From 1979 until 2001, Hang Fung was purely a manufacturing and distribution business, but in 2001, became vertically integrated by opening its first exhibition hall, and later its first retail outlet in 2002. Today, the Company has a complete offering of manufacturing, distribution, wholesale, and export, as well as retailing through 6 exhibit halls, 92 company owned and 48 franchised stores. The brand is considered middle tier and caters primarily to locals, but is becoming more widely recognized as they build out the retail network, and was recently authorized to be an official designer, manufacturer, distributor, and retailer of jewelry items specifically designed for the 2008 Beijing Olympics, which should give them further brand recognition. Hang Fung officially divides their business into two segments, wholesale and retail, but for the purpose of our analysis, we further break out retail into company owned stores, franchised stores, and exhibit halls due to the very different economics of the three businesses.

 

Hang Fung’s legacy wholesale / manufacturing business produces and distributes fine gold and jewelry products under various brands, including 3D Gold (gold products), LaMilkyWay (silver products), and a handful of proprietary watch brands. Hang Fung is among the leading wholesalers and exporters of jewelry in Hong Kong and mainland China, and also has distribution networks reaching the U.S., Europe, and southeast Asia.  In the U.S., their product can be found on QVC and ShopNBC. The Company manufactures the majority of these products internally at facilities located in Beijing, Tianjin, and Shenzhen, with over 100,000 square feet of collective gross production area and 4,500 employees. As the Company’s wholesale business grows, both organically and through the build out of the franchisee network (which the Company does not include in the wholesale segment), the Company plans to outsource more of its production as it approaches full capacity utilization (which is now at 90%). Over the past 10 years, revenue has grown from just over 300 million HKD to over 1.7 billion HKD. Gross margins in this segment are approximately 16% and EBIT margins are approximately 7%.

 

As of June 30, 2007, Hang Fung has 83 company owned 3D Gold retail stores, 13 of which are located in Hong Kong and Macau that average approximately 1,000 square feet and 25 million HKD in average annual revenue, and 70 located in mainland China that average approximately 600 square feet and 7 million RMB in average annual revenue. On average, Hong Kong stores cost approximately 1 million HKD  in cap ex and have approximately 10 million HKD of inventory, whereas stores in mainland China cost approximately 600,000 RMB and require approximately 4 million RMB in inventory. Hang Fung company owned retail stores average roughly 45% gross margins and 8% EBIT margins. Currently, the product mix is ~40% jewelry and ~60% gold items, however jewelry as a percentage of sales is increasing, and jewelry sales carry a significantly higher gross margin than gold products. Although the Company’s plans are much more aggressive for franchised store expansion, they have also targeted an additional five company owned stores in Hong Kong by the end of 2008, as well as an additional 32 stores in mainland China. Within mainland China, Hang Fung’s company owned stores are located in 1^st tier cities and select 2^nd tier cities, while franchised stores are located in 2^nd and 3^rd tier cities. Company owned stores are currently spread out over 40 cities in mainland China.

 

Exhibit halls represent the final component of the Company’s retail segment. As of March 31, 2007, the Company’s five Hong Kong based exhibit halls featured a golden palace, windmill, zodiac, Buddha, and our personal favorite, a golden bathroom that is listed in the Guinness Book of World Records as the world’s most expensive bathroom. For those adventurous enough to visit the Company at its headquarters in Hong Kong, we highly recommend a visit to the golden bathroom exhibit in the lobby and a corresponding picture on the golden toilet! Since the first exhibit opened in 2001, Hang Fung’s exhibits have hosted over 4.3 million visitors, and FY 2007 revenue from this segment was approximately 550 million HKD. The exhibits themselves are made up almost entirely of gold, comprising over 6 tons overall, 4.5 of which are in the recently finished Golden Palace. The gold exhibits are held on the books at cost less a small depreciation factor (2.5% per year for 8 years), and as of March 31, 2007, the book value of just under 650 million HKD of these exhibits implies a US$475 per ounce value of gold, well below the current price of roughly US$665 per ounce. This hidden asset value is particularly noteworthy given that the Company has begun monetizing its gold exhibits, most recently with the sale of its golden carriage in March of 2007 at roughly 1.5x its book value.  Going forward, the Company plans to sell approximately 1 ton of gold exhibits per year over the next six years, and may or may not lease them back depending on trends within the exhibit hall business model. Since the creation of the individual travel scheme, which allows citizens of mainland China to visit Hong Kong and Macau on an individual basis (rather than in groups or on business visas), the exhibit halls have seen a significant decline in business because group tours represent a large component of exhibit hall revenue. As EBIT margins have trended toward lower single digits in the exhibit halls, the Company has concentrated its expansion on its retail network, which has actually benefited from the individual travel scheme in that it caters more to individuals than groups. It remains to be seen whether or not Hang Fung will completely exit this business or if it will be important to maintain it at least somewhat as part of its brand recognition. It’s comforting, however, that these exhibits have stored their value and actually appreciated with gold prices, and the hard asset value of this business can be completely detached from the Company’s remaining business as it is monetized. Below is a list of the Company’s remaining gold exhibits, including our estimate of cost and current market value:

Gold Exhibits	Cost (HK$, MM)	Market Value (8/15/07)	Hidden Value
Gold Buddha	13.4	32.4	18.1
Gold Zodiac	6.9	16.8	9.5
Gold Washroom	64.2	139.7	71.8
Gold Windmill	3.9	6.3	2.2
Gold Palace	575.0	746.9	154.9
Others	0.5	0.6	0.1
Total	663.9	942.7	256.6

 

 

The rapid growth in the Chinese economy has been widely published, so we will keep this section brief and focus more on Hang Fung’s industry and particular demographic. While overall Chinese consumer spending grew by approximately 13.5% in 2006, growth in luxury good consumption was far greater, and economists are predicting that China will become the largest consumer of luxury goods by 2015. In 2006 alone, jewelry expenditures grew by 22.3%, and gold consumption by approximately 17%. It’s also important to note that China’s growth is being led by the second and third tier cities (where the majority of Hang Fung’s growth will come), where GDP growth has been 2-3% above the national average.

 

 

Assuming full conversion of the Company’s remaining convertible debt, the Company has just under 1 billion fully diluted shares, representing an approximately 1.4 billion HKD market cap, and with approximately 800 million HKD of net debt, the Company has a 2.2 billion HKD enterprise value. If we ascribe a US$650 million per ounce of gold value for the exhibits and detach the associated 900 million HKD value from the enterprise value, then the remaining enterprise value is 1.3 billion HKD. In valuing the remaining business (everything except the exhibit halls), we first subtract out the exhibit hall operating performance from the fully consolidated performance. Although it is not broken out in the statements, the Company has inferred that the exhibit halls generated approximately 550 million HKD of revenue and mid single digit EBITDA margins (we assume 25 million HKD). Given that the Company’s FY 07 fully consolidated revenue and EBITDA were 3.1 billion HKD and 330 million HKD, respectively, we will assume that the remaining businesses (everything except for exhibit halls) generated approximately 2.55 billion HKD in revenue and 305 million HKD in EBITDA. Therefore, at an implied enterprise value of 1.2 billion HKD, the remaining businesses are being valued at 4.3x EBITDA. It is also worth noting that if we add the hidden asset value from the exhibits to the Company’s book value, then the Company has over 1.70 HKD per share in adjusted book value, and therefore at 1.45 HKD, the Company is trading for roughly 85% of its adjusted book value. Given that the majority of the Company’s assets are comprised of the exhibit halls (valued above), inventory (1.15 million HKD of book value, much of which is hedged), receivables (450 million of book value), and cash (250 million HKD), and that the cap ex component of their operating model is relatively minimal, we believe the stock is trading near its liquidation value.  

 

Beyond the trailing numbers and the current net asset value figures, we are also optimistic about the Company’s future performance. ROIC for company owned stores have averaged approximately 20%, and the return component has increased over time as same store sales have appreciated at an approximately 20% clip over the past few years. In the wholesale business (including sales to franchisees), ROIC has averaged approximately 15%, and this business stands to grow the most as the franchise network rapidly expands. Although the Company’s expansion targets may be a bit aggressive, the economics of the expansion are extremely compelling. Whether the store count targets are achieved by the end of calendar year 2008 or not, we believe that the Company will generate in excess of 4.5 billion HKD in revenue and over 500 million HKD of EBITDA once the targeted store expansion is complete. We also believe that the Company will be able to pay for most or all of this growth through existing free cash flow, and will additionally use exhibit hall sales to further de-lever their balance sheet. The chart below highlights historical operating performance as well as our expectations for 2008 and 2009 performance, assuming they achieve their targeted build-out goals, as well as 15% and 12% same store sales growth in 2008 and 2009, respectively.

(in MM of HKD)	Fiscal Year Ended March 31,
	2003A	2004A	2005A	2006A	2007A	2008E	2009E
Revenue	1700.9	2067.7	2566.8	2880.0	3127.0	3688.2	4667.4
Gross Profit	318.4	494.9	902.7	950.3	985.4	1161.8	1470.2
EBIT	60.3	84.4	135.3	171.3	239.2	313.5	443.4
EBITDA	167.2	193.5	256.8	283.3	333.6	405.7	536.8
EBDA (assuming 17.5% tax rate)	117.7	138.9	190.0	192.6	219.9	296.6	434.8
maintenance cap ex assumption (1% of sales)	17.0	20.7	25.7	28.8	31.3	36.9	46.7
FCFE	100.7	118.2	164.3	163.8	188.7	259.7	388.2
FCFE yield (FCFE / current market cap)	7.0%	8.2%	11.4%	11.4%	13.1%	18.0%	27.0%
Gross Margin	18.7%	23.9%	35.2%	33.0%	31.5%	31.5%	31.5%
EBIT Margin	3.5%	4.1%	5.3%	5.9%	7.6%	8.5%	9.5%
EBITDA Margin	9.8%	9.4%	10.0%	9.8%	10.7%	11.0%	11.5%
Store Count:
HK & Macau Stores	1	3	5	8	13	15	18
Mainland China Owned	23	23	52	59	70	100	109
Mainland China Franchised	5	12	26	25	40	99	191

 

 

 

Although we believe that the company trades well below peer group averages, as well as near current liquidation value, it is important to point out some of the risks / negatives that we see to our investment thesis:

• While the Company is well aware of their cheap valuation and has no plans for additional equity and/or convertible offerings, it is important to point out that Hang Fung has done a handful of raises at dilutive prices since going public, including a 240 million HKD convertible debt offering paying a 3% annual coupon and converting at 1.136 HKD.
• The Company’s expansion schedule is somewhat aggressive, and we wouldn’t be surprised to see some of the target store growth gets pushed off beyond the end of calendar 2008. Nevertheless, we are still compelled by the economics, and think that a slower than projected build-out might even be a blessing in disguise for their integration of new stores into the network.
• Given the decline in the exhibition hall economics in recent years, we question the Company’s decision to build the golden palace. Although the 4.5 tons of gold in the palace have appreciated from their cost basis of roughly US$525 per ounce, we believe the Company would have been better served to spend this capital towards expanding the retail or franchisee business, where the ROIC is significantly higher than exhibit hall investments.
• In April of 2007, a major Chinese TV network aired a report claiming that the Company was selling mis-represented jewelry in their exhibits, and the stock declined by over roughly 25% in the three following trading days.  The accusations were unfounded and were the result of a confusion in language by a customer that purchased a watch at one of the Company’s exhibit halls. Within two weeks of the incident, the Chinese TV station issued an apology, and explained the misunderstanding. Although the incident did not adversely affect their sales, and they were able to meet their sales targets for Golden Week, one of their busiest retail weeks that occurs in early May, the incident does highlight the Company’s reputational risk.
• There is risk associated with the price of gold.  Gold is the primary component of roughly 60% of the Company’s product, and also represents most of the value of the exhibit halls. If the price of gold declines significantly, the value of their exhibits will decline along with it.  However, they fully hedge the gold component of their inventory to limit their gold exposure and are planning on selling their exhibits in the coming years, so we are less concerned than we otherwise would be.
• The equity is not particularly liquid, and trades an average of ~4.5 million shares per day, which at today’s prices is approximately US$800,000 per day in average trading value.
• The company is closely held by insiders who own 37% of fully diluted shares, including the chairman and founder, who owns approximately 32% of the shares outstanding.

 

Hang Fung is incredibly well positioned to benefit from the growing consumption of gold and jewelry in the world’s largest emerging economy, a market where gold is the ultimate symbol of status. Given the current valuation, we believe patient investors will not only be afforded considerable downside protection, but could see multiples of upside in the coming years.  If we apply peer group EV / EBITDA multiples to Hang Fung, the stock has potential upside of more than twice the current price, without factoring in the substantial growth opportunities in their retail and franchisee segments.