Li & Fung’s Debt Outlook Lowered by Moody’s and S&P

Moody’s Investors Service and S&P Global Ratings both lowered their debt ratings outlooks on Li & Fung to negative from stable due to Hong-Kong-based sourcing giant’s deteriorating performance in recent quarters and challenged recovery prospects.

At the same time, both debt rating agencies affirmed Li & Fung’s current debt ratings.

“The change in outlook to negative reflects Li & Fung’s weakening performance over the past several quarters and our expectation that the company’s earnings will remain weak over the next 12-to-18 months because its major customers’ tight inventory management and sluggish consumer spending will strain its revenue growth,” said Gloria Tsuen, a Moody’s vice president and senior credit officer.

“This concern is mitigated by the company’s maintenance of a solid balance sheet and high cash position that provides a buffer against weak earnings and cash flow,” added Tsuen.

In its analysis, Moody’s wrote, “Li & Fung’s turnover and reported EBITDA fell 27 percent and 18 percent, respectively, in the first half of 2023 (H1 2023) compared with the same period a year ago, following an 18 percent revenue decline in H2 2022. This development was mainly the result of (1) a high-base effect in H1 2022 when the company benefited from retail customers’ inventory build-up; and (2) customers’ reduction of excess inventories since H2 2022. The impact of lower revenue on earnings was partly offset by its continued cost reductions.

“Moody’s also expects the company’s revenue to rebound moderately in 2024, against the backdrop of retail customers’ cautious inventory management and an anticipated deterioration in the U.S. economy that will discourage consumer spending. Its lower earnings than what Moody’s previously anticipated means that its cash flow generation will remain weak.

“Consequently and based on the assumption of stable debt levels, Moody’s expects Li & Fung’s adjusted net debt/EBITDA to increase to 3.0x in 2023 from 2.4x in 2022, and its adjusted debt /EBITDA to rise to 6.9x from 6.4x over the same period. Moody’s also forecasts that the company’s net and gross leverage will improve to 2.6x and 6.2x, respectively, in 2024 as earnings return to growth.

“While Li & Fung’s gross leverage is high for the Ba1 rating category, the risk is mitigated by its strong cash buffer and the fact that its subordinated perpetual securities with coupon deferral feature accounted for 53 percent of its adjusted debt as of the end of June 2023. Despite a reduction in H2 2022 due to large working capital deficits, its cash position of $767 million as of the end of June 2023 accounted for 61 percent of its adjusted debt.

“After experiencing multiyear structural declines in revenue and earnings as well as pandemic-driven weakness, Li & Fung made progress in improving the operating performance of its trading business in 2021 and 2022 by strengthening its customer bases, improving services, and reducing costs.

“However, execution risks to a sustained improvement and full earnings recovery to pre-pandemic levels remain high, amid tepid demand for apparel products in the US and the risk of retail bankruptcies after the pandemic.”

In its press release, S&P said, “Li & Fung’s weaker first-half performance indicates recovery could be delayed. The company’s core supply-chain solutions business, which contributed about 62 percent of EBITDA in 2022, saw a 30 percent year-on-year decline in turnover and a 42 percent fall in EBITDA in the first half of 2023. The sharp decline was due to the high base in the first half of 2023. That said, the revenue scale for the segment has now shrunk to below 2020 levels.

“Li & Fung’s growing presence with off-price and discount retailers as well as its wallet share gain with existing customers were not sufficient to offset the depth of inventory adjustments retailers are undergoing. This is not in line with our previous expectation that the company would continue its recovery even amid slowing economic growth in the U.S. and eurozone.

“Ordering outlook could stay challenging over the next 18 months. Brand owners and retailers’ cautious approach to channel inventory levels will continue to constrain Li & Fung’s turnover. This is particularly so in the soft goods (apparel-driven) segment, from which the company derives the majority of its revenue.

“Despite efforts by retailers to reduce inventories in the first half of 2023, the levels remain high. This means retailers will likely place smaller batches of chase orders and will be less willing to go for new products/product freshness orders. The weak order environment would likely stay because we forecast slow economic growth in the U.S. through 2025, and that consumer sentiment toward discretionary spending will remain fragile.

“We assume Li & Fung’s revenue growth will be stronger in the second half of the year. Besides the favorable seasonality factor, Li & Fung’s turnover could benefit from the company’s recent efforts to revive the business. These include reshuffling the customer list, shifting sector exposure away from department stores and toward discounters and specialty retailers, and helping customers manage costs and disruption.

“Li & Fung’s ongoing expansion in market share within existing customers and ability to win new orders could help it achieve a flat 2023 by topline. Based on our assumption, this means the second half will contribute about 62 percent of full-year turnover, a similar weighting as in 2020.

“Li & Fung’s growing EBITDA contribution from the onshore business and leaner overheads will support EBITDA. Lower freight costs that boosted the company’s onshore business profits in the first half of 2023, and streamlining the organization’s cost structure helped halve the EBITDA hit from the supply-chain solutions business. We expect these benefits to stay. A recovery in the second half should help lift Li & Fung’s EBITDA to a higher level than in 2022. This translates to an improvement in EBITDA margin to 2.4 percent for 2023, compared with 2.2 percent in the first half of 2023 and 1.9 percent in 2022. We expect the credit metrics to remain sound, with EBITDA interest coverage above 3x and a ratio of debt to EBITDA below 2x.

“Li & Fung’s financial strength allows it to stomach volatility in business. The company has US$767 million cash on hand as of June 30, 2023. Moreover, Li & Fung typically has stronger cash inflow in the second half of the year, given seasonality factors from turnover and working capital reversal. The cash holding, together with limited capital expenditure needs and the absence of major merger and acquisition plans, leaves the company with sufficient financial resources to weather the weak retail environment.

“Li & Fung could also complete the US$250 million tender on its US$600 million 2025 notes, of which US$172.5 million has not been repurchased. Without the repurchase, we forecast the cash balance at end-2023 will be higher than at June 2023.

“The negative outlook reflects our view that Li & Fung could take longer to rebuild its supply chain strength than we expected, possibly due to lower supply chain scale.”