Sunday, 6 July 2014

Luk Fook, or will the conspicuous consumption ever make a comeback

I’d like to put a disclaimer up front by saying that when I started the research the stock was around HK$19 (from here on $ refers to HK$, unless otherwise stated), consecutively reaching $24, which was close to my near-term target price. It’s always a great outcome when things work out faster than expected (very fast in this case) but building a substantial position can be made fairly challenging.

So, if I’d want to be completely blunt about this idea the following is what I’d say. Luk Fook (590:HK) is a HK listed jewellery manufacturer and distributor focusing mostly on middle aged Mainland Chinese customers via stores in HK, Macau, Mainland China and a few other in the US, Singapore etc. The stock got a bit hammered recently on tough SSSG comps and of course the clampdown on Chinese style excessive consumption (think baiju out of golden cups) which got me interested in the sector and the company. Now, Luk Fook (“LF”) generated double digit returns on capital over the last five years (20%+), grew sales and earnings by c. 4x, store count to 1,268 yet it trades at 7.5x TTM PE and 8.5x forward PE and pays a 5.5% TTM dividend.

I like the stock as (i) the sentiment around Luk Fook and it’s comps are improving, (ii) fundamentals remain solid (just returned from a long-trip to Asia and saw first hand the level of consumption…) (iii) expansion plans remain intact (iv) HK IVS (essentially the individual travel permit for Mainland Chinese) is not expected to change materially thus this overhang is removing (v) valuation is very attractive (both absolute and relative vs peers).

Key concerns from the Street are (i) tough SSSG comps for this FY (ii) IVS scheme changes (iii) China macro but to a most extent are mitigated or priced in (clearly no one company can solve the China macro picture). My target price is around $25 for the near term, which is roughly where the stock trades now but for the longer term, it could be a very interesting story.

Now let’s get to the details.

A very enterprising HK businessman founded Luk Fook by the name of Wong Wai Sheung. He practically grew up in the jewellery business as his father run a small store in HK but eventually realised that you needed scale. In 1991 he set up LF with one store in North Point and to cut a long story short it grew to 1,268 stores in the ensuing years. Company has been listed since 1997 and he maintains a majority stake in the company.

The business is structured in three segments: retailing, wholesaling and licensing by operations and to HK/Macau/Overseas and China by geography:
  • Retail segment represents the majority of sales and EBIT mostly coming from HK/Macau/Overseas. Margins are the lowest across the segments due to substantial opex (rent, staff etc) to operate company owned stores
  • Wholesale consists of two parts: (1) sales of merchandise mostly to licensees in China/corporate clients to a smaller extent and (2) sales of scrap gold and platinum to merchants (from traded-in products)
  • The licensing business is the smallest (but one could salivate over the margins) also made up of two parts: (1) royalty fees LF earns from jewellery sales to licensees and (2) consultancy fees inc. joining fees per outlet and other training fees etc
The below chart shows an overview of consolidated results over the last five years:

Source: Luk Fook public filings

Additionally, LF closed the 50% acquisition of 3D Gold in FY2014, which is a Chinese retailer and licensor of jewellery, from HK Resources for c. $245m consideration, $57m convertible debt and a $100m loan for working capital. The company will provide consultancy services to the company and help grow the company using its track record.

In terms of products, the breakdown is roughly 65%/35% gold and gem-set, with average gross margins of 8-15% and 35%, respectively.

Source: Luk Fook public filings

The company has 1,268 stores across its network. The stores in HK/Macau/Overseas are self-operated (total of 60 at end of 2014) while in China LF has 83 self-operated stores and 1,125 on a license basis. In terms of location and format the majority of stores in HK are in prime locations and mostly street-side vs malls whereas in China malls are preferred. In China, self-operated stores are based in higher tier cities to basically show good example for the licensees on how they should operate, which are mostly in China’s lower tier cities. In terms of growth the company guided for stores to grow 15% in the next few years, mainly in the Mainland. Additionally, the company has one manufacturing facility in China and gem lab for certification.

Source: Luk Fook public filings

Location of one of LF’s stores in TST in Hong Kong with a 3D Gold store right next door. Primary research.

Despite China providing around 60% of self-operated stores, it only makes up 10% of retail sales. On a per store basis, one store in China generates $20m while the others around $240m. This is due to higher traffic and average ticket price. Indeed, as the chart below shows avg ticket size in HK is around 2x vs Mainland China, however flat vs HK/Macau stores where customers pay with UnionPay (favoured payment method of Mainland Chinese customers when abroad).

Source: Luk Fook public filings

Brand positioning of LF is geared for mass-market in China proudly showcasing its HK origin, which can provide reassurance to customers of better quality vs Mainland brands.

In terms of positioning vs other brands in the domestic market, customers view Western brands such as Tiffany’s, Cartier etc as high-end while HK brands like Chow Tai Fook, Chow Sang Sang and LF as mid-high end with differing avg. ticket prices, product mix etc. This positioning essentially gave LF the flexibility to rapidly expand presence in China, which say a higher-end brand would have probably done slower. However, this also gives the company weaker channel checks and potential for weaker brand positioning due to fragmented operations, which it tries to mitigate via using self-operated stores to set examples of operations and additional security measures.

A few words on the recent annual results and consecutive update. FY2014 was a banner year for LF partly due to lower gold prices, which resulted in a gold rush accompanied by higher gem-set sales. The company increased sales 43%, EBIT by 54% and net profit increased to c. $1.9bn from $1.2bn yoy. Same store sales growth for the year was 25% (7.4% in 2013) of which 22% in HK/Macau and 46% in China respectively (7% for both yoy). On the call the company tempered expectations and noted that April and May 2014 SSSG was -56% (vs +93% yoy) thus this FY is up against a tough comp and 2012 will be a better comp, but some weakening can be expected. Indeed, overall May HK retail sales are down by 4.1% yoy mostly driven by jewellery/luxury segment downturn. Q1 trading update from LF is expected in July, so we will have more clarity then.

Let's look at valuation. So, you get all of the above for $13bn at current prices and the question is what it’s really worth. To note the company has generally been debt free but added $568m on a short-term basis for RMB cash needs. It doesn’t really worry me and net cash remains at roughly the same $1.2bn level as last year. I prefer debt over dilution, however it's worth highlighting that LF raised equity capital twice in the last few years so this could potentially be an issue.

Historically, the company traded on a PE of between 7-9x, the lowest amongst peers, due to perceived more “mass-market” approach vs peers, lowest gold hedging etc. If we compare to peers, Chow Tai Fook (“CTF”) normally trades mid double digits of 13-15x, it is the largest of the peers, best brand recognition, highest gold hedge-ration (LF only hedges 20-25%) and Chow Sang Sang (“CSS”) is somewhere between the two and has a full-retail model (vs element of licensing for the others).

A key item to the thesis is the spending habit of Mainland Chinese in HK, who are ever increasing in presence and contribute more and more to HK retail spending. While initially visitors arrived in groups, under the Individual Visit Scheme (IVS) mainlanders from select cities could travel to HK and Macau on an individual basis since 2003. The government aimed to rein this in which made retailers and investors jittery, however what seems to be transpiring is a limitation of individual travel to a maximum of 52 times a year, which honestly shouldn’t cause a material change to status quo. I mean really, how much jewellery you can buy in a week but just in case you'd need more golden ornaments I'm sure you have contacts who haven't maxed out their travel limit.

I estimate that earnings in the next year will be down vs FY 2014’s $3.17 per share and will be more comparable to FY2013 vs FY2014. Based on my calculations the company will be earning somewhere between $2.5-3 per share in FY 2015 and $3-3.5 per share the year after. Now depending on how bullish you want to be the question remains the multiples. As the SSSG decline for FY 2015 is likely getting priced into the stock (there was some decline over the last few days when May HK retail sales were released) and the IVS overhang is getting removed (which was key to the bear thesis) the stock could be up for a re-rating. If we assume an 8-9x multiple (so avg of 8.5x) for FY 2015 and 2016 this would imply a share price of $25 (blended for the two years) conservatively with a 4.5-5% dividend yield to boot. Any weakness in the share price will be a good reason to add to a position.

So the above was my thinking when I first looked at the stock initially at $19, however it since came up, essentially hitting my target price. I’d say that based on what we know for the near-term it’s a fair price for this stock. I actually prefer LF over the peers due to least challenging valuation and largest contributor of HK to EBIT which is positive regarding the developments around the IVS.

But something tells me that it could be a very interesting story for the long-term. I can give you the usual story about how emerging Chinese consumer will be buying more and in a society where jewellery, especially gold, plays such a huge role this is the case more so. I do think this story is valid but probably China will go through a few contractions, which will impact spending but companies like LF with increasing presence in the Mainland, acting as consolidators are sure to do well in the long-term.

Source: publically available filings found on Luk Fook investor relations site