Is Li and Fung a good business to source from?
If you think the way stock markets do, Li and Fung (L&F) is currently an awful company to get involved with. If you think the way garment buyers do, recent events at L&F might make you think a bit harder about increasing you business with them or reviewing alternatives– but for most of us, most of the time, they’re still the best third-party sourcing operation in the world.
But that’s not how it would look if you followed their share prices. After a pretty torrid six months, with a ton of bad news (not all properly understood by the stock markets) they’re now the worst performing major share on the Hang Seng Index
. A great deal of that news has nothing to do with buying garments so we need to understand what kind of business L&F is.
For the past century or so, L&F have sourced manufactured products, mostly in China, for Western companies. They’re pretty good at that, have easily the widest network of buying offices around the developing world – and that network has the most impressive depth of technical understanding of fabrics, components and the logistics of getting goods profitably from remote factories to a Western port. L&F aren’t quite as big as they and the outside world like to think: their 2011 “soft goods” sales of $8.2 bn, for example, made up just 3% of the West’s imports of apparel from foreign countries. It buys about the same amount of clothes as Gap, H&M or Inditex – and a great deal less than Walmart.
But that sourcing business has grown over the past 20 years. Though it’s highly profitable, the L&F sourcing business is probably close to reaching maturity in my view: the West has offshored as much as it ever will (for apparel: around 99% by volume in the US, Japan, Britain, France and Germany), and L&F customers’ sales will grow at best only in line with their economies: up a percentage or two in a good year, down a bit in a bad one. As long as L&F’s business is focussed on retailing in the West, its problem isn’t whether retail markets are growing or not, but that the L&F growth between 1990 and 2010 caused by the move offshore can’t grow further: for growth, L&F needs either to increase its share of Western offshore sourcing, or find another business.
Personally, I can’t see why it’s struggled so unsuccessfully to increase its share of Western sourcing. In 2011, for example, its sales to the US were three times its sales to Europe – though European garment buyers spent over twice as much buying garments from abroad as their American peers did. L&F sold five times as much to the US as to Asia – though US procurement of clothes from abroad was only three times bigger than Japan. L&F’s failed to make serious headway in Europe or Japan, just as it’s struggled in consumer products outside apparel – and there are lots of Western garment buyers it’s failed to bring on board as well.
But, for whatever reason, L&F decided that its growth strategy was going to be in other business streams. It calls those streams Distribution (handling brands in Western markets) and Logistics (which is much as it says, but mostly in Asia). Distribution in the first half of the current financial year accounted for about 30% of the company’s sales (almost all the rest is the sourcing business) but over 50% of its operating costs, and it’s extraordinarily difficult to get a simple explanation of why.
It’s actually pretty difficult to get a simple explanation of what the Distribution division actually does. L&F officially says it “addresses [retailers’ and brands’ specific needs in the areas of design, sales and marketing, and distribution as well as managing the supply chain”, which sounds like an awful lot. But when it lost the Distribution contract it had with Fifth & Pacific
(the rump of the company formerly known as Liz Claiborne, without the Liz Claiborne brand), L&F were quick to insist all the contract actually involved was just warehousing and physical distribution in the US. But the Distribution business has paid some pretty fancy prices to acquire businesses other third-party logistics providers simply sign a service contract with, and one of the things stock analysts complain about is that they don’t actually understand what the division does either.
So on January 11, L&F put out a profit warning, saying “Based on the preliminary review of the ongoing restructuring of LF USA’s business, including the reduction in the number of brands distributed in the USA which negatively impacted the Company’s margin, the Group’s efforts to improve the second half results will not achieve an improvement in core operating profit, and core operating profit is expected to be lower by approximately 40% compared to 2011”. To cut a longish warning short: Distribution was losing money in the US, it needed restructuring, and doing that was going to eat into group profits for 2012, which would be reported in late March 2013. The warning went out of its way to stress that the sourcing division (confusingly called Trading) was performing just fine.
That was greeted with some scepticism by the market, since neither it nor I had fully grasped what the implications really were of a kerfuffle in autumn 2012
when Walmart seemed to be cutting back the business it was doing with L&F. The Wall Street Journal claimed L&F was going to lose revenue, L&F denied that and the market was waiting for the full year results to understand all this properly. The market’s pretty fixated on L&F’s performance against its group target, and it’s an indication of just how untransparent the business has become that analyst comments vary so spectacularly: from complaints of highly creative accounting inflating recent reported profits, to the belief that sorting out Distribution will get it back on track, to lots of deep-rooted worries about the stability of its sourcing business.
I don’t profess to be able to comment usefully on the Distribution division or the creativity of the company accounts: this Blog is about sourcing, and since L&F is the world’s biggest sourcing specialist, that’s what I ought to be addressing. But there’s one very important point to stress about the Distribution division. L&F is based in Hong Kong, but its core Sourcing business is built on Western markets. Developing the Distribution division didn’t change that: it merely added a set of management skills L&F had no previous expertise in (marketing and logistics) to those it was arguably the world’s greatest expert in. There’s no more compelling reason for L&F sourcing clients to buy their marketing or logistics needs from L&F than to buy their auditing from L&F if it had chosen to diversify into accountancy. L&F’s revenues are still mostly dependent on the health of Western consumer markets – though many lazy analysts have long assumed the company is some kind of entry into fast-growing Asian businesses.
What spooks the stock markets about L&F’s sourcing business, though, is a recurring belief that it’s losing its retail clients. Not too surprising: L&F spent much of the past few years telling shareholders the growth in sourcing was going to come from buying brands’ and retailers’ sourcing departments. That hasn’t quite worked out, and once stock analysts start losing faith in a company, they start thinking for themselves.
To many, it sounds counter-intuitive that retailers will let someone else source for them. It’s not, of course – any more than it’s a law of nature that retailers will own their own stores or employ their own warehouse staff. Having a sourcing agent for some or all of a retailer’s or brand’s range is just good management: no retailer will ever be able to survey all possible eligible suppliers, everywhere in the world, of his whole range and an agent will always be able to add something to any buyer’s capabilities.
Equally, though, there’ll be times and circumstance when buyers will think their business is relying too much on third party agents: apart from anything else, if a predecessor has decided to let a supplier have the monopoly on a company’s buying, how are you going to tell if he’s giving the best value unless you’ve got other supplier to test him against? So any decent buying company will be churning suppliers to some extent – and that means there can be periods a buying agent will be a net loser of business unless he’s working hard to promote himself.
I doubt L&F have got the resource to promote themselves properly: their “growth” strategy till lately has been to get into businesses they know little about – and that leaves little management time marketing their skills in their core business
But they’re also suffering from a few self-inflicted wounds:
There’s a very odd flaw emerging in their business model. Mainly dependent on sales to the US, their average income per transaction must be falling, because average US apparel import prices are falling
. This isn’t, as we’ll see in a moment, how L&F expected to see the world develop (which does rather undermine their self-appointed, and quite unjustified, role as global sourcing gurus). But on an average of 5% of selling price, they lose income if costs decline. Meanwhile, inflation (in things like posh office rent, travel and management salaries) is higher in the developing market business centres their staff operate in than it is in the cheap places where their clients work.
– This does rather undermine their credibility. On May 31, 2011 Bruce Rockowitz, L&F’s CEO announced the end of the deflation era, and for garment prices “The long-term trend is 5, 6 percent a year up, probably, over the next five years”. In May 2012, US imported apparel prices were precisely where they’d been the day Rockowitz spoke: in December 2012, they’d been precisely where they’d been five years earlier. A minor bit of poor judgement?
– At the same time, Rockowitz also announced L&F’s buying costs were 15% up on the year before, and they were passing those rises on to retailers. Average US apparel import prices that month were 14% up – a trivial difference, except that L&F were claiming to be better buyers than average. How many retailers would be likely to pick up the phone to L&F after realising that what L&F were doing for their 5% was finding higher price rises than the average buyer had negotiated for himself?
– This sort of silly prediction is par for the L&F course. In March 2010, they announced “they” intended to move production out of China (their clients’ opinions seem not to have mattered). In August 2011, they revealed “they” had done precisely the opposite. Again: a minor discrepancy, and who can really predict the future? So why make such assertions? The answer is, of course, that “leaving China” in 2010 was the sort of trite ponderous nonsense people were churning out at Davos, just as “the end of the deflation era” is the kind of meaningless generalisation stock analysts love to hear.
Sadly, though, it’s not just shallow public speeches that undermine L&F’s sourcing credibility with professional buyers. When Walmart garments were found in the wreckage of the burnt out Tazreen factory in November 2012, and it became clear the factory was built in defiance of the most fundamental safety principles, most other buyers uncharitably assumed Walmart had simply not bothered checking it. But when L&F garments were found there, buyers were horrified. L&F have never been famous for strict compliance, and in 2009 even stockbrokers were registering alarm about L&F’s ethical standards
. But what L&F claims it does is to find and verify suppliers. And if its staff in Dhaka couldn’t spot a firetrap, went the buzz, what chance was there they’d spot anything else? Complicity in a lethal fire was a shock for Walmart: it was an extraordinary indictment of L&F’s competence in the basics of a craft they claim to lead the world in. And not a word has been heard from the company about it since.
L&F’s sourcing business is still the world’s biggest and its service the world’s most comprehensive, and we all make mistakes. But, with just 3% of the world’s apparel sourcing, L&F knows a great deal less about what’s going on in the world than it thinks – or pretends to its shareholders and clients. And its sourcing business model has a couple of real vulnerabilities – some of which might be sorted by a lot more management attention to the basics of its core business.
If it can turn its Distribution division into a real profit earner, the division is still going to contribute less to the business than its sourcing core, and L&F faces far more competition in the area than it does in sourcing, where no-one has anything like its scale. But with more energy being put into the sourcing operations of Luen Thai
and Mast Global
, that competition will get tougher. And self-inflicted wounds will do a lot more damage