Li & Fung - Potential loss of another large customer

Li & Fung’s (L&F) may lose one more major customer, Arcandor, as it could either go bankrupt or be acquired by Metro. The Group still faces sluggish sales and credit risk. Maintain SELL.

Following KB Toys and Mervyn’s, another major customer of L&F – Arcandor – may go bust as well. Arcandor, the operator of the largest department store chain Karstadt, may need to file for bankruptcy if it fails to refinance Eur650m (US$928m) of loans by 12 Jun 09. The German government has rejected Arcandor’s application for an emergency loan. Metro, another large retailer in Germany, said it is interested to buy 60 of Karstadt’s 90 stores.

In a worst-case scenario where Arcandor is insolvent, L&F could lose as much as HK$611m in net profit in 2009 (23% of total) and HK$78m (3% of total) a year from 2010 onwards. The negative impact on L&F should be three-fold. It loses the business from Arcandor, it will need to write off the investment in Arcandor and write off the trade receivables from Arcandor.

• L&F paid US$77m for Karstadt sourcing in Oct 06, including US$68m (HK$530m) of goodwill, which it would need to write off if Arcandor goes bankrupt.
• The Group said it has outstanding trade receivables of HK$42m from Arcandor.
• We estimate L&F will derive US$500m (HK$3.875b) of revenue from sales to Karstadt in 2009. Assuming a net margin of 2%, this translates into an annual profit contribution of HK$78m (half-year impact for 2009).

If Metro acquires Arcandor’s assets, L&F may not need to make provision for its due from Arcandor. However, the Group may also lose Arcandor as a customer. Note that Metro has its own purchasing office in Hong Kong which can serve the merged entity of Merto and Karstadt. L&F would then need to try hard to procure business from Metro.

The market has been over-emphasising the accredition of the outsourcing deals and M&As, including Karstadt, Tommy Hilfiger and Mexx (Liz Claiborne). However, we believe these deals would only fill up the income gap left by a drop in sales or the disappearance of some customers. Our earnings forecasts have factored in such cases. Thus, we maintain our 2009-11 profit forecasts for L&F.

A further contraction in retail sales in the US and Europe, a result of deleveraging by consumers and unemployment, could prompt the Group’s customers to further cut orders. Furthermore, any bankruptcy of the Group’s customers would result in unexpected write-offs in trade receivables.

Based on our earnings forecasts, L&F trades at 28x 2010F PE, the mid- to high-end of its historical PE band. Given the stretched valuations and considerable earnings risks, maintain SELL with a fair price of HK$15.60, based on 20x 2010F PE (the historical average one-year forward PE).

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