Description

Executive Summary

Hengdeli (listed as 3389 on the HK stock exchange, or “3389”) is a classic net net play, trading below <50% of liquidation value, with the added bonus of being profitable and benefitting from structural tailwinds in Chinese luxury goods demand.  After cleaning up the corporate structure in a 2017 transaction, 3389 is now a clean HK-centric luxury watch retailer that has started to reward shareholders via dividend payments and share buybacks funded by its overcapitalized balance sheet. At today’s share price around HKD0.37, Hengdeli is trading at a ~50-60% discount to conservatively estimated liquidation value mainly supported by (i) its large cash holdings (~HKD0.50) and (ii) large watch inventory (HKD0.27). We are classic value investors that normally invest in DM situations or at least want to invest in USD assets or be compensated for EM risks, but we think the risk-reward is quite favourable in this instance.  We appreciate retail isn’t the flavour of the month, especially retailers based in Hong Kong that have a controlling shareholder, but we think the attractions of the business and valuation outweigh the risks. Despite fears about Chinese growth slowing, there is structurally increasing wealth in China and burgeoning demand for luxury products.

Company Background

3389 was founded and is controlled by Mr Zhang Yuping. Hengdeli is the original luxury watch retail brand in mainland China and starting with the Beijing store, Mr Zhang rolled up numerous the historical Hengdeli branches and IPO’d them as 3389 in September 2005. Since IPO, 3389 has gone through a series of acquisitions and divestitures, including the acquisition of Elegant International Holdings Limited, which forms the core of 3389’s present day operations, and several divestitures, including the divesting of the original mainland Hengdeli operations, which were sold back to Mr Zhang in the “Very Substantial Disposal” (“VSD”) transaction in 2017. Today, 3389’s operations primarily comprise the Elegant-branded stores in Hong Kong, luxury watch retailing operations in Taiwan and in Malaysia, as well as an accessories manufacturing business.

Industry Description

Whilst the unit economics of luxury watch retailing isn’t as attractive as it may be for other retail subsectors, we think the close relationships the major watch retail chains enjoy with the watchmakers make the watch retailers resilient even during downturns and makes these retailers less prone to disruption by online retailers.

Luxury watch retailing is a decent business with ROCEs in the 10-20% range on a group level including all overheads and after taxes, whereas store-level ROCEs on an EBIT level can be as high as 30-50%, for stores in HK at least. The biggest capital outlay when opening new stores is the watch inventory that they need to have ready for the customers, given typical inventory days range between 120-240 days. Atypical for most retail operations, these businesses are very working capital intensive; this fact lends them stability in downturns as they can monetize the inventory, thereby releasing cash. Based on our research, the average store in HK has turnover of around HKD150mn, generating EBIT of ~HKD15mn with average inventories per store of HKD50-75mn, although precise numbers can vary depending on the store size, brand mix, and point in the cycle.

Unlike many other retail subsectors, luxury watch retailers tend to have a symbiotic relationship with the watch manufacturers which make the major luxury watch retail chains a lot more resilient compared to other retail formats. For the big watchmakers brand image management is of utmost importance, given that time measurement is frankly the least important function of a luxury watch. Physical retail has been an essential part of brand management as it provides a direct touchpoint between end consumers with the brands. Therefore, watchmakers exert a lot of control over its authorized retailers with regards to store design, enforcing strict no-discounting policies, but also providing support, e.g. by buying back unsold inventory. In our view, the very nature of luxury retail generally makes this subsector relatively more internet-proof because (i) buyers are generally less price or efficiency-focused, (ii) the purchasing process in itself is part of luxury process, and (iii) these high value items don’t lend themselves to existing shipping and returns processes.

Recent Developments

VSD aside, we want to talk about the boom and bust journey that’s resulted in today’s overcapitalized balance sheet. As mentioned before, the biggest outlay when opening new shops is inventory, so when the company embarked on its expansion spree between 2010 and 2015 almost doubling its store count in Hong Kong from 15 to 29 stores, they tied up significant amounts of cash in inventory (~RMB700mn) for incremental stores that failed to turn a profit.  However, as they closed down these unprofitable shops and scaled down to today’s estate of 13 stores in Hong Kong, group level inventory levels are down to a still elevated but more reasonable 245 inventory days. Together with the VSD described in the next section, these stores closures culminated in the substantially overcapitalized balance sheet and improved group profitability.

Liquidation Value

On a headline basis, at HKD 0.37, 3389 trades at a P/B of 0.35x. Having repaid all debts, 3389 has recently managed to turn a net profit too, which is helpful but immaterial for our investment thesis. Our liquidation analyses yield liquidation values close to book value of the shares around HKD 0.84 because of the company’s large cash holdings and watch inventories. Given the watch manufacturers would rather buy back excess inventory rather than see discounting, our sense is that even in a liquidation scenario, we will likely not need to see heavy discounting on the company’s RMB1.3bn watch inventory.

Note: whilst the company reports in RMB, its shares trade in HKD.

Related Party Transactions

This is always a very sensitive point for us and a real test of character for management teams as it is always very tempting to extract economics via off-market transactions. Whilst some acquisitions or business decisions may not have played out as one may have hoped, there’s been no evidence that Mr Zhang has been enriching himself at the expensive of minority shareholders. In fact, 3389 has started to return capital to shareholders via buybacks and dividends now that the business has been simplified and is recovering. The biggest transaction was the VSD by which 3389 sold its mainland China activities apart from the accessories manufacturing business and one investment property in Shanghai.

Very Significant Disposal (“VSD”)

Over the years, 3389 expanded its business in China by a mixture of organic growth, acquiring majority stakes in regional Hengdeli businesses, and outright acquisitions or more or less related businesses. As the anti-corruption campaign unfolded, even the Hong Kong stores saw sales decline whilst newly opened stores in mainland China hardly turned a profit whilst absorbing a lot of cash to fund inventory for the new stores. This culminated in the VSD that was done at around 0.90x book value, funded with RMB3.5bn in cash, most of which was used to repay debt and to fund a RMB1.2bn dividend to 3389 shareholders.  We view these actions as fair and aligned with minority shareholders.

Risks

Lower import taxation regime: currently, HK watch retailers benefit from extraordinarily high import duties of almost 100% for luxury watches imported and sold in mainland China due to a mixture of tariffs, VAT, and consumption taxes. Once abolished or lowered, this will materially reduce the competitive advantage luxury watch retailers based in Hong Kong currently enjoy compared to those on the mainland.

Rental costs: this is a perennial problem in Hong Kong where the rental system that greatly favors landlords over tenants. Particularly for prime real estate where luxury watch retailers tend to reside, rental levels tend to be high and can materially eat into profitability, which becomes especially acute when there is a sudden downturn and rental levels are not adjusted downwards in time. Hengdeli rents all its stores in Hong Kong, so is particularly exposed to this issue relative to peers.

Watchmakers: whilst we don’t think the risk from a web-based direct selling strategy is very high, technically there is little holding back watchmakers from entering the retail business themselves, particularly for the multi-brand houses like LVMH or Swatch. In the scheme of things, the actual retailing activity isn’t excessively attractive from a financial point of view to make it worth the watchmakers’ time.

Tech disruption: we’ve outlined some reasons why physical luxury retail is unlikely to be disrupted by pure-play online retailers, however, proliferation of smart watches is certainly a threat to the watch industry. For men in particular though, watches are almost more jewellery rather than fulfilling for time telling, but given much wider functionality of modern smart watches, it certainly poses a threat to the established watchmakers.

Country / governance risk: whilst there is negligible FX risk given the nature of the products being sold and HK has good listing rules, one needs to bear in mind that Mr Zhang owns 34% of the shares. Based on his track record so far, we can say that he’s treated minority shareholders fairly, which is one of the reasons why we recommend this investment.

Disclaimer

The author and affiliates may or may not have material positions in issuers and securities mentioned in this note and will not be obligated to give notice of any changes in their views or positioning. You agree to hold the author harmless and to waive the right to any legal action against the author in relation to this note. The views expressed here reflect the author’s personal views about the issuers and securities and do not constitute investment advice. The author makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information. This note is for information purposes only and should not be construed as either projections or predictions. Before making any investment decision, you should seek independent investment, legal, tax, accounting or other professional advice as appropriate, none of which is offered to you by the author in this note. The author accepts no duty of care to you in relation to investments. Past performance cannot be relied on as a guide to future performance. You should not assume that the performance of any specific investment or investment strategy will be profitable or equal to corresponding past performance levels. Any investment or investment strategy can be impacted by numerous factors, including market and economic conditions, and may result in a loss to investors. As with any investment, there can be no assurance that any investment objectives or strategies will be achieved or that an investor will not lose a portion or all of its investment.

Catalyst

- Accelerated returns to shareholders either via sharebuybacks or a step-up / increase in dividends, potentially via special dividends