Wal-Mart Stores Inc. (WMT) has canceled much of a deal in which Hong Kong's Li & Fung Ltd. (0494.HK, LFUGY) would supply goods for the U.S.-based retailer's overseas stores, according to people close to the companies, as Wal-Mart moves to buy more of its products directly from factories.

The move dealt another blow to Li & Fung, which serves as a buying agent for an array of goods, from toys to clothes, for retailers such as Wal-Mart and Target Corp (TGT). Li & Fung's operating profit fell 22% in the first half, prompting analysts to slash their ratings on the company's stock.

A sluggish global economy and price competition are putting pressure on the world's middlemen. Li & Fung clients, including baby-clothes maker Carter's Inc. (CRI) and Gymboree Corp., have also said they plan to buy more products directly from factories.

In a Thursday filing with the Hong Kong Stock Exchange, Li & Fung said Wal-Mart had terminated its option to buy Direct Sourcing Group, a unit the middleman set up two years ago solely to serve the world's largest retailer. Li & Fung said it would continue to supply products for Wal-Mart's Sam's Club operations and for certain categories of Wal-Mart's domestic and international operations. The Hong Kong company said Wal-Mart no longer needed the option to buy Direct Sourcing because of the companies' "strong" partnership.

But Li & Fung told employees last month that it was losing the sourcing business for much of Wal-Mart's international stores, according to people who read an internal memo.

Wal-Mart spokesman Anthony Rose said Thursday that the retailer maintains a "good relationship" with Li & Fung. Wal-Mart U.S. President Bill Simon said at an analysts' conference in New York this month that the Bentonville, Ark., retailer used Li & Fung to "do things that are complicated for us but less complicated for them."

Li & Fung declined to comment on the loss of Wal-Mart's international business but said "the substantive terms" and "nature" of the partnership "remains essentially unchanged." Li & Fung said it would now be able to offer design, development and distribution services for Wal-Mart goods in Latin America, services the Hong Kong company said it couldn't provide before as Wal-Mart's buying agent.

Li & Fung's shares closed at 12.52 Hong Kong dollars (US$1.61), down 22 cents, or 1.7%, in Hong Kong on Thursday. Wal-Mart's shares were up 20 cents at $74.57 in afternoon trading on the New York Stock Exchange.

Li & Fung Chief Executive Bruce Rockowitz said in August that even when retailers work directly with factories, they need an intermediary to manage factory logistics, communications and quality checks--services that Li & Fung is eager to provide beyond supplying goods.

Li & Fung hasn't disclosed how much sourcing it does for Wal-Mart's international operations or the revenue earned from such operations.

But UBS analyst Spencer Leung wrote last year that under the 2010 agreement between the two companies, Li & Fung likely was sourcing goods for stores in Wal-Mart's international operations, in places such as South America and Japan. Wal-Mart, meanwhile, was using its own staff to procure more than 70% of the company's product volume, in countries such as the U.S., Canada and the U.K., he estimated.

Li & Fung's deal with Wal-Mart was seen by some analysts as a catalyst for the Hong Kong company's growth. Goldman Sachs in January 2010 called it a "transformational" agreement that could double Li & Fung's business. "We think this partnership offers the strongest proof to date that even at L&F's current scale, growth does not need to slow down," Goldman Sachs said.

Other analysts questioned how profitable Li & Fung could be under the agreement, given Wal-Mart's reputation for cutting costs in its supply chain.

To handle sourcing for Wal-Mart's U.S. and international operations, Li & Fung set up a separate company, Direct Sourcing Group, and said the unit would employ hundreds of people. The development was seen as part of Wal-Mart's move toward direct sourcing, since the company had an option to acquire Direct Sourcing and take over its supplier relationships in 2016. Wal-Mart at the time said it hoped eventually to use its own staff to source 80% of private-label goods, such as Faded Glory clothing, cutting costs 5% to 15% within five years.

Li & Fung had estimated that the deal would generate $2 billion in revenue in the first 12 months. But Direct Sourcing fell short of this goal, generating $1.7 billion in revenue and recording an operating loss last year.

HSBC analyst Chris Zee this week upgraded Li & Fung's stock to "overweight," writing that U.S. monetary policy would provide "impetus for a significant revival in earnings at Li & Fung."

--Shelly Banjo contributed to this article.

Write to Kathy Chu at kathy.chu@wsj.com

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