Samsung Securities - (Research - SSA Li & Fung (494 HK))

January 8, 2010

This report has been prepared by Samsung Securities (Asia) Limited.

*Not licensed in Hong Kong nor carrying on any business in Hong Kong. ANALYST CERTIFICATION AND IMPORTANT DISCLOSURES BEGIN ON PAGE 29

Li & Fung (494 HK)

COMPANY INSIGHTS

Don’t fight The Matrix… own the Outsourcing Oracle

Bears attack Li & Fung due to lack of organic growth and aggressive

acquisitions. However, the company’s strategy has been successful in

delivering historical growth; our case study of Oracle (ORCL US, N/R) plus

analysis from McKinsey shows that the market rewards ―Active Acquirers‖

that take advantage of a downturn (while 60% of companies simply freeze).

Given the fragmented nature of the sourcing market, far from being

problematic, a policy of acquisitive growth strengthens Li & Fung’s formidable

Global Matrix, which represents a sustainable competitive advantage.

Moreover, we believe that the present macro recovery will surprise on the

upside led by inventory restocking and a shift to an inflationary cycle.

Importantly, the Li & Fung Matrix is demonstrating operational leverage for

the first time. Combined, these factors drive impressive earnings growth.

We think that a moderate re-rating to the historical average 25x PE is justified

by 32% 2009-11e EPS CAGR. Note - this CAGR is NOT inflated by calculating

it from the cyclical low (which would be 2008), and is above the 27% EPS

CAGR from 2005-07, which triggered a re-rating to over 35x PE. Given ROE

recovery and all time high EBIT margins plus positive newsflow from better

retail sales, a return to the average 25x PE may even be conservative.

Our 12-month target of HK$43.00 represents 31% upside. BUY Li & Fung.

SUMMARY FINANCIAL DATA 12-07 12-08 12-09E 12-10E 12-11E

Revenue (HK$m) 92,460 110,722 115,686 148,925 176,120

YoY growth 36.0% 19.8% 4.5% 28.7% 18.3%

EBIT (HK$m) 3,600 3,044 4,547 6,452 7,794

EBIT margin 3.9% 2.7% 3.9% 4.3% 4.4%

EPS (diluted, HK$) 0.88 0.69 1.06 1.54 1.86

YoY growth 32.9% -22.1% 54.0% 45.4% 20.7%

Net margin 3.3% 2.2% 3.4% 3.8% 3.9%

ROE 31.0% 18.1% 21.8% 28.4% 31.2%

PE 37.1x 47.7x 31.0x 21.3x 17.6x

Dividend yield 2.2% 1.7% 2.6% 3.8% 4.6%

Source: Company reports, Samsung Securities. Price based on close 6 January 2010 HK$32.80.

0

1,000

2,000

3,000

4,000

5,000

6,000

1999-2001 2002-2004 2005-2007 2008-2010E

Evolution of Li & Fung's 3-year plans

Net profit (HK$m)

Lead industrychange.Reinvent

distribution through value-chain logistics.

Create new culture.Regional stream

organization, operations

focus and IT invesment.

Net profit (HK$m)

New service agency model.

Unbundling distribution and the creation of

a "Menu of Services."

Create operating leverage.

Active acquisition strategy.

HK$43.00

Target price

Upside +31%

Current price HK$32.80

Matt Marsden

[email protected]

+852 3411 3710

Technical analysis contributed by:

Seung Min You and Sang Cheol Im

Samsung Securities Korea*

SAMSUNG vs THE STREET

Li & Fung Reloaded

Samsung target price vs Consensus +19%

Samsung 2010e EPS vs Consensus +15%

Street recommendation distribution 62% Buy

19% Hold

19% Sell

Our 2010e EPS numbers are 15% ahead of

consensus, driven by a combination of operating

leverage (Li & Fung is demonstrably increasing

EBIT margins for the first time), the impact of

2009 acquisitions, plus a macro recovery which

will surprise on the upside.

Three Oracles help us divine that this stock will

reward investors:

Our case study of Oracle (ORCL US, N/R)

and McKinsey’s work shows that the market

will reward companies that can successfully

grow via “Active Acquisition.”

The Oracle of Omaha. Warren Buffet, looks to

invest in companies with a sustainable

competitive advantage. Li & Fung’s sourcing

network has been strengthened by recent

acquisitions and qualifies as a “Deep moat.”

The Oracle from the Matrix movie trilogy

shows that countercyclical investment can

bring rewards. Our 12-month price target of

HK$43 is significantly ahead of consensus.

“What is the Matrix? Control”

Morpheus, The Matrix, 1999.

January 8, 2010

THE PITCH

Growth by acquisition is not a negative. Our case studies show that the market rewards reputable companies that are “Active acquirers.”

The acquisitions completed during the downturn will help Li & Fung outperform during recovery, and have strengthened the company’s core sustainable competitive advantage; Li & Fung’s Matrix of global sourcing capabilities.

For the first time, Li & Fung is achieving operational leverage through cost savings. As top line picks up, earnings will explode. We see 32% EPS CAGR 2009-11e, which easily justifies a return to the historical mean PER of 25x.

FUNDAMENTALS p3

The company’s core strength - its global matrix - has been enhanced by recent acquisitions. Li & Fung operates in a fragmented market; so far from being problematic, their policy of acquisitive growth is essential to success.

Macro recovery will surprise on the upside. We forecast 29% YoY revenue growth in 2010e helped by inventory restocking, a shift to inflation and 2009 acquisitions.

Top line recovery will combine with operational leverage, for the first time, resulting in earnings upside surprise. Our 2010e EPS is 15% above consensus.

VALUATION p17

A moderate re-rating to the historic average of 25x PE is supported by 32% EPS CAGR 2009-11e. Note - our EPS CAGR is NOT inflated by calculating it from the cyclical low (which would use 2008 as a base).

We note that our 2009-11e EPS CAGR is above the 27% EPS CAGR seen in 2005-07, which triggered a re-rating to over 35x PE.

ROEs are heading back to historic highs and EBIT margins are actually going to be higher. Plus newsflow will be positive. Far from being aggressive, a return to the historic average PE of 25x may even be conservative.

Using a 25x PE target applied to blended 2010 / 11e EPS gives us a January 2011 price objective of HK$43.00, representing 31% upside.

A DCF yields a fair value of HK$44.00, representing 34% upside.

TECHNICALS p20

A mild correction is in the offing over the next two quarters.

That said, with the medium-term support line remaining intact, a strong downward trend reversal is unlikely in the near term.

In the medium to long term, we find the stock attractive technically.

BEAR VIEWS & BLUE SKIES p22

A bear view PE based valuation yields a fair value of HK$19.00, representing 42% downside.

A blue sky PE based valuation yields a fair value of HK$54.00, representing 65% upside.

Li & Fung

RETURN FORECAST

<15% 15-30% >30%

Stars reflect absolute value of u/downside to target price

Fundamentals Li & Fung’s acquisition strategy is NOT a negative, and has helped build The Matrix of global sourcing capabilities which is a sustainable competitive advantage. Earnings should surprise on the upside as top line growth combines with operational leverage to deliver 32% EPS CAGR 2009-11e.

Valuation

Our base case PE valuation yields a January 2011 price objective of HK$43, which represents 31% upside.

Technicals

Mild correction near-term likely. We find the stock attractive long-term technically.

VALUATION

12-08A 12-09E 12-10E

PER (x) 47.7x 31.0x 21.3x

PBR (x) 8.6x 6.7x 6.0x

EV/EBITDA (x) 34.4x 23.5x 17.1x

Dividend Yield (%) 1.7% 2.6% 3.8%

ROE (%) 18.1% 21.8% 28.4%


Samsung Street

Target price (HK$) 43.00 36.03

EPS 10E (HK$) 1.54 1.34

Buy/Hold/Sell Buy 10/3/3

AT A GLANCE

Li & Fung is the world’s leading sourcing agency.

Sector Sourcing

Market capitalization US$15.5bn

Shares outstanding (float) 3,776m/60.8%

52 week high-low HK$12.4 – 36.2

Bloomberg 494 HK

One year performance 1M 6M 12M

Li & Fung +0% +59% +136%

Hang Seng Index -1% +22% +43%

THREE NUMBERS THAT MATTER

Top line growth 2010e EPS CAGR 2009-11e ROE recovery 2010e

+29%

+32%

28% After -2% YoY top line decline in H1 2009 (the first

ever YoY decline in our memory) we think that a return to organic growth and acquisitions will boost top line, and forecast 29% growth this year.

After a 22% YoY decline in 2008, EPS growth is

returning. We forecast 32% CAGR 2009-11e.

Top line growth and operational leverage will lead

to a recovery in return metrics. We forecast ROE will improve from 18% in 2008 to 28% in 2010e.

January 8, 2010

Li & Fung

3

1. Business Fundamentals

Of Oracles and Acquisitions…

Three Oracles

Three Oracles help us divine that this stock will reward investors:

1) A case study of the software services giant Oracle (ORCL US, N/R), reveals that

the company’s active acquisition strategy has driven share price outperformance

since mid-2004. We explore McKinsey’s study of acquisition strategies, and

conclude that far from being a negative, the market should reward Li & Fung for

its ―Active Acquisition‖ policy.

2) The ―Oracle of Omaha‖, Warren Buffet, looks to invest in companies which have

dug deep economic moats. This serves to remind us of Li & Fung’s core strength of

its Global Sourcing Matrix, which has been strengthened further by recent

acquisitions. The Matrix acts as a sustainable competitive advantage, locking in

customers and suppliers.

3) The Oracle from The Matrix movies. This oracle has the power of foresight, but

she herself claims that she lacks the ability to see past her own choice, explaining

that no one, including herself, can see past a choice they do not understand. This

reminds us of how bears on Li & Fung don’t understand that inorganic growth can

be entirely a good thing.

We forecast an earnings explosion in 2010-11e driven by top line growth as the

macroeconomic recovery surprises on the upside, combined with acquisition gains and

(for the first time) operational leverage at Li & Fung. We forecast 32% EPS CAGR

2009-11e.

1) Oracle (ORCL US) "We'd be interested in buying almost anything"

Bears attack Li & Fung for the previous lack of organic growth (H1 09 revenues

declined by 2% YoY), and for the highly acquisitive nature of the company i.e. Li &

Fung has effectively been buying revenue, but has still not managed to generate top line

growth during the downturn.

However, McKinsey have found that, long-term, a company’s actual choice of markets

and M&As are four times more important than outperforming in its markets.

In The Granularity of Growth, McKinsey created a database of roughly 200 global

companies and decomposed the most important sources of growth; market

momentum, mergers, and share gains.

Then they identified segments that had experienced significant upturns or downturns

and looked at the strategies companies adopted during those periods. Finally,

McKinsey computed each company’s total returns to shareholders so as to compare

performance across growth strategies.

INDEX

1. Business fundamentals p3

2. Valuation p17

3. Technical analysis p20

4. Bear Views & Blue Skies p22

Fundamentals Li & Fung’s acquisition strategy is NOT a negative, and has helped build The Matrix of global sourcing capabilities which is a sustainable competitive advantage. Earnings should surprise on the upside as top line growth combines with operational leverage to deliver 32% EPS CAGR 2009-11e.

McKinsey have found that a company’s actual choice of markets and M&As are crucial.

January 8, 2010

Li & Fung

4

McKinsey found that of the potential strategic moves companies can take to grow in a

downturn—divest, acquire, invest to gain share—an effective acquisition strategy

(defined as growth through M&A at a rate higher than that of 75% of a company’s

peers) created significant value for shareholders. During an upturn, on the other hand,

divestments created slightly more value than acquisitions did.

Many companies simply freeze: 60% of companies in the database made no portfolio

moves at all in downturns (vs. 40% in upturns).

―The best growth companies take a different approach. They view a downturn as a

time to increase their leads and make acquisitions. They pounce on the opportunities

it creates with an alacrity that is the stuff of legends: think of GE’s speedy dispatch of

an army of deal makers to Asia after the financial markets took a downturn in 1998.

We’re not saying companies should go on a spending spree in a downturn and tighten

their belts in an upturn. Nor are we unaware that some companies simply aren’t in a

financial position to exploit the opportunities downturns present. But for large

numbers of healthy companies and their CEOs, we hope our research findings are a

useful counterweight to the natural tendency, which is likely to harm shareholders.

Simply put, countercyclical investment can separate the leaders from the also-rans.‖

Source: M&A strategies in a down market, McKinsey, August 2008.

In conclusion, while organic revenue growth through gaining market share is

important for companies, this alone seldom guarantees long-term growth. We believe

that Li & Fung’s is an Active Acquirer, and as such has taken advantage of the

downturn to add to its capabilities and competitive edge, increasing ―stickiness‖ to

clients. We think that the acquisition strategy will help to generate EPS CAGR of 32%

2009-11e, which will be reflected in the future stock price.

Oracle case study

The watershed event for Oracle this decade was in June 2003 when executives

launched an unwelcome bid to acquire archrival PeopleSoft. Oracle's hostile, litigious

takeover scheme, finally consummated some 18 months later in January 2005, marked

the opening salvo in Oracle's new acquisition and growth strategies, a path which it had

appeared unwilling to take on such a grand scale in the past.

"We'd be interested in buying almost anything," CEO Ellison proclaimed at an

analyst’s meeting in July 2003.

True to Ellison's word, by the close of 2009 Oracle had acquired 56 companies—30 of

which filled out Oracle's applications portfolio, and 26 of which spruced up its

technology lines of business.

―What about the results for Oracle's diverse groups of willing and not-so-willing

customers? Industry analysts interviewed for this article claim it's a mixed bag:

"Customers have benefited from increased number and range of solutions—from

continued investment, such as Apps Unlimited, and especially from the integration

work that Oracle has done," says Warren Wilson, research director at Ovum. "But

they're increasingly locked in to Oracle—with far fewer options and switching costs

[that] are high."

In a downturn, an effective acquisition strategy creates significant value for shareholders.

Li & Fung’s is an Active Acquirer, and has taken advantage of the downturn to add to its capabilities, increasing “stickiness” to clients.

http://advice.cio.com/thomas_wailgum/oracle_bingham_mccutchen_litigating_the_competition_into_submission_since_2003

http://advice.cio.com/thomas_wailgum/oracle_bingham_mccutchen_litigating_the_competition_into_submission_since_2003

http://www.computerworld.com/s/article/print/82905

http://www.ovum.com/

January 8, 2010

Li & Fung

5

Three Oracles

Oracle’s CEO Larry Ellison ―Oracle of Omaha‖ Warren Buffet The Oracle from The Matrix

Sources SHCollective.com, Hackthematrix.org

Its most recent quarterly data reveals that during a global economic recession—with steep drops in software spending by its customers—the vendor was able to increase profitability and operating margins, year over year. And, in comparison to rival SAP, the returns from Oracle's acquired customer bases have been able to cushion deep dives in software revenues.

In a 2008 interview with The New York Times, Ellison said: "It's crazy to say you will

only grow through [in-house] innovation. It's bizarre that there's a stigma to buying

something rather than building it yourself."

Source: CIO.com, December 2009.

From FY00 to FY09, Oracle’s revenues grew from US$10bn to US$23bn. Moreover, the

stock price has significantly outperformed since the company adopted an active

acquisition strategy. From the beginning of 2003, Oracle shares have put on 112%, over

five times as much as the 22% gain in the S&P, and twice as much as the broad S&P I.T.

index’s gain of 59%.

Oracle’s stock price outperformance 2003-09

Source: Bloomberg

Li & Fung has also pursued an aggressive acquisition strategy, announcing 23

purchases from the beginning of 2006 (we expect more smaller ―roll up‖ acquisitions,

completed in H2 2009, to be reported at the 2009 results announcement in late March

2010).

5

10

15

20

25

30

Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Oracl stock price Rel to S&P 500 index Rel to S&P IT index

US$

We do not think that there should be a stigma to buying something rather than building it yourself.

Li & Fung has also pursued an aggressive acquisition strategy, announcing 23 purchases from the beginning of 2006.

Oracle’s stock price has significantly outperformed since the company adopted an active acquisition strategy.

http://advice.cio.com/thomas_wailgum/oracle_q1_results_a_tale_of_two_companies

http://www.cio.com/article/510689

http://www.cio.com/article/506236

http://www.nytimes.com/2008/03/11/business/11sorkin.html

January 8, 2010

Li & Fung

6

Li & Fung’s acquisitions 2006-09

Announced

date

Consolidated

from

Acquired company Total acquisition price Deal multiple Business scope Reason for acquisition Financing

Upfront

amount

Performance

based

Oct-09 Nov-09 Wear Me Apparel US$102m US$300m in

2010-14

5.6x-22x 2008

PBT

US-based designer and seller of

young men's and children's apparel

Expand into new markets and

categories including those for

young men and juniors

Internal cash

Jun-09 Clearskies (Shubiz's

sourcing operation

in China)

N.A N.A N.A UK-based designer and supplier of

ladies' fashion footwear to UK

retailers

Grow Li & Fung's footwear

presence in Europe

N.A

Mar-09 Shubiz

Mar-09 JMI N.A N.A N.A Shanghai-based producer of high-

end gloves, outerwear and

accessories

Expand product offering for

existing customers

N.A

Feb-09 Mar-09 Liz Claiborne'

sourcing operation

US$83m None N.A US-based designer and retailer of

fashion brands, apparel, accessories

and fragrance products with FY07

sales of US$1.3bn

Enhance Li & Fung's sourcing

platform

Internal cash

Nov-08 Nov-08 Miles Fashion US$51m None 4.9x 2007 PBT German apparel wholesaler to

discounters and retail chains in

Europe

Accelerate the Europe onshore

business

Internal cash

Aug-08 Sep-08 Van Zeeland US$200m US$295m in

2009-11

5.3x-13x 2007

PBT

NYC based importer of mid-tier and

department store handbags

Strengthen the handbag business

in the US. Expand retail

distribution channels

Internal cash and

borrowings

Jul-08 Wilson & Wong

Trading

N.A N.A N.A HK based manufacturer focusing on

ladies fashion garments

Expands fashion customer base N.A

Jul-08 RT Sourcing N.A N.A N.A Sourcing company specializing in

primary packaging and components

for beauty brands

Strengthen health, beauty and

cosmetics business

N.A

Apr-08 Giant

Merchandising's

T-shirt licensed

business

N.A N.A N.A US licensee of brands Provide further category and

brand expansion in licensed

product business

N.A

Feb-08 Silvereed Group N.A N.A N.A HKbased manufacturer focusing on

ladies fashion garments

Expand fashion customer base N.A

Jan-08 Jan-08 Imagine (C.D.P

Asia)

HKD$33m None 2.7x 2007 PBT Asian based company designing and

developing point-of-sales displays for

retailers and manufacturers globally

Strengthen health, beauty and

cosmetics business

Internal cash

Sep-07 4Q 07 Liz Claiborne' four

brands (Emma

James, Intuitions,

JH collectibles,

Tapemeasure)

No initial cash

consideration

N.A N.A US based designer and retailer of

fashion brands of apparel,

accessories and fragrance products

Expand Li & Fung's proprietary

brand portfolio

N.A

Nov-07 Nov-07 American Marketing

Enterprises

US$128m None 8.6x 2006 PBT US based children's entertainment

character licensed company

Expand Li & Fung's leadership in

the children's sleepwear business

Internal cash

Dec-07 Alliance

Merchandising

US$13m None N.A One of the largest Indian buying

agency specializing in home

hardgoods

Strengthen geographical mix of

business

N.A

Aug-07 Sep-07 Regatta US$148 US$152m by

Apr 2012

5.3x-10.7x 2006

PBT

US apparel and brand management

company offering proprietary brands

and private label products

Enhance Li & Fung's designing

and marketing ability in

proprietary brands

Cash raised via

new share

issuance plus

internal reserves

Aug-07 Aug-07 Peter Black GBP48m None 5.2x FY07 PBT Supplier of footwear, accessories and

personal care merchandise to UK

and Continental European retailers

Develop Li & Fung's European

onshore business and support the

health, beauty and cosmetics

business

Internal cash

Jun-07 Jun-07 CGroup US$120m US$80m per

half year from

Mar 2008

10.3x-17.2x

2006 PBT

HK based health, beauty and

cosmetics supplier chain company

Leverage synergies with existing

customers

Cash raised via

new share

issuance plus

internal reserves

Feb-07 Mar-07 Tommy Hilfiger's

sourcing operation

US$248m None 8x FY06 PAT Tommy Hilfiger is a designer brand

with American lifestyle

Reinforce Li & Fung's designer

brand souring capabilities

Internal cash

Sep-06 Mar-07 KarstadtQuelle's

sourcing arm

EUR60m None 5.5x 2005 PBT Leader in the department store and

mail order business in Germany

Rebalance Li & Fung's

geographical mix and enhance

sourcing capabilities

Internal cash

January 8, 2010

Li & Fung

7

2006 2006 Homestead N.A N.A N.A US home textile company Enhance the home textiles

business

N.A

Jul-06 Sep-06 Rossetti Handbags

and Accessories

US$162m US$41m 5.7x 2005 PBT Designer and importer of handbags in

the US

Expand the handbag category Internal cash and

bank borrowings

May-06 May-06 Oxford womenswear

Group

US$37m None 3.7x FY05 OP Design-intensive producer of mid-

priced private label women's apparel

collections targeting US mass

merchants

Boost private label wholesale

business in the US

Internal cash and

bank borrowings

Source: Samsung Securities, Company reports

We see a direct comparison between the acquisition strategies of Oracle and Li & Fung:

Both companies make opportunistic acquisitions of larger companies, while also

employing a ―Roll up‖ acquisition strategy which selectively acquires smaller

companies to gain core competencies, gain access to a new geography or gain

entry or increased penetration into clients.

Oracle buys the intellectual property of others, while Li & Fung buys sourcing

capabilities. Oracle has gained market leverage by building a full technology stack

and a broad portfolio of applications to offer customers. In a similar fashion, Li &

Fung has become an ―Automatic go to‖ in the sourcing market because of its scale,

reach into 40 sourcing territories and extensive category sourcing capabilities.

Both companies have achieved customer ―stickiness.‖

Both companies use acquisitions to ensure continuous growth.

Both gain new talent from acquisitions. In fact, the majority of Li & Fung’s

directors have been bought into the company via acquisition.

However, a key difference in the situation between Oracle and Li & Fung, is that

Oracle’s aggressive buying strategy has nudged other enterprise vendors, including SAP

and IBM, to make purchases that they might not have otherwise made if Oracle wasn't

a deep-pocketed and ever-present threat to buy up every promising vendor in sight.

SAP and IBM have bought dozens of other companies over the last five years.

Li & Fung has much more limited competition in making acquisitions. This is simply

because no other player in the sourcing agency space has achieved anywhere near the

scale of Li & Fung (the nearest competitor, The Connor Group, commands around one

tenth of Li & Fung’s billings).

Li & Fung tends to employ a three-year earn-out policy when paying for acquisitions, in

order to retain management talent and maximize acquisition value / minimize risk.

Management guide that they can afford to be patient and wait for opportunities that

represent real value e.g. the acquisition of Wear Me Apparel announced in November

2009 for US$102m, was at just US$20m above the NAV value of the company and at

around 3.5x 2010e PE. Li & Fung was able to take advantage of a Private Equity owner

who needed to exit this company to make the purchase at such an attractive valuation.

Agent Smith: If you can't beat us...

Agent Smith Clone: ...join us!

Agent Thompson: You!

Agent Smith: Yes, me.

[turns Thompson into another Smith]

Agent Smith: Me... me... me...

Agent Smith Clone: Me too!

Source: The Matrix Revolutions, 2003.

Acquisitions have helped both companies achieve growth and customer “stickiness.”

A key difference in the situation between Oracle and Li & Fung, is that Li & Fung faces less competition when making acquisitions.

Li & Fung management can wait for opportunities that represent real value.

January 8, 2010

Li & Fung

8

War chest makes Li & Fung dangerous to short

After two rounds of fundraising, US$500m in new shares to Temasek in September

2008 (issued at no discount) and a placement of 120m shares at a 6% discount in May

2009 raising US$346m, Li & Fung guide that they are able to finance around

US$900m of acquisitions per annum from existing cash, credit lines and operational

cash flow.

It occurs to us that shorting Li & Fung stock can be a very dangerous game –

management have the capability to surprise the market by announcing a large

acquisition (or outsourcing deal) at any time.

2) The Oracle of Omaha

The ―Oracle of Omaha‖ Warren Buffet looks to invest in companies he describes as

having an ―Economic moat‖, which is the ability of the company to keep its competitors

at bay from hurting its profits – we think this is just a poetic way of saying ―Sustainable

competitive advantage‖.

The wider the moat, the longer the company can protect its profits. The deeper the

moat, the more profitable the company is.

In general, there are four ways for a company to build an economic moat:

1. Low costs or prices.

2. Locking in customers.

3. Locking out competitors.

4. Product differentiation and branding.

It’s worth reminding ourselves that Li & Fung’s acquisitions have helped to build a

moat that is both wide and deep:

Li & Fung has built a sourcing matrix with over 80 offices, sourcing from 40

countries. Li & Fung’s Matrix is illustrated on page 10.

The Matrix provides customers with prices that they could not source themselves,

hence locking them in.

Li & Fung seeks to become a partner to selected suppliers (Li & Fung has a

network of over 8,000 suppliers) providing trade finance, a steady flow of orders

from a large customer base and so is able to secure competitive prices – although

Li & Fung does not seek to represent more than 30% of any one suppliers output.

In terms of product differentiation, no competitor has Li & Fung’s scale, and Li &

Fung can provide a one-stop-shop service for design, material sourcing, product

testing, quality assurance, compliance checking of factories, logistics and help

clients navigate around quota systems and trade restrictions.

In terms of branding, our channel checks indicate that, because of scale, Li &

Fung has achieved an automatic ―Go to‖ status in the sourcing market. Moreover,

company management is adept at investor and public relations (perhaps too

polished sometimes), have a sound reputation and a good track record.

The example of the ―Cargo Pants‖ illustrated below, taken from the book Competing

in a flat world, Fung, Fung and Wind, 2008, nicely summarizes the capabilities of Li

& Fung’s network.

Shorting Li & Fung can be dangerous because of management’s capacity to announce deals.

Li & Fung’s sourcing Matrix provides a sustainable competitive advantage.

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January 8, 2010

Li & Fung

9

Cargo pants: The power of network orchestration

Source: Competing in a flat world, Fung, Fung & Wind, 2008.

―A US retailer places an order with Li & Fung for 300,000 pairs of men’s twill cargo

shorts. Li & Fung owns no factories, no weaving machines, no dye, no cloth, no

zippers. It does not directly employ a single seamstress. Yet one month later, the order

is shipped. The buttons come from China; the zippers come from Japan; the yarn is

spun in Pakistan, and woven into fabric and dyed in China; and the garment is sewn

together in Bangladesh. Because the customer needs quick delivery, the order is

divided among three factories.

If the order had come in two weeks later, it would have resulted in a completely

different supply chain, using different partners drawn from a network of 8,300

suppliers around the globe. Like a message routed through Internet, the project

moves along the best specific path chosen from a broader network. The supply chain

is evoked by the order the customer. This is the power of network orchestration.‖

3) The Oracle from the Matrix

In the Matrix film trilogy, the Oracle is a mysterious but powerful figure, incongruously

depicted as a cheerful old lady who enjoys smoking cigarettes and baking cookies. She

possesses the power of foresight, which she uses to advise and guide the humans

attempting to fight the system. We liken this to the Li & Fung management team, with

the foresight to actively acquire companies during the downturn. We also liken this to

our own forecasts, which predict strong earnings growth at Li & Fung 2009-11e.

Later, she is revealed to be a sapient program that is integral to the very nature of the

Matrix itself. Whether her power of prediction is deterministic or not is a concept given

much treatment in all three films. She herself claims that she lacks the ability to see

past her own choice, explaining that no one, including herself, can see past a choice

they do not understand. This reminds us of how bears on Li & Fung don’t understand

that inorganic growth can be entirely a good thing.

Management had the foresight to actively acquire companies during the downturn.

http://en.wikipedia.org/wiki/Foresight

http://en.wikipedia.org/wiki/Sapient

http://en.wikipedia.org/wiki/Computer_program

http://en.wikipedia.org/wiki/Determinism

January 8, 2010

Li & Fung

10

The Li & Fung Matrix

Source: Li & Fung

Dalian Beijing

Qingdao Nanjing Suzhou

Shanghai Hangzhou Ningbo

Hepu Longhua Shantou

Chengdu Guangzhou

Dongguan Shenzhen Liuyang

Zhanjiang Taipei Seoul

Tokyo Macau Hong Kong

Bremerhaven Bucharest

Dusseldorf Sofia Istanbul

Izmir Denizli Cairo

Huddersfield St Albans

London Amersfoort Paris

Vienna Turin Oporto

Madrid Barcelona Warsaw

Amman Sharjah

Faisalabad Karachi Lahore

Delhi

Mumbai Bangalore

Chennai Tripura

Colombo

Dhaka

Durban

Antananarivo Moka

Bangkok

Hanoi Phnom Penh Ho Chi Minh City

Makati Saipan Kuala Lumpur

Singapore Jakarta

San Francisco Boston

New York City

Gaffney Guadalajara Mexico City

Guatemala City Managua

San Pedro Sula

Santo Domingo

January 8, 2010

Li & Fung

11

Earnings explosion

A combination of factors will drive strong earnings growth at Li & Fung through 2009-

11e:

Inventory restocking at Li & Fung’s major customers, supported by a Western

consumer that simply refuses to lay down and die.

The evidence points to the end of the current deflationary cycle. We believe that

the macroeconomic environment is likely to provide a positive surprise to the

market. Our top line forecasts for Li & Fung are ahead of consensus by 9% in

2010e and 13% in 2011e, see page 14.

We estimate that acquisitions made through 2009 will add at least HK$817m to

2010e EBIT (13% of 2010e EBIT).

For the first time ever, Li & Fung is achieving operational leverage as part of the

current 2008-10 three-year plan, see page 16.

Soft base effect. H1 2009 revenues declined by 2% YoY. Li & Fung had to grapple

with deflation of 7%, plus bankruptcy of some key accounts. No accounts have

gone bankrupt since the results were released in August, and we think that

deflationary pressures are easing fast.

We forecast that Li & Fung will grow net profit by a CAGR of 32% 2009-2011e (NB we

do not inflate this figure by using the weak year of 2008 as a base).

Li & Fung’s revenue growth and net profit 2006-12E.

Source: Company reports, Samsung Securities

The stage is set for a better cyclical start for 2010

Apart from raising productivity and reducing costs, one of the other ways Li & Fung’s

customers have reacted to the downturn, is to reduce inventory levels.

Li & Fung tell us that most of their clients have reduced inventory substantially in 2009

in order to reduce risk. We understand that most businesses prefer to re-stock only

when there are sure signs of end-demand, even if this proves to be a more costly

approach to managing inventory.

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

2006 2007 2008 2009E 2010E 2011E 2012E

Net profit (HK$m, RHS) Revenue YoY growth (LHS)

Macro environment is likely to provide a positive surprise to the market.

We forecast that Li & Fung will grow net profit by a CAGR of 32% 2009-2011e.

For the first time achieving operational leverage.

January 8, 2010

Li & Fung

12

China and HK monthly freight volume by air (YoY change)

Source: Bloomberg

We think that the Inventory to Sales ratio of US wholesalers has now fallen to levels

that suggest that a correction is imminent. Indeed, volumes of air freight are growing

rapidly, which suggests that the inventory restocking cycle has actually begun.

China exports and US wholesale inventory / sales ratio

Source: Bloomberg

Anecdotally, low inventory levels at some North American retailers may rapidly be

becoming a problem. The economist Louis Gave provides some amusing anecdotal

evidence from his Christmas holidays:

―Louis recently relayed his frustration from his holiday in Whistler, Canada:

He could not find a single shop stocking ski boots for his youngest son,

He had to visit three shops before finally finding gloves to the kids,

He had to see five shops before being able to find sleds for the kids,

-40

-30

-20

-10

0

10

20

30

40

Jan-0

7

Mar-

07

May-

07

Jul-07

Sep-0

7

Nov-

07

Jan-0

8

Mar-

08

May-

08

Jul-08

Sep-0

8

Nov-

08

Jan-0

9

Mar-

09

May-

09

Jul-09

Sep-0

9

Nov-

09

(%)

HK Freight Volume by Air (RHS) China Freight Volume by Air (LHS)

1.10

1.15

1.20

1.25

1.30

1.35

1.40 -30

-20

-10

0

10

20

30

40

50

60

70

93 95 97 99 01 03 05 07 09

(%)

China Exports (3mma, YoY%)

US Wholesale Inventory to Sales Ratio (3mma, RHS Inverted)

(x)

Inventory restocking is imminent.

January 8, 2010

Li & Fung

13

He was forced to do three shops before finding ski boots of his size (and no

freakish feet size either, just a normal size 10).

In fact, every shop told Louis the same story: "we under-ordered, because we feared

demand would be very weak..." Meanwhile, yesterday Whistler had its biggest-ever

day, with more than 20k people on the mountain! This might quickly get problematic.

After all, the Olympics are five weeks away, and it takes two to three months to get

stock in...The way we see it, the low inventory levels does not portend well for the

deflationists out there. Indeed, after a day of very frustrating shopping, Louis would

have gladly paid whatever the asking price was for his kid’s boots, sleds and gloves...

This all comes back to a theme that we have tried to highlight in our research: the risk

is not that the US recovery will be anemic, the risk is that is it will be anything but

anemic. After all, a stronger-than-expected rebound could trigger a scramble by

policy makers to get out from behind the curve and a scramble to restock goods on the

shelves, putting pressure on prices.... As such, the recent rally in the US$ makes sense,

as does the weakness of government bonds.‖

Source: Ticking the boxes, GaveKal, 29 December 2009.

Our strategist, Alfred Chin, believes that a lower CPI base and pressure from rising

food prices will likely lead to inflationary expectations in the equity market generally.

Consumer price index YoY %

Source: Bloomberg

Li & Fung guide that they think that the current deflationary cycle will shift to inflation

from mid-2010. This will relieve ASP pressure across the board and help Li & Fung’s

cost plus sourcing agency model.

So far, the official data is showing minimal restocking at company levels, but it seems

that the U.S. consumer simply refuses to lay down and die.

Indeed, SpendingPulse, a unit of MasterCard Advisers, has reported that US Christmas

holiday sales rose 3.6% YoY, or 1% taking in to account the extra day between

Thanksgiving and Christmas in 2009 (SpendingPulse relies on data from the

MasterCard payments network and estimates for use of cash and other payment forms.

It excludes automobile and gasoline sales).

This does not appear to just be low-end discount spending: Apple reported strong holiday sales too (pushing shares to a new record high), highlighting decent discretionary consumer demand.

-4

-2

0

2

4

6

8

10

05 06 07 08 09

(%)

US Eurozone CHINA

Inflationary expectations return.

U.S. Christmas holiday sales rose 3.6% YoY.

January 8, 2010

Li & Fung

14

Our forecasts vs market consensus

FY ending 31 Dec 2009E 2010E 2011E

Revenue (HK$m)

Consensus 115,431 136,103 156,047

Highest 133,646 154,325 182,546

Lowest 109,615 119,116 139,124

Samsung 115,686 148,925 176,120

Difference 0% 9% 13%

EBIT (HK$m)

Consensus 4,299 5,832 7,000

Highest 4,819 7,189 8,161

Lowest 3,121 4,502 5,181

Samsung 4,547 6,452 7,794


Net profits (HK$m)

Consensus 3,669 5,017 6,007

Highest 4,275 6,254 7,341

Lowest 3,012 3,920 4,603

Samsung 3,882 5,645 6,814


Diluted EPS (HK$)

Consensus 0.99 1.34 1.59

Highest 1.15 1.66 1.94

Lowest 0.81 1.04 1.23

Samsung 1.06 1.54 1.86


DPS (HK$)

Consensus 0.80 1.07 1.27

Highest 0.94 1.33 1.56

Lowest 0.57 0.85 0.80

Samsung 0.85 1.24 1.49


Source: Bloomberg consensus, Samsung Securities

On 24 December the company’s own guidance turned upbeat. During an interview with

Bloomberg, Bruce Rockowitz, Li & Fung’s President, stated:

The cycle is at the bottom and ―Things are incrementally coming up.‖

Western consumers are no longer concerned about what they only really need and

the price. ―It’s now changing to what people want.‖

The luxury sector, which died in the depths of the downturn, is recovering.

Mr. Rockowitz was feeling ―Much more happy, much more bullish by far….than a

year ago.‖

We forecast YoY top line growth of 29% in 2010e (helped by acquisitions made in

2009) and 18% in 2011e.

Li & Fung’s guidance has become more upbeat.

January 8, 2010

Li & Fung

15

Self flagellation of achieving operating leverage

―How do organizations plan in a way that allows for renewal but also creates enough

stability so entrepreneurial units know where they stand? How do companies in a flat

world balance the need to motivate their divisions to move towards a common goal

with the freedom to allow them to respond to changes in their immediate business

environments?

The solution for L&F has been to develop a planning process that creates stretch goals

that are renewed every three years. In this rapidly changing world, five-year plans

are too long and one-year budgets are too short to build anything meaningful (like

client relationships). Three years seems to be just the right duration.‖

From Competing in a Flat World, Fung, Fung and Wind, January 2008.

L&F’s management publicly announce three-year plans. These are not public guidance

but ―Stretch Goals.‖ While the company does not always hit the self imposed targets

(e.g. Li & Fung missed the 2002-2004 plan due to SARs and the general economic

slowdown), we are impressed with the challenge and management focus that the plans

generate.

Group Managing Director William Fung has referred to the ―Self flagellation of meeting

the three-year plans‖.

Li & Fung: Evolution of the 3-year plan

Source: Competing in a flat world, Samsung Securities

For the current 2008-10 plan, the company has the following goals:

To grow group revenues from US$12bn in 2007, to US$20bn in 2010. We forecast

that Li & Fung can generate US$19.2bn top line by 2010e, 4% short of its goal.

Of revenues, US$3bn is to come from the U.S. Onshore business and US$1bn is to

come from the European Onshore business. We forecast that the company can hit

its target to generate US$4bn revenues from the Onshore businesses.

To achieve a 2x goal, i.e. to grow core operating profit at twice the rate of revenues

to reach US$1bn by 2010 i.e. to create operating leverage. We forecast that core

operating profit will reach US$833m by 2010e, i.e. 17% short of management’s

goal.

0

1,000

2,000

3,000

4,000

5,000

6,000

1999-2001 2002-2004 2005-2007 2008-2010ENet profit (HK$m)

Lead industrychange.Reinvent

distribution through value-chain logistics.

Create new culture.Regional stream

organization, operations

focus and IT invesment.

Net profit (HK$m)

New service agency model.

Unbundling distribution and the creation of

a "Menu of Services."

Create operating leverage.

Active acquisition strategy.

Li & Fung’s current 3-year plan aims to create operating leverage.

January 8, 2010

Li & Fung

16

The big surprise at H1 2009 results was the cost savings achieved. Li & Fung reported a

6% YoY drop in total operating expenses. The company guide that operating expenses

can drop by 10% YoY i.e. 2008 operating expenses of HK$8.9bn can decrease to

HK$8.1bn in 2009e. Moreover, more cost cutting can be achieved in 2010e.

A look through our historical accounts indicates that Li & Fung have never achieved

economies of scale, despite an incredible 22% top line CAGR 1992 – 2007. In our

opinion, a focus on expense control and operating leverage marks a milestone in the

maturity of Li & Fung, and a strong new earnings driver going forward.

Samsung forecasts vs Li & Fung’s 2008-10 plan

(in US$m) Samsung Li & Fung’s 2010 plan Difference

Total revenue 19,216 20,000 -3.9%

Sourcing 14,818 16,000 -7.4%

US onshore 3,392 3,000 13.1%

European onshore 1,006 1,000 0.6%

Core operating profit 833 1,000 -16.7%


The operational leverage that we are currently seeing at Li & Fung positions the

business very nicely for any rebound in top line. This is exactly what we anticipate for

2010e.

We forecast that EBIT margin will recover from 2.7% in 2008 to a normalized 3.9% in

2009e, but then reach a new high of 4.3% in 2010e.

Li & Fung EBIT and EBIT growth 2006-14E


The Architect: What you did was dangerous.

The Oracle: Change always is, but it’s worth it.

Source: The Matrix Revolutions, 2003.

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

2006 2007 2008 2009E 2010E 2011E 2012E 2013E 2014E

EBIT (HK$m, LHS) EBIT YoY growth (RHS)

The operational leverage that we are currently seeing, positions the business very nicely for any rebound in top line.

January 8, 2010

Li & Fung

17

2. Valuation

Increasing return metrics lead us to Zion

At some point, Li & Fung’s growth rate will inevitably slow. But across 2010-11e, we

think that earnings will be propelled by a combination of improvement in the

macroeconomic environment, the impact of acquisitions and operational leverage.

Operational leverage should enhance return metrics. For 2008-11e, we forecast

expansion in ROE from 18% to 31%, ROA from 7% to 12% and ROIC from 15% to 32%.

Li & Fung’s return metrics 2006-12E


Examining the PE band for the stock from 2003 to date, we find that Li & Fung has

traded within a volatile one-year forward PE range of between 12x and 55x. The

average one-year forward PE has been 25x.

We choose to use this period, as pre 2003 the stock’s valuation was affected by the Dot

Com Bubble, trading over 50x PE during some periods, because of Li & Fung’s On-Line

Studio Direct internet business venture (now discontinued).

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

2006 2007 2008 2009E 2010E 2011E 2012E

ROE ROA ROIC

INDEX


2. Valuation p17



Valuation

Our base case PE valuation yields a January 2011 price objective of HK$43, which represents 31% upside.

At some point, Li & Fung’s growth rate will inevitably slow…

Increasing return metrics should support valuation multiples.

...but that point is not yet here. Operational leverage will help bottom line growth and increase returns.

January 8, 2010

Li & Fung

18

Li & Fung: One-year forward PE bands

Source: Company reports, Samsung Securities, Bloomberg

The stock price hit an all time high of HK$39.25 in November 2007. The stock

experienced multiple expansion from mid-2004 through 2007. We note that EPS

CAGR 2005-07, when the stock price really took off, was 27% (EPS CAGR 2004-07 was

20%).

We forecast 2009-11e underlying EPS CAGR of 32% (NB we are not inflating our EPS

CAGR number by using the low base year of 2008).

We are therefore comfortable using the historical 2003 -09 average of 25x as our one-

year forward PE multiple target.

In fact, we think that with recovering ROE, EBIT margins heading for an all time high,

positive newsflow from better retail sales plus fast EPS growth, targeting 25x PE may

even be conservative.

In January 2011 we believe that the market will partly be pricing the stock from

anticipated 2011 earnings. Thus, we blend our 2010e and 2011e EPS to arrive at

HK$1.70 and multiply this figure by 25x to yield a PE multiple based priced target of

HK$43, rounding to the nearest Hong Kong dollar.

Our price objective represents 31% upside. We initiate coverage of Li & Fung with a

three-star BUY rating.

DCF valuation for reference

We provide a DCF valuation for reference.

We use a WACC of 9.5% and a long-term growth rate of 3.0%.

We explicitly forecast out for 10 years. We think that our assumptions are reasonable.

Our FCF CAGR 2010-19e is 15%, this compares with historical FCF CAGR of 28% over

2001-09e.

Our DCF fair value emerges at HK$44 per share, rounding to the nearest Hong Kong

dollar, implying 34% upside.

0.0

5.0

10.0

15.0

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25.0

30.0

35.0

40.0

45.0

50.0

Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

HK$ 25x

20x

30x

15x

We are comfortable targeting the historical average PER of 25x.

Our price objective represents 31% upside.

EPS CAGR 2005-07, when the stock price really took off, was 26%.

We forecast 2009-11e underlying EPS CAGR of 32%.

We are not inflating our EPS CAGR by using a low base.

For reference, a DCF valuation emerges at HK$44 per share.

January 8, 2010

Li & Fung

19

Li & Fung: DCF valuation

Current price (HK$, 6 Jan 2010) 32.8

Weighted average number of shares - basic 3,651

Mkt cap (HK$m) 119,752

Net debt (2009E) 1,416

EV (HK$m) 121,168

% Equity 99%

% Debt 1%

Risk free rate 4.0%

Equity risk premium 6.0%

Beta 0.93

Cost of equity 9.6%

Cost of debt 3.0%

Tax rate 12.0%

WACC 9.5%

Explicit forecast (HK$m) 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E

NOPLAT 4,161 5,871 7,015 8,210 9,311 11,011 12,421 13,722 15,041 16,309 17,569

Depreciation and amortization 613 629 660 700 747 805 869 936 1,005 1,073 1,139

Change in working capital -156 -1,109 -1,005 -943 -1,101 -1,276 -1,151 -1,156 -1,579 -1,133 -1,123

CapEx -521 -655 -757 -854 -931 -1,046 -1,138 -1,223 -1,300 -1,365 -1,421

Free Cash Flow 4,096 4,736 5,912 7,113 8,027 9,494 11,001 12,279 13,167 14,885 16,164

PV of FCF

4,325 4,931 5,418 5,584 6,031 6,382 6,506 6,371 6,577 6,523

Sum of PV of explicit forecast 58,648

Terminal growth assumption 3.0%

WACC 9.5%

FCF at 2020E (HK$m) 16,649

Terminal value of FCF at 2019 (HK$m) 256,176

PV of terminal forecast 103,381

LT Growth Rate

Enterprise Value (HK$m) 162,029

2.0% 2.5% 3.0% 3.5% 4.0%

Net debt ((HK$m, 2009E) 1,416

WA

CC

8.5% 43.7 46.2 49.1 52.7 57.0

Intrinsic Market value (HK$m) 160,613

9.0% 41.7 43.8 46.3 49.3 52.8

Value per share (HK$) 44.0

9.5% 40.0 41.8 44.0 46.5 49.5

Current price (HK$, 6 Jan 2010) 32.8

10.0% 38.5 40.1 42.0 44.1 46.6

Upside potential 34%

10.5% 37.1 38.6 40.2 42.1 44.3

Source: Samsung Securities estimates.

January 8, 2010

Li & Fung

20

3. Technical Analysis

Welcome to the machine Agent Smith: Never send a human to do a machine’s work.

Source: The Matrix, 1999.

Undergoing a technical correction

The stock has been stuck in a narrow range since October 2009 on investor caution as

the stock approaches its historic high (hit in November 2007).

We do not find any evidence to suggest that the recent correction has eroded the stock’s

medium-term uptrend. However, we believe the technical correction will continue for

another one to two quarters for the following reasons:

1) Our trend-following trading model based on the fraction MACD showed a selling

signal at end-2009, indicating a slowdown in upside momentum.

2) Relative strength vs the Hang Seng Index will likely turn down, facing resistance

at the March 2009 high.

In the medium to long term, we find the stock attractive technically, as it has remained

in an uptrend within a gradual, but stable band since 2000 and the RS vs HSI has

sustained an uptrend over the same period.

Li & Fung (494.HK) weekly log, 40-week EMA, fraction MACD, RS

Identifying market trend: When 40-week EMA turn positive and Fraction MACD is above 1, we indicate that the market is in bullish trend. Trading signal: Long signal (L) is indicated when the stock surpasses the weekly high, which formed when the fraction MACD breaches its signal line upward. Conversely, short signal (S) appears when the stock surpasses the weekly low, which formed when the fraction MACD breaches its signal line downward. Source: Bloomberg, Samsung Securities

2005 A M J J A S O N D 2006 A M J J A S O N D 2007 A M J J A S O N D 2008 M A M J J A S O N D 2009 M A M J J A S O N D 2010 A M J J A

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Relative Strength to HSI (RHS)

frac MACD(10,20)

Bullish Bullish BullishBearish Bearish Bearish

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40

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30

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40

Bull

Bear

Bull

↑

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S

↓

40-Week EMA40-Week EMA shifted 5 weeks forward

S

↓

↑

L

S

↓↑

L

S

↓↑

L

S

↓

↑

L

S

↓

↑

L

S

↓

Analysts SeungMin You [email protected] (822) 2020-7024

SangCheol Im [email protected] (822) 2020-7779

INDEX


2. Valuation p17



Technical

A mild correction is in the offing over the next

two quarters. That said, with the medium-term

support line remaining intact, a strong

downward trend reversal is unlikely in the

near term. In the medium to long term, we

find the stock attractive technically.

In the medium to long term, we find the stock attractive.

We believe the current technical correction will continue for another one to two quarters.

January 8, 2010

Li & Fung

21

Li & Fung (494.HK) monthly log, RS

Source: Bloomberg, Samsung Securities

Our SSC model-based significant peaks have declined from HK$36.2 to HK$34.6 since

Oct 2009, while the MACD has rapidly fallen into negative territory. That said, with the

medium-term support line remaining intact, a downward trend reversal is unlikely in

the near term.

Our first and second support lines lie at HK$30 and HK$25, respectively, the latter

carrying more importance technically, based on resistance lines formed between

Apr~Jul 2009 and our SSC model-based meaningful troughs. Share-price declines

year-t0-date have been mild despite the rapid decline in the MACD, thanks to bargain

hunting demand, which has been equally as strong as selling pressure. All in all, a mild

rather than deep correction is in the offing.

Li & Fung (494.HK) daily log, MACD, Stochastics, RS

Note: The Samsung stochastics cycle (SSC) model is used to determine short-to-medium-term trend reversals, and set meaningful resistance (or support) targets using stochastics (slow 10, 5). Meaningful resistance occurs at the Share’s intraday peak during a period when the stochastics oscillator turns downward at the 70% level and falls to 30%. In contrast, meaningful support occurs at the Share’s intraday trough during a period when stochastics turn upward at 30% and rise to the 70% threshold. Breakthroughs at such targets (30% and 70%) are thought to mark trend reversals


December 2009 February March April May June July August September October November December 2010 February

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70

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90

0.800.850.900.951.001.051.101.151.201.251.301.351.401.45

RS to HSI (RHS)

Stochastics Slow (10,5,1)

15

20

25

30

35

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MACD (12,26 RHS)

23.50

12.40

17.24

14.90

18.80

20.95

17.44

24.70

19.20

25.25

19.50

29.20

25.95

23.0524.40

36.20

31.40

35.00

30.10

34.60

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

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50

All in all, a mild rather than deep correction is in the offing.

A downward trend reversal is unlikely in the near term.

January 8, 2010

Li & Fung

22

4. Bear Views & Blue Skies

The red pill, or the blue pill?

Markets are all about balance of probability. We provide strong opinions but do not

ignore the possibility that events will go against us. We therefore try to quantify the

risks if we are wrong. Given two stocks with an identical percentage upside to Target, it

is critical to know that one has, for example 5% downside and the other 25%. We

believe that this is how many investors think, and we attempt to reflect this in our

research.

Addressing the bear arguments

There are several reasonable bearish arguments on Li & Fung that we will address here:

1. The company’s organic growth is deeply negative in 2009. Without acquisitions,

Li & Fung would not be growing at all – this is not a sustainable business model.

We argue that history shows that the market still rewards inorganic growth. We

believe that Li & Fung’s acquisition strategy has helped to build the company’s

sourcing matrix capabilities, enhancing its sustainable competitive advantage,

and creating a new earnings stream in the U.S. Onshore business. We also think

that Li & Fung will be able to return to organic growth from 2010e, benefiting

from a better than expected macroeconomic recovery. Moreover, there are many

opportunities for Li & Fung e.g. develop its inter-Asia sourcing business to cater

to rising Asian consumer spending, spurring a new leg of growth in the mid-term.

2. The company’s strategy of buying growth must eventually lead to declining

ROIC. Li & Fung is demonstrating that it can achieve (for the first time) operating

leverage. This will result in improving return metrics. We anticipate that ROIC

will improve from 15% to 32% 2008-11e.

3. Li & Fung can only buy poor businesses at low multiples. Acquisitions or

acquired outsourcing procurement contracts are of underperforming brands.

Good businesses simply won’t sell out to Li & Fung. The example of Wear Me

Apparel, acquired for just 3.5x 2010e PE shows that Li & Fung is, in fact, well

positioned to opportunistically buy decent businesses at good valuations. This is

because acquisition targets realize that they can benefit from plugging in to the

sourcing matrix, and Li & Fung does not have to enter a bidding war for

acquisitions – there are no competitors with anywhere near the same scale.

4. The stock trades at consensus 24x 2010e PER. Surely, this must be too expensive

for a company that has to buy all of its growth and is dangerously exposed to

weak retail sales in The U.S. and Europe? We think that the macro will surprise

on the upside - the company is nicely positioned for recovery. The stock’s

historical PER from 2003 has been 25x. We forecast 32% EPS CAGR 2009-11e,

superior to the 27% EPS CAGR produced 2005-07, when the stock re-rated to

over 35x PER. Our PER target of 25x is conservative considering fast EPS growth,

recovering ROE, and EBIT margins going to new all time highs.

INDEX


2. Valuation p17



Bear Views & Blue Skies Our bear views valuation gives 42% downside, while our blue skies valuation gives 65% upside.

We address the bear arguments on Li & Fung.

Li & Fung may develop its inter-Asia sourcing business to cater to rising Asian consumer spending, spurring a new leg of growth in the mid-term.

Li & Fung does not have to enter a bidding war for acquisitions.

Our PER target of 25x is conservative considering fast EPS growth, recovering ROE, and EBIT margins going to new all time highs.

January 8, 2010

Li & Fung

23

5. Li & Fung is becoming a large company and is threatened by On-line

competition e.g. Ali-Baba. At some point, the growth rate must slow, which

should be followed a PE multiple de-rating. This argument must eventually be

true, but we think that Li & Fung is far from reaching maturity yet (forecasting

32% EPS CAGR 2009-11e). Li & Fung’s clients mostly source in size, so a face-to-

face business relationship, rather than sourcing via On-line methods, is necessary.

We note that Li & Fung discontinued its Studio Direct On-line business unit six

years ago.

6. The company refuses to give any financial disclosure on how previous

acquisitions are fairing. This is more than disappointing, and must mean that

not all acquisitions have been successful. We completely agree with this point. We

urge management to increase financial disclosure on previous acquisitions, so

that the market can be reassured that the acquisition strategy is working overall.

Bear view valuation gives 42% downside

Our bear view quantifies the risks we see for Li & Fung by factoring in a worst case

scenario into the valuation. In our bear view scenario we take the following

assumptions:

Sales stagnate. We factor in flat sales in 2009e, 2010e and 2011e. Despite the clear

signs of economic stabilization and inventory restocking, plus acquisitions, we

assume flat revenues from 2008e.

Despite the positive trend we see at present, in our bear view we that margins stay

flat from 2009e. We assume 2010e and 2011e net margin of 3.4%.

Valuation multiples for the stock decline. We use 18x blended 2010/11e for our

bear view PE target multiple.

We arrive at a blended 2010/11e EPS of HK$1.03, which is 40% below our base case

forecast of HK$1.70.

Using a PE multiple target of 18x, and rounding to the nearest Hong Kong dollar, we

arrive at bear view valuation of HK$19 per share. This implies 42% downside from the

stock’s current price.

Blue sky valuation gives 65 % upside

In our blue sky scenario, we keep our 2010e forecasts unchanged, but become more

optimistic on our 2011e assumptions:

We increase our 2011e YoY top line growth rate from +18% to +25%, resulting in

2011e group revenues of HK$186,156m. This could happen if the group continues

to actively acquire.

Net margins increase from 3.8% in 2010e to 4.1% in 2011e (up from our current

2011e base case assumption of 3.9%) due to further operating leverage gains.

This results in 2011e EPS of HK$2.08.

Valuation multiples for the stock become excited. We use 30x blended 2010/11e

for our blue skies PE target multiple.

We arrive at a blended 2010/11e EPS of HK$1.81, which is 6% above our base case

forecast of HK$1.70.

Using a PE multiple target of 30x, and rounding to the nearest Hong Kong dollar, we

arrive at blue skies valuation of HK$54 per share. This implies 65% upside to the


Our bear view quantifies the risks we see for Li & Fung by factoring in a worst case scenario…

..which emerges at HK$19 per share, implying 42% downside to the current share price.

Our blue sky valuation implies 65% upside to the current share price.

In our blue sky scenario, we become more optimistic for our 2011e assumptions.

For large clients, a face-to-face relationship, rather than sourcing on-line, is necessary.

We urge management to increase financial disclosure on previous acquisitions.

January 8, 2010

Li & Fung

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Li & Fung ratios 2004-13E

FY ending 31 Dec 2004 2005 2006 2007 2008 2009E 2010E 2011E 2012E 2013E

YoY growth

Total revenue 10.6% 17.9% 22.3% 36.0% 19.8% 4.5% 28.7% 18.3% 15.5% 11.6%

Gross profit 14.4% 31.0% 29.6% 33.2% 18.8% 6.4% 29.9% 19.4% 16.6% 12.6%

Core operating profit 17.9% 19.6% 26.0% 35.9% -3.2% 47.4% 41.9% 20.8% 18.4% 14.7%

Total operating profit (EBIT) 18.6% 21.1% 28.0% 49.2% -15.4% 49.4% 41.9% 20.8% 18.4% 14.7%

Net profit 19.4% 20.1% 23.0% 39.0% -20.9% 60.3% 45.4% 20.7% 18.0% 14.1%

Margins

GP margin 9.2% 10.2% 10.8% 10.6% 10.7% 10.7% 10.8% 10.9% 11.0% 11.1%

Core OP margin 3.3% 3.3% 3.4% 3.4% 2.8% 3.9% 4.3% 4.4% 4.5% 4.7%

OP margin 3.3% 3.4% 3.5% 3.9% 2.7% 3.9% 4.3% 4.4% 4.5% 4.7%

Net margin 3.2% 3.2% 3.2% 3.3% 2.2% 3.4% 3.8% 3.9% 4.0% 4.0%

Returns

ROE 31.7% 38.7% 26.6% 31.0% 18.1% 21.8% 28.4% 31.2% 33.3% 34.5%

ROA 13.2% 11.7% 10.0% 9.6% 6.5% 9.0% 11.3% 12.2% 13.0% 13.6%

ROIC 48.8% 30.6% 26.5% 22.7% 15.4% 21.5% 28.6% 32.4% 36.1% 38.7%

Working capital

Inventory days 4 5 8 9 9 9 9 9 9 10

AR days 36 51 50 54 49 50 50 50 50 50

AP days 39 44 45 50 47 49 49 49 49 49

Gearing

Current ratio 2.7x 2.2x 2.3x 1.5x 1.3x 1.5x 1.8x 2.2x 2.5x 2.8x

Debt/equity 16.0% 54.3% 45.8% 61.2% 48.2% 35.8% 32.0% 29.1% 26.4% 23.9%

Net cash/equity 33.9% -27.3% -4.8% -46.3% -31.2% -8.0% -2.6% 1.4% 6.1% 9.9%

Valuation

PE 64.4x 59.4x 49.3x 37.1x 47.7x 31.0x 21.3x 17.6x 14.9x 13.1x

PB 20.3x 22.8x 13.0x 11.4x 8.6x 6.7x 6.0x 5.5x 5.0x 4.5x

EV/EBITDA 71.2x 59.6x 46.1x 31.4x 34.4x 23.5x 17.1x 14.3x 12.2x 10.7x

Dividend yield 2.0% 1.5% 1.7% 2.2% 1.7% 2.6% 3.8% 4.6% 5.4% 6.1%


January 8, 2010

Li & Fung

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Li & Fung income statement 2004-13E

FY ending 31 Dec, HK$m 2004 2005 2006 2007 2008 2009E 2010E 2011E 2012E 2013E

Total revenue 47,171 55,617 68,010 92,460 110,722 115,686 148,925 176,120 203,408 226,969

Cost of sales -42,848 -49,956 -60,675 -82,692 -99,119 -103,343 -132,886 -156,976 -181,095 -201,845

Gross profit 4,323 5,661 7,335 9,768 11,603 12,343 16,039 19,144 22,313 25,125

Other income 223 264 312 518 421 463 596 704 814 908

Total core operating expenses -2,990 -4,065 -5,303 -7,099 -8,940 -8,259 -10,182 -12,054 -13,902 -15,452

Core operating profit 1,556 1,861 2,344 3,187 3,084 4,547 6,452 7,794 9,225 10,581

Gain on disposal of assets 0 28 69 457 0 0 0 0 0 0

Other non-core operating expenses 0 -4 0 -43 -40 0 0 0 0 0

Total operating profit (EBIT) 1,556 1,885 2,412 3,600 3,044 4,547 6,452 7,794 9,225 10,581

Depreciation and amortization -145 -147 -217 -263 -482 -613 -629 -660 -700 -747

EBITDA 1,701 2,032 2,629 3,863 3,527 5,160 7,081 8,454 9,924 11,328

Interest income 43 70 98 208 113 106 159 185 216 252

Interest expenses -11 -21 -148 -500 -480 -416 -414 -414 -414 -414

Share of profits of associates 36 9 11 5 6 6 6 6 6 6

PBT 1,623 1,942 2,373 3,314 2,683 4,243 6,204 7,571 9,033 10,426

Taxation -133 -151 -172 -253 -259 -361 -558 -757 -994 -1,251

PAT 1,490 1,791 2,202 3,061 2,424 3,882 5,645 6,814 8,040 9,175

Minority interests 1 0 0 -1 -2 0 0 0 0 0

Net profit 1,491 1,790 2,202 3,060 2,422 3,882 5,645 6,814 8,040 9,175

Weighted average number of shares - diluted 2,928 3,243 3,312 3,464 3,520 3,664 3,664 3,664 3,664 3,664

Diluted EPS (HK$) 0.51 0.55 0.66 0.88 0.69 1.06 1.54 1.86 2.19 2.50

YoY growth

Total revenue 10.6% 17.9% 22.3% 36.0% 19.8% 4.5% 28.7% 18.3% 15.5% 11.6%

Gross profit 14.4% 31.0% 29.6% 33.2% 18.8% 6.4% 29.9% 19.4% 16.6% 12.6%



Net profit 19.4% 20.1% 23.0% 39.0% -20.9% 60.3% 45.4% 20.7% 18.0% 14.1%

Margins

GP margin 9.2% 10.2% 10.8% 10.6% 10.7% 10.7% 10.8% 10.9% 11.0% 11.1%

Core OP margin 3.3% 3.3% 3.4% 3.4% 2.8% 3.9% 4.3% 4.4% 4.5% 4.7%

OP margin 3.3% 3.4% 3.5% 3.9% 2.7% 3.9% 4.3% 4.4% 4.5% 4.7%

Net margin 3.2% 3.2% 3.2% 3.3% 2.2% 3.4% 3.8% 3.9% 4.0% 4.0%


January 8, 2010

Li & Fung

26

Li & Fung balance sheet 2004-13E


Cash and bank balance 2,350 1,248 3,394 1,472 2,275 4,950 5,842 6,675 7,839 8,993

Inventories 458 628 1,331 2,060 2,329 2,492 3,204 3,871 4,465 5,253

Trade & bills receivables 4,642 7,739 9,231 13,716 14,715 15,847 20,401 24,126 27,864 31,092

Prepayments, deposits and other receivables 767 885 1,316 1,747 2,028 2,155 2,774 3,281 3,790 4,228

Due from related companies 29 25 62 72 84 84 84 84 84 84

Derivative financial instruments 0 4 0 0 35 35 35 35 35 35

Current assets 8,247 10,528 15,335 19,067 21,466 25,563 32,340 38,071 44,076 49,686

PPE 715 948 1,114 1,130 1,283 2,749 2,859 3,038 3,269 3,528

Intangible assets 1,304 2,809 4,713 11,375 14,602 14,531 14,465 14,402 14,343 14,286

Prepaid premium for land leases 765 766 681 3 3 2 2 2 2 2

Investment in associated companies 56 7 14 15 24 24 24 24 24 24

Available for sale financial assets 0 92 82 85 20 20 20 20 20 20

Deferred tax assets 73 118 106 116 111 111 111 111 111 111

Investment securities 110 0 0 0 0 0 0 0 0 0

Non-current assets 3,024 4,740 6,710 12,723 16,043 17,437 17,481 17,597 17,770 17,971

Total assets 11,270 15,268 22,045 31,789 37,509 43,000 49,821 55,668 61,846 67,657

Trade and bills payables 4,625 6,059 7,544 11,231 12,667 13,873 17,840 21,074 24,311 27,097

Accrual charges and sundry payables 741 1,006 1,316 2,395 2,772 2,831 3,641 4,301 4,961 5,530

Current portion of LT liabilities 41 0 0 0 0 0 0 0 0 0

Short term bank loans 203 0 2,777 442 278 200 200 200 200 200

Bank overdraft 0 204 92 205 93 93 93 93 93 93

Bank advances for discounted bills 0 1,554 123 328 313 313 313 313 313 313

Taxation payable 291 391 321 466 466 466 466 466 466 466

Others 125 648 765 1,279 1,259 1,259 1,259 1,259 1,259 1,259

Total current liabilities 6,026 9,862 12,937 16,346 17,848 19,036 23,811 27,705 31,604 34,958

Long term liabilities 509 753 797 5,064 5,760 5,760 5,760 5,760 5,760 5,760

Balance of purchase consideration payable 0 0 0 464 383 300 250 200 200 200

Pension obligations 18 20 25 30 24 24 24 24 24 24

Deferred taxation 7 8 18 21 112 112 112 112 112 112

Non-current liabilities 535 781 841 5,579 6,279 6,196 6,146 6,096 6,096 6,096

Share capital 73 73 85 86 91 91 91 91 91 91

Reserves 3,064 3,540 6,883 8,082 12,122 15,580 16,709 18,072 19,680 21,515

Proposed dividend 1,605 1,043 1,331 1,727 1,199 2,127 3,093 3,734 4,405 5,027

Minority interest -32 -32 -32 -31 -30 -30 -30 -30 -30 -30

Total shareholders' equity 4,709 4,625 8,267 9,864 13,382 17,769 19,864 21,867 24,147 26,603

Total liabilities and shareholder's equity 11,270 15,268 22,045 31,789 37,509 43,000 49,821 55,668 61,846 67,657


January 8, 2010

Li & Fung

27

Li & Fung cashflow 2004-13E


EBIT 1,556 1,885 2,412 3,600 3,044 4,547 6,452 7,794 9,225 10,581

Depreciation and amortization 145 147 217 263 482 613 629 660 700 747

Gain / Loss on disposals 2 -25 -62 -426 -2 0 0 0 0 0

Others 41 47 58 112 86 0 0 0 0 0

Operating profit before changes in working capital 1,744 2,054 2,625 3,549 3,610 5,160 7,081 8,454 9,924 11,328

Change in working capital -524 174 -1,930 664 214 -156 -1,109 -1,005 -943 -1,101

Cash generated from operating activities 1,221 2,228 695 4,213 3,825 5,004 5,972 7,449 8,982 10,227

HK profits tax paid -80 -60 -149 -122 -165 -361 -558 -757 -994 -1,251

Overseas tax paid -26 -54 -73 -71 -82 0 0 0 0 0

Net cash inflow / (outflow) from operating activities 1,115 2,114 473 4,020 3,578 4,643 5,414 6,692 7,988 8,976

Purchase of PPE -206 -369 -302 -320 -494 -521 -655 -757 -854 -931

Acquisitions -67 -708 -1,264 -4,565 -2,457 -1,468 0 0 0 0

Settlement of consideration payable for acquisitions -146 -133 -685 -814 -919 -83 -50 -50 0 0

Disposals 6 9 22 491 73 0 0 0 0 0

Interest Income 43 70 98 208 113 106 159 185 216 252

Others -31 51 117 -36 -27 -12 -12 -12 -12 -12

Net cash inflow / (outflow) from operating activities -401 -1,079 -2,014 -5,035 -3,711 -1,978 -558 -634 -650 -690

Net proceeds from new shares 122 175 2,886 275 4,072 2,682 0 0 0 0

New bank loans 0 0 0 0 0 0 0 0 0 0

Repayment of bank loans 0 -44 2,594 -2,737 71 -78 0 0 0 0

Issue of long-term notes 0 0 0 3,862 0 0 0 0 0 0

Interest paid -11 -14 -148 -431 -400 -416 -414 -414 -414 -414

Dividends paid -1,078 -2,034 -1,564 -2,051 -2,560 -2,178 -3,550 -4,811 -5,760 -6,718

Others -6 -191 0 0 0 0 0 0 0 0

Net cash inflow / (outflow) from investing activities -973 -2,108 3,768 -1,081 1,183 10 -3,964 -5,225 -6,174 -7,132

Net increase / (decrease) in cash and cash equivalents -259 -1,074 2,228 -2,097 1,050 2,675 892 833 1,164 1,155

Foreign exchange difference 15 -29 31 61 -135 0 0 0 0 0

Cash and cash equivalents (year beginning) 2,391 2,147 1,044 3,302 1,267 2,182 4,857 5,748 6,581 7,745

Cash and cash equivalents (year-end) 2,147 1,044 3,302 1,267 2,182 4,857 5,748 6,581 7,745 8,900


January 8, 2010

Li & Fung

28

Appendix: Our favorite lines from The Matrix

Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up

in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how

deep the rabbit-hole goes.

Morpheus: The pill you took is part of a trace program. It's designed to disrupt your input/output carrier signal so we can

pinpoint your location.

Neo: What does that mean?

Cypher: It means buckle your seatbelt, Dorothy, 'cause Kansas is going bye-bye.

Oracle: I'd ask you to sit down, but, you're not going to anyway. And don't worry about the vase.

Neo: What vase?

[Neo turns to look for a vase, and as he does, he knocks over a vase of flowers, which shatters on the floor]

Oracle: That vase.

Neo: I'm sorry...

Oracle: I said don't worry about it. I'll get one of my kids to fix it.

Neo: How did you know?

Oracle: Ohh, what's really going to bake your noodle later on is, would you still have broken it if I hadn't said anything?

Neo: I know kung fu.

Morpheus: [eyeing him, hand on chin] Show me.

Morpheus: How did I beat you?

Neo: You... you're too fast.

Morpheus: Do you believe that my being stronger or faster has anything to do with my muscles in this place? Do you think

that's air you're breathing now?

Agent Smith: Tell me, Mr. Anderson, what good is a phone call when you are unable to speak?

Neo: What are you trying to tell me? That I can dodge bullets?

Morpheus: No, Neo. I'm trying to tell you that when you're ready, you won't have to.

Neo: Okey dokey.. free my mind. Right, no problem, free my mind, free my mind, no problem, right...

Oracle: You're cuter than I thought. I can see why she likes you.

Neo: Who?

Oracle: Not too bright, though.

Agent Smith: Do you hear that, Mr. Anderson? That is the sound of inevitability.

Cypher: I know what you're thinking, 'cause right now I'm thinking the same thing. Actually, I've been thinking it ever since

I got here: Why oh why didn't I take the BLUE pill?

Tank: So what do you need? Besides a miracle.

Neo: Guns. Lots of guns.

Trinity: Neo... nobody has ever done this before.

Neo: That's why it's going to work.

Source: neoandtrinity.net

http://www.imdb.com/name/nm0000401/






















January 8, 2010

Li & Fung

29

Disclosures & Disclaimers

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reprinted, sold or redistributed without the written consent of Samsung Securities (Asia) Limited.

January 29, 2010

This report has been prepared by Samsung Securities (Asia) Limited. ANALYST CERTIFICATION AND IMPORTANT DISCLOSURES BEGIN ON PAGE 8

Li & Fung (494 HK)

The Ultimate Outsourcer WHAT’S THE STORY?

Event: Li & Fung announced a major new deal to act as a direct sourcing agent for Wal-Mart, to add at least US$2bn per annum to top line from mid-2010.

Impact: This deal proves that the company’s sourcing network provides a sustainable competitive advantage. Li & Fung becomes the ultimate outsourcer.

Action: The impact on market consensus EPS estimates will be limited to around +1% to +5% in 2010-11e. However, we expect valuation multiple expansion to 25x PER on better long-term growth prospects. BUY Li & Fung.

THE QUICK VIEW

After market close yesterday, Li & Fung announced that they have entered into a series

of agreements to supply clothes and other consumer goods to Wal-Mart. This was

followed by an international conference call.

Main points:

Management guide that the deal should initially generate an additional annual

US$2bn of sales (conservatively) from July 2010e. Wal-Mart isn’t obligated to any

sourcing volume under the agreement or exclusivity to Li & Fung i.e. Wal-Mart

may still source any goods from other suppliers (Li & Fung began supplying Wal-

Mart in 2003) but the deal is expected to become a major growth driver for Li &

Fung for the next two three-year plans, through 2016.

We estimate that Wal-Mart, the world’s largest retailer, will become Li & Fung’s

biggest client by 2012e, overtaking Kohl’s by sourcing US$2.5bn worth of goods.

The long-term potential of this deal is clearly significant. We estimate that Wal-

Mart will add US$5bn to top line, with an EBIT margin of 1.5%, by 2017e.

Li & Fung will create a buying agency within its network called WSG (Wal-Mart

Sourcing Group) to handle the business, which will be based in Hong Kong and

“over time, will employ hundreds” of employees, Li & Fung President Bruce

Rockowitz said. The company is transferring top management talent to run the

new unit, which will be co-located with Li & Fung’s existing business. WSG will

not compete with Wal-Mart’s direct sourcing arm.

Wal-Mart will have a call option to acquire WSG after January 1, 2016. No details

are available on the option price, but William Fung guided that the option

represented a “Fair deal for both parties.” He added that this mechanism actually

gave Li & Fung a higher degree of security than usual, as most clients could just

leave at any time, if they became unhappy, without paying any penalty.

The deal means that Li & Fung stands a very good chance of hitting its three-year

plan revenue target of US$20bn by the end of 2010. We increase our 2010e top

line estimate from US$19.2bn to US$20.2bn.

The margins for WSG will be “in line with those of a very high volume business,”

Rockowitz said. During the conference call, management guided that typical net

margins for a very high volume client are between 1% and 4%.

We increase our EPS estimates by 1% in 2010e, 2% in 2011e and 3% in 2012e.

A replay of the call is available for 14 days on:

International dialing: +852 2112 1555

Passcode: 218552#

Matt Marsden [email protected] +852 3411 3710

Company Update


Don’t fight The Matrix

Samsung target price vs Consensus +14%

Samsung 2010e EPS vs Consensus +14%

Street recommendation distribution 67% Buy

17% Hold

17% Sell

Our 2010e EPS numbers are 14% ahead of

consensus, driven by a combination of:

Operating leverage (Li & Fung is demonstrably

increasing EBIT margins for the first time).

The impact of 2009 acquisitions.

The impact of the new Wal-Mart deal.

Plus a macro recovery which will surprise on

the upside.

AT A GLANCE

HK$43.00

Target price

Up/downside +33%


Sector Sourcing

Market capitalization US$15,743m

Shares outstanding (float) 3,777m (61%)

52 week high-low HK$36.20 – 14.22

Bloomberg 494 HK


Li & Fung +1% +35% +102%

Hang Seng Index -5% -1% 55%

January 29, 2010

Company Update – Li & Fung

2

Don’t fight The Matrix

Li & Fung’s policy of acquisitive growth has created a global

sourcing matrix, which represents a sustainable competitive

advantage. The latest deal with Wal-Mart proves that Li &

Fung’s scale - the ability to source from over 15,000 suppliers

in more than 40 territories - makes it an “Automatic go to” for

retailers looking to improve their supply chain.

We see 2009-11e EPS CAGR of 34% driven by:

The macro recovery will surprise on the upside led by

inventory restocking and a shift to an inflationary cycle.

Importantly, Li & Fung is demonstrating operational

leverage for the first time. We note that H1 2009 net

income for Li & Fung in rose 13% YoY to HK$1.4bn

(US$180m) on sales which were down 2% YoY to

HK$46.3bn (US$6bn) due to cost savings. Management

guide that margins will continue to improve in 2010e

driven by continuing repositioning of staff and general

cost efficiencies.

Gains from recent acquisitions and the Wal-Mart deal.

Please see our report Don’t fight The Matrix…Own the

Outsourcing Oracle, published January 8, 2010, for our

full thesis.

Samsung forecasts: Old vs new 20010-12E

FY ending 31 Dec, HK$m New Old Change

2010E

Total turnover 156,675 148,925 5%

EBIT 6,530 6,452 1%

Diluted EPS (HK$) 1.56 1.54 1%

2011E

Total turnover 191,620 176,120 9%

EBIT 7,980 7,794 2%


2012E

Total turnover 222,783 203,408 10%

EBIT 9,515 9,225 3%


Source: Samsung Securities

Base case valuation gives 33% upside

We think that a moderate re-rating to the historical average

25x PE is justified by 34% 2009-11e EPS CAGR. Note - this

CAGR is NOT inflated by calculating it from the cyclical low

(which would be 2008), and is above the 27% EPS CAGR from

2005-07, which triggered a re-rating to over 30x PE.

Given ROE recovery and all time high EBIT margins plus

positive newsflow from better retail sales, a return to the

average PE could even be conservative.

In January 2011 we believe that the market will partly be

pricing the stock from anticipated 2011 earnings. Thus, we

blend our 2010e and 2011e EPS to arrive at HK$1.73 and

multiply this figure by 25x to yield a PE multiple based priced

target of HK$43, rounding to the nearest Hong Kong dollar

No change to our target price).

Our 12-month price objective represents 33% upside. We

reiterate our three-star BUY rating on Li & Fung.

Li & Fung: 1-year forward PE band chart


Bear views and blue skies

Markets are all about balance of probability. We provide

strong opinions but do not ignore the possibility that events

will go against us. We therefore try to quantify the risks if we

are wrong. Given two stocks with an identical percentage

upside to Target, it is critical to know that one has, for

example 5% downside and the other 25%. This is how many

investors think, and we attempt to reflect this in our research.


Our bear view quantifies the risks we see for Li & Fung by

factoring in a worst case scenario into the valuation. In our

bear view scenario we take the following assumptions:

Sales stagnate. We factor in flat sales in 2009e, 2010e

and 2011e. Despite the clear signs of economic

stabilization and inventory restocking, plus acquisitions

and the Wal-Mart deal, we assume flat revenues from

2008e.

Despite the positive trend we see at present, in our bear

view we that margins stay flat from 2009e. We assume

2010e and 2011e net margin of 3.4%.

Valuation multiples for the stock decline. We use 18x

blended 2010/11e for our bear view PE target multiple.

We arrive at a blended 2010/11e EPS of HK$1.03, which is

41% below our base case forecast of HK$1.73.

Using a PE multiple target of 18x, and rounding to the nearest

Hong Kong dollar, we arrive at bear view valuation of HK$19

per share. This implies 41% downside from the stock’s current

price.

0

5

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15

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25

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35

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Ja

n-0

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r-0

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p-0

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y-0

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06

Ma

r-0

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g-0

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n-0

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Ap

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l-1

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30x

HK$ 25x

20x

15x

January 29, 2010


3


In our blue sky scenario, we keep our 2010e forecasts

unchanged, but become more optimistic on our 2011e

assumptions:

We increase our 2011e YoY top line growth rate from

+22% to +25%, resulting in 2011e group revenues of

HK$195,844m. This could happen if the group continues

to actively acquire or the Wal-Mart business does better

than estimated.

Net margins increase from 3.8% in 2010e to 4.1% in

2011e (up from our current 2011e base case assumption

of 3.9%) due to further operating leverage gains.

This results in 2011e EPS of HK$2.19.

Valuation multiples for the stock become excited. We

use 30x blended 2010/11e for our blue skies PE target

multiple.

We arrive at a blended 2010/11e EPS of HK$1.88, which is 9%

above our base case forecast of HK$1.73.

Using a PE multiple target of 30x, and rounding to the nearest

Hong Kong dollar, we arrive at blue skies valuation of HK$56

per share. This implies 73% upside to the stock’s current

price.

Self flagellation of the three-year plan

“How do organizations plan in a way that allows for

renewal but also creates enough stability so entrepreneurial

units know where they stand? How do companies in a flat

world balance the need to motivate their divisions to move

towards a common goal with the freedom to allow them to

respond to changes in their immediate business

environments?

The solution for L&F has been to develop a planning process

that creates stretch goals that are renewed every three years.

In this rapidly changing world, five-year plans are too long

and one-year budgets are too short to build anything

meaningful (like client relationships). Three years seems to

be just the right duration.”

From Competing in a Flat World, Fung, Fung and Wind,

January 2008.

L&F’s management publicly announce three-year plans. These

are not public guidance but “Stretch Goals.” While the

company does not always hit the self imposed targets (e.g. Li

& Fung missed the 2002-2004 plan due to SARs and the

general economic slowdown), we are impressed with the

challenge and management focus that the plans generate.

Group Managing Director William Fung has referred to the

“Self flagellation of meeting the three-year plans”.

For the current 2008-10 plan, the company has the following

goals:

To grow group revenues from US$12bn in 2007, to

US$20bn in 2010. We forecast that Li & Fung can reach

this goal, generating US$20.2bn top line by 2010e.

US$4bn of revenues to come from the Onshore

businesses. We forecast that this target will be hit.

To achieve a 2x goal. To grow core operating profit at

twice the rate of revenues to reach US$1bn by 2010 i.e.

to create operating leverage. We forecast that core

operating profit will reach US$843m by 2010e, 16%

short of management’s goal.

Li & Fung: Evolution of the 3-year plan

Source: Competing in a flat world, Samsung Securities

0

1,000

2,000

3,000

4,000

5,000

6,000

1999-2001 2002-2004 2005-2007 2008-2010E

Lead industry

change.Reinvent distribution through value-chain

logistics.

Create new

culture.Regional stream

organization,

operations focus and IT invesment.

Net profit

forecast (HK$m)

New service

agency model. Unbundling

distribution and the

creation of a "Menu of Services."

Create operating

leverage.Active acquisition

strategy.

January 29, 2010


4

Li & Fung Ratios 2004-13E

(FY ending 31 Dec) 2004 2005 2006 2007 2008 2009E 2010E 2011E 2012E 2013E

YoY growth

Total revenue 10.6% 17.9% 22.3% 36.0% 19.8% 4.5% 35.4% 22.3% 16.3% 12.3%

Gross profit 14.4% 31.0% 29.6% 33.2% 18.8% 6.4% 36.7% 23.4% 17.3% 13.3%



Net profit 19.4% 20.1% 23.0% 39.0% -20.9% 60.3% 47.2% 22.1% 18.9% 14.3%

Margins

GP margin 9.2% 10.2% 10.8% 10.6% 10.7% 10.7% 10.8% 10.9% 11.0% 11.1%

Core OP margin 3.3% 3.3% 3.4% 3.4% 2.8% 3.9% 4.2% 4.2% 4.3% 4.4%

OP margin 3.3% 3.4% 3.5% 3.9% 2.7% 3.9% 4.2% 4.2% 4.3% 4.4%

Net margin 3.2% 3.2% 3.2% 3.3% 2.2% 3.4% 3.6% 3.6% 3.7% 3.8%

Returns

ROE 31.7% 38.7% 26.6% 31.0% 18.1% 21.8% 28.7% 31.7% 34.0% 35.2%

ROA 13.2% 11.7% 10.0% 9.6% 6.5% 9.0% 11.2% 12.0% 12.8% 13.3%

ROIC 48.8% 30.6% 26.5% 22.7% 15.4% 21.5% 28.6% 32.3% 36.0% 38.4%

Working capital

Inventory days 4 5 8 9 9 9 9 9 9 10

AR days 36 51 50 54 49 50 50 50 50 50

AP days 39 44 45 50 47 49 49 49 49 49

Gearing


Debt/equity 16.0% 54.3% 45.8% 61.2% 48.2% 35.8% 32.0% 28.9% 26.1% 23.6%

Net cash/equity 33.9% -27.3% -4.8% -46.3% -31.2% -8.0% -3.8% -0.7% 3.8% 7.2%

Valuation

PE 63.4x 58.5x 48.6x 36.6x 46.9x 30.5x 20.7x 17.0x 14.3x 12.5x

PB 20.0x 22.5x 12.8x 11.2x 8.4x 6.6x 5.9x 5.4x 4.8x 4.4x


Dividend yield 2.1% 1.5% 1.7% 2.2% 1.8% 2.6% 3.9% 4.7% 5.6% 6.4%

Source: Company data, Samsung Securities, all multiples based on the close price of HK$32.3 on 28 Jan 2010

January 29, 2010


5

Li & Fung Income statement 2004-13E

(FY ending 31 Dec, HK$m) 2004 2005 2006 2007 2008 2009E 2010E 2011E 2012E 2013E

Total revenue 47,171 55,617 68,010 92,460 110,722 115,686 156,675 191,620 222,783 250,219

Cost of sales -42,848 -49,956 -60,675 -82,692 -99,119 -103,343 -139,802 -170,791 -198,344 -222,521

Gross profit 4,323 5,661 7,335 9,768 11,603 12,343 16,873 20,828 24,439 27,698

Other income 223 264 312 518 421 463 627 766 891 1,001




Other non-core operating expenses 0 -4 0 -43 -40 0 0 0 0 0



EBITDA 1,701 2,032 2,629 3,863 3,527 5,160 7,164 8,655 10,241 11,714

Interest income 43 70 98 208 113 106 156 174 199 231



PBT 1,623 1,942 2,373 3,314 2,683 4,243 6,278 7,747 9,307 10,753

Taxation -133 -151 -172 -253 -259 -361 -565 -775 -1,024 -1,290

PAT 1,490 1,791 2,202 3,061 2,424 3,882 5,713 6,972 8,284 9,463


Net profit 1,491 1,790 2,202 3,060 2,422 3,882 5,713 6,972 8,284 9,463


Diluted EPS (HK$) 0.51 0.55 0.66 0.88 0.69 1.06 1.56 1.90 2.26 2.58

YoY growth

Total revenue 10.6% 17.9% 22.3% 36.0% 19.8% 4.5% 35.4% 22.3% 16.3% 12.3%

Gross profit 14.4% 31.0% 29.6% 33.2% 18.8% 6.4% 36.7% 23.4% 17.3% 13.3%



Net profit 19.4% 20.1% 23.0% 39.0% -20.9% 60.3% 47.2% 22.0% 18.8% 14.2%

Margins

GP margin 9.2% 10.2% 10.8% 10.6% 10.7% 10.7% 10.8% 10.9% 11.0% 11.1%

Core OP margin 3.3% 3.3% 3.4% 3.4% 2.8% 3.9% 4.2% 4.2% 4.3% 4.4%

OP margin 3.3% 3.4% 3.5% 3.9% 2.7% 3.9% 4.2% 4.2% 4.3% 4.4%

Net margin 3.2% 3.2% 3.2% 3.3% 2.2% 3.4% 3.6% 3.6% 3.7% 3.8%

Source: Company data, Samsung Securities

January 29, 2010


6

Li & Fung Balance sheet 2004-13E



Inventories 458 628 1,331 2,060 2,329 2,492 3,371 4,211 4,891 5,792





Current assets 8,247 10,528 15,335 19,067 21,466 25,563 33,479 40,356 46,957 53,143

PPE 715 948 1,114 1,130 1,283 2,749 2,888 3,118 3,405 3,722








Total assets 11,270 15,268 22,045 31,789 37,509 43,000 50,989 58,033 64,862 71,309





Bank overdraft 0 204 92 205 93 93 93 93 93 93



Others 125 648 765 1,279 1,259 1,259 1,259 1,259 1,259 1,259







Share capital 73 73 85 86 91 91 91 91 91 91

Reserves 3,064 3,540 6,883 8,082 12,122 15,580 16,723 18,117 19,774 21,666






January 29, 2010


7

Li & Fung Cashflow 2004-13E


EBIT 1,556 1,885 2,412 3,600 3,044 4,547 6,530 7,980 9,515 10,930


Gain / Loss on disposals 2 -25 -62 -426 -2 0 0 0 0 0

Others 41 47 58 112 86 0 0 0 0 0


Change in working capital -524 174 -1,930 664 214 -156 -1,364 -1,269 -1,075 -1,263

Cash generated from operating activities 1,221 2,228 695 4,213 3,825 5,004 5,800 7,386 9,166 10,451

HK profits tax paid -80 -60 -149 -122 -165 -361 -565 -775 -1,024 -1,290

Overseas tax paid -26 -54 -73 -71 -82 0 0 0 0 0


Purchase of PPE -206 -369 -302 -320 -494 -521 -689 -824 -936 -1,026

Acquisitions -67 -708 -1,264 -4,565 -2,457 -1,468 0 0 0 0

Settlement of consideration payable for acquisitions -146 -133 -685 -814 -919 -83 -50 -50 0 0

Disposals 6 9 22 491 73 0 0 0 0 0

Interest Income 43 70 98 208 113 106 156 174 199 231

Others -31 51 117 -36 -27 -12 -12 -12 -12 -12

Net cash inflow / (outflow) from operating activities -401 -1,079 -2,014 -5,035 -3,711 -1,978 -596 -711 -748 -807


New bank loans 0 0 0 0 0 0 0 0 0 0

Repayment of bank loans 0 -44 2,594 -2,737 71 -78 0 0 0 0


Interest paid -11 -14 -148 -431 -400 -416 -414 -414 -414 -414

Dividends paid -1,078 -2,034 -1,564 -2,051 -2,560 -2,178 -3,567 -4,888 -5,908 -6,924

Others -6 -191 0 0 0 0 0 0 0 0

Net cash inflow / (outflow) from investing activities -973 -2,108 3,768 -1,081 1,183 10 -3,981 -5,301 -6,322 -7,338

Net increase / (decrease) in cash and cash equivalents -259 -1,074 2,228 -2,097 1,050 2,675 659 598 1,072 1,016



Cash and cash equivalents (year-end) 2,147 1,044 3,302 1,267 2,182 4,856 5,515 6,113 7,185 8,201


January 29, 2010


8


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March 25, 2010

This report has been prepared by Samsung Securities (Asia) Limited. ANALYST CERTIFICATION AND IMPORTANT DISCLOSURES BEGIN ON PAGE 9

Li & Fung Ltd (494 HK)

The Matrix unplugged…

WHAT’S THE STORY?

Event: Li & Fung reported record earnings in 2009, with 39% YoY net profit

growth in the toughest ever trading environment. Management gave upbeat

guidance for 2010 and long-term growth prospects look rosy.

Unfortunately, the market’s expectations have become unplugged from reality.

The 2009 results actually missed consensus net profit estimates by 10%, and for

the first time ever YoY revenues fell, by 6%. All gains were from cost cutting,

acquisitions and new outsourcing deals.

Impact: Li & Fung has been the best performer in the HSI so far this year,

gaining 29% YTD. The stock will surely correct downwards after missing the

market’s estimates by such a wide margin.

The stock was within a whisker of reaching our old target price of HK$43.00,

reaching an all time high of HK$42.45 yesterday.

We now downgrade our EPS by 12% in 2010e, and 4% in 2011e, and reduce our

12-month target by 7% to HK$40.00.

Even though the long-term prospects still look good, market estimates have

become over-optimistic. We expect a rash of consensus EPS downgrades.

We downgrade the stock to a SELL. Our new target is 4% below the current

share price.

Action: At 30.5x 2010e PE, the stock price has run ahead of itself. We

recommend that investors take profits.

We think that the stock price is likely to overshoot on the downside. Traders

should look to profit from shorting this stock in the near-term.

We suggest a short Li & Fung / long Esprit pair trade.

We suggest that longer-term investors look to re-enter the stock at around

HK$35.00 (-17% from the current level).

Welcome back to reality

Li & Fung has gained 27% since we initiated coverage on January 8 2010, and has

been the best performer in the HSI, outperforming the index by 33% YTD. The

stock came within a whisker of hitting our old target price of HK$43.00 when it

made a new all time high of HK$42.45 yesterday.

Unfortunately, market consensus estimates have become unplugged from reality.

The 2009 results released after market close yesterday revealed a net profit

number of HK$3,369m, which was 14% below our forecast, and 10% below

Bloomberg market consensus.

After such a stellar performance, we don’t believe that the stock will be able to

withstand such a significant earnings miss unscathed.

In the Q&A session at the analysts meeting in Hong Kong yesterday, William

Fung, who is preparing for his third marathon in London on 25 April, apologized

to the analysts present. Dr. Fung said that the company probably should have

given updated guidance, when they realized that revenues were going to be down

YoY in late 2009 – previously Li & Fung’s guidance was for flat 2009 revenues.

Given the better than expected operational leverage achieved in 2009, if revenues

were flat then market consensus expectations would not have been disappointed.

Company Update


Early seller catches the worm

Target price vs Consensus -5%

2011e EPS vs Consensus +0%

Recommendation distribution 68% Buy

16% Hold

16% Sell

The market has become over-bullish on this

stock with a 68% BUY rating distribution.

This is the first SELL published since mid

December 2009 (when the stock was at HK$31),

according to Bloomberg.

We believe that this report will be amongst the

first of a series of downgrades as the market

adjusts EPS figures back to reality.

Matthew Marsden

Analyst

[email protected]

+852 3411 3710

Summer Wang

Research Associate

[email protected]

+852 3411 3723

AT A GLANCE

HK$40.00 Target price

Up/downside -4%


Market capitalization HK$158.0bn

Shares outstanding (float) 3.78bn (70%)

52 week high-low HK$42.05-18.00

Bloomberg 494 HK


Li & Fung Ltd +17% +38% +117%

Hang Seng Index +3% 0% +51%

March 25, 2010

Company Update – Li & Fung Ltd

2

The sound of inevitability…

Ironically, the 2009 results show areas of strength:

The company delivered strong operating leverage

during the year due to effective cost control measures.

Indeed, Li & Fung delivered record net profit in 2009.

Margins improved from 2008 due to strong relative

performance from the onshore businesses and

increasing contribution from higher margin value-

added services. Overall core operating margin

expanded from 2.8% in 2008 to 3.8% in 2009.

Turnover was affected by exceptionally weak

consumer sentiment combined with inventory

destocking and customer insolvencies, which could be

considered one-off events.

The business was also affected by record 9% deflation

in 2009. Li & Fung guide that they expect overall

inflation to be flat in 2010.

Moreover, management guidance for 2010 and beyond is

upbeat:

Top line growth for 2010 YTD is “north of 20%.”

The company is very well positioned to continue to

take market share and benefit from the long slow

recovery and ongoing inventory restocking cycle.

“The mother of all outsourcing deals” with Wal-Mart

should contribute to earnings from 2011e. Due to start

up costs, we forecast no contribution to the bottom

line from the Wal-Mart deal in 2010. We forecast that

Wal-Mart will add HK$186m to group EBIT in 2011e

(2% of total group EBIT) growing to HK$775m in 2013

(6% of total EBIT).

Li & Fung will continue to benefit from operational

leverage in 2010, as cost cuts made in Q4 2009 filter

through to operational expenses. For the existing

business, excluding recent acquisitions and

outsourcing deals, operating costs should be able to

drop again on an absolute basis in 2011e.

We forecast an underlying net profit CAGR of 31% 2010-

12e. But, we believe that, trading at a 2010e PE multiple of

30.5x, all of the good news is priced in.

We note that Li & Fung is trading at the top of its PE band

range – see the chart on page 3. Moreover, our 2010e PE

estimate of 30.5x factors in 52% YoY net income growth

this year.

For now, we believe that the stock price will inevitably

underperform for a period as the market adjusts its

forecasts downwards.

We recommend longer-term investors to look to re-enter

the stock at around HK$35.00 (-17% from the stock’s

current level).

Li & Fung: Wal-Mart deal contribution to group revenue

Source: Samsung Securities forecasts

Disciplined valuation call; Short 494 / Long 330

We must stress that we don’t see Li & Fung as a long-term

structural short; this is a disciplined valuation call.

However, we do see a pair trade opportunity; Short Li &

Fung / Long Esprit (330 HK, BUY rating, Target Price

HK$79.00).

We have the most bullish view on the street on Esprit. We

think the company's fortunes will turn around as we go

through CY10, driven by:

Solid progress in the Retail Division, the positive sales

momentum seen in Q2 FY10 (October – December

2009) of +18.5% YoY should continue, driven by new

store openings and a return to gentle same-store-sales

growth. We think that this will combine with margin

expansion to deliver FY10e Retail Division EBIT YoY

growth of over 20%.

An ending of the deterioration in the Wholesale

Division. We think that the weak franchise partners

are being shaken out. Management guide that

wholesale orders will be encouraged by the new

designs and positive Retail Division same-store-sales

growth. We anticipate that the Wholesale Division

will return to gentle growth in H1 FY11e.

Moreover, Esprit will gain 100% control of their China

business, which will add around 4% to EPS and

become a long-term earnings driver.

We see a return to EPS growth by 34% YoY in FY11e,

and a re-rating to the average PE multiple of 16x

(Esprit is currently trading on a FY11e PE of 12.0x).

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

2010E 2011E 2012E 2013E 2014E 2015E 2016E

Total revenue (HK$m) Wal-mart Sourcing Group (HK$m)

March 25, 2010


3

Our 12-month target price for Esprit is HK$79.00,

representing 33% upside, and is the highest in the market.

Moreover, we notice that the PE valuation premium

commanded by Li & Fung vs Esprit has never been higher.

We think that the market will now correct this anomaly.

Esprit vs Li & Fung: One year forward rolling PE bands

Source: Datastream

The currency issue

One word of caution; It is widely known that Esprit’s

earnings are highly correlated to EUR / HK$ movement as

85% of sales are in Europe and all profits are reported in

HK$. There is a clear currency translation effect - a 1%

increase in the EUR vs HK$ translates into around a 1%

EPS increase, and vice-versa.

We understand that some investors may be nervous about

market speculation of a sharp reversal in the dollar’s

fortunes in 2010 hurting Esprit’s earnings.

In H2 FY09 (January – June) average EUR / HK$ was

10.35. Today EUR / HK$ is back at 10.35. If the Euro

weakens by more than 4% on average over the next three

months, Esprit would experience negative currency effects

in H2 FY10e results.

Li & Fung: Samsung forecasts old vs new 2010-12E

HK$m, FY ending 31 Dec New Old Change

2010E

Total turnover 142,728 156,675 -9%

EBIT 5,828 6,530 -11%

Diluted EPS (HK$) 1.38 1.56 -12%

2011E

Total turnover 182,925 191,620 -5%

EBIT 7,746 7,980 -3%

Diluted EPS (HK$) 1.83 1.90 -4%

2012E

Total turnover 234,255 222,783 5%

EBIT 9,883 9,515 4%



Please see our reports on Li & Fung Don’t fight The

Matrix…Own the Outsourcing Oracle, published January

8, 2010, and our latest report on Esprit The last piece of

bad news. BUY!, published on February 4 2010 for our full

thesis on these stocks.

Valuation: Base case gives 4% downside

We think that a moderate de-rating to the historical

average 25x PE is justified by the earnings miss, which will

cause a flurry of consensus EPS downgrades on the stock.

In March 2011 we believe that the market will partly be

pricing the stock from anticipated 2011 earnings. Thus, we

blend our 2010e and 2011e EPS to arrive at HK$1.59 and

multiply this figure by 25x to yield a PE multiple based

priced target of HK$40.00, rounding to the nearest Hong

Kong dollar.

Our 12-month price objective represents 4% downside.

That leads us to downgrade our rating to SELL.

Li & Fung: 1-year forward PE band chart


Bear views and blue skies

Markets are all about balance of probability. We provide

strong opinions but do not ignore the possibility that

events will go against us. We therefore try to quantify the

risks if we are wrong. Given two stocks with an identical

percentage upside to Target, it is critical to know that one

has, for example 5% downside and the other 25%. This is

how many investors think, and we attempt to reflect this in

our research.


Our bear view quantifies the risks we see for Li & Fung by

factoring a worst case scenario into the valuation. In our

bear view scenario we take the following assumptions:

We factor in 10% YoY sales growth in 2010e. This is below

management guidance for revenue growth “north of 20%”

so far in 2010, and ignores the clear signs of economic

0x

5x

10x

15x

20x

25x

30x

35x

40x

Mar-

04

Jul-04

Nov-0

4

Mar-

05

Jul-05

Nov-0

5

Mar-

06

Jul-06

Nov-0

6

Mar-

07

Jul-07

Nov-0

7

Mar-

08

Jul-08

Nov-0

8

Mar-

09

Jul-09

Nov-0

9

Mar-

10

ESPRIT HOLDINGS LI & FUNG

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0 30x

HK$ 25x

20x

15x

March 25, 2010


4

stabilization and inventory restocking, plus acquisitions

and the Wal-Mart deal, which should boost revenue

growth further.

Despite the positive trend we see at present, in our bear

view we that margins stay flat from 2009. We assume

2010e net margin of 3.2%.

Valuation multiples for the stock decline to 20x PE, and we

use 2010e EPS.

We arrive at a 2010e EPS of HK$0.99, which is 38% below

our base case forecast of HK$1.38.

Using a PE multiple target of 20x, and rounding to the

nearest Hong Kong dollar, we arrive at bear view valuation

of HK$20 per share. This implies 52% downside from the



In our blue sky scenario, we use a DCF model to capture

the long-term value of Li & Fung.

We provide a three-stage DCF valuation, using a WACC of

10.5%.

We explicitly forecast out for ten years to the end of 2019e.

We then assume a 3.0% terminal FCF growth rate into

perpetuity.

Our DCF fair value emerges at HK$53.00 per share,

rounding to the nearest Hong Kong dollar, implying 27%

upside.

Agent Smith: Do you hear that Mr. Anderson? That

is the sound of inevitability.

Source: The Matrix, 1999.

Li & Fung: DCF valuation


Risk free rate 4.0% Equity risk premium 7.0% Beta 0.93 Cost of equity 10.5% Cost of debt 3.0% Tax rate 10.0% WACC 10.5%

Explicit forecast (HK$m) 2009 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E

NOPAT 3,621 5,408 7,126 9,043 11,437 14,248 17,075 19,487 21,717 23,815 25,897

Depreciation and amortization 540 462 544 652 752 823 910 997 1,083 1,168 1,252

Change in working capital 1,483 -1,783 -1,222 -1,479 -2,173 -2,265 -2,332 -1,101 -1,843 -1,192 -1,282

Capex -470 -628 -787 -984 -1,217 -1,479 -1,730 -1,808 -1,892 -1,959 -2,027

Free Cash Flow 5,174 3,459 5,662 7,232 8,799 11,327 13,924 17,575 19,065 21,833 23,840

PV of FCF

3,209 4,754 5,494 6,049 7,046 7,838 8,952 8,788 9,106 8,998

Sum of PV of explicit forecast 70,234

Terminal growth assumption 3.0% WACC 10.5% FCF at 2020E 24,555

Terminal value of FCF at 2019a 326,961

PV of terminal forecast 123,404

LT Growth Rate

Enterprise Value 193,638

HK$ 2.0% 2.5% 3.0% 3.5% 4.0%

Net debt (2009E) 2,572

WA

CC

9.5% 52.7 55.2 58.1 61.5 65.6

Intrinsic Market value 196,210

10.0% 50.6 52.8 55.4 58.3 61.7

Value per share (HK$) 53.0

10.5% 48.8 50.8 53.0 55.6 58.5

Current price (HK$, 24 March 2010) 41.8

11.0% 47.2 49.0 50.9 53.2 55.7

Upside potential 27%

11.5% 45.7 47.3 49.1 51.1 53.3

March 25, 2010


5

Li & Fung: Financial ratios

FY ending 31 Dec 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E

YoY growth

Total revenue 10.6% 17.9% 22.3% 36.0% 19.8% -5.6% 36.6% 28.2% 28.1% 26.7%

Gross profit 14.4% 31.0% 29.6% 33.2% 18.8% 4.0% 28.6% 29.3% 29.2% 27.8%



Net profit 19.4% 20.1% 23.0% 39.0% -20.9% 39.1% 51.9% 32.8% 28.2% 27.5%

Margins

Gross margin 9.2% 10.2% 10.8% 10.6% 10.7% 10.8% 10.9% 11.0% 11.1% 11.2%

Core operating margin 3.3% 3.3% 3.4% 3.4% 2.8% 3.8% 4.1% 4.2% 4.2% 4.2%

EBIT margin 3.3% 3.4% 3.5% 3.9% 2.7% 3.7% 4.1% 4.2% 4.2% 4.2%

Net margin 3.2% 3.2% 3.2% 3.3% 2.2% 3.2% 3.6% 3.7% 3.7% 3.7%

Returns

ROE 31.7% 38.7% 26.6% 31.0% 18.1% 19.0% 26.1% 31.2% 35.5% 39.6%

ROA 13.2% 11.7% 10.0% 9.6% 6.5% 8.1% 10.7% 12.2% 13.2% 14.2%

ROIC 48.8% 30.6% 26.5% 22.7% 15.4% 18.4% 22.3% 26.6% 30.6% 34.9%

Working capital

Inventory days 4 5 8 9 9 9 9 9 9 10

AR days 36 51 50 54 49 44 48 48 48 48

AP days 39 44 45 50 47 47 49 49 49 49

Gearing


Debt/equity 16.0% 54.3% 45.8% 61.2% 48.2% 38.2% 34.6% 31.1% 27.6% 24.2%

Net cash/equity 33.9% -27.3% -4.8% -46.3% -31.2% -14.5% -26.8% -25.4% -22.9% -18.9%

Valuation

PE 82.0x 75.6x 62.8x 47.3x 60.7x 46.1x 30.4x 22.9x 17.8x 14.0x

PB 25.8x 29.1x 16.6x 14.5x 10.9x 8.7x 7.9x 7.1x 6.3x 5.5x


Dividend yield 1.6% 1.2% 1.3% 1.7% 1.4% 1.8% 2.6% 3.5% 4.5% 5.8%

Source: Company data, Samsung Securities, Valuation based on HK$41.75 as at market close 24 March 2010

March 25, 2010


6

Li & Fung: Income statement

HK$m, FY ending 31 Dec 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E

Total revenue 47,171 55,617 68,010 92,460 110,722 104,479 142,728 182,925 234,255 296,805

Cost of sales -42,848 -49,956 -60,675 -82,692 -99,119 -92,406 -127,205 -162,847 -208,308 -263,633

Gross profit 4,323 5,661 7,335 9,768 11,603 12,073 15,524 20,079 25,947 33,172

Other income 223 264 312 518 421 645 571 732 937 1,187




Other non-core operating expenses 0 -4 0 -43 -40 -111 0 0 0 0



EBITDA 1,701 2,032 2,629 3,863 3,527 4,420 6,290 8,291 10,535 13,320

Interest income 43 70 98 208 113 91 85 40 34 38



PBT 1,623 1,942 2,373 3,314 2,683 3,606 5,514 7,388 9,519 12,207

Taxation -133 -151 -172 -253 -259 -240 -397 -591 -809 -1,099

PAT 1,490 1,791 2,202 3,061 2,424 3,366 5,117 6,797 8,710 11,108


Net profit 1,491 1,790 2,202 3,060 2,422 3,369 5,117 6,797 8,710 11,108


Diluted EPS (HK$) 0.51 0.55 0.66 0.88 0.69 0.91 1.38 1.83 2.34 2.99

DPS (HK$) 0.67 0.49 0.56 0.72 0.57 0.77 1.11 1.47 1.88 2.40

YoY growth

Total revenue 10.6% 17.9% 22.3% 36.0% 19.8% -5.6% 36.6% 28.2% 28.1% 26.7%

Gross profit 14.4% 31.0% 29.6% 33.2% 18.8% 4.0% 28.6% 29.3% 29.2% 27.8%



Net profit 19.4% 20.1% 23.0% 39.0% -20.9% 39.1% 51.9% 32.8% 28.2% 27.5%

Margins

Gross margin 9.2% 10.2% 10.8% 10.6% 10.7% 10.8% 10.9% 11.0% 11.1% 11.2%

Core operating margin 3.3% 3.3% 3.4% 3.4% 2.8% 3.8% 4.1% 4.2% 4.2% 4.2%

EBIT margin 3.3% 3.4% 3.5% 3.9% 2.7% 3.7% 4.1% 4.2% 4.2% 4.2%

Net margin 3.2% 3.2% 3.2% 3.3% 2.2% 3.2% 3.6% 3.7% 3.7% 3.7%


March 25, 2010


7

Li &Fung: Balance sheet



Inventories 458 628 1,331 2,060 2,329 2,383 3,067 4,015 5,136 6,862





Current assets 8,247 10,528 15,335 19,067 21,466 21,579 26,127 32,817 41,558 52,996

PPE 715 948 1,114 1,130 1,283 1,256 2,745 4,101 5,537 6,601








Total assets 11,270 15,268 22,045 31,789 37,509 41,847 47,778 55,728 65,820 78,240





Bank overdraft 0 204 92 205 93 47 47 47 47 47



Others 125 648 765 1,279 1,259 1,462 0 0 0 0







Share capital 73 73 85 86 91 94 94 94 94 94

Reserves 3,064 3,540 6,883 8,082 12,122 15,811 16,834 18,194 19,936 22,157






March 25, 2010


8

Li & Fung: Cash flow


EBIT 1,556 1,885 2,412 3,600 3,044 3,880 5,828 7,746 9,883 12,568


Others 43 22 -4 -314 84 0 0 0 0 0


Change in working capital -524 174 -1,930 664 214 1,483 -1,783 -1,222 -1,479 -2,173

Tax paid -106 -115 -222 -193 -247 -240 -397 -591 -809 -1,099


Capex -419 -1,209 -2,252 -5,699 -3,870 -1,978 -3,181 -1,837 -1,984 -1,717

Disposals 6 9 22 491 73 0 0 0 0 0

Interest Income 43 70 98 208 113 91 85 40 34 38

Others -31 51 117 -36 -27 -3,828 -10 -10 -10 -10

Net cash inflow / (outflow) from operating activities -401 -1,079 -2,014 -5,035 -3,711 -5,715 -3,106 -1,807 -1,960 -1,689


Change in bank loans 0 -44 2,594 -2,737 71 -335 0 0 0 0


Interest paid -11 -14 -148 -431 -400 -372 -406 -406 -406 -406

Dividends paid -1,078 -2,034 -1,564 -2,051 -2,560 -2,179 -3,269 -4,558 -5,966 -7,631

Others -6 -146 -2,594 2,737 -71 0 0 0 0 0

Net cash inflow / (outflow) from investing activities -973 -2,108 3,768 -1,081 1,183 -538 -3,676 -4,964 -6,373 -8,038

Net increase / (decrease) in cash and cash equivalents -259 -1,074 2,228 -2,097 1,050 1,973 -2,672 -294 -86 321



Cash and cash equivalents (year end) 2,147 1,044 3,302 1,267 2,182 4,155 1,483 1,189 1,103 1,424


March 25, 2010


9


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