Description

Company/Industry Overview

Luk Fook Holdings International Ltd. ("LF") is a leading jewelry company based in Hong Kong("HK").  The company owns 45 self-operated stores in HK and 10 in Macau, which account for the majority of the company's retail revenue.  In China, the company has 1,125 stores, of which 83 are self-operated and the rest licensed.  LF is vertically integrated and manufactures most of the gem-set jewelry for its self-operated stores as well as its licensees at a central processing facility in Guangzhou.

In the Greater China region (China plus HK and Taiwan), a very large portion of jewelry consumption is driven by annual events such as Chinese New Year, the Mid-Autumn festival as well as weddings, births and birthdays.  These events have significant cultural meaning and the use of jewelry as gifts has been going on for hundreds of years - this is consumer behavior that is just not going to change for the foreseeable future.  These cultural connotations also drive specific brand distinction with international brands such as Tiffany & Co. and as a result they are not directly competitive with the HK/Chinese jewelers.

Luk Fook (means "Six Fortunes") focuses on this "mass luxury" segment of the market, where unit prices range from $250 to $12,500 (USD).  This segment accounts for roughly 50-60% of the overall market in China, HK and Macau.  Alongside the two other leading HK retailers, Chow Tai Fook ("CTF") and Chow Sang Sang ("CSS"), the "Big Three" represent approximately half the HK market and roughly 15-20% in China.  The rest of the market is quite fragmented, made up of dozens of lesser brands and thousands of independent vendors (i.e. small "mom and pops").

Driven by rapid increase in disposable income, aggregate jewelry consumption in China (incl. HK) has grown rapidly in recent years to approximately $94 billion, with combined retail sales eclipsing the United States as the largest market in 2012 and more than doubling since 2007 (Source: Euromonitor).  After rising 20%+ per year from 2008 to 2013, per capita jewelry consumption has reached around $64 inChina.  This compares to $187/person in the United States and $171/person in Taiwan.

The seminal event for the HK jewelry market (as well as many other retail/luxury categories) was the introduction of the Individual Visa Scheme in 2003, which led to a sharp increase in tourists from mainland China.  Since 2003, the number of annual visitors from mainland China has increased over five-fold to around 41 million in 2013 and this figure continues to grow at a double-digit rate.

Investment Thesis - Summary

Luk Fook is a leading jewelry brand in China/HK.  It is the #2 player by size but the best operator out of the Big Three featuring industry leading long-term ROEs of well over 20%.  Its addressable market is still under-penetrated and growth will continue for the foreseeable future as disposable income rises as well as through the gradual consolidation of independent "mom and pop" vendors.   The stock currently trades at a very attractive multiple - I believe this is from a fundamental misunderstanding of its business model, lack of recognition for superior operating performance and recent selling pressure from a couple of the large foreign institutional shareholders.

(1) Underlying demand is stable with room for significant LT growth

• Historical top-line volatility driven by swings in gold prices masks stable underlying consumer demand from recurring celebrations like weddings, Chinese New Year and the Mid-Autumn Festival.
• Jewelry consumption in China is still low compared to developed countries and rising disposable income in China will continue to drive rapid growth for the foreseeable future.

(2) Long-term industry consolidation favors the Big Three

• The jewelry industry has been consolidating and this process favors established leaders such as LF.
• The Big Three have significant competitive advantages: established brands built over decades, vertically integrated operating models, centralized raw materials purchasing/hedging and pricing advantages.

(3) Superior operator with management team that is heavily aligned

• LF has maintained superior returns on capital and operating metrics compared to the Big Three (as well as less direct international comps such as Tiffany & Co.) while growing faster.
• First-generation founder/management team owns approximately 40% of the company and have maintained this level for the past decade.

 (4) Attractive absolute and relative valuation

• LF currently trades at <8x LTM P/E and <9x FY2015 estimated P/E.
• Despite superior operating performance, this represents a substantial discount to both CTF (15x LTM) and CSS (11x LTM), which I believe are also valued attractively.

Investment Thesis - Detailed

(1) Underlying consumer demand is stable with still room for significant long-term growth

LF is focused on the "mass luxury" jewelry segment, which is driven primarily by weddings and recurring annual events such as Chinese New Year's and the Mid Autumn Festival.  Gift-giving is a staple custom at many of these events across all socioeconomic strata and carries significant cultural meaning.  For example, gold is a symbol of wealth and prosperity in Chinese culture as well as other Asian cultures.  These demand drivers are about as stable and predictable as they come as habits/customs die hard.  There is very little risk here of technology obsolescence or rapid changes in consumer behavior/preferences.

Management estimates that 60-70% of LF's sales are wedding-related and noted that this percentage has been relatively stable through the years, even during the massive growth of the last 3-4 years.  Gold and jewelry products are an important component of gift-giving at Chinese weddings, particularly by close family members.  And once you receive a gift (say at your daughter's wedding), there is often pressure to "one up" and return the favor with an even better gift when you have a chance.  This dynamic in combination with fast-rising disposable incomes is recipe for continued rapid secular growth for the foreseeable future.

Diamond products are still relatively rare with <10% of women in mainland China owning one.  However, to the chagrin of many mainland China suitors, the diamond engagement is starting to catch on (as if purchasing a decent apartment wasn't already hard enough).  Note that it took Japan 15 years to go from nearly zero penetration to 60% (by the early 1980s) and today, 90% of Japanese married women have an engagement ring.  Today, only about one-fifth of retail revenue at a typical China store are for gem-set products, compared to two-fifths in a typical HK outlet.  This should shift over time and this will benefit jewellers because they make much higher margins on gem-set (LF: ~40% gross margin) vs. gold/platinum products (around ~12%).

China still remains under-penetrated.  In 2009, per capita spend on jewelry in China was less than 20% of developed economies like the United States and Taiwan.  Today, after five years of robust (20%+) growth, it remains less than 40%.  This catch-up dynamic should continue, especially as the country shifts from an investment to consumption-driven growth strategy.

(2) Long-term industry consolidation favors the Big Three

The Big Three dominate the HK market and are also the leading brands in the China market.  Outside of the Big Three there are dozens of smaller brands and hundreds to thousands of independent vendors (mostly small "mom and pop" businesses).

One reason the Big Three have seen great success in mainland China was because they enjoy certain advantages over Chinese counterparts (e.g. Lao Feng Xiang) and other competitors.  As HK is several decades ahead of mainland China in terms of development, the Big Three had a head start in brand-building.  And over multiple decades, they have built time-tested brands that represent trust and authenticity.

Another "home court advantage" is significantly lower prices for luxury goods in HK vs. mainland China due to a 15-20% VAT and consumption tax advantage.  As a result, mainland Chinese tourists often come to HK just to shop and can often more than cover the cost of their trip with their cost savings.  In addition, for many mainland Chinese tourists, HK is usually their first international experience and exposure to brands such as LF, and invariably considered superior to domestic jewellers.

The jewelry industry is gradually consolidating as smaller retail chains and independent vendors are phased out.  Independent vendors tend to be small family-run businesses, many of which often naturally phase out as the older generation retires.  Moreover, business is getting harder for the small "mom and pop" as attributes like brand, vertically integrated operations and the ability to manage gold price volatility.  With rental and labor costs rising (the two largest input costs after the cost of inventory), it has been difficult for these sub-scale independent businesses to cope.  Moreover, with the nearly 3x rise in gold prices over the last decade, running a jewelry business requires significantly more working capital to fund inventory.  As a result, many independent vendors are closing up shop, with quite a few of them joining ranks with LF as licensees.

We are seeing the consolidation trend play out in real-time.  In 2006, estimated HK market share of the Big Three was around 30-35% and today it is close to half - this is a process that has been going on for a while and should continue for the foreseeable future.  The Big Three have also grown market share in China proportionately.

Recently, LF acquired 50% of 3D-Gold, a struggling retailer with 400 retail outlets in China- another good example of the consolidation dynamics at play.  Already running at historically thinner margins than the Big Three, in recent years 3D-Gold had seen its profit margins shrink until it was barely breaking even at the gross profit level.  As a result, LF was able to acquire half of it for less than book value.  In addition to consulting fees, LF will replace 3D-Gold's supply chain, adding significant profitable wholesale revenue to the top line.

(3) Superior operator with management team that is heavily aligned

The company has a long track record of out-performance, generating superior returns on capital and growth compared to the Big Three as well as Tiffany & Co.:

Notes: CTF went public in 2011 and data prior to 2009 is not available. 2013 represents FYE 3/31/2014 for LF and CTF and FYE 1/31/2014 for Tiffany & Co.(and same for preceding years).  Return on Capital is calculated as EBIT *(1- 37.5%) / Total Capital.  With lower prevailing corporate tax rates for the HK retailers, this understates returns on capital for the Big Three relative to Tiffany & Co.

Source: Capital IQ

LF was founded by a group of experienced jewelry specialists in 1991 and the founding group currently owns around 40% of the company (up to 45% if you include directly held interests), a figure that has remained relatively the same since the IPO (in fact, the main shareholder vehicle has not sold any shares at all).  Unlike CTF and CSS (founded six decades before LF), this is a first-generation management team with a hard-nosed founder mentality.  The CEO/Chairman (and his family) have been recent buyers in the market, purchasing shares in the HK23-24 range in June/July after reporting year-end results.

Wage compensation is reasonable - the CEO/Chairman creates the vast majority of value for himself through dividends (which have increased from 6 HK cents per share 10 years ago to HK1.26 last year) and "look-through" earnings on his equity.  Very typical for HK family-run businesses, dividends scale up and down depending on income and cashflow generated as well as investment priorities.

In the last decade there have been two major equity financings, with the company raising HK$1.1 billion at HK23 per share in December 2010 and HK$1.4 billion in February 2012 at HK29 per share.  The proceeds were used to accelerate growth to take advantage of the rapidly increasing jewelry consumption by mainland Chinese.  Since then, both revenue and operating income have more than doubled and returns have remained excellent.  In addition, the company has grown faster than the Big Three and the overall market, suggesting that the dilution from those capital raises were value-enhancing capital allocation decisions.

One of the main ways that LF has been able to both grow faster and generate higher returns is by relying more on a license/franchise approach in high-growth China compared to CSS and CTF.  Around 93% of its Chinese retail network are licensed outlets.  LF supplies gem-set jewelry (accounted for under its "Wholesale Revenue" segment) to its retail licensees and provides back-office operational and marketing support.  The licensee funds the inventory requirement and focuses on retail operations.  As mentioned earlier, LF's licensing model draws many former independent vendors that have found running a sub-scale jewelry business to be too difficult.

(4) Attractive relative and absolute valuation...

Currently, LF trades at a 8x LTM P/E multiple compared to 11x for CSS and 15x for CTF.  Based on its superior operating profile and growth, I believe LF should be valued at a premium to CSS and closer to CTF's multiple.  I speculate that it has to do with the fact that CSS and CTF (both established more than 80 years ago) have been around much longer than LF (a relatively newbie established in 1991).  As prominent HK luxury brands, they are both more recognized than LF and perhaps attract a lot more interest from the local HK retail investors.  With its scale, CTF in particular gets a "market leader" premium even though its actual operational performance may not warrant it.  But while this historical discount has persisted over many years, we all know even the HK version of Mr. Market is a weighing machine over the long run.

My fair value calculation based on conservative growth assumptions (LT compounded ROE of 20% - well below historical rates; 15x P/exit E multiple) suggests a valuation in the mid to high HK40s, or 80-110% upside from current prices.

... So why is this so cheap?

Over the last five years, LF has increased revenue 5x and operating income by over 7x.  In its most recent fiscal year (FY2014), LF increased YoY revenue 43% and operating income by 52%.  Even the most conservative forecasts in the industry call for healthy long-term growth in Chinese jewelry consumption and LF continues to increase its market position and brand value every year.  Yet the company trades at an unleveraged P/E ratio of 8x.  So what is going on here?

Recent Negative SSSGs: One reason may be a string of "poor" SSSGs for the last couple of quarters.  In calendar Q1 2014 SSG was down 10% and Q2 2014, SSSGs were down by more than 50%.  Analyst reaction was negative and the share price reacted negatively and the stock price fell from the low 30s to the low 20s (as of today, it is HK24.40 per share).  However, I believe the negative reaction is not warranted as these SSSGs were coming off the back of extremely high SSSGs a year earlier (Q1 2013: 29% in HK and 14% in mainlandChina; Q2 2013: 86% in HK and 115% in mainlandChina).  These abnormally high SSSGs were a result of a "gold rush" by consumers after gold prices declined significantly in early 2013.  As the high base effect wears off, SSSGs should improve in the coming quarters.

Potential Effect of Anti-Corruption Drive: Another reason for negative sentiment is from potential negative effects of the ongoing anti-corruption drive inChina on luxury names.  While the anti-corruption drive is certainly affecting gift-giving practices inChina, I believe the impact on LF is relatively small compared to other luxury categories.  The vast majority of LF's sales are driven by the stable dynamic of gift-giving at recurring annual events such as weddings and Chinese New Year.  LF's management estimates that between 60-70% of LF's sales are wedding-related and noted that this percentage has been relatively stable through the years.

Tension Between Hong Kongers and Mainlanders: The escalating enmity against mainlanders by HK locals (e.g. Occupy Central) has started to impact mainland visitors in HK, which accounts for the majority of LF's retail revenue.  Mainland visitors to HK have increased significantly since they were allowed to travel on an individual basis in 2003, rising from 8.5 million that year to over 40 million in 2013.  The first half of the year has seen the growth slow somewhat, but I believe that there will continue to be healthy growth over the long-term.  Also, with over 1,100 outlets in mainlandChina (up from <200 eight years ago), LF can still serve mainland customers even if they stay away from HK.

Drop in the Gold Price: LF partially hedges its gold exposure and historically, the most consistently cited reason (by equity research analysts) for LF's valuation discount was the potential risk from a sudden decline in gold prices.  While declining gold prices have had some negative effect on LF's retail operations in mainlandChina, if anything LF has seen its overall margins and profitability improve even as gold prices fell from a peak in the $1,700s to the $1,300s today.  This is because LF turns over its inventory faster than its competitors - LF turns over its inventory very quickly (138 days for LF vs. 238 for CTF) and has franchised a higher proportion of its stores (less capital intensive approach; licensees pay for product on a cash-on-delivery basis).  As a result, I believe the sharp drop in gold price in 2013 disproportionately impacted smaller operators and independent vendors compared to LF.  This is evidenced by distressed situation at 3D-Gold which allowed LF to purchase it at less than book value.

Institutional Selling: Three large asset management firms (JPMorgan, Templeton Asset Management and Fidelity) reduced their positions from a combined ~23% shareholding to ~16% from February to June.  I have no special insight into the reasons for their sale other than the points I made above, but this was certainly a proximate factor in the decline in share price in the first half of the year.  I would note that Templeton purchased a large number of its shares at a cost basis below HK16 during the summer of 2012.

Overall, I believe that these are mainly short-term issues and the medium/long-term fundamentals of the business and the industry remain intact for LF and allows the long-term oriented investor to purchase shares at a very attractive valuation.

Summary Financials and Trading Metrics

Catalyst