Finally, Li & Fung reveals why 2012 gains will crash 40%

It's a 'persistent' bad performance.

According to Barclays Resesarch, at a conference call, Li Fung Management gave details on why 2012 profits are likely to decline 40% y-y. Management said that persistent underperformance of certain parts of the LF USA business (which the firm believes refers to the US arm of the Group’s Distribution business) had led the Group to close down several brands.

While the Group did not give details on all the brands and businesses involved, it said a majority of this restructuring pertains to brands in the MESH Joint Venture that was launched in 2010.

Investors will recall that Li Fung had launched a JV with Star Branding (where partners include Tommy and Andy Hilfiger, Brent Ullman and Joe Lamastra) called MESH (Music Entertainment Sports Holdings) to launch licensed brands ‘ inspired by music, entertainment and sports celebrities’.

Several brands in this business, it seems, have run into trouble and appear to be chronically under-performing. The company has therefore decided to close down several of these licensed brands, amongst other parts of the LF USA business. This decision has two consequences, a one-off charge and a recurring one.

For now, this restructuring will lead to a one-off charge of about US$200m. This charge has three main components. The first is a write-down related to the impaired brands. 

The second component is discounts offered to retailers to unwind the inventory related to all merchandise of these brands. The third component relates to staff retrenchment costs.

Here's more from Barclays Research:

Our understanding from listening to the call on Friday night is that the first component has a charge of US$80m which seems to be non-cash in nature.

The second and third components add up to a charge of a further US$80-100m, which seem to be cash losses, though non-recurring.

Finally, the Group lost about US$25m due to Hurricane Sandy and the dock strike in Los Angeles. Cumulatively, these three factors lead to one-off losses of US$200m of which, more than half are non-cash losses.

Given that the Group has guided to a 40% reduction in core operating profit, the y-y decline works to cUS$350m. The one-offs mentioned above add up to only US$200m.

Therefore, this implies that the ongoing business’s profits are tracking US$150m below expectations for 2012. It is this slippage that concerns us most.

Reasons for this slippage are not far to seek. Management said during the call its revenue for 2012 is likely to be flat y-y. This is a disappointment for even in the first half of the year, the Group had managed to eke out 3% revenue growth.

In fact, we were expecting revenue growth to accelerate to 9% in the second half (in line with Consensus) and for the full year number to show about 7% growth.

This revised guidance for flat revenue growth implies a revenue shortage of US$1.5bn. Further, if one applies the 5% EBIT margin that the Group earned in 2H11 to this number, one gets to an operating profit shortfall of US$75m on account of this revenue shortfall.

The remaining US$75m slippage (150 less 75) is on account of worse than expected gross margins in the LF USA business, in our view.

LF USA has a revenue run-rate of around US$3.5bn and a 2 percentage points lower than expected gross margin could explain the entire remaining US$75m slippage.