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Morningstar | Li & Fung Posted Lackluster Result; With Retail Headwinds Due to Persist, FVE Reduced to HKD 2.49. See Updated Analyst Note from 22 Aug 2018

Li & Fung reported another disappointing earning result that missed both consensus and our estimates. Revenue for the first half of 2018 was down almost 10%, and profits attributed to shareholders dropped by a staggering 19% on a like-for-like basis. Management continues to cite the overall promotional environment and weak retail sentiment in developed markets as the reasons behind its poor operational performance, and we think these headwinds will persist. It has also been a year and a half since the company started investing in various technologies in the hope of regaining traction with its clients. Yet, tangible results are few and far between. Over the next few years, we believe the company will continue to experience a decline in overall sales, while margin recovery will be more gradual. As a result, we are cutting our fair value estimate for Li & Fung to HKD 2.49 from HKD 2.89 per share.

We think Li & Fung's core trading business will continue to pressure the top line in the next three years as a result of retail destocking and bankruptcies in the U.S. and Europe. The company should be able to stem revenue decline by 2021 as investments in technologies will help retailers reduce production lead time. On the cost side of the equation, the previously announced corporate reorganization plan shows little effort in cutting headcount, leading to our belief that the group's operating cost will remain elevated in the near term.

One bright spot for the first half has been the robust performance of the group's logistics arm. The 11% and 15% expansions in top and bottom line respectively are slightly ahead of our expectation. This segment now contributes to around 30% of the group's operating profit and will most likely be a major driver of the business going forward. Management also announced the plan to spin-off and list around 25% of its logistics business, in an attempt to deploy proceeds to accelerate growth and enhance financial flexibility for the group. A minimal amount of information is available regarding the IPO. While we do expect the timing will be around first half of 2019, the partial listing should not materially alter our fair value estimate for Li & Fung, as the group will remain the majority owner of its logistics arm.

On the trade war, the company suggests that the first two rounds of U.S. tariffs had zero impact to its existing business, and the final USD 200 billion tariffs will merely impact 2% of its top line. While we are relieved by the fact the company remains relatively immune to tariffs that have been announced so far, we are maintaining a very high uncertainty rating on Li & Fung. Our bear case for the company revolves around what would happen if a full-blown USD 500 billion trade war takes place. In that scenario, we think the company will suffer sales and margin declines for an extended period, leading to our bear-case fair value of HKD 1.22.

Lastly, we are not fond of the Li & Fung's proposed cut to its dividend payout ratio from 80% to somewhere between 50% and 70%. Even though the lowering of the dividend payout ratio on itself has minimal impact to our free cash flow to firm projection for the company, we are more concerned that this decision might reflect management's less optimistic outlook for the business in the years to come.