Li & Fung:Increasing headwinds

Cutting FY earnings forecast. Downgrade from O-PF to U-PF.

Li & Fung is facing increasing headwinds. The softer retail environment inthe US, lower raw material prices, FX impact from a weaker Euro, and thehigher investments in VSS should weigh on margins and COP in FY15.

While we believe ROE should continue to improve post spin-off of GBG,slower earnings growth in the short-term and further downgrades shouldput pressure on stock performance. We arrive at our new price target ofHK$7, based on 15x CY16 earnings. Downgrade from O-PF to U-PF.

Discounting in the US; Deflationary market。

US retail market has softened, slowing down from 2-3% 3-month rollingaverage real-term growth in Q1 to 1% in Q2. Meanwhile, CPI also got intonegative zone. We believe that the US retail market should remain in adiscount-driven mode going into the 2H, which weighs on the wider-marginprincipal trading business. Raw material prices, such as cotton and leather,also continue to trend down. These should put pressure on Li & Fung’s costpluscommission-based trading business.

FX impact from Euro。

Retail market in Europe is growing in volume terms partially due to an easybase. However, Euro has depreciated by -20% yoy in the 1H, which shouldtranslate into lower turnover in US$ terms. Europe accounts for around 20%of Trading turnover. The unfavourable FX should more than offset the positiveretail development in Europe.

Cutting forecasts。

We understand that the company continues to invest heavily in VendorSupport Services, to create value in areas such as compliance, creditfinancing and logistics, and to cultivate additional revenue in the mediumterm. However, earnings contribution should only come in starting in FY16-17CL. In the near term, higher investments should weigh on COP. We lowerour revenue forecasts by 3-4% and COP by 11-16% in FY15-16CL.

Downgrade to UPF to a new price target of HK$7。

We believe that the street hasn’t fully reflected the softer retail environmentin the US, lower raw material prices, FX impact from a weaker Euro, and thehigher investments. We expect consensus estimates to come down. Our newprice target of HK$7 (previously HK$8.70) is based on 15x CY16 earnings.

With +5% implied upside, we downgrade the stock from O-PF to U-PF.