Li & Fung is fighting a two-front war. Not only are the Hong Kong sourcing giant's fortunes inextricably linked to anemic economies in the U.S. and Europe, which account for 80% of its revenue, but it is also battling a rise in commodities and Chinese labor costs.

That means that, even after a 15% fall in net profit in the first half, there may be more bad news to come.

Shares in the company, which sources products for U.S. companies such as Wal-Mart, have slumped 34% this year to about HK$14.80 (US$1.90), compared with the benchmark Hang Seng Index's 11% drop. It now trades close to 23 times consensus earnings forecasts for 2011, which still looks rich, despite the company's historical average of 27 times.

Li & Fung's defenses look limited. In the past, the supply-chain manager, which makes 70% of its revenue through sourcing, has been able to fuel growth even amid the global financial crisis through an aggressive acquisition strategy that saw its work force double to 27,542 as of June 30 from 13,402 at the end of 2009.

But this model can't work forever. The company's return on equity is shrinking, while its balance sheet is getting heavier. UBS analyst Spencer Leung, who has a 'sell' rating and HK$9.00 target price on the company, estimates Li & Fung's net ROE will drop to 14.4% this year from a five-year average of 24.5%. William Fung, Li & Fung's executive deputy chairman, said the company's lower ROE was "understandable, given the very challenging operating environment."

This time around, Li & Fung must also contend with rising commodities prices and escalating labor costs in China, from where it sources 53% of its goods. The high-cost environment has the potential to strain everyone on the supply chain, from factories to intermediaries like Li & Fung to retailers.

The company has said its partner factories will remain loyal because of its customer base. But Mr. Leung is forecasting that the tough backdrop will lead to a serious profit redistribution along the supply chain over the next three years. He expects Li & Fung's operating profit from its key sourcing business to fall 37% and its operating margins to drop to 2.2% from 4%. In turn, he predicts suppliers' current 3% operating margins will rise to 4%.

Mr. Fung noted that the company's total margin, defined as gross margin plus other income, has been rising this year. It was up 40% in the first half from a year earlier.

Investors shouldn't simply rely on Li & Fung's history of strong growth as the company heads into a cloudier future