Description

I am recommending the purchase of LJ International Inc. (symbol: JADE). The company is a wholesale supplier of precious and semi precious jewelry, which JADE crafts them self, to the U.S. retail market. JADE, with 2005 revenue of $94.6 million, supplies products to 21 of the largest 35 jewelry retailers, including the 5 largest, as measured by jewelry sales volume in the United States. (The five largest are Wal-mart, Zale Corp, Sterling Jewelers, QVC, and JC Penny) I believe JADE to be an inexpensive stock on the merits of its wholesale business alone, which currently represents 97% of company revenue. However, the company has growth potential unusual for the jewelry business which I believe will contribute significantly to company revenues, bottom line profits, and ultimately to the stock price. This growth potential arises from the company’s foray into the fast growing Chinese retail market with JADE’s high end retail jewelry concept called Enzo. Enzo’s roll out began at the end of 2004. Jade has opened 23 Enzo stores to date and will grow to 100 stores by the end of 2008. Management forecasts that company wide revenue will grow 50% by 2008 largely driven by Enzo. It is this combination of the deep value of the wholesale business combined with the unusual growth prospects of the Chinese retail business that makes JADE a compelling purchase at these levels.

The Bullet Point Summary
• JADE consists of wholesale business that has improving operational metrics and is growing faster than the industry while trading at a discount to its peer group. The true financials and corresponding value of the wholesale division are being masked by new investment the company is making in the fast growing Chinese retail market. The retail invest will generate strong growth and benefit the operating model over the next three years.
• JADE wholesale division has gained share by growing faster then the industry average and a comparable group. Top line has grown at over 20% while the industry grows at approximately 7%. The wholesale division has done this while increasing gross margins and increasing contribution to the bottom line.
• The company trades at lesser valuations on multiple of earnings (15.29x’s), book value (1.17x’s), and earnings yield (12%) than does the comparable group’s average. (averages of 21.4x’s, 2.60x’s, and 2.9% respectively)
• When the financials are adjusted to isolate the financials of the wholesale division, the multiples become more attractive and the operating model’s efficiency, as measured by ROIC, is exceptional.
• The Enzo retail business generates exposure to the fast growing Chinese retail market, which is growing at 3 times the rate of the U.S. jewelry market.
• JADE trades at a compelling valuation based on its core wholesale business. Additionally, true company fundamentals are being hidden by JADE’s growth vehicle that is exposing them to a Chinese retail market which is growing at three times the rate of the US retail jewelry market.

The Company Overview
The company has an operating history of over 20 years, has traded on the Nasdaq for 8 years, and is still run by its founder Lorenzo Yih. The company is head quartered in Hong Kong but the majority of its products are sold to U.S. retailers (72%). Though head quartered in Hong Kong, the company is traded on the Nasdaq small cap market as a foreign issuer. It is important to point out that the company has exceptional disclosure in its SEC filings with regard to the company’s operations. The 20-f provides a level of detail about its operations that is uncommon for domestic companies, let alone foreign issues. Additionally, the company provides quarterly results through 6-k filings even though as a foreign issuer, they are not required. Lastly, the management team is very accessible. So the combination of financial statement transparency combined with the accessible management team helps minimize the risk of an investment in a foreign issuer. Lastly, all accounting is done within the standards set forth by U.S. GAAP.

Wholesale Business Overview
The company employs a “mine-to-market” strategy where they source semi precious stones directly from the mines of Brazil, Africa, India, and China, craft the jewelry in their own production facilities in China, and sell product directly to customers globally without the use of middlemen. The company believes this vertical strategy provides a competitive advantage in pricing, efficiency, and lead times.
JADE produces rings, bracelets, necklaces, earrings and pendants featuring colored gemstones that are ultimately bought by a whole spectrum of consumers. They provide products to the mass market, with products retailing from $29.99 to $99.99, all the way up to the higher end Cartier and Chanel type products that retail for up to $5,000.
The wholesale customers are a “who’s who” of jewelry retailers. Their customers represent 32% of the domestic jewelry market and, as previously mentioned, they sell to 21 of the top 35 jewelry retailers in the U.S. Top customers include QVC, Sterling, Zales, and Walmart.
Currently the wholesale business represents 97% of company revenue. And as will be discussed below, this business alone trades at a compelling valuation.

Enzo Retail Business Overview
JADE entered the Chinese retail jewelry business at the end of 2004 when they opened their first Enzo retail store in Shanghai. The Enzo concept targets the high end jewelry market. JADE is attempting to take advantage of the fast growing Chinese retail market. The Chinese jewelry market is growing at a 19% yearly pace compared to estimated growth at U.S. retail of 6-7%. Currently, Jade runs 23 Enzo stores in 12 Chinese cities and plans to open 80 more over the next 3 years. As will be discussed below, there is much about the Enzo business model that is very attractive for JADE and their economics going forward.

The Valuation Play
In a nut shell, the reason I think there is compelling value in JADE is as follows: Comparable analysis shows that JADE’s business is inexpensive on an “as reported” basis and looks attractive on traditional value metrics such as ROIC, earnings yield, and price to book. However, the company becomes even more attractive if you peel away the costs associated with their entrée into the retail business which is currently masking the true fundamentals of the core business. Additionally, the ENZO business will make the company wide business model more attractive in 2 years and will generate both top and bottom line growth.
In doing comparable analysis, it is difficult to find companies that are exact comparables to JADE’s wholesale business. It is important to realize that the companies that I use as comps are largely retailers, not wholesalers. The reasons for this; there are no competitors to the wholesale business that are public. Wholesalers are usually private companies. A benefit of being a private wholesaler is customers are unable to see the company’s financials, and in turn, attempt to squeeze their gross margin. The comps I have used are retailers which have similar industry growth characteristics whose businesses are driven by the same end customer demand.
I will first show you how the company compares on an “as reported” basis. I will then adjust the numbers in a way that I believe more truly shows the economics of the wholesale business. I think JADE is attractively valued on an “as reported” basis, but becomes truly compelling on an adjusted basis. Each step of the way I will explain the adjustments I am making and describe the rational for each adjustment.
The comparable base that I have identified includes Finlay Enterprises (symbol: FNLY), Tiffany & Co (symbol: TIF), Birks & Mayors Inc (symbol: BMJ), Zale Corp (symbol: ZLC), Movado (symbol: MOV), and Lazare Kaplan (symbol: LKI).
Comparable Analysis as Reported
P/E(1) ROIC(2) Ern Yld(3) P:B(4) 03-04growth 04-05growth
JADE 15.29 16.14% 12.0% 1.17x 33.03% 22.27%
FNLY neg -12.6% -10% 1.00x -3.04% 2.35%
TIF 20.99 21.2% 7.7% 2.92x 14.43% 6.32%
BMJ 34.0 23.6% 3.1% 7.33x 31.30% 17.16%
ZLC 14.15 15.2% 4.9% 1.70x 6.58% 4.28%
MOV 22.05 16.8% 8.0% 2.01x 8.76% 24.88%
LKI 31.88 3.7% 3.6% .67% 12.35% 78.73%
(1) Price per share/earnings per share
(2) EBIT/ [(working assets-working liabilities-cash)+net fixed assets]
(3) EBIT/ Enterprise Value
(4) Market Value of Equity / Total Shareholders Equity

A quick overview of the above chart shows that JADE, as reported, is growing significantly faster than the comparable group over the last two years. JADE shows an about industry average ROIC but its valuation metrics are clearly at the low end of the group. I believe this discount is undeserved given the strong growth rates and the company’s history of strong execution and market share gains. Industry statistics indicate that the U.S. Jewelry market is growing at approximately 6-7%. The 20%+ growth rate of JADE indicates that they are gaining share. The share gains have occurred at customers such as Zale and Sterling where Jade’s sales grew at approximate 80% in 2005. Zale and Sterling are JADE’s largest two customers representing 11% and 13% of revenue in 2005. No other customer is over 10% of revenue.
I had previously mentioned that I think the “as reported” numbers do not fully reflect how good of a business JADE’s wholesale division is. I am now going to walk you though a few adjustments to JADE’s numbers that I think are necessary to better understand the true economics of the wholesale division. After the adjustments are made I will return to compare the adjusted ratios to the comparable set.

Adjusted Price/Earnings Multiple
In 2005 JADE reported fully diluted earnings per share of 24 cents. This equates to a price earnings ratio of 15.3x’s. This is an attractive ratio for a company that has grown its core top line at a 20%+ clip. However, the number becomes more attractive when you reverse out the necessary investment of the Enzo division. Since the Enzo division is in its infancy, it was a drag on earnings in the amount of 12 cents per share in 2005. Without the necessary ENZO investment and the costs necessary to ramp the retail business, JADE’s core wholesale business would have generated 36 cents in earnings. This adjusted EPS equates to a P/E of 10.2x’s; even more attractive.
So you have an understanding of how the adjusted numbers were derived, I will walk you through the necessary calculations in this paragraph. Please keeping mind that all numbers, except per share numbers, are in thousands. On a reported basis, JADE earned 24 cents in 2005 on $94,612 in total sales. Within these numbers the retail revenue of $2,501 is included. COGS at the retail level were $1,611 and operating costs were $2,649. If we back out the expenses related to the retail division the core business generated sales of $92,111 and generated a net profit of $5,197. (These numbers can all be harvested from the company’s 20-f filings or from corporate presentations.) This level of net income divided by the fully diluted shares of 14,322 equates to 36 cents of EPS. At this EPS level, the stock’s P/E is 10.2x’s. I believe this adjustment helps illustrate the earnings power of the wholesale business and helps show that the stock is significantly undervalued on a P/E basis compared to the above comp chart and JADE’s historic growth rate.

Adjusted ROIC
Similarly I think it is necessary to back out the retail division and take another look at the wholesale business’ ROIC. As reported, the company generates an ROIC of 16.14%. When I back out the “drag” on EBIT caused by ENZO the ROIC increases to 27.23%.

The adjusted ROIC is calculated as follows: As I mentioned above, the formula to calculate ROIC is EBIT/ [(working assets-working liabilities-cash)+net fixed assets]
EBIT as Reported = $5,026 Working Assets = $98,604
Working Liabilities = $63,050 Cash = $10,635
Net Fixed Assets = $6,221
When those numbers are plugged into the formula for ROIC, an as reported ratio of 16.14% is generated. But as I mentioned, I think to understand the dynamics of the wholesale division we need to back out the EBIT drag caused by ENZO. To do that, we need to adjust the EBIT as Follows:

$5,026 Reported EBIT (minus) -$1,759 EBIT generated at Enzo = $6,785 core wholesale EBIT.

Using $6,785 as our new numerator in the ROIC formula we arrive at the adjusted ROIC of 27.23%. However, I think there is a further adjustment necessary to truly analyze the core business. As part of the Enzo retail store roll out JADE was obviously required to take on inventory at each of their 20 stores (year end number). Therefore, I think I should back out the total retail inventory that is included in the “working assets” line in the ROIC calculation. The company has stated that they had $6 to $7 million of inventory in total at the 20 retail locations at the end of 2005. Since this is not inventory necessary to run the wholesale division, I think it is necessary to look at ROIC without its affects.
$98,604 working assets (minus) $6,500 Enzo inv = $92,104 Adjusted Working Assets
When I recalculate the adjusted ROIC using both the adjusted EBIT and the adjusted working assets I arrive at a new ROIC of 36.84%
I think these adjustments are necessary to get an understanding of the operating model of the core business. Once the onion is peeled it is easier to see that the core wholesale business is not only growing at a faster clip than the industry as a whole, but is in fact is a very good business that generates returns on capital significantly higher then its brethren in the jewelry market.

Adjusted Earnings Yield
I had previously mentioned how I thought the EBIT should be adjusted to best reflect the core business. This adjustment obviously has implications for the company’s earnings yield. As I previously said, earnings yield is calculated as follows:
Earnings Yield = EBIT/ Enterprise Value
Substituting the adjusted EBIT calculation (from above) for the reported EBIT increases the Earnings Yield from 12.0% to 15.86%. Looking at the adjusted metric, the company looks even more attractive.
Now that I have made the adjustments, I would like to revisit the comparable chart to inspect how the wholesale business might look as a stand alone entity.

Comparable Analysis (Adjusted)
P/E(1) ROIC(2 )Ern Yld(3)P:B(4) 03-04growth 04-05growth
JADE(adj) 10.2 36.84% 15.9% 1.17x 33.03% 22.27%
FNLY neg -12.6% -10% 1.00x -3.04% 2.35%
TIF 20.99 21.2% 7.7% 2.92x 14.43% 6.32%
BMJ 34.0 23.6% 3.1% 7.33x 31.30% 17.16%
ZLC 14.15 15.2% 4.9% 1.70x 6.58% 4.28%
MOV 22.05 16.8% 8.0% 2.01x 8.76% 24.88%
LKI 31.88 3.7% 3.6% 0.67x 12.35% 78.73%

When I look at the adjusted comparable analysis, the wholesale business looks even more compelling. The company is growing significantly faster than the industry as a whole and the members of the comp group. The ROIC suggests that the company is able to wisely spend their capital and generate above average returns, and importantly to this write up, the stock trades at a valuation significantly below the peer group.
Additionally, the company managed to increase their gross margin from 20.8% in 2004 to 23.2% in 2005.

Book Value Supporting the Price
The stock currently trades at a multiple of only 1.17x’s the value of the equity. The company has very little goodwill, so the valuation against tangible book is 1.21x’s. I believe this book value should support the price in a down side scenario. It is rare in my experience to find a company that has a high book value supporting the price and as high of an ROIC as JADE exhibits. I believe it speaks to the strength of the underlying business. I am encouraged that the company has been successfully executing for 20 years, has no long term debt, is growing faster then the market, has increasing gross margins AND has tangible book value underlying it to support the price; a value indeed.

The Growth Opportunity
Enzo Retail Division
So far in this recommendation I have largely removed the effects of Enzo on JADE’s financial statements. This is not meant to diminish the opportunity brought on by the retail division. In fact, the growth potential of the retail division is a major premise of my recommendation.
The retail division is addressing the Chinese jewelry market that is growing approximately 3 times faster than the U.S. market. Enzo stores will target the high end Chinese customer. China’s jewelry market has grown over 6 fold since 1991 and continues to grow at near a 20% rate. Additionally, the economics of the retail business are more attractive as measured by one important metric: Gross margin. The GM of the wholesale business was approximately 23% in 2005. The retail business currently has a gross margin of approximately 45% which management has guided to approximately 50% in the future. So, not only will the retail division provide top line growth that is hard to find in companies that trade at such compelling valuations, it will also improve the overall operating model through an increase in company wide gross margin.

Enzo Results to Date
To date, JADE has opened 23 Enzo stores in 12 Chinese cities. The first store was opened in Hong Kong (the only store not in mainland China) in March of 2004 and the second opened in Shanghai in November of 2004. These are the only two stores that have been open long enough to compare year over year sales trends. However, in both January and February of 2005 these two stores showed same store sales growth over 200% and are both profitable at the store level.
Investment in each store is moderate and early results show that the retail concept has traction. Each store requires approximately $150k to $200K of inventory and $50k of CapEx. In China the company is not required to sign long term leases, labor is inexpensive, and the CapEx is expensed in the same year that it is spent. Company wide, JADE spent approximately $800k on Enzo advertising in 2005 and expects to spend approximately $1 mm in 2006.
Currently, the 23 stores are contributing $700K per month to JADE’s top line and that number is growing quickly. At these run rates, even if JADE didn’t open another store in 2006, Enzo would generate $8.4mm to JADE’s top line. This would be a 235% year over year increase compared to the stores revenue contribution in 2005. In fact, the contribution will be higher than this as the monthly contribution continues to rise and JADE is going to continue to open stores. (As an important aside, I should mention that JADE management is guiding the Enzo business to be neutral to company wide EBITDA in 2006.)
Management has guided investors to an Enzo store count of 100 stores by 2008. The plan is to have approximately 40 at the end of 2006, 70 by the end of 2007, and the aforementioned 100 by the end of 2008. Management has indicated that they have the money to fund the store roll out through the end of 2006. At that time the company will require additional money to fund the continued roll out. The need to raise money could be a blessing in disguise for JADE. As is the way with Wall Street, with banking deals comes analyst coverage. This new coverage will cause more eyes to focus on the stock and more will see the value of the wholesale business and the growth potential of the retail business. Management has indicated to me that they have been speaking with investment houses that focus on small cap stocks for both potential financing and research coverage. To date, JADE has largely been a research orphan. The deal that is likely at the end of 2006 or the beginning of 2007 should change this.
Management of the retail division is equally strong. The Enzo retail business is being managed by 3 regional managers that have over 20 years experience in retail jewelry in China. This is particularly noteworthy because 20 years history is about the total history of capitalist China.

Guidance
Management has given long term 3 year guidance. They forecast JADE’s top line growth at over 50% over the next three years to a range of $155mm to $165mm. They expect bottom line to grow at approximately 100% over the next three years to an EPS level of 45 cents to 50 cents in 2008. By now you know my feeling. This is handsome growth for a company that has a history of execution, a strong track record, and trades at such a compelling valuation.

The Risks
Share Count Increase
A risk I have seen in this stock is that the fully diluted share count has substantially grown over the last three years. The share count has increased from 8.7mm in 2003 to 13.4mm in 2005. To date this has been almost exclusively the result of stock option performance incentive plans. Additionally, as I mentioned above, the company is going to need to raise money; most likely though an equity financing to fund the store roll out. Management is aware of the affects of dilution but has told me that they believe that the earnings benefit from the financing and the subsequent roll out will outweigh dilution. In other words, the bottom line opportunity that the retail business affords them will be greater the drag caused by an increased share count.

Working Capital
An inspection of the balance sheet from 2004 to 2005 reveals that inventory days increased from 218 days to 281 days. On the surface this could be a potential concern. However, this increase is partly the result of the retail channel fill for the Enzo division but more the result of an acquisition made by JADE in the beginning of 2005. JADE had previously owned 22% of the acquired company prior to acquiring the balance during 2005 for $2.8mm. In completing the acquisition, JADE switched from accounting for the company using the equity method to accounting using full consolidation as GAAP mandates. In doing so, JADE now shows the acquired company’s inventory of rough gem stones on its own balance sheet. This was inventory that JADE had access to prior, but was not required to put on its balance sheet. Additionally, the inventory consists of rough gem stones that are in no way perishable. I think these factors mitigate the risk brought on by the inventory increase.
Accounts Receivable days increased from 74 days to 96 days in the most recent 20-f filing. This was not related to the acquisition or to Enzo. The company has told me this simply the result of the timing of sales, and by January receivable days were back down to historic levels.

The Catalysts:
1 – Continued increased exposure into the fast growing Chinese retail market
2 – Potential new analyst coverage is likely because of the company’s stated need to do a financing at the end of 2006.
3 – Markets appreciation of the deep value at which the core wholesale business trades.

Conclusion
I believe JADE is a rare example of a company with a 20 year track record of performance, that trades at a deep value, that has an exciting growth “kicker” to its business model. With an investment in JADE you are getting a wholesale business that is gaining share with unusual growth in its own right and improving operational metrics. You also get a retail business that is entering China, one of the fastest growing economies in the world, which has shown good success during its short operating history. I think an investment in JADE has downside protection afforded by its tangible book value and a high likelihood of above average returns over the course of JADE’s retail rollout.

Catalyst

1 – Continued increased exposure into the fast growing Chinese retail market
2 – Potential new analyst coverage is likely because of the company’s stated need to do a financing at the end of 2006.
3 – Markets appreciation of the deep value at which the core wholesale business trades.