Description

Disclaimer: for those not inclined to invest in the Chinese markets regardless of valuation, and/or those with much larger sums of money to deploy (stock has an Average Daily Traded Volume of < USD 2 million), please kindly move on.

Lao Feng Xiang (LFX) is a heritage jewelry retailer that has been in business for almost 180 years. Established in 1848, LFX trades on the Shanghai Stock Exchange in 2 different classes - the ‘traditional’ A shares, and B shares, which are known as Domestically Listed Foreign Investment shares. The domestic A shares trade at approximately 14-15x trailing twelve-month (TTM) earnings and 3% yield, whereas the B shares trade at a huge discount of around 5x TTM earnings and 7% yield. I believe that the investor today can purchase a fractional ownership in a business that has been growing at a low teens rate per annum, with attractive returns on capital, run by conservative management who has accumulated a net cash balance across the years, at a heavily discounted price. I believe such an opportunity is present primarily due to a lack of attention to the archaic B share class, which has generally received less investor attention compared to H shares, as well as somewhat more limited market access.

Brief history / background of LFX

LFX has its roots in Shanghai and was setup in the Qing Dynasty in 1848. It was taken over by the People’s Bank of China in 1952 but had to stop business in 1972 during the Chinese Cultural Revolution. After some name changes, the LFX name was restored in 1985. The China First Pencil Co. was listed in 1992 and became its controlling shareholder in 1998. In 2002, when the Shanghai Gold Exchange (SGE) was established, LFX became one of the first members of the SGE. 2012 was a milestone for them as they opened their first overseas store in Australia, having had rapid growth in the past decade to around CNY 25bn in sales by then. By 2013, LFX’s store count reached about 2,000, and this number rose to about 3,000 in 2017 (including franchised stores). Shanghai SASAC is now the largest shareholder in LFX.

The focus of LFX is on the classic/traditional gold jewelry space, different from its main competitor, Chow Tai Fook, which focuses more on trendy designs. LFX has been repositioning itself in recent years from the mass affluent market towards the mid/high end tier market.

LFX participated in the “Double Hundred Action” program in 2018 as part of the State-owned Assets Supervision and Administration Commission (SASAC) State Owned Enterprise (SOE) reform initiative to improve on accountability and profitability of the firm. In February 2024, LFX announced that their Board approved an initiative to establish a comprehensive professional manager system company-wide to further improve on profitability and growth metrics.

Landscape

Broadly, the Chinese jewelry market is heavily focused on gold products as gold plays an important role in Chinese culture. By retail sales value, the breakdown is approximately 60% gold, 20% jade, and 10% diamonds. These are approximate figures and are only meant to be used as a reference point.

These are the general market share figures around 2022, which are necessarily meant to be estimates. Reporting metrics are a bit different for each company.

Chow Tai Fook: 16%

LFX: 9%

Chow Tai Seng / Luk Fook: 5-10%

Chow Sang Sang: 3%

The combined market share of the top 5 players in markets like Japan is around 50+%, and the larger chains have been increasing their market share, signaling a further concentration in the future.

China’s jewelry retail industry had been weak due to the Covid lockdowns and general dampening of consumption. However, in the last couple of years, there has been a craze in a specific area in Shenzhen, Shuibei, which is a local jewelry wholesale market, partly due to short format videos on Douyin. Shuibei is an area in Luohu, Shenzhen. However, in 2023, things changed. The Shuibei format is essentially a bypassing of the middlemen through a B2C format, essentially bringing wholesale prices straight to retail customers. The industry players price jewelry based on weight and international gold prices, with the additional of a manual labor fee. The latter fee is much lower at Shuibei format stores. Big sized jewelry retailers sell roughly 50kg of gold per month, but some can sell around 2-300kg per month.

The Shuibei format development mainly went through 3 main phases:

Phase 1: just using Douyin and other short live video formats where influencers would buy based on their followers’ demand on a “back-to-back” basis.

Phase 2: after Lunar New Year, people started heading to Shuibei to make purchases themselves especially given the easing of Covid era lockdown restrictions.

Phase 3: The Shuibei format started to slowly spread to other cities/provinces.

A few factors contributed to the Shuibei development, with 1 of the key factors being the affordability of jewelry sold in these stores. Aside from that, there was also a tailwind where a delay in weddings from Covid period until around 2023 resulted in a rise in retail sales (you can see this in the increase in revenues for most players). Dowry in the Chinese culture is normally sold in the form of “3 gold” (necklace, earrings, rings), or up to “5 gold” (addition of bracelet and bangles).

The Shuibei development has certainly been a development to observe closely. However, in my opinion, the jewelry industry is in the business of trust. Gold / diamonds are commodities after all, and the reason why brands exist and thrive in the business is because the buyer needs to be able to trust that the retailer is selling exactly what they are marketing. Other factors like design etc would certainly come into play as well. This is why I believe the existing larger players are likely to continue seeing market share gains while smaller players could tend to lose further market share.  According to LFX management, during the AGM in Jun 2024, they claim they currently do not see the Shuibei format as a threat now, as there are regulatory issues around it which renders the sustainability of such stores questionable.  

Aside from the Shuibei development, there have been several other observations on consumer trends as well amongst the younger generation. According to a Chow Tai Fook consumer trends study, around 61% of surveyed consumers in Mainland China and Hong Kong wear pure gold jewelry as accessories (partly because of the value that gold jewelry is perceived to retain), 74% regard natural diamonds as more valuable compared to lab-grown diamonds, and 91% are likely to buy jewelry with elements of Chinese cultural heritage. This explains why retailers have been selling different designs with historical flavor (e.g. Chow Tai Fook’s HUA design with a touch of historical Tang Dynasty culture).

Source: CTF Corporate Presentation (ctfjewellerygroup.com)

Overall business of LFX and other retailers

LFX’s business segments are mainly divided into Gold and Silver Jewelry, Pencils, Handicraft and others. Each retailer segments their business a little differently.

Production facilities for LFX are in 3 places, Shanghai, Hainan and Dongguan. Like CTF, LFX counts amongst a small handful of jewelers who can handle the full value chain, i.e. from design to manufacturing to retailing. About 50% of their jewelry is self-manufactured, however, management stated in the 2024 AGM that this number can vary quite a fair bit, and there is no relation between the proportion of outsourcing vs their business volume, and that this mainly depends on the outsourcing capacity available at any point of time. In other words, they do not outsource more when business is better or vice-versa, there is no definite relationship between both factors, rather it depends more on whether it is more economically favorable to outsource or not.

Its main competitor CTF has a more diversified geographical footprint, being present in Southeast Asia as well, although both still have Hong Kong / Mainland China as their main markets. LFX’s management indicated in the 2024 AGM that they do have plans for international expansion, although their approach is likely to be done sustainably and slowly. In their 14^th 5-year plan, their original plan for 2021-2025 was to reach 100bn CNY in revenue (now around CNY 71.4bn). Although management has not outright mentioned it, they do admit that this plan was made prior to Covid, and their progress has certainly been slowed down because of the Covid lockdowns. Therefore, the CNY 100bn revenue is unlikely to be attainable by next year.

Focus on wholesale business and turnover

LFX’s gross margins are lower compared to the likes of CTF and CTS. 1 key reason behind this has been the focus on the jewelry wholesale/franchisee business, which is a generally lower margin business, as well as the product mix focus on gold (vs other business areas like Platinum, Gem Set etc. for CTF). The wholesale business is a ~10% GPM business while the retail margins are ~20% for retail vs Gem Set/Platinum and fixed price jewelry which can be a 50% GPM business. However, having franchisees allow them to grow faster as well as in a more asset light manner. LFX currently holds 4 procurement events on a yearly basis, where they sell to distributors / wholesale (i.e. franchisees).

Inventory turnover is roughly 3 months or 4x a year, compared to e.g. CTS which turns over once every 4 months.

CTF and CTF’s positioning belong to the mid/higher tier in pricing, while LFX is considered a more mid/mass market luxury product, though efforts are being made to change this now. LFX works on a lower margin but higher turnover basis, which explains why despite the substantially lower margins, LFX still has comparable returns on equity compared to CTS and CTF. This is also shown in the fact that their revenues are much larger (except vs CTF), as they are more focused on volume vs margin.

LFX now has closer to 6,000 stores but of which only ~3% are self-operated, while the other 90+% are franchised stores. This is a similar modus operandi compared to other similar jewelry retailers, but proportions are different e.g. CTF has about 63% franchised with the rest being self-operated, while CTS is also mostly franchised, with some self-operated ecommerce vs self operated offline.

Valuation of LFX B is not only at a discount to LFX A, but also to almost all of its peers

LFX A shares trade on the Shanghai Stock Exchange along with CTS, China National Gold, as well as CHJ, while CTF, CSS and LF trade on the Hong Kong Stock Exchange. LFX B shares are on the Shanghai Exchange as well but denominated in USD.

There are a total of 523,117,764 shares comprising of both A and B shares. At USD 3.66/share, this amounts to a market capitalization of USD 1,914,611,016 (~USD 1.9bn), or CNY 13,902,564,972 (CNY 13.9bn). LFX’s B shares not only trade at a substantial discount to its own A shares, but also at a discount to all its peers as well, except for Luk Fook. Given Luk Fook’s weaker market position compared to the rest of its peers, the valuation discount for Luk Fook appears at least slightly warranted. However, LFX’s market leading position within its peer group should reflect a premium in its valuation, which can be seen in its A shares valuation, but the B shares valuation appears unjustified and stands out. After considering its net cash position of about CNY 3.6bn (would be CNY 9.2bn if you do not consider the gold loans, which will be discussed later), the enterprise value of LFX B shares would be CNY 10.6bn. I believe the margin of safety to be substantial and cannot be simply explained away by the USDCNY FX risk of the shareholder.

Will this valuation change?

Despite the undervaluation, the important question is whether one would expect the undervaluation to be corrected eventually. At the 2024 AGM, the management did not address this explicitly, but did say that buyback and cancellation of B shares will change the shares composition, presumably referencing the proportion of foreign vs domestic shareholders. They are paying attention to the H shares market and might switch listing to Hong Kong at some stage so as to resolve the “problem” of the B shares. There would still potentially be a A-H share valuation difference as with the case for most Chinese companies, but in such a situation, the relisting could at least potentially narrow the valuation difference. However, even if this were not to happen, the investor today gets paid north of 7% yield to wait, and should the valuation simply remain at its current level, the investor should obtain a return equal to the rate at which its earnings would grow.

Capital allocation – conservative, but also utilization of gold lease

LFX is currently sitting on a net cash position, with cash of CNY 9,487mn, long-term borrowings of CNY 200mn, and short-term borrowings consisting of gold loans at CNY 5,623mn. These gold loans are used to finance working capital – when the jewelry is sold to retail, LFX purchases gold on the spot market, and then uses the gold purchased on the spot market to return the metal that is borrowed on the interbank market via a gold lease (uncollateralized). LFX hedges almost all their gold inventory and does not tend to run gold price risk. These gold loans should arguably not be considered part of gearing.

Gold lease rates have been borrowed at <2% rates currently. Gold leases are priced as a function of the gold curve vs the CNY curve. XAUCNY swaps are effectively the net interest rate differential between the cost to borrow XAU vs the cost to lend CNY. LFX borrows only the metal portion and not swaps.

Below is the XAUUSD curve on the interbank market on 19^th June 2024. These rates obviously will change over time (due to implied lease rates moving, USD rates moving etc), spreads will narrow or widen also, but the purpose is to illustrate the cost of gold leases for players like LFX and CTF.

Lease rates do not include credit charges (CVAFVA), these are uncollateralized loans. Prices will differ from bank to bank based on the internal credit ratings assigned to LFX etc.

On the dividend payout front, LFX currently pays out around 40%. Currently, management has stated they have no specific plans to increase this payout nor increase the mid-year payout. Their emphasis is on ensuring the dividend payout per share can be maintained / increased steadily over time.

Management has also stated there are open to acquisitions, but they do not have specific targets now.

Risks of LFX’s business

One of the key risks of LFX’s business is a potential shift in consumer sentiment. The Shuibei format has turned out to be a change in consumer behavior towards more affordable luxury products, which could impact higher-tier players like CTF less than LFX. However as aforementioned, LFX has been making efforts to slowly shift towards the higher-end tier of the market.

As most consumers do see gold as a form of investment, a drop in gold prices could potentially cause a souring of sentiment. Also, other changes in consumer sentiments could include switching in preference from Chinese cultural pieces to non-Chinese jewelry designs, although in the past few years, there has been a rise in “Guochao” where consumers have increasingly turned back towards traditional Chinese designs.

Catalyst

Rising earnings and increase in dividend payout

Conversion from B to H shares