Li Fung: An Analysis

Li Fung: An Analysis Rahul Jacob, Inside Track: Traditional Values at the Click of a Mouse, Financial Times, August 1, 2000, p. 14. Online bookseller Amazon.com transformed the book industry forcing traditional book retailers to respond. Some information in this section comes from previous Harvard Business School Case Studies: Li Fung: Beyond Filling in the Mosaic-1995-98, (HBS Publishing No. 398-092) Michael Y. Yoshino, Carin-Isabel Knoop, Anthony St. George; January 1, 1998; and Li Fung (Trading) Ltd., HBS Publishing (No. 396-075) Gary Loveman, Jamie OConnell, October 26, 1995. With a press conference the following day, William was confident of the Groups performance and lifung.coms prospects. But he knew that important issues remained unresolved: Was there any chance of channel conflict or cannibalization between the offline business and the start-up? How would the market react to the start-up once it was launched the following year? And how specifically would e-commerce ultimately transform his familys century-old company? Company Background Li Fung was founded in 1906 by Williams grandfather, Fung Pak-Liu and his partner, Li To- Ming in Guangzhou, China as an export trading company selling to overseas merchants. In the 1920s and 1930s the company diversified into warehousing and the manufacture of handicrafts. Shortly after Fung Pak-Liu passed away in 1943, his son Fung Hon-Chu assumed charge of the company. Two years later, silent partner Li To- Ming retired and sold his shares to the company. The company retained Lis surname, a homophone Im not an Internet guy, Im a business guy, quipped William Fung, managing director of Li Fung Trading Co. Clad in his chinos and black American Eagle T-shirt, Fung looked much more like a new economy entrepreneur than the selfdescribed offline, old economy relic: Im 51, Im more than a grey hair in Internet terms, Im a fossil.1 Nor did lifung.com, his elder brother Victors new online company, resemble a typical Internet start-up, particularly with a 96-year-old parent born at the end of the Qing Dynasty. In August 2000, the day before beta launch of the new business-to-business (B2B) e-commerce portal, William described the challenges facing Li Fung: About three or four years ago, Victor and I discussed the Internet and how it impacts us. Our starting point was a defensive posture: Would the Internet disintermediate us? Would we get Amazoned2 by someone who will put together all of the information about buyers and factories online? After a lot of research we realized that the Internet facilitates supply chain management and we werent going to be disintermediated. The key is to have the old economy know-how and yet be open to new economy ideas. EXHIBIT 1 Li Fung Consolidated Income Statement (December 31, 1999), in HK$* 2000 1999 1999 1998 (HK$ thousands) (HK$ thousands) (HK$ thousands) (HK$ thousands) (June 30) (December 31) (June 30) (December 31) Turnover 10,267,606 16,297,501 6,583,730 14,312,618 Cost of sales (9,262,171) (14,585,881) (5,895,432) (12,891,709) Selling expenses (191,616) (354,124) (143,136) (287,524) Administrative expenses (87,741) (867,842) (56,436) (747,725) Profits before taxation 328,943 613,861 208,936 471,098 Taxation (29,805) (36,638) (14,536) (16,425) Profit after taxation 299,338 577,223 194,400 454,673 *In August 2000, US$1 _ HK$7.78. for profit in Chinese, which, along with Fung, a homophone for abundance, had an auspicious ring when combined. Li Fung relocated permanently to Hong Kong at the end of World War II, expanding its operations to include toys, garments, plastic flowers, and electronics. In the early 1970s, both Fung brothers had just returned from the United States: William had earned his MBA from Harvard Business School and returned to the business in 1972. Victor had recently completed his PhD in economics at Harvard University and, following a two-year stint teaching at Harvard Business School, rejoined the business in 1974. Their return heralded Li Fungs transition from a family-owned business to a professionally managed firm, with a planning and budgeting system in place for the first time. William and Victor, the third generation to run the company, felt that the next logical step in growing the company was to go public. In 1973, Li Fung became the holding company for the Group and was listed on the Hong Kong Stock Exchange (HKSE). Throughout the 1980s, Li Fung expanded its regional network of offices throughout the Asia-Pacific region as more sources of supply emerged in the rapidly industrializing Asian economies. In 1988 the Group was privatized and streamlined, incorporated in Bermuda in 1991, and its trading activities were again listed on the HKSE in July 1992. With the 1995 acquisition of Inchcape Buying Services (formerly Dodwell), Li Fung expanded its customer base in Europe while simultaneously shifting its sourcing network beyond East Asia to include the Indian subcontinent, the Mediterranean, and Caribbean basins. By 2000, Li Fung was a $2 billion global export trading company with 3,600 staff worldwide, sourcing and managing the global supply chain for high-volume, time-sensitive consumer goods. (Exhibit 1 shows recent Li Fung financial data.) By 2000, 69 percent of LiFungs sales were in the United States and 27 percent in Europe. Key customers included The Limited, Gymboree, American Eagle,Warner Brothers, Abercrombie Fitch, and Bed Bath Beyond. Tesco, Avon Products, Levi-Strauss, and Reebok had become customers within the last two years; Royal Ahold, GUESS? jeans, and bebe had signed on in 2000. Li Fungs product mix included hard and soft goods. Soft goods referred to apparel, including woven and knit garments for men, women, and children. Hard goods included fashion accessories, festive or holiday products, furnishings, giftware, handicrafts, home products, fireworks, sporting goods, toys, and travel goods. Hard goods provided higher margins than soft goods because, despite a generall y lower item value per unit, they required higher value-added services for orders that were also usually much smaller than soft goods orders. Hard goods items such as watches, shoes, suitcases, kitchenware, or teddy bears required an inspector for quality control evaluation for even the smallest batch order, thereby greatly increasing what Li Fung could charge. Margins for soft goods were roughly 6 percent to 8 percent, while we get an order from a European retailer to produce 10,000 garments. We determine that, because of quotas and labor conditions, the best place to make the garments is Thailand. So we ship everything from there. And because the customer needs quick delivery, we may Product Development Raw Material Sourcing Production Planning Factory Sourcing Manufacturing Control Quality Assurance Export Documentation Shipping Consolidation Fashion Accessories Festive Products Furnishings Garments Giftware Handicrafts Home Products Sporting Goods Toys Travel Goods Li Fung Total Value-Added Package EXHIBIT 2 Li Fung Total Value- Added Services Source: Company documents. divide the order across five factories in Thailand. Effectively we are customizing the value chain to best meet the customers needs. Five weeks after we received the order, 10,000 garments arrive on the shelves in Europe, all looking like they came from one factory.5 Li Fung clients benefited in several ways: supply chain customization could shorten order fulfillment from three months to five weeks, and this faster turnaround allowed clients to reduce inventory costs. Moreover, in its role as a middleman, Li Fung reduced matching and credit risks, and also offered quality assurance to its customers. Furthermore, with a global sourcing network and economies of scale, Li Fung could offer lower cost and more flexible sourcing than its competitors. In addition, through acquisitions and global expansion, Li Fung was extending this knowledge base to sub-Saharan Africa, Eastern Europe, and the Caribbean. Finally, Li Fung provided up-to-date fashion and market trend information to clien ts. As a result of its Camberley acquisition in 1999, it started offering clients virtual manufacturing or product design services. According to Victor, Li Fung does not own any of the boxes in the supply chain, rather we manage and orchestrate it from above. The creation of value is based on a holistic conception of the value chain. In recent years, however, Li Fung had begun to improve operations by controlling or owning strategic links in the chain. In some cases, Li Fung offered raw material sourcing. In the past when clients placed an order, Li Fung would determine the manufacturer best suited to supply the goods, and that factory would source its own raw materials. But Li Fung understood its clients needs better than its manufacturing plants did, so by offering raw materials to its suppliers, the company both ensured greater quality control and bought larger and thus more cost effective amounts of raw materials, thereby producing cost savings for each manufacturer. In such cases, Li Fung also earned revenue by charging its factories a commission on each raw material purchase they made. By mid-2000, ne arly 15 percent of Group sales involved Li Fungs raw material sourcing service. Joan Magretta, Fast, Global, and Entrepreneurial: Supply Chain Management, Hong Kong Style, An interview with Victor Fung, Harvard Business Review, September-October 1998, p. 106. Corporate Culture and Compensation From the 1992 privatization on, the division of labor between the Fung brothers was clear-cut: as Group chairman, Victor was primarily concerned with the Groups strategic issues and long-term planning; as Group managing director, William attended to everyday operations of the publicly listed trading arm, or as he joked in a recent interview, Victor is the deep thinker, and I just make the money.6 In another interview, Victor joked that William calls me the visionary, meaning that I dont really know whats going on.7 But both brothers lived in the same apartment building as their mother and sisters and conversed every day to keep abreast of developments at Li Fung. The duo created a strong synergy that was described by the CEO of the Groups e-commerce venture as A combination of both thought leadership and execution, with the unique relationship between Victor and William cementing the entire organization. They create a very particular kind of culture that blends pragmatism and, at th e same time, a recognition of and openness to innovation. According to Victor, once the business was successful, it was essential to keep an open mind and rather than resting on their laurels, that the challenge was to move past success and look forward. Furthermore, Victor held that it was imperative to cultivate a corporate culture that not only tolerated but encouraged diversity, or in his words, keep the culture so that it remains humble, agile, and responsive all the time and keep the people externally focused. Biannual retreats were held in Hong Kong, senior management meetings attended by division-level managers in order to foster communication across the Group. Li Fungs 3,600 employees were spread around the globe in offices ranging in size from 6 staff in Saipan to 1,100 in the Hong Kong head office. Five of the 48 offices were hubs-Hong Kong, Taiwan, Korea, Thailand, and Turkey. Each 8 Joanna Slater, Corporate Culture, Far Eastern Economic Review, July 22, 1999, p. 12. (except the Hong Kong office) had 200 to 300 employees. Li Fung was entrepreneurial, allowing senior managers to run 90 small, worldwide management teams as separate and individual companies. These dedicated teams of product specialists focused on the needs of specific customers and were grouped under a Li Fung corporate umbrella that provided centralized IT, financial, and administrative support from Hong Kong. This decentralized corporate structure allowed for adaptability and rapid reaction to seasonal fashion shifts. As a meritocracy, performance-based promotion and compensation were cardinal principles. Each of Li Fungs top executives negotiated individual compensa tion packages. In contrast to companies that restricted executive bonuses to a fixed percentage of salary, Li Fung bonuses were based on profits with no ceiling. Its not every company that calls its executives little John Waynes. But for Li Fung, the image captures perfectly the drive, dedication, and independence of the companys far-flung managers. As Li Fung extended its geographic reach, it also expanded its mix of cultures. And to manage the mix it uses a simple formula: give managers the freedom to work as they see fit, so long as they get the job done.8 Tripartite Growth Strategy In 2000 Li Fung saw its future growth coming from a combination of organic growth, expansion through acquisition, and extension of its supply chain to new markets via the Internet. Organic Growth Since 1995, the Group had grown organically by receiving more orders from existing clients and by securing new mandates from strategic clients. Li Fung further extended its network and diversified its sourcing around the globe with new offices in places as diverse as Bangladesh, sub-Saharan Africa, and Manchester, England (see Exhibits 3 and 4). Louis Kraar, The New Net Tigers, Fortune Magazine, May 15, 2000, p. 310. Joanna Slater, Masters of the Trade, Far Eastern Economic Review, July 22, 2000, p. 10. The Mediterranean Cairo Denizli Florence Istanbul Izmir Oporto Tunis Turin South Africa Durban Madagascar Mauritius South Asia Bangalore Bombay Chittagong Colombo Dhaka Karachi Katmandu Madras New Delhi Sharjah North Asia Beijing Dallan Guangzhou Hong Kong Liuyang Nanjing Qingdao Southeast Asia Bangkok Ho Chi Minh City Jakarta Johor Bahru Manila Phnom Penh Saipan Singapore The Americas Guatemala Honduras Mexico City New York Vancouver Seoul Shanghai Shantou Shenzhen Taipei Zhanjiang EXHIBIT 3 Li Fungs Global Network Source: Company documents. Central America 3% Hong Kong/PRC 40% Southeast Asia 20% South Asia 8% Korea 12% Taiwan 9% Europe 6% Africa 2% EXHIBIT 4 Li Fung Sourcing Markets (Q1 and Q2, 2000) Source: Company documents. David Wilder, Internet Key to More Gains for Li Fung, South China Morning Post, September 4, 2000, Business Post, p. 1. In 1996 Li Fung adopted a three-year plan system, one which William described as having been adopted directly from the economic planning system of the Chinese Communist Party, that allows the company to look ahead, but not too far ahead. William elaborated: We thought that the Chinese had a neat system. They have five-year plans, fixed; we have three-year plans, fixed. We dont want moving goalposts, we want set goals. At the beginning of every three-year plan we sit down and look at the business from its fundamentals. We use backwards planning, we recognize where we want to be in three years time, identify the gaps between that and where we are now, and see what we have to do to get there. During its first three-year plan (FY1993-1995), entitled Filling in the Mosaic, Li Fung focused on filling in the gaps in its network of offices to cover new sourcing markets. The second three-year plan (FY1996-1998), Margin Expansion, was launched immediately after the Inchcape acquisition to in crease its profitability. A third three-year plan Doubling Profits (FY1999-2001), established the goals of doubling profits every three years and achieving $3 billion in annual sales. Investors liked the results: Li Fung outperformed the Hang Seng Index by over 75 percent in 2000. The reward was inclusion in the Morgan Stanley Country Index for Hong Kong in May 2000, subsequent inclusion in the HSI in August 2000 and on the FTSE World Index Hong Kong Section in September 2000. With a market capitalization of $6.6 billion, by mid-2000 Li Fung was the nineteenth largest Hong Kong stock trading with a company record price to earnings (P/E) ratio of nearly 60_. A local newspaper declared: It is difficult to find a bad word [about Li Fung]. It could be a poster-child for shareholder value, with a return-on-equity of 60.2 percent at the end of last year. The firm is well positioned to benefit from the opening of the mainland market and Beijings accession to the World Trade Organization, with 40 percent of sourcing on the mainland and Hong Kong.9 Acquisitions Li Fungs acquisition strategy was based on buying rival sourcing companies, thereby gaining new client accounts, integrating their operations, and eventually bringing the operating margins of these acquired units up to Li Fung levels. In 1995 Li Fung acquired Inchcape Buying Services, a 100-year-old company roughly the same size as Li Fung and its closest competitor. The Dodwell acquisition brought access to sourcing markets on the Indian subcontinent and European export markets. This acquisition took nearly three years to be fully absorbed into Li Fungs operations. Within three years, Dodwells operating margins increased from 0.8 percent to 3 percent, primarily through the provision of Li Fung value-added services to Dodwell customers. In December 1999, Li Fung acquired the export trading operations of the Swire Group, Swire Maclaine and Camberley, which were Li Fungs next two largest Hong Kong-based competitors, and in the process became the only listed supply chain management company in Hong Kong. Like Li Fung, Camberley did not own its factories. Instead, it provided virtual manufacturing in the form of in-house design, pattern and sample making, and raw material sourcing. Manufacturing was subcontracted to factories in China. Through Camberley, Li Fung gained access to the design process- another link in the value chain-as well as access to new clients such as the Asia buying offices of Laura Ashley and Ann Taylor. As it had with Inchcape, Li Fung expected to bolster its own bottom line by raising the operating margins of these two companies. With a robust cash flow and the solid financial performance of past acquisitions, Li Fung was in position to continue growing its business by further acquisitions. By August 2000, Li Fung was nearly five times the size of its two closest local competitors, William E. Connor and Associates and Colby International, which had twice postponed the IPO of its B2B portal in 2000. See Appendix A for more details on the intranet and extranet. E-Commerce A core element of Li Fungs three-year planning system included an introspective look at whether we are still relevant, including whether or not we are going to be disintermediated. Part of its response was an Internet initiative of its own. In 1995 Li Fung launched an intranet to link the Groups offices and manufacturing sites around the world, thereby expediting and simplifying internal communications. The progress of orders and shipments could be tracked in real time, and digital imagery allowed for online inspection and troubleshooting. For example, past quality problems with Bangladeshi production would require an on-site Li Fung inspector to send physical samples to Hong Kong by express mail, whereas the intranet now allowed a high-resolution digital photo to be sent via the intranet for real-time response and remedy. In 1997, Li Fung launched secure extranet sites. Each site linked the company directly to a key customer and was customized to that customers individual needs. By 2000, 10 such extranets were in place, each taking nearly 6-9 months to fully implement, from design to testing of the user interface. Through each site, Li Fung could carry out online product development as well as order tracking, obviating much of the cost and time necessary to send hard copies of documents back and forth. Furthermore, with Li Fung as the key link between manufacturers and retailers, the extranet provided a platform for the two to interface, thus streamlining communications as the order moved through the supply chain. Customers could track an order online just as it was possible to track a UPS delivery. This monitoring of production also promoted quick response manufacturing. Until the fabric was dyed, the customer could change the color; until the fabric was cut, the customer could change the styles o r sizes offered, whether a pocket or a cuff would be added, and a number of other product specifications. According to William, some customers went as far as connecting their entire ERP (enterprise resource planning) system to Li Fungs extranet system. Li Fungs IT division had 60 people, all based in Hong Kong, but software development of both the intranet in 1995 and its extranets in 1997 was outsourced.10 Successful implementation of these systems provided the initial building blocks of Li Fungs e-commerce solution and with them in place, the Fungs became further aware of the extent to which integration of Internet technology enhanced internal efficiency and improved communication between Li Fung divisions and customers and began to consider extending the organizations online presence. Competitive Threats The Fung brothers said that they decided to go online to avoid being disintermediated. But a closer examination of local B2B portals and online exchanges led Victor to conclude that the online threat to their offline business was far less than first imagined. People from the first wave were so far out and garbled in their thinking that we felt that there was no immediate threat, he noted. Therefore, we needed to think through e-commerce properly, to formulate a proper response. In Victors words, B2B exchanges were a molecule thick and a mile wide, based on many depthless relationships. Li Fung preferred narrow and deep relationships nurtured with fewer customers and including value-added services. As William professed, The same reason why we were not disintermediated by the offline guys is going to be the reason why were not going to be disintermediated by the online guys. However, William discovered on a 1999 visit to the United States that Li Fungs old economy retail customers felt seriously threatened by Internet pure plays. At first this hype did not make much sense: I asked my friend at Toys R Us, Why are you concerned about eToys? It does about $28-$30 million in sales whereas you do $11 billion, and it loses as much as its entire turnover? How can you worry about them? And the first lesson I learned was that its not their size that is the threat but the fact that investors are throwing money at them. William discovered that Internet companies could use the money that was pouring in to damage offline competitors, often by acquiring them or their key people. They can hire away all of the talent that you have. The biggest weapon is the money they have. At one point, they could have hired away my entire management. Other possible threats came from online companies acquiring an old economy trading company, or from offline companies like Japanese trading companies or local sourcing firms that could partner with a dot-com and become a competitor overnight. William hinted that the Swire Maclaine acquisition was a defensive move to preempt acquisitions by new economy companies. William gave his view of the Internet revolution: I started off saying that the Internet is just another technology that affects the way information is transferred and people communicate with each other. It has a very dramatic impact, more dramatic than the fax. But for me its yet another in a series of technological changes that affects our business that we have to be keenly aware of. It may be the most important change until now, but it is probably not the last. According to Victor, The Internet is a revolutionary technology, but new technology is nevertheless still technology. Li Fung always has been aggressive in adopting new technologies. When the telephone came along, my grandfather was shocked. When the fax came around, the technology changed our turnaround time into just days. With Internet technology, now we get answers within hours. When broadband and WAP comes online, there will be even less lag. Bubble In Once the Fungs determined that Li Fung needed an e-commerce strategy, the remaining question was how and in what shape it would emerge, how specifically e-commerce would eventually add value to Li Fung, and whether it would use the existing IT department of 60 or absorb a new team of entrepreneurs. Victor felt strongly that their e-commerce strategy should come from within the company, not outsourced as the intra- and extranets were, or as he phrased it, bubble in, not bubble out. According to Victor, only if the solution was an internal one could he be certain that the technology would pervade the entire Li Fung organization. Neither did Victor care to start a brand-new entity separate from the parent: Im not interested in starting a dot-com division, getting a high valuation with, a $13 million cash flow, and then spinning it off. I want Li Fung to be around for another 100 years, not just 5 or 15. To start a pure Internet division is as equally absurd as starting a fax division, a division that exclusively uses faxes. To better grasp the fundamentals of embarking on a new IT venture, Li Fung added two new technical directors to its board, one a technology company CEO, the other an academic. According to William: The one thing certain about our business is that it will be constantly changing, so we need to install a mechanism for monitoring external environmental changes that impact our business. We decided a long time ago that we were an information and knowledge-based services company, so anything to do with information technology is crucial to us. We keep up with whats happening with board members who can help us scan the horizon. Enter Castling In 1997, Michael Hsieh (HBS 84), president of LF International Inc., Li Fungs venture capital arm and 15-year Li Fung veteran, received a telephone call from John Suh (HBS 97), CEO of Castling Group, an Internet start-up company that, like the chess move allows you to defend your king and simultaneously position your rook for attack, used the Internet to both defend the offline, old economy companies against online companies threat to their markets while simultaneously extending their own online presence. The two met in San Francisco to discuss how a focused combination of technology and supply chain reform could transform retail. Hsieh, well aware that Li Fung was working on its own e-commerce strategy, noted: As a VC, I see numerous business plans that say that with Li Fung behind an online exchange, we create significant value and therefore offer you 5 percent if you join us. However most of the plans do not make sense. They offer very little value and the founders lack either industry or technology expertise. John had the right blend of technology and business sense, the right mix of right and left brain. Like the Fungs, Hsieh favored a bubble in approach. He compared outsourcing e-commerce implementation to a third-party consultant for a $10 million fee as putting the fox in the chicken coop. It created a risky dependency on outsiders, particularly if future design changes were required and also provided outsiders with proprietary information, strategy, and the entire business model. Finally, Hsieh remarked: As a venture capitalist, I always have to think about the strength of the management team and what could go wrong with the venture. Can they deliver? Do they know the industry? Is this a credible business proposition? What if there is a negative reaction? By late 1999, the time was right to act on their initial meeting. Hsieh commented that both the evolution of Castling from B2C to B2B and Li Fungs needs complemented each other nicely; John had a real appreciation for the supply chain and a record for building successful e-commerce models. In December 1999 Hsieh joined Castlings board and LF International invested in Castling. They subsequently co-invested in an initial round of financing for lifung.com, and Castling committed key managerial staff to lifung.com. Suh described Li Fung as the perfect strategic partner. They have an entrepreneurial philosophy rooted at the core of their system. Theyve got an aggressive and visionary leadership team at the for efront of supply chain management. And theyre ready to operate according to the rules of the new economy. In one fell swoop, San Francisco-based lifung.coms management team was immediately staffed with Castlings professionals, serving as vice president of Business Development, vice president of Operations, director of Marketing, and CTO (Chief Technology Officer). Suh stepped down as CEO of Castling, retaining the position of nonexecutive chairman, and signed on as CEO of lifung.com. Apart from Suh and CTO Derek Chen, 20 percent of lifung.coms initial staff came from Castling, amounting to an in-house e-commerce incubation team that represented a slight twist on Victors bubble in strategy. Suh and Chen, the latter formerly of Andersen Consultings Advanced Network Solutions Group, brought along their experience from Castling e-commerce strategy projects for jcrew.com, hifi.com, giftcertificate.com, and ferragamo.com. The rest of the team came from either within Li Fung (e.g., the se nior vice president of Merchandising) or from outside the Li Fung organization (e.g., the vice presidents of Sales and of Marketing). To facilitate the integration of the new online entity into the Li Fung fold, a senior manager was tasked to provide an interface between the two groups. By Q3 2000, lifung.com had 40 full-time professionals and 25 consultants, with 80 full-time staff expected by years end. For B2B ventures, moving first and fast was often a prerequisite for dominance. Scarcely a year had passed since the initial meeting with Castling and its first round of financing. According to Suh, there were three stages of launching an online venture: the business strategy, the design-build-test phase, and then actual execution. Moving quickly, Suh remarked, Requires a fundamental trust in an organization that best arises from the experience of a team that has built things together, with members who know each others strengths and weaknesses. We do a lot of team building, becau se without trust you cannot move at the speed required. There are certain elements critical to the success of a dot-com . . . openness and constant communication are essential because there are so many skills and inter-functional dependencies that must be navigated for a successful launch. At lifung.com, we have a great mix of people, individuals with 30 years of merchandising experience, a deep operations staff,