Luk Fook Holdings Int'l

Transcription

1 Asia Pacific/Hong Kong Equity Research Luxury Goods Rating OUTPERFORM* [V] Price (3 Jan 11, HK$) 26.9 Target price (HK$) 33.8¹ Chg to TP (%) 25.7 Market cap. (HK$ mn) 14,593 (US$ 1,878) Enterprise value (HK$ mn) 13,519 Number of shares (mn) Free float (%) week price range *Stock ratings are relative to the relevant country benchmark. ¹Target price is for 12 months. [V] = Stock considered volatile (see Disclosure Appendix). Share price performance Price (LHS) Research Analysts Gabriel Chan, CFA gabriel.chan@credit-suisse.com Phoebe Tse phoebe.tse@credit-suisse.com Rebased Rel (RHS) Jan-9 May-9 Sep-9 Jan-1 May-1 Sep The price relative chart measures performance against the HANG SENG index which closed at on 3/1/11 On 3/1/11 the spot exchange rate was HK$7.77/US$1 Performance Over 1M 3M 12M Absolute (%) Relative (%) (59.HK / 59 HK) INITIATION Further re-rating elements in place Initiating coverage with an OUTPERFORM rating. We are initiating coverage of Luk Fook with an OUTPERFORM rating and a target price of HK$33.8, which is based on a conservative.55x PEG or 17x FY3/12E P/E. Beneficiary of accelerating inflation. Among all retail segments in Hong Kong, jewellery retailers typically see above-average revenue growth and the strongest margin expansion during high inflation periods, thanks to their strong pricing power and high operating leverage cost structure. In our view, Luk Fook is a key beneficiary within the segment. The company sees its strong revenue growth in 1H FY3/1 lingering into 2H (we project 35% YoY growth), despite a high base comparison, thanks to the improved economy in Hong Kong and continuing influx of mainland Chinese shoppers. Two other reasons for a further re-rating. We identify two reasons for a Hong Kong-based retailer to trade at premium valuations against peers: 1) a profitable China operation [e.g. I.T. (999.HK)] and 2) a high proportion of income generated in Hong Kong from mainland Chinese shoppers [e.g. Sa Sa (178.HK)]. Luk Fook actually fits into both categories. It generates about 4% of its operating profit in China, while over 5% of its sales in Hong Kong is to mainland visitors, with both trends expected to continue to rise. Undemanding valuations despite strong share price performance. While Luk Fook s share price has shown significant outperformance over the past 12 months, we believe its robust earnings growth we project a threeyear EPS CAGR of 3% should drive a further re-rating. Trading at 14.6x CY11 P/E and implying about a 25% valuation discount to other Chinafocused luxury retailers, we see further potential upside. We also believe the recent share placement has removed the major overhang on the stock. Key investment risk would be a sharp decline in gold price, which we believe is unlikely during high inflation periods. Financial and valuation metrics Year 3/1A 3/11E 3/12E 3/13E Revenue (HK$ mn) 5, , , ,742.3 EBITDA (HK$ mn) ,37.7 1, ,62.6 EBIT (HK$ mn) , ,513.7 Net income (HK$ mn) ,44.4 1,275.8 EPS (CS adj.) (HK$) Change from previous EPS (%) n.a. Consensus EPS (HK$) n.a EPS growth (%) P/E (x) Dividend yield (%) EV/EBITDA (x) P/B (x) ROE Net debt/equity (%) 1.6 net cash net cash net cash Source: Company data, Thomson Reuters, Credit Suisse estimates. DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. U.S. Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Focus charts Figure 1: Core operating margins of Hong Kong retailers (%) Low-to-mid-end Mid-to-high-end Luxury Figure 2: Shopping spending by Chinese visitors (HK$ mn) 6, 5, 4, 17.8% CAGR 3, 2, 1, Shopping spending by Chinese v isitors Source: Company data Figure 3: Luk Fook s robust sales growth to linger Source: CEIC Figure 4: Luk Fook s EBITDA and EBITDA margins (HK$ mn) 12, 1, 8, 6, 4, 2, - FY3/9 FY3/1 FY3/11E FY3/12E FY3/13E Hong Kong Retail China Retail (direct) Wholesaling Licensing incom e (HK$ mn) (%) 2, 17 1,6 15 1, FY3/9 FY3/1 FY3/11E FY3/12E FY3/13E EBITDA (HK$ mn) EBITDA margin (%) Source: Company data, Credit Suisse estimates Figure 5: Share price performance: Luk Fook vs others 1,2 1, accelerated inflation period Jul 3 Jul 4 Jul 5 Jul 6 Jul 7 Jul 8 Overall Low-to-mid-end Mid-to-high-end Luxury Hang Seng Index Luk Fook Source: Company data, Credit Suisse estimates Figure 6: Luk Fook s P/E band (HK$) 17x 14x x 2 8x x 5 Apr 2 Apr 3 Apr 4 Apr 5 Apr 6 Apr 7 Apr 8 Apr 9 Apr 1 Apr 11 Luk Fook 5x 8x 11x 14x 17x Source: Datastream Source: Company data, Credit Suisse estimates, Datastream (59.HK / 59 HK) 2

3 Further re-rating elements in place A beneficiary of accelerating inflation in Hong Kong Inflation has become a meaningful concern for retailers, with products, rental and labour costs all rising. Among all retail segments in Hong Kong, during high inflation periods, jewellery retailers typically see above-average revenue growth, as product prices are normally marked to spot prices of precious metals and gems, which typically experience significant increases during high inflation periods; plus, there is additional demand for investment/inflation-hedging purposes. On the other hand, jewellery retailers usually see the strongest margin expansion, during accelerating inflation periods, on the back of strong pricing power, and relatively less impact from rising costs, as rental and labour costs account for a much smaller proportion of operating costs compared to other retail segments. That said, Luk Fook is a key beneficiary of accelerating inflation in Hong Kong, which Credit Suisse s economist projects to accelerate from 2.8% in 21 to 5.2% in 211. Luk Fook is a high-end China consumption play In our view, there are two major reasons for mainland Chinese to shop in Hong Kong: 1) concerns about product quality/authenticity and 2) price differentials due to sales tax and import duties. For big-ticket items such as jewellery, both of the above are strong reasons for them to buy in Hong Kong, or at Luk Fook s shops in China given the strong brand recognition for high-quality, genuine projects. On the other hand, we identify two reasons for a Hong Kong-based retailer to trade at premium valuations to peers: 1) a profitable China operation [e.g. I.T (999.HK, HK$5.81, Not rated)] and 2) a high proportion of income in Hong Kong generated from mainland Chinese shoppers [e.g. Sa Sa (178.HK, HK$4.79, OUTPERFORM [V], TP HK$5.5)]. Luk Fook actually fits into both categories. It generates about 4% of its operating profit in China, while over 5% of its sales in Hong Kong is to mainland Chinese visitors, with both trends expected to continue to rise. That said, mainland Chinese shoppers actually account for over 6% of Luk Fook s total profit. Undemanding valuations despite recent strong run While we understand Luk Fook s share price has shown significant outperformance over the past 12 months, we believe its robust earnings growth we project a three-year EPS CAGR of 29.6% should drive a further re-rating. Trading at 14.6x CY11 P/E and implying about a 25% valuation discount to other China-focused luxury retailers, we see further potential upside. In addition, our studies show that the share price performance of the luxury retail segment outperformed the Hang Seng Index by as much as 6%. Furthermore, we see the recent share placement has removed the stock s major overhang. Based on the above, we are initiating coverage of Luk Fook with an OUTPERFORM rating and a target price of HK$33.8, which is based on a conservative.55x PEG or 17x FY3/12E P/E. Major investment risks include a sharp decline in precious metals/gems prices, as the company typically sits on three to four months inventory and higher-thanexpected increases in rental costs, as well as failure to monitor product controls of its franchisees. Jewellery retailers typically see above-average revenue growth and the strongest margin expansion during high inflation periods Luk Fook generates about 4% of its operating profit in China, while over 5% of its sales in Hong Kong is to mainland Chinese visitors We initiate coverage of Luk Fook with an OUTPERFORM rating and a target price of HK$33.8, which is based on a conservative.55x PEG or 17x FY3/12E P/E (59.HK / 59 HK) 3

4 Financial summary Figure 7: Luk Fook s profit and loss Year-end 31 Mar (HK$ mn) FY9A FY1A FY11E FY12E FY13E Turnover 3,959 5,386 7,731 9,756 11,742 Gross profit 874 1,294 1,817 2,293 2,759 Other income SG&A (ex. depreciation) (547) (659) (849) (1,69) (1,272) EBITDA ,38 1,323 1,621 Depreciation (36) (44) (68) (86) (17) EBIT ,237 1,514 Net interest income/(cost) (4) (3) (2) 2 31 Associates, others, exceptional Profit before tax ,259 1,547 Taxation (38) (98) (145) (214) (271) Minority interest (3) (5) (13) () () Net profit ,44 1,276 Source: Company data, Credit Suisse estimates Figure 8: Luk Fook s balance sheet Year-end 31 Mar (HK$ mn) FY9A FY1A FY11E FY12E FY13E Assets Cash ,389 1,622 1,987 Inventories 1,219 1,736 2,492 3,144 3,784 Other current assets Leasehold land and rights Interest in associates Other non-current assets Fixed assets Total assets 1,754 2,61 4,69 5,695 6,827 Liabilities Current debt Other current liabilities ,156 LT debt Other non-current liabilities Total liabilities ,24 1,59 1,762 Shareholders equities Share capital Reserves 1,147 1,556 3,31 4,37 4,916 Share premium acct Minority int Total equities 1,273 1,687 3,449 4,186 5,65 Source: Company data, Credit Suisse estimates Figure 9: Luk Fook s cash flow statement Year-end 31 Mar (HK$ mn) FY9A FY1A FY11E FY12E FY13E Pre-tax profit ,259 1,547 Taxes paid (48) (71) (5) (145) (214) Dep & amortisation Others 23 (9) (2) (2) (2) Gross cash flow ,197 1,438 Net capex (3) (315) (232) (146) (176) Net change in wc 12 (287) (59) (59) (5) Free cash flow 311 (4) Dividends paid (11) (133) (219) (38) (397) Chg in share capital 1,158 Others (11) (1) Net cash flow 199 (138) 1, Source: Company data, Credit Suisse estimates (59.HK / 59 HK) 4

5 A beneficiary of accelerating inflation in Hong Kong Inflation has become a meaningful concern to retailers, with products, rental and labour costs all rising. Among all retail segments in Hong Kong, during high inflation periods, jewellery retailers typically see above-average revenue growth, as product prices are marked to spot prices of precious metals and gems, which typically experience significant increases in times of high inflation, in addition to additional demand for investment/inflation-hedging purposes. On the other hand, jewellery retailers normally also see the strongest margin expansion on the back of their high operating leverage cost structure, with rental and labour costs accounting for a much smaller proportion of their operating costs, compared to other retail segments. That said, Luk Fook is a key beneficiary of accelerating inflation in Hong Kong, which Credit Suisse s economist projects to accelerate from 2.8% in 21 to 5.2% in 211. The following is an abstract from our recent report, Who benefits most from inflation?, dated 11 November 21, which contains our detailed analysis on the subject. High-end items outperform peers in sales revenue during inflationary periods We have studied Hong Kong retail sales data since 2 and chose four particular categories to represent the different sub-segments, namely supermarkets for low-end, clothing and footwear for mid-end and jewellery and watches for high-end. It is not a surprise that our studies show the high-end segment showed superior performance during inflationary periods, while underperforming general retail sales during deflationary cycles, which in our view, is mostly because deflationary periods normally signify recessions. On the other hand, the low-end retail segment showed the opposite pattern, compared to high-end segment, during the period we studied. In terms of retail sales, the high-end retail segment outperformed others during inflationary periods, and underperformed in deflationary periods. Lowend retailers showed the opposite pattern Figure 1: Sales revenue trend, Jan -Jul 3 Figure 11: Sales revenue trend, Aug 3-Aug accelerated inflation period Jan Jul Jan 1 Jul 1 Jan 2 Jul 2 Jan 3 Jul Aug 3 Aug 4 Aug 5 Aug 6 Aug 7 Total retail sales Clothing & Footw ear Super market Jew ellery & Watches Total retail sales Clothing & Footwear Super market Jewellery& Watches Source: CIEC, Credit Suisse estimates Source: CEIC, Credit Suisse. (59.HK / 59 HK) 5

6 Figure 12: Sales revenue trend, Jul 8-Jul 9 Figure 13: Sales revenue trend, Aug 9-Aug Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Aug 9 Nov 9 Feb 1 May 1 Aug 1 Total retail sales Super market Total retail sales Super market Clothing & Footw ear Jew ellery & Watches Clothing & Footw ear Jew ellery & Watches Source: CEIC, Credit Suisse estimates as well as in sales volume Source: CEIC, Credit Suisse estimates While high-end retailers outperformed peers in sales revenue during inflationary periods, pricing power is more important to determine profitability. We studied the retail sales volume of the three segments mentioned above and found that 1) the mid-end segment showed the strongest retail sales volume growth during inflationary periods, followed by the high-end segment, while the low-end segment underperformed; and The mid-end segment showed the strongest volume growth during inflationary periods, followed by the high-end segment Figure 14: Sales volume trend Figure 15: Sales volume trend Accelerated inflation period 2 Jan Jan 1 Jan 2 Jan 3 6 Jul 3 Jul 4 Jul 5 Jul 6 Jul 7 Jul 8 Total retail sales Super market Total retail sales Super market Clothing & Footw ear Jew ellery & Watches Clothing & Footwear Jewellery& Watches Source: CEIC, Credit Suisse estimates Source: CEIC, Credit Suisse. Shaded period: accelerated inflation (59.HK / 59 HK) 6

7 Figure 16: Sales volume trend Figure 17: Sales volume trend Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 6 Aug 9 Nov 9 Feb 1 May 1 Aug 1 Total retail sales Clothing & Footw ear Super market Jew ellery & Watches Total retail sales Clothing & Footw ear Super market Jew ellery & Watches Source: CEIC, Credit Suisse estimates Source: CEIC, Credit Suisse estimates 2) high-end items showed the most sales revenue outperformance against sales volume, during all periods we studied, suggesting that high-end retailers typically have the strongest pricing power. Figure 18: Sales revenue versus volume (overall) 18 accelerated inflation period Jul 3 Jul 4 Jul 5 Jul 6 Jul 7 Jul 8 Figure 19: Sales revenue versus volume (supermarkets) 14 accelerated inflation period Jul 3 Jul 4 Jul 5 Jul 6 Jul 7 Jul 8 Revenue Volume Revenue Volume Source: CEIC, Credit Suisse estimates Source: CEIC, Credit Suisse estimates Figure 2: Sales revenue vs volume (clothing & footwear) accelerated inflation period Jul 3 Jul 4 Jul 5 Jul 6 Jul 7 Jul 8 Figure 21: Sales revenue vs volume (watches & jewellery) 25 accelerated inflation period f 75 5 Jul 3 Jul 4 Jul 5 Jul 6 Jul 7 Jul 8 Revenue Volume Revenue Volume Source: CEIC, Credit Suisse estimates Source: CEIC, Credit Suisse estimates (59.HK / 59 HK) 7

8 Retailers P&L confirm this thesis We studied the revenue growth and cost structures of 18 Hong Kong-based retailing companies over the past 1 years, dividing them into three segments: Low-to-mid end, mid-to-high end and luxury. Figure 22: Valuation comps Market cap Price Target price P/E (x) 3-year PEG Company Ticker (US$ mn) 3-Jan-1 Rating (HK$) (x) Low- to mid-end Aeon stores 984.HK NR n.a n.a. Bonjour 653.HK NR n.a. n.a. n.a. n.a. Bossini 592.HK NR n.a n.a. CRA 852.HK NR n.a. n.a. n.a. n.a. Giordano 79.HK NR n.a n.m. Average n.a. Mid- to high-end Bauhaus 483.HK NR n.a. n.a. n.a. n.a. Dickson Concepts 113.HK NR n.a. n.a. n.a. n.a. I.T. 999.HK NR n.a Joyce Boutique 647.HK NR n.a n.a. Le Saunda 738.HK NR n.a. n.a. n.a. n.a. Moiselle 13.HK NR n.a. n.a. n.a. n.a. Sa Sa 178.HK 1, O-PF Veeko 1173.HK NR n.a. n.a. n.a. n.a. Average Luxury Chow Sang Sang 116.HK 1, NR n.a n.a. Emperor Watch 887.HK NR n.a n.a. King Fook 28.HK NR n.a. n.a. n.a. n.a. Luk Fook 59.HK 1, O-PF Oriental Watch 398.HK NR n.a. n.a. n.a. n.a. Average Overall average Source: Company data, Datastream; I/B/E/S estimates for non-rated companies, Credit Suisse estimates for Sa Sa and Luk Fook Mid- to high-end segment shows strongest revenue growth Among the three retail groups, the mid-to-high-end segment showed the strongest average revenue CAGR of 14.3% during the inflationary period, while the luxury segment showed a slightly lower growth rate of 11.3%. The low- to mid-end segment showed the worst performance with only a 9.4% median revenue CAGR. The above numbers confirm our analysis of the Hong Kong retail sales data that mid- to high-end items typically see stronger sales growth during inflationary periods. (59.HK / 59 HK) 8

9 Figure 23: Hong Kong retailers sales trend Low- to mid-end Ticker (%) (%) (%) (%) (%) (%) (%) (%) (%) CAGR (%) Aeon stores 984.HK Bonjour 653.HK Bossini 592.HK CRA 852.HK Giordano 79.HK Low- to mid-end average Mid- to high-end Bauhaus 483.HK Dickson Concepts 113.HK I.T. 999.HK Joyce Boutique 647.HK Le Saunda 738.HK Moiselle 13.HK Sa Sa 178.HK Veeko 1173.HK Mid- to high-end average Luxury Chow Sang Sang 116.HK Emperor Watch 887.HK n.a. King Fook 28.HK Luk Fook 59.HK Oriental Watch 398.HK Luxury average Overall average Source: Company data Figure 24: 22-8 revenue CAGR of different retailers (%) Low -to-mid-end Mid-to-high-end Lux ury rev enue CAGR Source: Company data (59.HK / 59 HK) 9

10 Differences in cost structure Typically, the three-largest cost items for retailers are: 1) cost of goods sold (COGS); 2) staff costs and 3) rental expenses, while other minor items include advertising and promotion, logistic and corporate overheads. In our study, we define core operating margin as profit after the three biggest cost items only. Among our study groups, it is not surprising that luxury retailers have the highest COGS as a percentage of revenue (29 average = 77.3% in 29), followed by the low- to midend segment (29 average = 58.6%), then mid- to high-end segment (29 average = 42.1%). On the other hand, staff costs showed the opposite picture, with the mid- to high-end segment having the highest staff cost to-revenue ratio (29 average = 17.9%) followed by the low to mid-end segment (29 average = 14.7%), then luxury segment (29 average = 5.5%). Rental expenses follow the same pattern of staff costs, with the mid to high-end segment having the highest rental expenses-to-revenue ratio (29 average = 2.2%) followed by the mid- to high-end segment (29 average = 13.6%), then luxury segment (29 average = 5.2%). Luxury retailers have the highest COGS (% of revenue), followed by the low to mid-end segment, then mid-to-high-end segment Staff and rental expenses (as a % of revenue): the mid-to-high-end has the highest ratio, followed by the low to mid-end, followed by the luxury segment Figure 25: Operating cost structure of different segments (based on 29 median figures) (%) Low-to-mid-end Mid-to-high-end Luxury COGS Staff costs Rental Source: Company data (59.HK / 59 HK) 1

11 Figure 26: COGS as % of revenue Company Ticker (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) Low- to mid-end Aeon stores 984.HK Bonjour 653.HK Bossini 592.HK CRA 852.HK Giordano 79.HK Low- to mid-end average Mid- to high-end Bauhaus 483.HK Dickson Concepts 113.HK I.T. 999.HK Joyce Boutique 647.HK Le Saunda 738.HK Moiselle 13.HK Sa Sa 178.HK Veeko 1173.HK Mid- to high-end average Luxury Chow Sang Sang 116.HK Emperor Watch 887.HK King Fook 28.HK Luk Fook 59.HK Oriental Watch 398.HK Luxury average Overall average Source: Company data Figure 27: Staff cost as % of revenue Company Ticker (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) Low- to mid-end Aeon stores 984.HK Bonjour 653.HK Bossini 592.HK CRA 852.HK Giordano 79.HK Low- to mid-end average Mid- to high-end Bauhaus 483.HK Dickson Concepts 113.HK I.T 999.HK Joyce Boutique 647.HK Le Saunda 738.HK Moiselle 13.HK Sa Sa 178.HK Veeko 1173.HK Mid- to high-end average Luxury Chow Sang Sang 116.HK Emperor Watch 887.HK King Fook 28.HK Luk Fook 59.HK Oriental Watch 398.HK Luxury average Overall average Source: Company data (59.HK / 59 HK) 11

12 Figure 28: Rentals as % of revenue Company Ticker (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) Low- to mid-end Aeon stores 984.HK Bonjour 653.HK Bossini 592.HK CRA 852.HK Giordano 79.HK Low- to mid-end average Mid- to high-end Bauhaus 483.HK Dickson Concepts 113.HK I.T 999.HK Joyce Boutique 647.HK Le Saunda 738.HK Moiselle 13.HK Sa Sa 178.HK Veeko 1173.HK Mid- to high-end average Luxury Chow Sang Sang 116.HK Emperor Watch 887.HK King Fook 28.HK Luk Fook 59.HK Oriental Watch 398.HK Luxury average Overall average Source: Company data Luxury segment saw the most core operating margin improvement during inflationary periods Among the three study groups, luxury retailers experienced the most core operating margin improvement between 22 and 28, with an average improvement of 4.9 p.p., whereas the low- to mid-end and mid- to high-end segments recorded 4.2 p.p. and 3.3 p.p. improvements, respectively. While the absolute margin improvements in percentage points among the three segments look similar, since the luxury segment typically earns much lower core operating margins compared to the other two segments, the magnitude of improvement is actually much more significant compared to the other segments. During 22-8, luxury retailers experienced a 4.9 p.p. operating margin improvement, the highest among segments (59.HK / 59 HK) 12

13 Figure 29: 22 versus 28 core operating margin (%) Low-to-mid-end Mid-to-low-end Luxury Source: Credit Suisse estimates Figure 3: Core-operating margin trend Company Ticker (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) Low- to mid-end Aeon stores 984.HK Bonjour 653.HK Bossini 592.HK CRA 852.HK Giordano 79.HK Low- to mid-end average Mid- to high-end Bauhaus 483.HK Dickson Concepts 113.HK I.T 999.HK Joyce Boutique 647.HK Le Saunda 738.HK Moiselle 13.HK Sa Sa 178.HK Veeko 1173.HK Mid- to high-end average Luxury Chow Sang Sang 116.HK Emperor Watch 887.HK King Fook 28.HK Luk Fook 59.HK Oriental Watch 398.HK Luxury average Overall average Source: Company data (59.HK / 59 HK) 13

14 What are the sources of strong pricing power for luxury retailers? In our view, there are two reasons behind luxury retailers, particularly jewellery retailers, superior pricing power and margin performance during high-inflation periods. Firstly, unlike other consumer goods, jewellery prices are typically marked to spot prices of raw materials, i.e. precious metals and gems, which typically rise along with accelerating inflation. Also, for jewellery retailers like Luk Fook, it normally keeps three to four months inventory for gold and other raw materials, and the rise in metal prices during the period offers extra room for margin improvement, and vice versa. Secondly, there is often extra demand for jewellery during high-inflation periods for investment/ inflation-hedging purposes. Thus, the higher prices are less likely to impact demand for jewellery. Sources of pricing power: 1) jewellery prices are marked to spot prices of its raw materials; and 2) extra demand for jewellery during high-inflation periods for investment and inflationhedging purposes (59.HK / 59 HK) 14

15 Luk Fook is a high-end China consumption play Chinese spending is the key growth driver It is apparent that the influx of mainland Chinese shoppers is one of the key, if not the most important, drivers of retail sales growth in Hong Kong. Since 22, mainland Chinese visitor arrivals have increased by 163% from 6.8 mn to 18. mn in 29, representing a 14.3% CAGR. In addition, average spending on shopping per overnight mainland Chinese visitor also increased 51% from HK$3,356 to HK$5,51 mn. Moreover, according to CEIC statistics, total shopping spending per overnight mainland Chinese visitor increased from HK$15.5 bn in 22 to HK$48.8 bn in 29, implying a 17.9% CAGR. Note also that mainland Chinese visitors contribution to Hong Kong retail sales rose significantly from 8.7% in 22 to 17.8% in 29. An influx of tourists from China and increased average spending drive Hong Kong retail sales Figure 31: Influx of mainland Chinese visitors (mn) CAGR Mainland Chinese visitation Source: Company data, Credit Suisse estimates Figure 33: Shopping spending by Chinese visitors (HK$ mn) 6, Figure 32: Shopping spending per Chinese visitor (HK$) 6, 5, 6.% CAGR 4, 3, 2, 1, Spending on shopping per mainland Chinese visitor Source: Company data, Credit Suisse estimates Figure 34: % of retail sales by Chinese visitors (%) 2 5, 4, 17.8% CAGR 15 3, 1 2, 1, Shopping spending by Chinese visitors Mainland Chinese visitors' contribution to HK retail sales (%) Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates (59.HK / 59 HK) 15

16 Two reasons for mainland Chinese to shop in Hong Kong In our view, there are two major reasons for mainland Chinese to shop in Hong Kong: 1) concerns about product quality/authenticity, for products including personal care, cosmetic and luxury items; and 2) price differentials due to sales tax and import duties for most luxury items, particular those that are imported. For big-ticket items, such as jewellery, both of the above are strong reasons for them to buy in Hong Kong, or in Luk Fook s shops in China given strong brand awareness for highquality, genuine projects. Therefore, Luk Fook, being a leading jewellery retailer in Hong Kong, with a wellrecognised brand name in China on the back of its aggressive advertising and promotion efforts, as well as its over 6 (and still expanding) retail outlets in China, has enjoyed stronger sales growth compared to the general Hong Kong retail market and Hong Kong jewellery segment. Concern about product quality/authenticity and price differentials bring mainland Chinese shoppers to Hong Kong Figure 35: Luk Fook s sales in Hong Kong outpace general retail and industry growth Luk Fook sales in YoY HK jewellery and YoY YoY (HK$ mn) Hong Kong chg. (%) watches sales chg. (%) HK retail sales chg. (%) FY3/1 1,66 22, ,674 FY3/2 1, , , FY3/3 1, , , FY3/4 1, , ,582.5 FY3/5 1, , , FY3/6 2, , , FY3/7 2, , , FY3/8 2, , , FY3/9 3, , , FY3/1 4, , , years CAGR Source: Company data, Credit Suisse estimates Two reasons for a HK-based retailer to re-rate Over the years, we have seen significant valuation differential between Hong Kong and China-based retailers. While there is the strong earnings growth potential of mainlandbased counterparts, on the back of the faster growing Chinese economy and a relatively less developed market, we believe the market has often ignored the similar growth potential of some retail segments, even though they based in Hong Kong. Based on the above, we identify two reasons for a Hong Kong-based retailer to trade at premium valuations against peers: 1) a profitable China operation; and 2) a high proportion of income generated in Hong Kong from mainland Chinese. One example in the first category is I.T. (999.HK). I.T. s share price has increased 321% since April 21 after the company announced the successful turnaround of its China operation. Based on I/B/E/S consensus estimates, the market expects I.T. s net profit to increase 29% YoY in FY2/11. While I.T. s share price performance clearly outpaced that of its earnings growth, it received a substantial valuation re-rating. Reasons for a Hong Kong based retailer to re-rate: 1) a profitable China operation; and 2) a high proportion of income in Hong Kong from mainland Chinese (59.HK / 59 HK) 16

17 Figure 36: I.T has experienced a significant valuation re-rating (HK$) 3x 25x x 15x 1x 2 Jun 4 Jun 5 Jun 6 Jun 7 Jun 8 Jun 9 Jun 1 Jun 11 Jun 12 Jun 13 I.T 1x 15x 2x 25x 3x Source: DataStream, I/B/E/S An example in the second category is Sa Sa. While its China operation is still loss-making, the company continues to trade at a 3-5% valuation premium, in terms of one-yearforward P/E, compared to other Hong Kong-based retailers (even though some are already profitable in China). Figure 37: Sa Sa s CY11 P/E versus peers Sa Sa Joy ce Boutique I.T Chow Sang Sang Bossini Aeon stores Luk Fook Emperor Watch Giordano 211 PE Source: DataStream, I/B/E/S We reckon the major reason behind this is that over 5% of Sa Sa s revenue generated in Hong Kong is actually contributed by mainland Chinese visitors, while shop profitability is generally higher in Hong Kong (on the back of higher operating efficiency and a lower tax rate). Furthermore, for those mainland Chinese visitors shopping in Hong Kong, they tend to be from higher income groups with relatively higher purchasing power, as witnessed by the much higher sales per ticket recorded by retailers with both sales networks in Hong Kong and mainland China. (59.HK / 59 HK) 17

18 Three reasons for Luk Fook to trade at a higher valuation Strong earnings growth to linger on In our view, there are three reasons why Luk Fook s valuation re-rating should continue. On the one hand, being a leading jewellery retailer in Hong Kong and mainland China, it is set to benefit from the accelerating inflation. While the improving economy is likely to fuel demand for jewellery, the accelerating inflation should stimulate additional demand for investment/inflation-hedging purposes. In addition, the continuing influx of mainland Chinese shoppers into Hong Kong suggests Luk Fook s strong demand growth should linger on. We project Luk Fook s revenue to grow 44%, 26% and 2% YoY in FY3/11, FY3/12 and FY13/13, respectively. On the other hand, thanks to the unique cost structure of jewellery retailers, Luk Fook should comfortably pass on the higher raw material costs of metals and gems to its customers. Furthermore, most of the time, even more than the actual raw material price hikes and on the back of its strong pricing power, retail prices of jewellery are normally marked to spot prices of precious metals and gems, which are rising. Other major cost components, namely staff salaries, rentals and advertising and promotions, in our view, are likely to be controllable, and are expected to grow lower than that of its revenue. That said, possible profit margin expansion is likely further stimulate Luk Fook s earnings growth, as long as inflation remains and barring any significant economic downturn. We project Luk Fook s net profit to grow 57%, 29% and 22% YoY in FY3/11, FY3/12 and FY13/13, respectively. We will discuss our earnings forecast in greater details in the next section. Already profitable in mainland China Luk Fook obtained the sole-proprietary licence to manufacture wholesale and retail gold jewellery in July 23, which is the milestone of Luk Fook s presence in mainland China. The company employs both self-managed and franchisee models in China. As of the end of September 21, Luk Fook had 35 self-managed stores and 573 franchisee stores in China, covering almost all provinces. In 1H FY3/11, self-managed stores in China accounted for about 5.2% of Luk Fook s total revenue and 6.2% of the company s operating profit. Most of the self-managed stores are located in tier-one cities, such as Beijing, Shanghai, Guangzhou and Shenzhen. Despite a higher contribution from lower margin gold/ platinum jewellery, self-managed shops in China yield a higher operating margin than their counterparts in Hong Kong (~15% versus ~1%), thanks to lower staff and rental costs, as well as relatively lower headquarter overheads, and advertising and promotion expenses. Luk Fook targets to open 1-12 self-managed shops per annum in the next few years. However, management admits that it is difficult to find good locations at reasonable rentals. Most of its shops are in high-end shopping malls, and therefore, its opening schedule is likely to be in line with that of high-end shopping malls in first-tier cities in China. For the franchising business, Luk Fook generates revenue from three major sources: 1) wholesaling to licensees (a 3-4% discount to the retail price); 2) royalty income (3-12% of purchase cost); and 3) consultancy fees (a Rmb1, joining fee per outlet, plus project, training and other fees). In 1H FY3/11, the franchising business accounted for about 13.3% (1H FY3/1 = 11.1%) of Luk Fook s total revenue and about 37% (1H FY3/1 = 39%) of the company s We project Luk Fook s net profit to grow 57%, 29% and 22% YoY in FY3/11, FY3/12 and FY13/13, respectively Luk Fook meets the criteria for a re-rating, i.e. a Hong Kong-based retailer having a profitable operation in China (59.HK / 59 HK) 18

19 operating profit. Note that the decline in profit contribution as percentage of total operating profit was largely due to Luk Fook offering a bigger wholesaling discount to its franchisees to boost sales, while wholesale revenue actually increased by 99% during the period. Luk Fook targets to expand its franchisee network by 7-8 shops p.a. (implying mid-teen growth in terms of number of stores from the current level). Therefore, all together, China retail operations nowadays account for over 4% of Luk Fook s total operating profit, with the percentage expected to rise in the longer tem given the faster sales network expansion in mainland China. That said, we believe Luk Fook meets the criteria for a re-rating, i.e. a Hong Kong-based retailer having a profitable operation in China. Most sales in Hong Kong (and Macau) are to visiting mainland Chinese According to management, based on customer payment records (mainland Chinese banks debt/credit cards and Unipay), 5-6% of Luk Fook s retail sales in Hong Kong and over 7% of its retail sales in Macau are made by visiting mainland Chinese, with a gradually rising trend over the years. Furthermore, Luk Fook meets more criteria for a re-rating, i.e. it is a Hong Kong-based retailer with most of its sales made by visiting mainland Chinese. Luk Fook meets another criterion for re-rating, i.e. a Hong Kong-based retailer with majority of its sales made by the visiting mainland Chinese (59.HK / 59 HK) 19

20 Undemanding valuations despite recent strong run While Luk Fook s share price has significantly increased over the past 12 months, outperforming the Hang Seng Index by over 3%, we believe its robust earnings growth we project a three-year EPS CAGR of 3% should drive a further re-rating. A 3% revenue CAGR in FY3/1-13 We project Luk Fook s revenue CAGR at 3% between FY3/1 and FY3/13E, rising from HK$5.4 bn to HK$1.7 bn. Among different divisions, retail operations in China are expected to be the core growth driver. Figure 38: Luk Fook's robust sales growth to linger (HK$ mn) 12, 1, 8, 6, 4, 2, - FY3/9 FY3/1 FY3/11E FY3/12E FY3/13E Hong Kong Retail China Retail (direct) Wholesaling Licensing income Source: Company data, Credit Suisse estimates Hong Kong retail sales to experience a 3% CAGR from FY3/1-13 We project a 3% revenue CAGR for Luk Fook s Hong Kong retail operation from FY3/1-13. The company recorded revenue growth of 58% YoY in 1H FY3/11, which was partly driven by around 3% same-store-sales (SSS) growth, and partly by the opening of its flagship store in Tsimshatsui in April 21, which now accounts for about 1% of Luk Fook s total sales in Hong Kong. Management has said that such strong growth is expected to linger on in 2H FY3/11, despite a high-base comparison. SSS growth remained at around 3% in October and November 21, while contributions from the new flagship store continue to drive extra growth. We project Luk Fook s full-year FY3/11 Hong Kong retail revenue to grow 46% YoY from HK$3,82 mn to HK$5,55 mn, implying 2H FY3/11 YoY revenue growth of 38%. For the next two financial years, we project sales growth to decelerate gradually to 25% and 2% in FY3/12 and FY3/13, with 1-15% driven by SSS growth and about 5-1% from new store openings. Note that for SSS growth, we project about 8-12% volume growth with the rest coming from rising selling prices. For the next two financial years, we project sales growth to decelerate gradually to 25% and 2% in FY3/12 and FY3/13, with 1-15% driven by SSS growth and about 5-1% from new store openings (59.HK / 59 HK) 2

21 China direct retail sales to experience a 42% CAGR from FY3/1-13 We project an even stronger revenue CAGR of 42% from FY3/1-13 for Luk Fook s direct retail sales in China, on the back of its even faster store expansion. In 1H FY3/11, the company recorded a 67.6% YoY increase in retail sales revenue in China, primarily driven by its robust SSS growth and improved store locations, despite the number of selfmanaged shops remaining largely the same during the period. We believe that Luk Fook s future direct retail sales in China will be driven by both the robust SSS growth and new shop openings. We project sales to grow 4% and 35% YoY in FY3/12 and FY3/13, respectively, with 1-15% driven by new store openings and the rest by SSS growth. Similarly, for SSS growth, about 5% is expected to come from rises in selling prices and the rest from volume growth. Wholesaling and licensing income to have a 26% CAGR As mentioned previously, Luk Fook s China franchising operations generate revenue from three major sources: 1) wholesaling to licensees (a 35% discount to the retail price); 2) royalty income (3-12% of purchase costs); and 3) consultancy fees (an Rmb1, joining fee per outlet, plus project, training and other fees). We project wholesale revenue to have a 23% CAGR from FY3/1-13. The slower growth rate compared to our 42% CAGR assumption for the company s direct retail is largely because: 1) Luk Fook started to offer bigger wholesale discounts to its franchisees in 1H FY3/11 in order to boost volume growth and 2) new shops to be opened by franchisees are in second or third-tier cities, thus purchasing power there is expected to be lower. On the other hand, we expect the company s royalty and other fee income to have a 38% CAGR between FY3/11 and FY3/13, partly driven by the overall sales volume growth of its franchisees and partly by the addition of new stores, with CS projecting the number of franchisee stores to increase from 573 as of end-1h FY3/11 to 8 by the end of FY3/13. We expect a stable gross profit margin We identify three factors that are most influential to Luk Fook s gross profit margin. On the retail business front, product mix and price trends of raw materials are the most important factors, while on the wholesaling front, the discount offered by Luk Fook to its franchisees is more important. For product mix, we are referring to revenue mix between gold/platinum jewellery versus gem-set jewellery. In general, gold/platinum jewellery yields a lower gross margin of about 1-15%, while gem-set jewellery yields a much higher margin of around 3%. Typically, jewellery retailers see sales contributions from gold/platinum increase during high-inflation periods (for investment/inflation-hedging purposes), which is a negative to Luk Fook s blended margin. However, the rising raw material prices are also beneficial to Luk Fook s gross margin, as the company typically keeps about three months of inventory for gold and about six months of inventory for jewellery. As retail prices are normally marked to spot prices of precious metals and gems, Luk Fook can earn a higher gross margin when raw material prices are rising, and vice versa. For instance, Luk Fook generates about a 14% gross margin from gold/platinum jewellery, compared to only about 1% two years ago. On the wholesaling front, Luk Fook s gross margin is also impacted by material price trends similar to the retail operations. It is also affected by the discount it offers to its wholesalers, as well as sales mix between jewellery to its franchisees and sales of scrap gold to other manufacturers. We project sales to grow 4% and 35% YoY in FY3/12 and FY3/13, respectively. Of this, 1-15% to be driven by new store opening and the rest by SSS growth We project wholesale revenue to have a 23% CAGR from FY3/1-13; and royalty and other fee income to have a 38% CAGR Increased sales contribution from gold/platinum is a negative to Luk Fook s blended margin However, rising raw material prices benefit Luk Fook s gross margin (59.HK / 59 HK) 21

22 According to management, Luk Fook has already offered a higher discount since 1H FY3/11, and therefore it is unlikely to offer even higher discounts to its franchisees in the foreseeable future. On the other hand, the sales mix largely depends on demand for scrap gold, which from Luk Fook s perspective, is a peripheral business. While the contribution from wholesaling of scrap gold to its overall revenue seems large at about 13.5% in 1H FY3/11, its contribution to the company s total operating profit is low at about 5% only. Even though the current economic trend favours Luk Fook s gross margin on the back of improving consumption power, thus favouring sales of gem-set jewellery, as well as the rising precious metal/ gems prices, we conservatively assume its gross margin to remain stable at 23.5% (the level Luk Fook achieved in 1H FY3/11) over the next three years. Positive operating leverage to drive even faster earnings growth Luk Fook s other major operating costs include staff salaries, rentals, other corporate overheads such as commission to credit card company as well as advertising and promotions, which account for about 4.5%, 3.5% 1.8%, 1% and.5% of its total revenue, respectively. For staff costs, these are about 7% fixed and 3% based on sales commission. Note also that only a very limited number of staff is required to handle its scrap gold wholesaling business and they are mostly on a fixed salary basis. Therefore, we believe Luk Fook should gain some operating leverage in staff costs over the next few years. As a result, we expect staff salaries as a percentage of turnover to drop from 4.9% from FY3/1 to 4.4% in FY3/13. We reckon the rising rental pressure will continue in both Hong Kong and China, and we have therefore factored this into our model with 35%, 15% and 5% increases in average rentals of all of its shops in FY3/11, FY3/12 and FY3/13, respectively. Based on our assumption, we expect rental costs as a percentage of turnover to drop from 3.7% in FY3/1 to 3.4% in FY3/13. Corporate overheads are another major area that Luk Fook can explore for operating leverage. Nevertheless, for conservativeness, we assume in our model that corporate overheads as a percentage of turnover stay unchanged at 1.8% from FY3/1 to FY3/13. Lastly, for commission expenses to credit card companies as well as advertising and promotion expenses, we also assume that their respective percentages of turnover stay unchanged during our forecast period. Based on the above conservative assumptions, we forecast Luk Fook s EBITDA margin to improve from 12.6% in FY3/1 to 13.8% in FY3/13, with its EBITDA having a 33.6% CAGR between FY3/1 and FY3/13 and rising from HK$679 mn to HK$1,621 mn. Luk Fook is unlikely to offer even higher discounts to its franchisees in the foreseeable future We conservatively assume its gross margin to remain stable at 23.5% over the next three years We expect staff salary as a percentage of turnover to drop from 4.9% from FY3/1 to 4.4% in FY3/13 We expect rental costs as a percentage of turnover to drop from 3.7% in FY3/1 to 3.4% in FY3/13 We expect Luk Fook s EBITDA margin to improve from 12.6% in FY3/1 to 13.8% in FY3/13 (59.HK / 59 HK) 22