on everything the U.S. imports from China. If that happens, it will have a detrimental impact on Li & Fung’s sales and margins. Revenue and profits derived from sourcing hard goods will undoubtedly suffer, as the company sits on a limited number of suppliers outside of China that can manufacture similar goods. While a portion of textile-related products (soft goods) that Li & Fung sources are currently manufactured in China, we think the company has sufficient suppliers in Southeast Asia to serve as alternatives if tariffs affect the full USD 500 billion of trade. Since imposing tariffs primarily serves as a tool for the Trump administration to get some intellectual-property-related concessions from China, we assign a relatively low probability to a "tariffs on everything" situation, as this would hurt U.S. consumers.