Luk Fook (590 HK) Buy (initiation) Target price: HK$ Strong China growth, undemanding valuation; initiate at Buy

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1 Equity Research Consumer Discretionary Luk Fook (59 HK) Buy (initiation) Target price: HK$28.8 Albert Yip, CFA SFC CE No. ADT GF Securities (Hong Kong) Brokerage Limited 29-3/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Strong China growth, undemanding valuation; initiate at Buy Initiate at Buy with TP of HK$28.8 Luk Fook (LF) posted strong interim results, with the highest profit growth among peers in the Chinese market, driven by strong revenue growth for gem-set products in both its retail and wholesale segments. We see further upside potential to gem-set sales as the product s sales mix ratio in China is still below that in HK. We also believe LF will be a beneficiary of the easing in street-shop rental costs given it had the most aggressive store expansion among peers in HK in FY13/14, when rental costs peaked. We forecast a 15% EPS CAGR in FY Its PEG- and ROEbased valuations are attractive (.5x FY16E PEG vs CSS s.6x and CTF s 1.2x; ROE highest among peers in most recent interim results). We value LF at HK$28.8/share, based on 9.x FY16E P/E, which is the five-year average of its 1-year forward P/E. We believe this is a fair valuation as it reflects an earnings recovery in FY15. China profit growth strongest among peers Profit contribution from China is divided into the contributions from its retail, wholesale and licensing segments. 1H15 total profit from these segments rose 22% YoY to HK$348m, which is better than CTF s -4% and CSS s % (our estimates) during the same period. We attribute this strong growth to: 1) LF s increased gem-set product offering at a more affordable price range and its incentive scheme for store staff to sell gem-set products. Sales mix of gem-set products as a percentage of total retail revenue at self-operated stores rose from 1% to YoY in 1H15, driving a 5.9ppt expansion in retail segment profit margin to 7.6%. 2) Profit in its wholesale segment rose 147% YoY in 1H15, driven by 5.9ppt segment profit margin expansion to 11.4% and revenue growth (mainly from gem-set products). As its gemset sales mix ratio in China () is lower than HK (38%), we see further upside potential. Key beneficiary of easing street-shop rental costs LF has had the fastest store expansion in HK over the past two years (19% CAGR in number in stores vs CTF s 9% and CSS s ~2%). The period has also seen peak street-shop rental costs. However, according to Savills, prime street-shop rentals fell 5-6% in 9M14 and a further 5% decline is expected in the last quarter. The softening of Chinese tourist arrivals growth is expected to ease rental pressure going forward. We therefore see LF as a key beneficiary of easing street-shop rental costs. Stock performance 1% % -1% - -3% -4% Nov-13 Feb-14 May-14 Aug-14 High ROE and margin due to licensing business in China The key difference between LF s business model and that of peers is its distribution model in China. In 1H15, about 94% of its stores in China were licensed stores (vs CSS s 1% self-operated and CTF s 62%). As most products in licensed stores are procured from specified suppliers (except the majority of diamond products and some gold products which come directly from LF), inventory turnover days was 213 days in 1H15, lower than CTF s 373 days. GM and segment profit margin in its licensing business came in at highs of 67.8% and 66% respectively in 1H15. Despite a lower overall GM (23.9% vs CTF s 31.8%), LF s overall OP margin was 12.8% in 1H15, slightly better than CTF s 12.1%. Its 19.9% ROE in 1H15 was also higher than CTF s 14.2% and CSS 13%. Source: Bloomberg HSI Luk Fook Key data Nov 28 close (HK$) 25.5 Shares in issue (m) Major shareholder Wong Wai Sheung (42.2%) Market cap (HK$ bn) M avg. vol. (m) W high/low (HK$) 34./19.26 Source: Bloomberg Stock valuation Year-end March Turnover (HK$ m) Net profit (HK$ m) Core profit (HK$ m) Core EPS (HK$) EPS YoY (%) P/E Yield (%) BPS (HK$) P/B ROE (%) ,412 1,266 1, ,215 1,865 1, E 17,76 1,655 1, E 19,5 1,883 1, E 21,155 2,177 2, Sources: Company data, GF Securities (HK) Research estimates Note: Core profit excludes fair value change of convertible bonds

2 China profit growth strongest among peers Profit contribution from China is divided into the contributions from its retail, wholesale and licensing segments. 1H15 total profit from these segments rose 22% YoY to HK$348m, which is better than CTF s -4% and CSS s % (our estimates) during the same period. We attribute this strong growth to: 1) LF s increased gem-set product offering at a more affordable price range and its incentive scheme for store staff to sell gem-set products. Sales mix of gem-set products as a percentage of total retail revenue at self-operated stores rose from 1% to YoY in 1H15, driving a 5.9ppt expansion in retail segment profit margin to 7.6%. 2) Profit in its wholesale segment rose 147% YoY in 1H15, driven by 5.9ppt segment profit margin expansion to 11.4% and revenue growth (made up of 12% organic growth and 8% growth from supplying diamond products [low-teen GM] to 3D-Gold since Jun 214). While LF s peers have similar gem-set sales mix ratios in both HK and China, LF s gem-set sales mix ratio () in China is still far below that in HK (38%), so we see room for improvement. In 1H15, China contributed 36% of overall segment profit, up a significant 12ppt YoY. Management wants the profit contribution from China to exceed that from Hong Kong within three years. Figure 1: Peer comparison China market profit contribution Last interim results (HK$m) Chow Tai Fook Luk Fook Chow Sang Sang Profit in previous interim results 1, As a percentage of overall segment profit 44% 24% 35% Profit in last interim results 1, As a percentage of overall segment profit 49% 36% 42% Profit growth (YoY) -4% 22% % Sources: Company data, GF Securities (HK) Research estimates Note: We estimate self-operated stores profit of CSS by assuming its China segment profit as a percentage of retail segment profit is the same as its China retail revenue as a percentage of retail segment revenue Key beneficiary of easing street-shop rental costs LF s operating leverage is higher than peers given its larger revenue contribution from both HK and Macau where the rental structure for its retail segment is mostly fixed. In addition, it has had the fastest store expansion in HK over the past two years (19% CAGR in number in stores vs CTF s 9% and CSS s ~2%). The period has also seen peak street-shop rental costs. However, according to Savills, prime street-shop rentals fell 5-6% in 9M14 and a further 5% decline is expected in the last quarter. The softening of Chinese tourist arrivals growth is expected to ease rental pressure going forward. LF should therefore benefit from this favorable rental trend upon lease renewals in FY16/17. We expect minimum rent as a percentage of total revenue to drop from 3.5% in FY15 to 2.9% in FY17. Figure 2: Peer comparison A&P and administrative expenses ratios Last interim results Chow Tai Fook Luk Fook Chow Sang Sang Total rental expense ratio 6.4% 4.6% 4.3% Minimum rent expense ratio 2.9% 3.7% 4.1% Sources: Company data, GF Securities (HK) Research High ROE and margin due to licensing business in China The key difference between LF s business model and that of peers is its distribution model in China. In 1H15, about 94% of its stores in China were licensed stores (vs CSS s 1% self-operated and CTF s 62%). Driven by this low capex store expansion, LF saw a five-year CAGR (FY9-14) in the number of its stores in China of 24%, higher than CSS s and CTF s 15%. As most products in licensed stores are procured from specified suppliers (except the majority of diamond products and some gold products which come directly from LF), inventory turnover days was 213 days in 1H15, lower than CTF s 373 days. Revenue model for its licensing business: 1) one-off joining fee; 2) consultancy fee for providing staff training etc; 3) royalty income charged for all purchases from licensee; 4) wholesale revenue for purchasing jewelry products from LF. GM and segment profit margin in its licensing business came in at highs of 67.8% and 66% respectively in 1H15. Despite a lower overall GM (23.9% vs CTF s 31.8%), LF s overall OP margin was 12.8% in 1H15, slightly better than CTF s 12.1%. Its 19.9% ROE in 1H15 was also higher than CTF s 14.2% and CSS s 13%. Page 2

3 Age group of -4 Age group of 5-9 Age group of 1-14 Age group of Age group of 2-24 Age group of Age group of 3-34 Age group of Age group of 4-44 Age group of Age group of 5-54 Age group of Age group of 6-64 Age group of Age group of 7-74 Age group of Age group of 8-84 Age group of Age group of 9-94 Age group of 95 Female population (mil) Company report China market to outpace HK market We expect the Chinese jewelry market to maintain double-digit growth in 215 and 216 driven by its growing middle-income class and the potential of sales network penetration in lower-tier cities. In addition, wedding jewelry demand in China should be supported by its current demographic structure. Based on the 21 Chinese Census, we estimate that the large female age group of 2-24 will mostly get married in the coming few years (see Figure 5). Spending by mainland Chinese tourists has been the key driver of jewelry & watch sales growth in Hong Kong (see Figure 7). However, we might see single-digit jewelry & watch sales growth in HK in 215 and 216 given that growth in mainland Chinese tourist arrivals is softening and that their average ticket size is decreasing. Figure 3: Retail sales of gold and jewelry products at Chinese companies above designated size Figure 4: Retail sales of jewelry, watches and valuable gifts in Hong Kong 35 Rmb bn (LHS) Growth (%) (RHS) 6% 14 HK$ bn (LHS) Growth (%) (RHS) 5% 3 5% 12 4% 25 4% 1 3% 2 3% M14 1% % -1% M14 1% % -1% - Sources: Wind, GF Securities (HK) Research Sources: Census and Statistics Department of HKSAR, GF Securities (HK) Research Figure 5: Number of females aged 2-24, most of which will get married in coming few years Sources: 21 China census report, GF Securities (HK) Research Page 3

4 Figure 6: Mainland Chinese tourist arrivals in Hong Kong (m) 2% No. of Mainland tourists arrival (LHS) 8% 14% 9% 7% 26% YoY growth (RHS) 24% 24% 17% 15% 16% Jan - Sep 214 Sept 29 - Oct 16 3% 1% % Sources: HKTB, GF Securities (HK) Research Figure 7: Mainland Chinese tourist spending key driver of HK jewelry and watch sales growth HK retail sales - jewelry, watches and valuable gifts (A) Mainland Chinese tourists' spending on jewelry & watches (B) Growth Growth Growth (HK$m) (%) (%) (A) - (B) (%) ,373 na 31,4 na 58,369 na , % 37, % 58,852.8% , % 48, % 69, % Sources: Census and Statistics Department of HKSAR, HKTB, GF Securities (HK) Research E-commerce LF currently co-operates with online platforms of Tmall, JD, Suning.com and VIPshop. FY14 e- commerce revenue was less than 1% of total revenue. LF targets to double its number of online platforms and revenue from e-commerce in FY15. Gold hedging policy LF hedges about 2-25% of its gold inventory by entering into short positions through the Chinese Gold & Silver Exchange Society, and through gold loans. Its hedging ratio is lower than CSS s 4% and CTF s 7%. Having said that, LF s GM for gold products was quite resilient at % in 2H14 and 1H15 despite gold price fell 3% and 6%, respectively, in the period. We think LF s relatively short turnover days of gold products (67 days in FY14 vs. CTF s 25 days) has mitigated the negative impact of gold price decline. Growth outlook We forecast -12%/15%/16% net profit growth for the company in FY15/16/17, led by -8%/1%/8% revenue growth and -.4/.5/.7ppt OP margin changes. Revenue growth led by China market For its China retail segment, we estimate -15%/13%/12% revenue growth in FY15/16/17, attributable to -19%/9%/8% SSSG and 4%/3%/3% store growth. For its licensing business, we forecast 2%/24%/21% revenue growth driven by 15%/14%/12% store growth. In its HK, Macau and overseas market retail segment, we anticipate -12%/8%/7% revenue growth in FY15/16/17 on -15%/6%/5% SSSG and 2%/2%/2% store growth. Page 4

5 Margin trend We expect GM to widen from 21.9% in FY14 to 23.2% in FY17, mainly led by a rising sales mix for high-margin gem-set jewelry (from 32.8% of total retail and wholesale revenue in FY14 to 37.5% in FY17). For OP margin, we expect contraction of.4ppt YoY to 11.6% in FY15 due to operating deleverage, despite an expected GM rise of 1 ppt to 22.9%. We forecast OP margin will widen by.5 /.7ppt in FY16/17 due to the decrease of rental expense ratio and GM improvement. Figure 8: SSS trend Figure 9: Store number trend 5% 4% 3% 1% % -1% - 46% 41% 25% 22% 9% 7% 8% 7% 6% 5% -15% -19% FY12 FY13 FY14 FY15E FY16E FY17E 2, 1,8 1,6 1,4 1,2 1, ,85 26% 1,621 22% 1,437 23% 24% 1,268 1,72 18% % 13% % FY1 FY11 FY12 FY13 FY14 FY15E FY16E FY17E 3% 25% 15% 1% 5% % China HK & Macau Total stores Growth (%) Sources: Company data, GF Securities (HK) Research Sources: Company data, GF Securities (HK) Research Figure 1: Key assumptions (HK$m) FY13 FY14 FY15E FY16E FY17E Total revenue 13,412 19,215 17,76 19,5 21,155 growth % 12.6% 43.3% -7.6% 9.8% 8.5% - Retail revenue - HK, Macau and overseas markets 9,92 14,514 12,761 13,769 14,711 growth % 11.2% 46.3% -12.1% 7.9% 6.8% store growth (%) 21.1% 19.6% 1.8% 1.8% 1.8% SSS (%) 7.2% 22.% -14.5% 6.% 5.% - Retail revenue - China market 1,14 1,65 1,398 1,578 1,761 growth % 36.3% 62.7% -15.2% 12.8% 11.6% store growth (%) 27.9% 6.4% 3.6% 3.5% 3.4% SSS (%) 7.3% 45.9% -19.% 9.% 8.% - Wholesale revenue 2,28 2,433 2,968 3,371 3,732 growth % 11.8% 2.% 22.% 13.6% 1.7% - Licensing revenue growth % 5.6% 37.3% 2.2% 23.9% 21.5% Gross profit 2,83 4,214 4,62 4,447 4,9 Gross margin (%) 21.1% 21.9% 22.9% 22.8% 23.2% Product mix (%) gold & platinum 62.7% 67.2% 61.4% 63.% 62.5% gem-set 37.3% 32.8% 38.7% 37.% 37.5% Selling expenses ratio (%) 9.8% 1.% 11.7% 11.1% 1.8% Administrative expenses ratio (%).9%.8%.9%.8%.8% Operating profit 1,524 2,39 2,66 2,362 2,78 growth % -4.3% 51.5% -1.5% 14.3% 14.7% OP margin (%) 11.4% 12.% 11.6% 12.1% 12.8% Core profit 1,266 1,865 1,639 1,883 2,177 growth % -5.1% 47.3% -12.1% 14.8% 15.6% Core profit margin (%) 9.4% 9.7% 9.2% 9.7% 1.3% Payout ratio (%) 4% 4% 4% 4% 4% Sources: Company data, GF Securities (HK) Research estimates Page 5

6 Valuation LF has been trading at between 3x and 19x 1-yr forward P/E over the past five years. We value LF at HK$28.8, based on 9.x FY16E P/E, which is the five-year average of its 1-year forward P/E. We believe this is a fair valuation as it reflects an earnings recovery in FY15. Figure 11: P/E band (HK$) 6 19x x x x x 5 Nov-9 May-1 Nov-1 May-11 Nov-11 May-12 Nov-12 May-13 Nov-13 May-14 Nov-14 Sources: Bloomberg, GF Securities (HK) Research estimates Figure 12: Valuation comparison for Hong Kong jewelry and watch retailers Price TP Mkt Cap Price change (%) P/E (x) EPS growth (%) Revenue growth (%) Yield (%) P/B (x) ROE (%) Ticker Rating () (HK$) (HK$ m) 1D 5D 1M 3M YTD FY13 FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY14E Chow Tai Fook # 1929 HK Hold , 3 (4) (7) (8) (7) Luk Fook # 59 HK Buy , (13) (12) (8) Chow Sang Sang 116 HK Accumulate , (5) (5) (14) Hengdeli 3389 HK NR 1.5 na 6,959 (1) (3) 2 5 (21) Emperor Watch 887 HK NR.36 na 2, (1) (24) (4) (12) Time Watch 233 HK NR 1.19 na 2,642 1 (2) (2) na na 2 22 na Oriental Watch # 398 HK NR 1.64 na 936 (1) 3 (5) (1) (2) Average (2) (13) Sources: Bloomberg, GF Securities (HK) Research estimates ^Company year-end in Jan. Financial year 214/215/216/217 data are shown as FY13/14E/15E/16E to facilitate data comparison. *Company year-end in Feb. Financial year 214/215/216/217 data are shown as FY13/14E/15E/16E to facilitate data comparison. #Company year-end in Mar. Financial year 214/215/216/217 data are shown as FY13/14E/15E/16E to facilitate data comparison. Figure 13: Valuation comparison for Chinese and international jewelry and watch retailers Price Mkt Cap Price change (%) P/E (x) EPS growth (%) Revenue growth (%) Yield (%) P/B (x) ROE (%) Ticker Rating () Crncy (US$m) 1D 5D 1M 3M YTD FY13 FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY15E FY16E FY14E FY14E Richemont # CFR VX NR CHF 42, Swatch UHR VX NR CHF 21,33 (1) (1) 6 (6) (19) (19) Tiffany ^ TIF US NR US$ 13,739 (1) Pandora PNDORA DC NR 53. DKK 11, Signet Jewelers ^ SIG US NR US$ 1,375 (2) FF Group FFGRP GA NR 28.6 EUR 2,383 3 () 7 (8) (61) Liaofengxiang 6612 CH NR RMB 2,263 (2) Guangdong CHJ 2345 CH NR 8.89 RMB 1,223 (2) 4 (6) Ming Jewellery 2574 CH NR 1.92 RMB 938 (1) 4 (1) (1) na Average () Sources: Bloomberg, GF Securities (HK) Research estimates ^Company year-end in Jan. Financial year 214/215/216/217 data are shown as FY13/14E/15E/16E to facilitate data comparison. *Company year-end in Feb. Financial year 214/215/216/217 data are shown as FY13/14E/15E/16E to facilitate data comparison. #Company year-end in Mar. Financial year 214/215/216/217 data are shown as FY13/14E/15E/16E to facilitate data comparison. Page 6

7 Company overview Established in 1991, LF is a leading jeweler in Mainland China, Hong Kong and Macau. It is engaged in the sourcing, designing, wholesaling, trademark licensing and retailing of a variety of gold and platinum jewelry, gold ornaments and gem-set jewelry. As of Sept 3 214, LF had 61 stores in Hong Kong, Macau and overseas markets, as well as 1,19 licensed stores and 82 self-operated stores in China. The company also holds a 5% stake in 3D-Gold, a subsidiary of Hong Kong Resources Holdings (2882 HK), which had five stores in Hong Kong, four stores in Macau, and 42 stores in China as at Jun Risk factors 1) A gold price slump could trigger a de-rating; 2) Longer-than-expected breakeven period for 3D-Gold business; 3) Possible increase in operating expenses ratio to enhance brand building and store management as sector competition is intensifying; 4) Slowdown in China s economy; 5) Slowdown in Mainland China tourist arrivals to HK. Figure 14: Financial statements Profit & loss (HK$m) Balance sheet (HK$m) Year ended 31 March FY13 FY14 FY15E FY16E FY17E Year ended 31 Mar FY13 FY14 FY15E FY16E FY17E Revenue 13,412 19,215 17,76 19,5 21,155 Fixed assets Cost of sales (1,582) (15,1) (13,698) (15,53) (16,256) PPE Gross profit 2,83 4,214 4,62 4,447 4,9 Land use rights Investment properties Other income Investment in associate and JV Selling & distribution expenses (1,311) (1,923) (2,83) (2,173) (2,289) Shareholders loans to an associate Administration expenses (115) (151) (155) (162) (171) CB Other gains/(losses), net Others Operating profit 1,524 2,39 2,66 2,362 2,78 Deferred tax assets ,41 1,528 1,495 1,492 Net finance cost Non-recurring gains 16 Current assets Share of profit/(loss) of associate and JV (1) () (33) (34) (9) Inventories 4,955 6,225 6,68 6,858 7,467 Profit before tax 1,53 2,321 2,73 2,367 2,755 A/C receivables Income tax expense (26) (454) (415) (481) (573) Deposits and prepayments Non-controlling interests (3) (2) (4) (4) (5) Others Net profit 1,266 1,865 1,655 1,883 2,177 Term deposit 158 1, 1,5 2, Core profit 1,266 1,865 1,639 1,883 2,177 Cash and cash equivalents 1,187 1,646 1,78 1,764 2,164 Core EPS (HK$) ,686 8,546 9,254 1,645 12,197 Growth rates (%) Total assets 7,562 9,586 1,782 12,14 13,688 Revenue (8) 1 8 Core profit (5) 47 (12) Current liabilities Core EPS (11) 47 (12) A/C payables Other payables Margin & ratios (%) Bank borrowings Gross profit margin Gold loans OP margin Others Net profit margin Tax liabilities Effective tax rate ,4 1,798 2,31 2,212 2,393 Payout ratio Cash flow statement Non-current liabilities Employee benefit obligations Year ended 31 March FY13 FY14 FY15E FY16E FY17E Deferred tax liabilities Profit before tax 1,53 2,321 2,73 2,367 2, Share of (profit)/loss of associate and JV Net finance cost (6) (12) (24) (4) (56) Equity Depreciation and amortization Shareholders' equity 6,425 7,641 8,63 9,772 11,132 Others (15) (9) (28) Non-controlling interests Change in amount due to an associate (25) 6 6,478 7,699 8,665 9,838 11,22 Change of working capital (839) (1,231) 123 (74) (561) Tax paid (32) (237) (434) (448) (527) Total liabilities & equity 7,562 9,586 1,782 12,14 13,688 Operating cash flow ,881 1,333 1,776 Financial ratios (HK$m) Capex (37) (258) (22) (15) (15) Year ended 31 March FY13 FY14 FY15E FY16E FY17E Disposals 1 Current ratio Interest received Quick ratio Purchase of financial assets (8) (57) Purchase of associate or JV (245) A/C receivable turnover days Shareholder loan to associate (1) A/C payable turnover days Change in term deposits 761 (158) (842) (5) (5) Inventory turnover days Others 3 Investing cash flow 461 (46) (1,425) (596) (579) Asset turnover Total assets/total equity Change of borrowings 568 Net cash 1,187 1,237 1,813 2,325 3,192 Change of gold loans Dividend paid (477) (654) (75) (78) (812) ROE (%) Interest paid () (3) (16) (17) (18) ROA (%) Financing cash flow (477) (89) (393) (682) (797) Net change of cash flow Forex changes 1 (8) Sources: Company data, GF Securities (HK) estimates Page 7

8 Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between -5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 1% Neutral Expected sector relative performance ranges between -1% and 1% Cautious Sector expected to underperform benchmark by more than 1% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. 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