Analysis: when economic bellwethers are treading water, is it time to fear drowning?

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It is relatively simple to identify trends in supply chain management, consumption and heavy investment around the globe.

If you want to know how retailers are doing worldwide, check out the latest trading performance of Hong Kong-based Li & Fung, arguably the most important supplier on Earth.

Likewise, don’t miss updates from an unrivalled construction machinery maker, Caterpillar of the US, whose $51bn market capitalisation dwarfs Li & Fung’s $6.6bn.

Closely watched by investors and analysts, Li & Fung is a bellwether for the health of the retail sector in the US and Europe, while Caterpillar – whose performance is a closely monitored gauge of construction activity in China – is a benchmark in the industrial sector.

Both are treading water.

Stock performance

Since mid-July 2014, when the shares of both companies traded around their multi-year highs, the market value of Li & Fung has fallen by about 39%, while Caterpillar’s stock price has plunged 25% over the period.

In about a year, Li & Fund has wiped a staggering $4.4bn of value off its market cap, although that figure is more accurately around $2.8bn once its Global Brands Group (GBG) spin-off – from which GBG emerged as an independent listed company in Hong Kong – is taken into account.

A licensing and brand business still controlled by the Fung family, GBG has a market cap of $1.6bn, but its equity value was much higher when its shares were originally listed 12 months ago.

“Following the Global Brands spin-off, Li & Fung has returned to its earlier business model of strong cash flow generation, less volatility on earnings and a strong balance sheet,” Li & Fung said in its annual report for 2014.

Last year, Li & Fung’s profitability, as measured by Ebit and net income margins, hit its lowest level for a very long time. By comparison, Caterpillar’s margins are holding up relatively well, but revenue growth has become more problematic.

It doesn’t take much to understand what is going on at Li & Fung: the supplier is in the midst of an identity crisis. Its two pillars – LF Trading, a sourcing platform that focuses on retailers, and LF Logistics – are not living up to expectations.

Even Wall Street analysts are disenchanted, with Goldman Sachs leading the bears, arguing that there are three key areas where Li & Fung could try and make an attempt to buoy its ailing operations:

• grow with the market – “US shipment trends are weak, core customers are not growing fast enough: EU is growing concern”;
• gain share with existing customers – “lower commission rates are a double-edged sword”;
• win new customers – “winning some customers, but Li & Fung is already ‘too big’ for new accounts to move the needle”.

I broadly agree, although I would not be surprised if Li & Fung decided to shock the world with a multi-billion bid in the freight forwarding industry. It has a strong track record in M&A, and it could exploit its balance sheet.

That said, a more urgent matter could be worth some consideration: additional divestments.

Disposals are an unlikely scenario, but Li & Fung now ranks in the top non-staples consumer stocks in the US, lagging behind Wal-Mart, Costco Wholesale, Amazon and Target, which are having mixed fortunes on the stock exchange.

“Now, with $60-80bn in retail revenues (assuming 3-4x mark-up in retail price vs trading price), it ranks as number five among non-staples US consumer stocks, and 3.5x larger than Gap, the largest apparel brand in the US.

“We believe the company’s sheer size may become an impediment to fast organic growth,” Goldman added, noting that the shares had retraced since the GBG spin-off, “reflecting concerns over earnings”.

Frankly, I don’t know if Goldman is after an advisory mandate, but its take reinforces the view that a smaller asset base could be considered.

Elsewhere, at the beginning of the year, Macquarie wondered: “Can it deliver organic growth?”

Things haven’t changed over the last six months of trade – research from CLSA, in which the Asian broker downgraded the stock to “underperform” on 23 June, argued that Li & Fung was faced with several headwinds, including a “softer retail environment in the US, lower raw material prices and FX impact from a weaker euro”.

Unbelievable?

“LF Logistics is a high-growth business,” Bruce Rockowitz, chief executive of GBG, said a few weeks before the split occurred last summer. “Over the past three years it has had a compound annual growth rate of over 40%, and we expect that to continue for the next three years.”

Fast-forward to May 2015, and The Wall Street Journal reported that Wal-Mart was “taking back much of the business it outsourced to Hong Kong-based factory middleman Li & Fung as the US retailer increasingly contracts directly with factories for goods”.

Unsurprisingly perhaps, I do not have any elements to blame the bears, whose judgment is based upon accurate analysis of fundamentals, business cycle forces, corporate strategy and a few other key factors – all of which are open to extraordinary corporate activity.

As far as Caterpillar is concerned, the recent collapse of the Shanghai Composite Index is worrisome, but the US company has more irons in the fire.