Li & Fung Outlook Revised To Negative Amid COVID-19 Hit; 'BBB' Rating Affirmed

  • The fast spread of COVID-19 in the U.S. and Europe, and efforts to contain the virus are likely to depress retail sales in these regions and disrupt the global supply chains of retailers and brands.
  • The growth prospects and operating cash flow of Li & Fung Ltd. is likely to weaken substantially over the next six to 12 months, before normalizing in 2021.
  • On March 25, 2020, S&P Global Ratings revised its outlook on Li & Fung to negative from stable. At the same time, we affirmed our 'BBB' long-term issuer credit rating on the company and our 'BBB' long-term issue ratings on the company's outstanding senior unsecured bond. We also affirmed our 'BB+' issue rating on Li & Fung's perpetual capital securities.
  • The negative outlook reflects our expectation of a difficult 2020 and higher debt leverage for Li & Fung amid the COVID-19 pandemic.
HONG KONG (S&P Global Ratings) March 25, 2020--S&P Global Ratings today took the rating actions listed above. We revised the outlook on Li & Fung to negative because we expect COVID-19 to significantly hit the company's core supply-chain services in 2020 as customers scale down or even cancel orders in light of weak consumer demand and economic uncertainty. Li & Fung's key credit measures will likely deteriorate beyond our thresholds for the current rating over next six to 12 months, before gradually normalizing in 2021.
The fast spread of COVID-19 in the U.S. and Europe, and efforts to contain it have resulted in temporary retail store closures, weak consumer sentiment, and heightened risk of a broad-based macroeconomic decline. This is on top of structural changes that retailers have been battling, including rising penetration of e-commerce and fast changing customer preferences. We believe retail sales across North America and Europe could decline by about 20% in 2020, assuming year-over-year declines of more than 50% for the next eight weeks or so and single-digit contraction year-over-year for the remainder of 2020.
Li & Fung's prospects and operating cash flow will likely worsen over next six to 12 months, given the challenges faced by its customers. As a global sourcing services provider, Li & Fung is assisting its U.S. and European customers, as well as Asia-based vendors in managing the global supply chain. The company generated about 65% of revenue from the U.S. and 15%-20% from Europe and about 50% of its core operating profit from the regions in aggregate in 2019, based on our estimate.
Our base case assumes that Li & Fung's revenue will decline by about 20% in 2020 and the company's core operating margin will narrow to 1.5%-1.7% from 2.0% in 2019, mainly due to the continued weakness of its supply-chain solutions and onshore wholesale businesses. The company's EBITDA could drop by 25%-30% in 2020, from an already low base in 2019. The relatively steady performance of the company's more profitable Asia-based logistics business, which contributed 41% of Li & Fung's core operating profit in 2019, will partially temper the risk. As a result, we expect Li & Fung's debt-to-EBITDA ratio to increase to 3.2x-3.4x in 2020, from about 2.7x in 2019, despite the company's reduction of its total debt balance by about 30%.
We expect Li & Fung's operations to gradually normalize and the debt-to-EBITDA ratio to fall below 3.0x in 2021 and 2022, assuming the virus is contained in 2020. The magnitude of the revenue and profit decline in 2020 and the timing for a return to normalcy will depend on the duration of the shutdowns and the trajectory of the rebound.
The global supply chains of retailers and brands have been disrupted since the outbreak of COVID-19, especially in February, when the outbreak peaked in China. However, with factories reopening and labor returning to work in China, the retail industry could avert a significant disruption in the supply chain. Lower demand amid the pandemic would also likely offset some of the supply-chain impact.
The evolving market conditions amid COVID-19 and trade tensions between China and the U.S. are likely to force out smaller players in the supply-chain services industry. This would lead to industry consolidation by market leaders such as Li & Fung. The company's investment in digitalization and speeding up the lead time to market should also gradually enhance market share with existing customers and help attract new customers. These initiatives underpin our anticipation that Li & Fung will maintain its leadership in global supply-chain services over the longer term, despite the decline in operating performance in 2020.
Li & Fung's commitment to maintaining low debt leverage and track record of prudent management of capital structure and liquidity continue to support its debt serviceability. This will increase the company's financial buffers and flexibility to absorb business volatility. We believe Li & Fung will screen and cut any unnecessary operating expenses to preserve cash and control debt leverage amid the revenue decline.
We do not foresee any major change to the financial policies or strategic directions of Li & Fung following the proposed privatization of the company. The Fung family will retain control over the company with 60% voting power and full control of the management team, although the new shareholder, GLP Pte. Ltd., will have 67.67% of the economic interest (40% of voting shares and 100% of non-voting shares) after the transaction. Li & Fung is also committed to maintaining the same level of information disclosure and corporate governance, despite the privatization and delisting from the Hong Kong stock exchange. While GLP is expected to bring benefits to Li & Fung given its global scale in logistics warehousing, diversified network of customers, and technological competencies, the potential benefit from this strategic partner has yet to be quantified.
The negative outlook reflects our view that Li & Fung's growth prospect and operating cash flow could significantly deteriorate over the next six to 12 months amid the COVID-19 pandemic. The company's debt-to-EBITDA ratio is likely to peak at 3.2x-3.4x in 2020, and fall below 3.0x at the end of 2021 and 2022, assuming the virus will be contained in 2020.
We could lower the rating if the prospect of Li & Fung maintaining its debt-to-EBITDA ratio well below 3.0x deteriorates, likely due to a more severe or prolonged impact of COVID-19. We could also lower the rating if the company's commitment to maintaining a low debt leverage and prudent capital structure changes after the proposed privatization.
We could also lower the rating if Li & Fung's competitive position weakens amid structural challenges including ongoing destocking, fast changes in consumer preference, and intensifying competition from new retail formats. A higher customer turnover or faster shrinkage of operating scale than we expect could indicate such deterioration.
We could revise the outlook to stable if Li & Fung's initiatives on reorganization and investment in digitalization restore its growth prospect and profitability after the virus is contained, and the company maintains its debt-to-EBITDA ratio below 3.0x.
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