This segment will drive Li & Fung's core op profits

Stock now trades ~22-25x .

According to Nomura, sourcing business forms 70% of Li & Fung's FY13F core op profit. Thus the stock is trading at ~22-25x sourcing business earnings and ~8x EV/sourcing business EBITDA. 

Here's more:

Though sourcing is not growing at a fast rate, it is stable, and the key swing factor over next 2 years would be distribution, we believe.

We estimate distribution business margins of ~3% in FY13F, in line with sourcing, which is low.

We believe Li & Fung would either ramp up the profitability of distribution or eventually exit if it is not able to increase the margin profile over medium term.

Li & Fung has corrected significantly after the profit warning (25%). It is now trading at ~16x CY13F P/E (on consensus and 19x on Nomura ests), which we believe are closer to floor (historical low).

Assuming our estimates as floor (which are significantly below management guidance and almost lowest on the street), the downside could be limited from here. We thus upgrade to Neutral post correction but don’t see it as a Buy yet.

Catalyst: No positive catalyst yet; M&A is double edged. Macro indicators are not positive (Walmart outlook, etc.) and the next reporting by the company should be negative (they already gave profit warning). 

Thus we don’t think the stock will go up in a hurry. It will take time for the company to regain shareholder favour, we think, and needs to be backed up by margin/earnings pickup.

M&A could be the next corporate action, but the market may wait to see returns. Plus, any significant M&A activity could raise concerns on capital availability.