Chow Tai Fook Jewellery

CONSUMER DISCRETIONARY

Initiation on Jewelry and Watch Sector 20 April 2012

Watch this space Analysts Though the long-term outlook for China’s jewelry and watch industry is Forrest Chan, CFA unambiguously bright, 2012 is shaping up to be a year of normalized, gradual (852) 2532 6743 [email protected] growth. Year-to-date, share prices of Chow Tai Fook Jewellery (1929 HK) Claudia Ching and Luk Fook (590 HK) have corrected around 20% and underperformed the (852) 2532 2528 [email protected] market by 30%, reflecting investor concerns about a slowdown in sales. Timothy Sun While long-term value has emerged even on cautious 2012 same-store sales (852) 2532 6746 growth (SSSG) assumptions, near-term share price volatility and downside [email protected] persist as SSSG is likely to see another major leg down in 2HCY12, providing an opportunity for accumulation. We initiate coverage on both names with a Neutral rating. Despite their strong share price performance year-to-date, we favor watch retailers as we believe their sales will be more resilient and their valuations are attractive. We maintain our Outperform rating on Hengdeli (3389 HK) and initiate on Emperor Watch & Jewellery (887 HK), which we also rate Outperform.

Please read the analyst certification and other important disclosures on last page Initiation on Jewelry and Watch Sector 20 April 2012

Table of Contents

Watch this space...... 3

A year of slower growth...... 4

More resilient sales from the watch segment ...... 10

Finding the right valuation...... 12

Key investment risks ...... 18

Porter and SWOT analysis...... 22

Chow Tai Fook Jewellery (1929 HK) ...... 24

Emperor Watch & Jewellery (887 HK)...... 43

Hengdeli Holdings (3389 HK)...... 59

Luk Fook Holdings (590 HK) ...... 75

Appendix : Peer comparison ...... 92

Initiation on Jewelry and Watch Sector 20 April 2012

Initiation on Jewelry and Watch Sector

Watch this space

 A year of slower growth. Though the long-term outlook for CCBIS jewelry and watch universe China’s jewelry and watch industry is unambiguously bright, Share P/E (x) 2012 will be a year of normalized, slower growth as a result of the more challenging macro environment as well as Stock price TP CCBIS volatility of gold price. Company code (HK$)* (HK$) Rating† CY12F CY13F Chow Tai Fook 1929 HK 11.90 12.50 N 15.6 12.4  Long-term value has emerged in jewelers… Emperor 887 HK 1.20 1.40 O 9.4 7.2 Year-to-date, share prices of Chow Tai Fook (1929 HK) and Hengdeli 3389 HK 3.43 4.15 O 12.3 9.9 Luk Fook (590 HK) have corrected about 20% and Luk Fook 590 HK 20.90 21.80 N 9.5 8.1 underperformed the market by 30%, reflecting material † Ratings: O = Outperform; N = Neutral; U = Underperform investor concerns about a considerable sales slowdown in * Prices as at close on 18 April 2012; jewelry. Yet long-term value has emerged: Chow Tai Fook and Luk Fook trade on 12x and 8x CY13F P/E, respectively, even if we cautiously assume low-teen SSSG in FY13F (year-to-March 2013) and mid-teen SSSG in FY14F (year-to-March 2014), compared with 35%+ SSSG in FY12F (year-to-March 2012).  …but the worst is yet to come. Nevertheless, we expect share price volatility and/or downside to persist in the near term as SSSG is likely to see another major leg down into 2HCY12. The price of gold reached its high in September 2011 and has since entered a period of consolidation, ending its rally that began in late 2008. Gold price has risen 20% YoY since the beginning of 2011. CCBIS’ gold price forecast of US$1,850/oz, equivalent to an 18% rise in the annual average price, also implies less positive trends will be seen over the remainder of 2012 as compared with 2010 and 2011. The absence of a clear uptrend in gold price will cause a worse-than-expected slump in Chinese jeweler SSSG due to the correlation of gold price with both prices of gold jewelry products and volume demand for gold jewelry. Most critically, 3QCY12 is likely to be a quarter of year-on-year gold price decline.

 Accumulate Chow Tai Fook and Luk Fook in 2HCY12. We initiate coverage of both Chow Tai Fook and Luk Fook with a Neutral rating, and view 2HCY12 as the best opportunity to accumulate the stocks. Of the two, we consider Chow Tai Fook, Greater China’s largest and most recognized jeweler, as the best-quality proxy for the long-term boom in jewelry consumption in China.

 Favor Hengdeli (3389 HK) and Emperor Watch & Forrest Chan, CFA Jewellery (887 HK). We have a clear near-term preference (852) 2532 6743 for watch retailers despite their strong share price [email protected] performance year-to-date. Watch sales will remain resilient in the more challenging retail environment. We maintain our Claudia Ching Outperform rating on Hengdeli, China’s largest mid-to-high (852) 2532 2528 end watch retailer. We also initiate coverage on Emperor, a [email protected] leading Hong Kong-based retail name with an exceptional franchise carrying exclusive European-made ultra-luxury Timothy Sun watch labels. Valuations are undemanding, with Hengdeli (852) 2532 6746 and Emperor trading on 10x and 7x CY13F P/E, respectively. [email protected]

Initiation on Jewelry and Watch Sector 20 April 2012

A year of slower growth

Phenomenal growth in jewelry China’s jewelry and watch sales have exhibited unprecedented strength since 2009. and watch sales between 2009 The retail market in the country was buoyant and there was a gush of liquidity amidst and 2011 negative real interest rates which fueled demand for luxury items. Gold product sales saw the biggest increase as the undisrupted uptrend from 2009 to 2011 in gold price stimulated demand from consumers seeking wealth protection. Operators with substantial exposure to Hong Kong benefited materially as the influx of mainland tourists into the city brought about an exceptional surge in their business.

China retail sales – jewelry and watches vs. non-jewelry and watches (YoY)

60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% (5)% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Overall retail sales Jewelry and watch Non-jewelry and watch

Source: CEIC, CCBIS research

Hong Kong retail sales – jewelry and watches vs. non-jewelry and watches (YoY)

50%

40%

30%

20%

10%

(10)% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Overall retail sales Jewelry and watch Non-jewelry and watch

Source: CEIC, CCBIS research

Initiation on Jewelry and Watch Sector 20 April 2012

Swiss watch export value to Hong Kong

CHFm YoY 4,500 55% 4,086 47% 50% 4,000 45% 40% 3,500 3,186 35% 30% 3,000 25% 2,697 28% 25% 2,500 2,433 20% 16% 11% 2,168 1,946 15% 2,000 5% 1,768 10% 1,549 1,642 1,433 1,508 1,420 10% 5% 1,500 8% 3% 0% (5)% 1,000 (8)% (10)% 500 (15)% (20)% (20)% 0 (25)% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total sales value (LHS) Total sales value (RHS)

Source: Swiss Watch Federation

While many of the structural drivers of luxury consumption growth over the long run remain intact, the near-term outlook for jewelry and watch retailers has deteriorated as the latent impact of the economic slowdown and credit tightening is beginning to discourage big-ticket item purchases. Consumers are more reluctant to purchase gold jewelry now that the price of gold has begun to consolidate from its high of US$1,900/oz in September 2011 while China’s negative real interest rates have begun to narrow.

Long-term structural drivers Sales of Swiss watches per 1,000 people intact 10 Austria Italy

5 China Taiwan Spain UK Greece Germany Saudi Arabia Portugal Japan USA Australia 2 Belgium Holland Thailand Canada 1 Turkey South Korea Market penetration of Swiss watches in China Russia Mexico Sales of Swiss watches in is low and there is huge pieces growth potential 0.5 Malaysia China 2018: 0.59/’000 people

0.2 China 2013: 0.34/’000 people (Swiss watches worth Ukraine China 2008: 0.23/’000 people over RMB10K) 0.1 0 100 200 300 Source: Hengdeli, Bain & Company, Euromonitor, Watch Association of Switzerland

Initiation on Jewelry and Watch Sector 20 April 2012

China jewelry consumption Hong Kong jewelry consumption

RMB b HK$b 1,300 330 2010-2015F CAGR: 2010-2015F CAGR: 1,170 Gold products = 40% 300 Gold products = 40% 322 Platinum/karat gold products = 39% Platinum/karat gold products = 40% 100 1,040 270 Gem-set jewelry = 35% Gem-set jewelry = 38% 240 910 240 266 210 780 66 180 650 178 192 150 43 520 120 132 138 29 224 390 703 90 98 99 19 168 260 504 71 60 12 126 72 361 93 130 45 54 50 258 3 6 8 68 28 35 30 37 184 30 2 50 18 23 77 94 130 23 30 34 36 0 45 59 0 2006 2007 2008 2009 2010 2011F 2012F 2013F 2014F 2015F 2006 2007 2008 2009 2010 2011F 2012F 2013F 2014F 2015F Gold products Platinum/karat gold products Gem-set jewellery Hong Kong Macau Source: Frost & Sullivan Source: Frost & Sullivan

Further downside to jeweler We forecast a material slowdown in the SSSG of jewelry and watch retailers in 2012 in SSSG comparison with2011. We expect a more pronounced slowdown from jewelry operators. Our forecast is supported by empirical evidence: During the last two consolidation cycles in gold price (2006 and 2008), retail sales volume growth of jewelry and watches underperformed that of the overall Hong Kong market. Although there is no separate data available for jewelry, we believe the overall weakness was more attributable to reduced consumer appetite for jewelry products during the period.

Same-store sales growth (%) of listed jewelry or watch plays

Jan – Jun Jul – Sep Oct – Dec 2010 2011 2011 2011 2012F** 2013F** Chow Tai Fook – Hong Kong 32 Over 70s Over 70s c.30 12 16 Chow Tai Fook – China 35 Over 40s Over 40s c.30 10 15

Emperor – Hong Kong 49 36 c.30 c.30 16 21 Emperor – China 17 19 Teens teens high single digit high single digit

Luk Fook – Hong Kong 30 over 40s over 40s 27 10 12 Luk Fook – China 33 over 30s over 30s 35 13 15

Oriental Watch – group – – – >20 – –

Hengdeli – Hong Kong* 41 39 mid 20s mid 20s 24 19 Hengdeli – China* 38 46 mid 30s mid 20s 27 23 * Denotes total sales growth ** 2012F = FY13F, 2013F = FY14F for Chow Tai Fook and Luk Fook Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

China’s real interest rate trend

(2)%

(3)%

(5)% Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12

Source: Bloomberg, CEIC

Weak jewelry and watch sales in Retail sales volume growth of jewelry and watches vs. Hong Kong’s overall Hong Kong during the last two retail sales volume growth consolidations in gold price 50%

25%

(25)% Jan-Feb Jul-06 Dec-06 Jun-07 Nov-07 May-08 Oct-08 Apr-09 Sep-09 Mar-10 Aug-10 Jan-Feb Jul-11 Dec-11 2006 2011 Retail sales volume index Retail sales volume: jewelry, watches, clocks & valuable fift

Source: CEIC, CCBIS research

3QCY12 has the highest As shown in the following chart, gold price reached its high in September 2011 and comparison base for gold price has since entered a period of consolidation, ending its rally that began in late 2008. year-on-year trends The significance is that increased volatility in gold price is likely to result in contracted purchases of jewelry products, in our view. CCBIS’ gold price forecast of US$1,850/oz, equivalent to an 18% rise in annual average price, implies less positive trends will be seen over the remainder of 2012 compared with 2010 and 2011. The price of gold has risen 20% YoY since the beginning of 2011. Most critically, given that the price of gold peaked in September 2011 at US$1,900/oz, 3QCY11 is most likely to see a year-on-year decline in gold price.

Initiation on Jewelry and Watch Sector 20 April 2012

Gold price – consolidation

US$/oz 2,000

1,800

1,600

1,400

1,200

1,000

800

600

400

200 4-Jan-00 17-Jul-01 28-Jan-03 10-Aug-04 21-Feb-06 4-Sep-07 17-Mar-09 28-Sep-10 10-Apr-12

Source: Bloomberg, CCBIS research

Gold price Historical and forecast average annual gold price

US$/oz US$/oz 1,950 75% 2,200 36% 2,000 2,000 1,850 60% 1,800 30% 1,660 1,565 1,600 45% 1,400 1,227 1,370 24% 1,200 974 30% 1,000 872 18% 1,080 800 697 605 15% 600 410 445 364 12% 790 400 0% 200 0 6% 500 (15)%

3-Jan-06 1-Apr-07 27-Jun-08 23-Sep-09 20-Dec-10 17-Mar-12 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012F 2013F Gold price (LHS) YoY (RHS) Gold price (LHS) YoY (RHS) Source: Bloomberg Source: Bloomberg, CCBIS estimates

Slowing mainland tourist For companies with a large presence in Hong Kong, slowing mainland tourist arrivals spending in Hong Kong into the city could be another negative factor. After several years of high growth in the number of mainland tourists, we have begun to note a slight deceleration, which we attribute to the higher base and competition from other travel destinations.

Initiation on Jewelry and Watch Sector 20 April 2012

Mainland tourist arrivals into Hong Kong (YoY)

80%

70%

60%

50%

40%

30%

20%

10%

(10)%

(20)% Jan-Feb Sep-05 May-06 Dec-06 Aug-07 Apr-08 Nov-08 Jul-09 Mar-10 Oct-10 Jun-11 Jan-Feb 2005 2012

Source: CEIC

Initiation on Jewelry and Watch Sector 20 April 2012

More resilient sales from the watch segment

Demand for gold jewelry is In the current cycle we expect watch sales to be more resilient than jewelry sales. correlated with gold price trends, Consumer sentiment has soured because of eroding macro conditions. Demand for in our view gold jewelry in volume terms is likely to be dented by much slower rises in gold price than what was seen in 2009-2011. Meanwhile, increases in product prices will be considerably lower than in past years due to less favorable gold price trends. Worsening consumer sentiment and the absence of a clear uptrend in gold price is a double whammy jewelry retailers are hoping to avoid.

The crux of our argument is that demand for gold products is positively correlated with the medium-to-long-term gold price expectations of consumers. We base our claim on the premise that gold jewelry is no ordinary discretionary consumer product in the eyes of Chinese consumers and as a result, purchase patterns pertaining to gold jewelry do not fit those of other discretionary consumer goods. The following features of gold jewelry explain why it is treated differently than other goods.

 An accessory. In its role as a decorative accessory, gold jewelry can be considered a normal luxury good. Like many other luxury products, gold jewelry serves the cultural function of signaling wealth and social status. In this respect, there is a long-term, structural growth component to the demand for gold jewelry. As the disposable income of Chinese consumers grows, so too does their desire to own luxury items to communicate their wealth and social standing. This long-term trend aside, in the short term, gold demand will fluctuate according to China’s general macro health in the same way that other luxury goods tend to do.

Event-driven demand is  Event-driven demand. Gold holds considerable symbolic meaning in many adjustable cultures, including the Chinese culture. It is often presented as a gift on various Chinese ceremonial occasions and festive events, including Chinese New Year, birthday celebrations, the arrival of a newborn and most notably, at weddings. Frost & Sullivan estimates that over 12m marriages were registered in China in 2010, a year when over 30% of the Chinese population was at the marriageable age of 20 to 39. In spite of the global financial crisis, the number of marriage registrations continued to increase at a CAGR of 9.8% from 2007 to 2009. Looking ahead, the number is forecasted to grow at a CAGR of 9.2% between 2010 and 2015. While such event-driven demand is usually steady over the long run and less affected by short-term changes in the economy, what is often overlooked is that consumers sometimes adjust their purchases according to their expectations of medium-term gold price movements. When consumers anticipate downside to current gold prices or else are uncertain about gold price trends, they tend to defer their purchases. Vice versa, purchases may take place earlier when consumers believe that the price of gold will continue to rise. A common counter argument to this purchasing behavior is that jewelers often see short-term increases in sales volume when gold prices begin to retreat or fluctuate. In our view, such a scenario is usually driven by purchases by consumers who look upon near-term dips as an opportunity to accumulate gold ornaments on the grounds that their gold price uptrend expectations in the medium-to-long term remain unchanged. However, event-driven demand can be delayed in periods when consumers become less certain about what direction the price of gold price is taking in the medium term.

Initiation on Jewelry and Watch Sector 20 April 2012

Number of marriages in Hong Kong

'000 70 14% 10.5% 10.5% 12% 58 58 60 7.7% 10% 52 52 50 51 51 51 8% 47 47 47 47 50 2.8% 6% 7.7% 4% (0.3)% 40 (0.3)% 2.8% 2% 0% 30 (2)% (4)% (7.0)% 20 (6)% (5.7)% (8)% 10 (10)% (12)% (11.9)% 0 (14)% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 No. of marriages (LHS) YoY (RHS)

Source: CEIC

Gold jewelry provides a tangible  Wealth protection. In our view, the market has failed to fully appreciate the way to preserve wealth importance of gold jewelry as a store of wealth and therefore underestimated its importance as an element in the extraordinary sales growth of gold jewelry in China between 2009 and 2011. To many Chinese consumers, gold jewelry products provide them with a tangible way to preserve wealth while at the same time serving the cultural functions of providing decoration and displaying wealth. Indeed, one can easily draw an analogy between the many ways Chinese value jewelry and the pragmatic and sentimental value they attribute to real estate as both a residence and as a means of preserving and transferring wealth across generations. This goes a long way to explaining why the dire condition of the Chinese property market (and to a lesser extent, the stock market) is behind the shift in wealth-protection demand to gold-related products, including direct holdings of gold and purchases of pure gold jewelry. It follows naturally that such wealth-protection demand is, again, correlated with expectations of medium-to-long-term gold price movements versus those of the property and stock markets. Similar to the aforementioned event-driven demand, near-term demand could contract when gold price trends become unclear.

Initiation on Jewelry and Watch Sector 20 April 2012

Finding the right valuation

Peer comparison is our primary Except Chow Tai Fook, companies we analyze in this report have a reasonably long valuation metric history as public companies, but the watch and jewelry space has become liquid and investible only since 2010, thanks to valuation and earnings expansion of listed watch and jewelry players. The listing of Chow Tai Fook in Hong Kong also put this segment under the spotlight.

When determining the fair valuation of watch and jewelry companies, historical valuations may not be the best reference given the many structural changes that have taken place in the industry, the impact of mainland spending on Hong Kong retail sales being the most critical.

We do not resort to the discounted cash flow (DCF) model as most investors converse in P/E terms and the results from the DCF methodology can change materially even with only small changes in assumptions. This leaves us with peer comparison as the most reliable primary valuation metric. In valuing the companies in our China watch and jewelry universe, we take into account the following factors.

Cyclicality and near-term earnings momentum

Momentum weakens in 2012 Our analysis has already indicated that watch and jewelry demand faces greater cyclicality than ordinary discretionary items due to the “big ticket” prices involved and correlation with commodity prices and the changing need of Chinese consumers to protect their wealth depending on macro economic environment. We project 2012 to be a challenging year for watch and jewelry retailers as we forecast much slower gold price movement and a mixed macro outlook that will affect consumer sentiment and lead to much slower SSSG. Earnings momentum will, in turn, be significantly weakened, possibly capping valuations for the entire segment.

Revenue growth (YoY) Earnings growth (YoY)

65% 105% 96 59 93 84 5352 52% 50 46 70% 6566 63 43 43 52 39 38 4749 39% 36 30 31 32 35% 27 24 232321 21 2123 20 25 24 24 25 24 26% 21 13 14 2019 19 16 16 0% 13% (1) 7 (16) (21) 0% (35)% 2009 2010 2011 2012F 2013F 2014F 2009 2010 2011 2012F 2013F 2014F Chow Tai Fook Emperor Hengdeli Luk Fook Chow Tai Fook Emperor Hengdeli Luk Fook Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data, CCBIS estimates Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Comparison with Chinese specialty and branded retailers

Different consumption patterns Throughout this report we have repeatedly argued that the “big ticket” nature of watch and jewelry sales makes them inherently more volatile than those of other discretionary consumer items, such as apparel and footwear. Wealth-protection needs play a significant role in creating demand for jewelry and, hence, complicate the nature of purchases. Jewelry sales are additionally correlated with gold price trends. More importantly, working capital requirements are extremely demanding in watch and jewelry retailing.

In conclusion, watch and jewelry retailers have a riskier business model and generally deserve to trade at a discount to specialty and branded retailers selling ordinary discretionary items through a comparable business franchise, other factors being equal. Chow Tai Fook and Hengdeli are widely recognized national leaders in their respective sub-segments and we therefore benchmark their fair valuations at a discount to Belle (1880 HK, Outperform).

Comparison with department stores

Premium valuations justified for Despite the vastly different business models of department store operators and watch department store operators and jewelry retailers, an accurate valuation of the latter should include a comparison with department stores because department stores remain among the best representations of China’s structural consumption growth, barring the growing challenges from oversupply within the retail space and alternative retail formats, such as online shopping. In our view, department stores are a balanced and diversified proxy for China’s mid-to-high-end discretionary consumption, whereas watch and jewelry purchases mainly reflect sentiment towards luxury consumption and prevailing wealth protection needs of Chinese consumers. Department stores, in theory, also have greater sales resilience and more favorable working capital requirements than jewelry and watch retailers. On a positive note, the degree of industry consolidation is higher for watch and jewelry retailing where leading operators enjoy strong market positioning and substantial market share at the national level. We therefore believe the best-quality watch and jewelry retailers deserve a small discount to department store operators.

Watch versus jewelry retailers

Jewelry retailers deserve a Watch retailers are focused mainly on distributing Swiss watch labels and do not have premium their own watch brands, while branded jewelry retailers are engaged in brand management, raw material sourcing, product design, production and distribution. A lack of brand ownership and pricing flexibility implies watch retailers rely heavily on differentiated merchandizing to compete, although at times strong relationships with selected suppliers can prove to be a crucial competitive advantage. The extent of involvement in the value chain will result in different valuations. As established earlier, jewelry demand is sensitive to gold price movements while watch demand is not. Yet, demand for luxury watches and jewelry share some similarities. For example, they both represent luxury consumption that also meets the wealth protection needs of consumers. Overall, we believe the watch retailing business deserves a small valuation discount versus branded jewelry retailing.

Initiation on Jewelry and Watch Sector 20 April 2012

Comparison with global watch and jewelry companies

Comparable global peers include some of the most widely internationally recognized luxury labels that come with long and distinguished histories. They are not single-market players and their diversified geographic exposure provides them with a stable yet generally slower growth profiles than those of China-focused operators. The Chinese market offers strong, structural long-term growth potential, albeit with significantly higher volatility as Chinese consumer sentiment swings with consumer investment needs and views on commodity prices – a feature of the Chinese watch and jewelry market that is not found elsewhere in the world. Despite their less attractive growth prospects, we believe global luxury watch and jewelry companies deserve a valuation premium over their Chinese counterparts to reflect their stronger brand equity.

Leader premium

Within the same sub-segment, it is clear that the leader defined as having higher market share and larger scale should trade at a premium to its smaller, niche competitors. In deciding appropriate valuation discounts for Emperor and Luk Fook to Hengdeli and Chow Tai Fook, respectively, we refer to the trading history of Belle versus Daphne (210 HK, Not Rated). Daphne has been trading at an average discount of 32% to Belle since Belle was listed in 2007. The historical average discount of Emperor to Hengdeli is larger at 46%.

P/E trends of Belle vs. Daphne P/E trends of Hengdeli vs. Emperor

48x 64% 29x 72% 60% 44x 56% 64% 52% 40x 24x 56% 48% 36x 44% 48% 32x 40% Average discount = 46% 19x 40% Average discount = 32% 36% 28x 32% 32% 28% 24x 24% 14x 24% 20x 20% 16% 16x 16% 12% 9x 8% 12x 8% 4% 8x 0% 0% 4x (4)% 4x (8)% May-07 May-08 May-09 Apr-10 Apr-11 Apr-12 Jan-09 Feb-10 Mar-11 Apr-12 Daphne (LHS) Belle (LHS) Daphne's P/E discount to Belle (RHS) Emperor Hengdeli Emperor's P/E discount to Hengdeli Source: Bloomberg, CCBIS estimates Source: Bloomberg, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Stock recommendations

The following table summarizes our target valuations for the listed jewelry and watch retailers covered in this report.

CCBI jewelry and watch universe

Target Implied share price Implied target Stock Share price price* CY12F EPS CY13F EPS upside P/E (x) P/E (x) Company code (HK$) (HK$) (YoY, %) (YoY, %) CCBIS rating (%) CY12F CY13F CY12F CY13F Chow Tai Fook 1929 HK 11.90 12.50 32 26 Neutral (initiation) 5 15.6 12.4 16.4 13.0 Emperor 887 HK 1.20 1.40 31 32 Outperform (initiation) 17 9.4 7.2 11.0 8.4 Hengdeli 3389 HK 3.43 4.15 21 21 Outperform (maintained) 21 12.3 9.9 14.9 12.0 Luk Fook 590 HK 20.90 21.80 3 17 Neutral (initiation) 4 9.5 8.1 9.9 8.5 * Price as at close on 18 April 2012 Source: CCBIS estimates

Justifications for our valuations are as follows:

 We value Chow Tai Fook at 13.0x CY13F earnings, compared with current CY13F P/E of 16.7x for Golden Eagle (3308 HK, Not Rated), 17.7x for Belle and 12.6x for Parkson (3368 HK, Not Rated). The discount of Chow Tai Fook to Golden Eagle and Belle that we assign echoes our earlier conclusion that watch and jewelry retailers generally deserve to trade at a discount to specialty and branded retailers as well as department store operators with comparable business franchises. We also hold the view that non-jewelry specialty retailers and department store operators are beginning to see a sales recovery that gives them stronger near-term revenue and earnings momentum than Chow Tai Fook.

 Our target CY13F P/E for Luk Fook is 8.5x, implying a 35% discount to our target for Chow Tai Fook. It was set after consulting the historical trading history of Belle and Daphne which revealed an average discount of 32%. Chow Tai Fook’s earnings outlook is also stronger than that of Luk Fook thanks to Chow Tai Fook’s active gold price hedging activities which have availed it of better gross margin stability during the recent period of gold price volatility. We project a 23% rise in Chow Tai Fook’s FY13F (year-to-March) earnings, and a 1% decline for Luk Fook.

 Hengdeli is valued at 12x CY13F P/E versus 13x CY12F P/E previously. As established earlier, we believe a valuation discount is justified for watch retailers versus jewelry retailers to reflect the lack of brand ownership of watch retailers. When we compare Hengdeli and Chow Tai Fook, the discount should not be material since Chow Tai Fook is forecast to see greater earnings deceleration in CY12F as a result of the decline in SSSG.

 Our target for Emperor is pegged at 8.4x, equivalent to a 30% discount to our target for Hengdeli and an average discount of 46% in the past. We anticipate the valuation discount between the two companies will narrow over time as Emperor continues to build its business franchise and lengthens its track record as a listed company.

Initiation on Jewelry and Watch Sector 20 April 2012

Valuation summary

Share price Market cap 3M average value traded EPS growth (%)# P/E (x) PE/G (x) Yield (%) P/B (x) ROAE (%) Net cash/ Net Company Stock code (local currency)† (US$m) (US$m) CY12 CY13 CY12 CY13 CY12 CY12 CY12 CY12 share (%) gearing (%) Jewelry and watch retailers Chow Tai Fook* 1929 HK 11.90 15,271 19 32 26 15.6 12.4 0.5 1.9 3.5 26.8 5 Net cash Hengdeli* 3389 HK 3.43 1,829 6 22 24 11.6 9.4 0.5 3.0 2.3 18.1 Net debt 6 Chow Sang Sang 116 HK 19.76 1,722 3 19 19 10.3 8.6 0.5 3.4 1.8 17.9 Net debt 27 Luk Fook* 590 HK 20.90 1,585 20 3 16 9.5 8.1 3.7 4.4 1.9 22.1 17 Net cash Emperor Watch* 887 HK 1.20 1,038 6 31 31 9.4 7.2 0.3 3.0 1.8 18.7 6 Net cash Oriental Watch 398 HK 3.40 250 2 15 14 5.8 5.1 0.4 4.3 3.8 15.2 15 Net cash Average 20 22 10.4 8.5 1.0 3.3 2.5 19.8

Department stores Golden Eagle 3308 HK 19.70 4,923 10 20 28 21.4 16.7 0.6 1.4 5.7 28.2 7 Net cash Parkson 3368 HK 8.62 3,119 8 15 20 15.2 12.6 0.6 2.9 3.2 22.7 13 Net cash Intime Dept Store 1833 HK 9.59 2,462 8 17 19 15.4 13.0 0.7 2.6 2.2 14.6 Net debt 32 Springland* 1700 HK 5.51 1,774 1 24 22 15.5 12.7 0.6 2.9 2.4 16.5 11 Net cash Maoye 848 HK 1.83 1,265 4 13 27 11.0 8.7 0.3 3.1 1.2 13.3 Net debt 38 NWDS 825 HK 5.24 1,138 1 (10) 15 13.1 11.4 0.8 3.0 3.0 11.5 47 Net cash PCD Stores 331 HK 0.99 539 3 21 28 8.9 7.0 0.3 3.8 1.3 15.1 9 Net cash Shirble Dept Stores 312 HK 0.72 231 2 16 18 5.8 4.9 0.3 5.5 0.8 15.1 125 Net cash Average 14 22 13.3 10.9 0.5 3.1 2.5 17.1

Sportswear brands ANTA* 2020 HK 7.85 2,521 8 (7) 7 9.9 9.2 NA 6.4 2.3 23.9 28 Net cash Li Ning* 2331 HK 7.89 1,073 7 9 100 16.0 8.0 1.9 1.9 1.7 11.4 6 Net cash Xtep* 1368 HK 3.58 1,003 1 2 7 6.4 6.0 2.9 7.8 1.4 23.4 33 Net cash China Dongxiang* 3818 HK 1.00 726 4 66 64 8.1 4.9 0.1 8.7 0.6 8.0 106 Net cash 361 Degrees* 1361 HK 2.29 610 3 (29) 6 4.8 4.5 NA 8.4 0.8 17.6 13 Net cash Peak* 1968 HK 1.86 502 2 (33) 16 6.1 5.3 NA 4.9 0.7 12.3 78 Net cash Average 1 33 8.5 6.3 1.6 6.3 1.3 16.1 (continued on next page)

Initiation on Jewelry and Watch Sector 20 April 2012

Valuation summary (continued from previous page)

Share price Market cap 3M average value traded EPS growth (%)# P/E (x) PE/G (x) Yield (%) P/B (x) ROAE (%) Net cash/ Net Company Stock code (local currency)† (US$m) (US$m) CY12 CY13 CY12 CY13 CY12 CY12 CY12 CY12 share (%) gearing (%) Supermarkets Sun Art Retail 6808 HK 10.08 12,381 10 28 27 31.9 25.2 0.9 1.1 4.9 15.5 9 Net cash CRE 291 HK 28.05 8,666 17 (1) 21 24.0 19.9 1.0 1.9 1.9 8.1 4 Net cash Wumart 1025 HK 16.96 2,798 2 35 21 22.1 18.2 0.9 2.0 4.5 21.6 6 Net cash Lianhua 980 HK 8.24 1,188 4 12 5 10.6 10.1 1.9 3.2 2.0 18.6 94 Net cash Beijing Jingkelong 814 HK 6.97 370 0 15 23 9.6 7.8 0.3 4.2 1.3 13.5 Net debt 97 Average 18 19 19.7 16.2 1.0 2.5 2.9 15.5

HK retailers Lifestyle 1212 HK 18.92 4,066 5 4 16 16.1 13.9 0.9 2.5 3.3 21.7 6 Net cash Sa Sa* 178 HK 4.72 1,711 4 22 20 18.1 15.2 0.8 5.5 7.8 45.8 5 Net cash Texwinca 321 HK 9.45 1,656 2 10 14 9.9 8.6 0.6 6.3 9.1 22.6 Net debt 3 Giordano 709 HK 6.26 1,232 3 13 14 11.5 10.1 0.7 6.7 3.2 29.5 13 Net cash I.T* 999 HK 4.38 693 2 20 29 9.7 7.5 0.5 3.6 2.0 18.2 9 4 Bonjour* 653 HK 1.13 438 1 25 27 11.3 8.9 0.5 7.2 9.9 93.4 8 Net cash Average 16 20 12.8 10.7 0.7 5.3 5.9 38.5

China specialty retailers / other brands Belle* 1880 HK 14.96 16,246 36 11 21 21.6 17.8 1.9 1.4 4.4 22.3 Net debt 20 Gome* 493 HK 1.59 3,455 50 (24) 47 15.4 10.5 NA 2.0 1.3 8.5 18 Net cash Bosideng 3998 HK 2.28 2,351 4 11 13 9.4 8.3 0.6 8.3 8.2 21.0 25 Net cash Daphne 210 HK 10.98 2,329 7 21 22 16.0 13.1 0.6 1.9 3.8 25.7 7 Net cash Trinity* 891 HK 6.67 1,470 4 23 23 17.9 14.6 0.8 4.0 3.3 19.1 4 Net cash Lilang* 1234 HK 7.19 1,112 2 17 18 9.6 8.1 0.6 6.1 2.8 30.9 18 Net cash Ports 589 HK 11.40 835 2 14 22 10.0 8.2 0.4 6.0 2.5 26.6 3 Net cash Pou Sheng 3813 HK 0.88 483 0 7 30 8.5 6.6 0.2 NA 0.7 6.0 1 Net cash Evergreen 238 HK 2.24 274 1 18 22 7.8 6.4 0.3 6.5 1.1 14.5 66 Net cash Sparkle Roll* 970 HK 0.70 269 1 32 27 6.2 4.9 0.2 3.2 1.2 19.6 14 Net cash Huiyin 1280 HK 0.49 65 2 236 23 7.8 6.4 0.3 NA 0.4 5.0 Net debt 34 Average 33 24 11.8 9.5 0.6 4.4 2.7 18.1 † Prices as at close on 18 April 2012; # Calculated in Hong Kong dollar terms; * Denotes CCBIS estimates Source: Bloomberg, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Key investment risks

Macro risk

A macro-driven segment High-end consumption is often sensitive to short-term fluctuations in macro conditions and, hence, shows greater volatility than mass-market or low-end consumption. During retail slowdowns due to macro-economic changes, it is not uncommon to see a decline in big-ticket item purchases. Such correlation is due to the discretionary nature of big-ticket consumption. In the case of jewelry retailers, as repeatedly elaborated, their sales are additionally correlated with gold price trends which drive ASP as well as sales volume.

Competition risk

Limited differentiation The jewelry retail market in both Hong Kong and China is generally fragmented and competitive. According to Frost & Sullivan, Chow Tai Fook, the No. 1 jeweler in China, had 12.6% market share in 2010. In the same year, the top-five jewelry brands collectively commanded 42.0% market share. In Hong Kong, Chow Tai Fook dominated the market with 20.1% share in 2010, and together with the No. 2-4 players, had a combined market share of 42.8%. Although major players are expected to increase their market share going forward leading to higher industry concentration, we believe competition will remain intense. Key areas of competition include brand reputation, product offerings, product design, marketing, in-store service, and store network (in terms of number of stores and store locations). Watch retailers, on the other hand, face a slightly different form of competition insofar as they compete mainly on brand portfolio and product offerings rather than product design. Overall, competition is most keen in the jewelry arena, as brand and product differentiation is limited.

POS for Chow Tai Fook POS for Emperor

2,600 150 2,378 2,400 110 124 2,200 2,123 106 120 2,000 1,879 110 100 33 1,800 1,620 95 31 1,600 92 90 1,361 80 1,400 28 1,183 84 1,200 61 23 965 85 2,268 1,000 2,017 60 821 70 1,779 40 21 800 69 1,528 91 79 600 1,277 67 1,098 30 16 895 19 57 400 752 40 200 15 24 0 0 4 FY08 FY09 FY10 FY11 FY12F FY13F FY14F FY15F FY08 FY09 FY10 FY11 FY12F FY13F FY14F China POS Hong Kong POS China POS Hong Kong & Macau POS Source: Chow Tai Fook, CCBIS estimates Source: Emperor, CCBIS estimates Note: Year to March

Initiation on Jewelry and Watch Sector 20 April 2012

POS for Hengdeli POS for Luk Fook

640 1,300 1,163 539 1,170 560 1,045 47 496 82 1,040 46 480 453 927 79 405 910 817 45 76 400 45 350 73 780 699 42 320 64 650 557 1,116 237 520 456 38 240 204 999 13 457 385 882 7 417 37 377 390 34 772 160 332 657 286 260 519 197 224 419 80 351 130

0 0 FY08 FY09 FY10 FY11 FY12F FY13F FY14F FY08 FY09 FY10 FY11 FY12F FY13F FY14F FY15F China POS Hong Kong, Macau & Overseas POS China POS Hong Kong, Macau & Overseas POS Source: Hengdeli data, CCBIS estimates Source: Luk Fook data, CCBIS estimates Note: Year to March

Intensive working capital requirements

Working capital most related to Watch and jewelry retailing involves heavy working capital stemming mainly from new openings inventory requirements. In particular, companies expanding their self-operated store network quickly usually see rapid growth in inventory turnover. For instance, each new directly-managed outlet of Chow Tai Fook would require start-up inventory of up to HK$9m. In Chow Tai Fook’s case, inventory cycle was 214, 194 and 192 days as at the end of FY09-FY11, respectively. However, Luk Fook has less exposure to direct retail to warrant faster turnover in inventory but its inventory cycle is still well above 100 days on average (146, 132 and 129 as at the end of FY09-FY11). Start-up inventory requirements can be even higher for watch companies carrying ultra-luxury labels.

Working capital cycle of companies*

259 251 243 250 219

180 165 159 143 115 110

25 40 14 12 4

(30) (6) (35) (32)

(100) (75) Chow Tai Fook Emperor Hengdeli Luk Fook Average inventory days Average receivable days Average payable days Cash conversion cycle (days)

* Latest balance sheet date Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Rising operating costs, especially rental

Rental risk All companies covered in this report have directly-run operations of meaningful scale in Hong Kong, exposing them to the risk of sharply rising rents. A key difference between the Hong Kong and China operations of these companies is that turnover-linked rental arrangements are less common in Hong Kong than in China. Retail rental has and is expected to continue to grow rapidly in Hong Kong. Any failure to produce high enough SSSG to offset the increases in rents can result in operating margin squeeze. Pressure stemming from rising staff costs in both China and Hong Kong is another concern though it is likely to be mitigated by flexible compensation structures commonly adopted by jewelry and watch companies that link a significant proportion of staff compensation to the performance of individual stores and staff members.

Concentration risk

Exposure to Hong Kong The following charts show the contribution of Hong Kong to turnover and EBIT of the four companies under our coverage. Companies with a strong and extensive presence in the Hong Kong market are highly vulnerable to any adverse changes in Hong Kong’s retail environment, which in turn is highly dependent on spending by mainland tourists. To this end, we note that any adjustments to China’s import tariff and tax policies on imported luxury products would at least marginally affect mainland consumers’ desire to shop in Hong Kong. In addition, any tightening, while unlikely, in the current individual visit scheme for mainland travelers would affect tourist traffic into Hong Kong. If these events were to take place, companies with solid establishment in China would be better off as they would benefit from increased domestic sales in China. In our view, Emperor and Luk Fook have the highest net exposure to the Hong Kong market.

Percentage of revenue from Hong Kong Percentage of EBIT from Hong Kong

90% 90% 83% 83% 80% 76% 80%

70% 70% 58% 60% 60% 49% 50% 44% 50%

40% 40% 28% 30% 30% 25%

20% 20%

10% 10%

0% 0% Chow Tai Fook Emperor Hengdeli Luk Fook Chow Tai Fook Emperor Hengdeli Luk Fook

Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data

Initiation on Jewelry and Watch Sector 20 April 2012

Commodity price risk

Gold exposure can be hedged Jewelers are vulnerable to fluctuations in the price of raw materials, including gold, platinum, diamonds and gemstones, which could cause margin volatility. Some operators actively hedge their gold price exposure through derivatives and/or gold loans but they remain subject to movements in the price of other raw materials, such as diamonds, for which there are no established hedging instruments. On the other hand, there are jewelers which choose not to aggressively hedge the risk of price changes in their gold inventory. Luk Fook, for instance, hedges only 20% of its gold price risk.

Initiation on Jewelry and Watch Sector 20 April 2012

Porter and SWOT analysis

Porter

Watches Jewelry Supplier's High Moderate bargaining Supplier concentration is relatively high as the core watch suppliers are from Jewelers purchase their gold at market prices. For diamonds and gemstones, power Switzerland. ASPs and supply quantity are determined by the Swiss watch sizeable operators with good trade reputations, such as Chow Tai Fook, may suppliers, and distributors are not allowed to grant discounts to customers. enjoy sourcing benefits by having access to quality materials at competitive Hengdeli and Emperor are therefore price takers and source watches locally prices. from Swiss watch suppliers. This policy is the same for all exported Swiss watches. Therefore, there is no differentiation between distributors. Threat of Low to moderate Low substitutes Watches can be viewed as a necessity in daily life for timekeeping purpose, Unlike in western countries, event-driven purchases are an important driver of although they have gradually turned into a popular accessory. The watch jewelry sales in Greater China. It is a Chinese tradition to present gold jewelry market is enormous and fragmented in China; however, there are only few as a gift at ceremonial and festive events such as weddings, Mid-autumn sizable and reputable luxury watch retailers and Hengdeli and Emperor are Festival, Chinese New Year, birthday celebrations and to celebrate the arrival leaders among them. Hengdeli also owns the largest luxury watch retail of newborns. As an accessory, gold jewelry can be substituted by gem-sets, network in China and has a large clientele. Buyer inclination to substitute pearls or other metal accessories through jewelry retailers have the flexibility foreign brand watches with local brand watches is minimal, given heightening to adjust and expand their product offerings to meet changing consumer brand consciousness in China. needs. Consumers seeking wealth protection, however, may switch to alternative investment options such as real estate or equity when and if the property and stock markets in China start to improve. Rivalry among Low to moderate Moderate to high existing Many retailers hope for a share in the rapidly growing luxury watch industry in Mass luxury jewelry retailers compete on branding, product offerings, product companies China, yet it is quite difficult to establish a scale comparable to Hengdeli. designs, marketing, in-store services, and store network (in terms of number Likewise, Emperor's network already occupies some of the best locations in of stores and location). At the individual product level, differentiation tends to prime tourist districts in Hong Kong. It would be difficult for peers to build a be limited and design differences subtle. Competition has intensified in recent strategic alliance with top Swiss watch suppliers as they are very cautious in years following rapid store network expansion of existing operators. For screening distributors. Hengdeli is one of the few that has been able to example, the Hong Kong market and the department store channel in maintain a solid bond with these top Swiss watch companies, and is therefore higher-tier cities are generally perceived as reasonably crowded. As a result, given priority in watch supply and deliveries. Emperor's relationships with its we expect leading companies to accelerate expansion into lower-tier cities to suppliers are similarly strong. Moreover, many customers prefer to shop at take advantage of growth opportunities. Hengdeli’s stores, which offer a diversified brand portfolio of mid-to-high end watches covering all major consumer segments while others have a limited product mix. Emperor, meanwhile, attracts customers seeking top luxury labels. Customers are confident that Hengdeli and Emperor products are authentic with high quality. Threat of new Low Moderate entrants It is very difficult for new players to secure distribution rights or access to In theory, entry barriers to jewelry retailing are not formidably high. However, Swiss watch suppliers. As Swiss watch suppliers are extremely strict in terms new player entry has become difficult due to heavy working capital of sourcing, they may only supply a limited range of products to local watch requirements and escalating rental levels in both Hong Kong and China. It retailers. Moreover, brand identity is exceptionally important for luxury watch can take a long time for a new brand to build a franchise comparable with that retailers, since their brand reputation signifies the assurance of quality and of the leading existing brands as consumer recognition and trust do not authenticity. The creation of brand identity requires a long period of operation develop overnight. The growing presence of foreign brands is a valid concern in the market where new players may struggle. but they are more concentrated in the luxury segment whereas Chow Tai Fook and Luk Fook target the mass segment. Buyer's Low Low bargaining Since all Swiss watches have a unified ASP, there is little room for buyers to Jewelers price their products based on raw material costs plus a mark up. As power bargain for discounts across the board. Buyers of luxury items are relatively a reflection of the mark up, gross margin has been largely stable for the less price sensitive since they have high spending power, and a minor price companies we track. Generally speaking, room for price negotiation is small, increment will not affect their purchasing decisions. especially at times of strong demand. Small discounts may be offered when the market is slow. Source: CCBIS research

Initiation on Jewelry and Watch Sector 20 April 2012

SWOT

Hengdeli, Emperor Chow Tai Fook, Luk Fook Strengths  Good and long relationships with key watch brands  Direct retail model, with multi-store format  Key suppliers as strategic investors  Leading players in their respective market segment, with strong customer recognition  Extensive and rapidly growing store network occupying favorable locations in Hong Kong and China Weaknesses  Lack of pricing flexibility  Limited brand differentiation  Use of franchising business model  Heavy working capital requirements Opportunities  Attractive industry growth supported by disposable income growth of Chinese consumers as well as other favorable macro developments  On-going industry consolidation as mom-and-pop stores and regional chains lose market share to leading national operators. This process can be driven by two forces: (1) local retailers with poor operations and/or branding offer acquisition opportunities; and (2) aggressive expansion plans of the national leaders to capture further market share  Opportunities in lower-tier cities Threats  Possibility of losing distribution licenses to competing chains upon expiry  Entry of foreign jewelry labels  Possibility of China lowering import tariffs and taxes on luxury items could reduce mainland customers’ desire to shop in Hong Kong Source: CCBIS research

Initiation on Jewelry and Watch Sector 20 April 2012

Chow Tai Fook Jewellery (1929 HK)

Company Rating: Neutral Diamonds are forever (initiation)

Chow Tai Fook Jewellery is Greater China’s largest and most recognized jewelry brand and retailer with over 80 years of Price: HK$11.90 history. It has a strong business franchise and an extensive store presence, among other positives. We view the company Target: HK$12.50 as the best-quality proxy for the long-term boom in China’s (initiation) jewelry consumption. Nevertheless, we believe the stock is fairly valued on 16x CY12F P/E against a notable SSSG Trading data deceleration ahead. We initiate coverage with a Neutral rating on the stock. 52-week range HK$11.66 – 15.16 Market capitalization (m) HK$119,000/US$15,331  Strong franchise. Chow Tai Fook is the No. 1 jeweler in Shares outstanding (m) 10,000 terms of retail sales in both Hong Kong (20%) and China Free float (%) 11 (13%). According to various surveys, Chow Tai Fook 3M average daily T/O (m share) 10.9 enjoys the highest customer recognition in both 3M average daily T/O (US$m) 18.9 markets. Its extensive yet still rapidly-growing store Expected return (%) – 1 year 7.3 network comprising over 1,500 POS is among the Closing price on 18 April 2012 largest in Greater China. More importantly, the company has strong coverage in China’s lower-tier cities where Stock price vs. HSI consumption is booming. HK$ 18.0  High-quality operator. We see several major advantages in Chow Tai Fook. It has an effective 16.7 vertically-integrated business model that provides major cost and product quality benefits. Its exposure to 15.4 franchising is limited. Active hedging of gold price 14.1 reduces volatility of its gross margin.

12.8  Initiate with Neutral. Our earnings projection for FY13F is 6% below consensus estimate. In addition, share 11.5 14-Dec-11 1-Jan-12 19-Jan-12 6-Feb-12 24-Feb-12 13-Mar-12 31-Mar-12 18-Apr-12 price performance is likely to be restricted as SSSG is Chow Tai Fook HSI (rebased) set to slow materially in the coming months. We initiate Source: Bloomberg coverage with a Neutral rating and our target price implies CY12F and CY13F P/E of 16x and 13x, respectively.

Financial forecast Year to 31 March FY10 FY11 FY12F FY13F FY14F Revenue (HK$m) 22,934 35,043 55,615 68,937 86,205

Net profit (HK$m) 2,139 3,538 6,516 7,998 10,127 Forrest Chan, CFA EPS (HK$) 0.214 0.354 0.652 0.800 1.013 (852) 2532 6743 EPS (YoY, %) – 65 84 23 27 [email protected] P/E (x) 55.6 33.6 18.3 14.9 11.8 Claudia Ching Yield (%) – – 0.7 2.3 2.9 (852) 2532 2528 FCF yield (%) 0.4 0.7 (2.0) (1.5) 5.8 [email protected] ROAE (%) 29.5 36.4 32.5 24.9 25.6 P/B (x) 14.3 10.2 4.0 3.3 2.6 Timothy Sun Net gearing (%) 2.9 10.3 Net cash Net cash Net cash (852) 2532 6746 Source: Company data, CCBIS estimates [email protected]

Initiation on Jewelry and Watch Sector 20 April 2012

Investment highlights

Number one player, mass-market Chow Tai Fook is Greater China’s largest and most recognized jewelry brand and focus retailer with over 80 years of history. The company focuses on the mass-luxury end of the jewelry market, which is the key segment accounting for 57% of the overall jewelry market of China in 2010. Its leading yet growing scale, market leadership and strong customer recognition make it the best proxy for attractive long-term growth in China’s jewelry consumption. In addition, Chow Tai Fook has a favourable vertically integrated business model featuring balanced exposure to both the China and Hong Kong markets as well as limited franchising.

Market position of jewelers Luxury Van Cleef & Arpels Cartier

Bulgari

Tiffany Tesiro Chow Sang Sang

3D-Gold Lukfook Emperor Watch TSL & Jewellery CHJ Jewellery Laofengxiang Chow Tai Seng Jovan Limited Kimberlite Extensive Daimengde Diamond Laomiao geographic geographic Fuqi Ming First Asia Jewellery coverage Fuhui Jewelry Jewelry coverage

Batar Jewellery

Affordable Source: Frost & Sullivan

Retail value of jewelry market in China with breakdown by price range (2010)

Low-end (price less than HK$2,000) 10%

High-end (price greater than HK$100,000) 33% Mass luxury (price ranging from HK$2,000 to HK$100,000) 57%

Source: Frost & Sullivan

Initiation on Jewelry and Watch Sector 20 April 2012

Leader with strong customer recognition and a reputation for quality

A clear market leadership, Chow Tai Fook was the No.1 jewelry retailer in value terms in both China and Hong well-recognized by customers Kong/Macau in 2010, based on Frost & Sullivan’s estimates. The Chow Tai Fook (周大福) brand was ranked along with Tiffany and Cartier as the top-three brands most likely to be purchased in 2010 in China according to consulting firm Bain & Company. Frost & Sullivan ranked Chow Tai Fook first in jewelry brand awareness in China, Hong Kong and Macau. These rankings are strong evidence of the company’s branding and market position.

Jewelry market share by retail value in China (2010)

14% 13% 12%

10% 9%

8% 7% 7% 6% 6%

4% 4% 4% 3% 3% 2% 2% 2%

0% Chow Tai Lao Feng Chow Tai Lao Miao Beijing First Asia Zhe Jiang Cartier Luk Fook Kimberlite Chow Fook Xiang Seng Caishikou Ming Diamond Sang Sang

Source: Frost & Sullivan

Jewelry market share by retail value in Hong Kong and Macau (2010)

22% 20% 20% 18% 16% 14% 12%

10% 9% 8% 7% 6% 4% 4% 3% 2% 2% 2% 2% 2% 2% 0% Chow Tai Chow Sang Luk Fook MaBelle Cartier Tiffany & King Fook Seng Feng Qeelin CSS Fook Sang Co

Source: Frost & Sullivan

Initiation on Jewelry and Watch Sector 20 April 2012

Unaided brand awareness on total market – China (2011) Unaided brand awareness on total market – Hong Kong and Macau (2011)

80% 80% 74% 74%

70% 70%

60% 60% 58% 49% 50% 50%

40% 40% 35% 34% 30% 30%

20% 20%

10% 10%

0% 0% Chow Tai Fook Lao Feng Xiang Chow Sang Sang Chow Tai Fook Tsw Sui Luen Chow Sang Sang

Source: Frost & Sullivan Source: Frost & Sullivan

Extensive and fast growing store network with strong access to lower-tier cities

Solid presence in lower-tier cities Chow Tai Fook has an extensive store network of over 1,500 self-operated and franchised point of sales (POS) as of end-September 2011 covering over 320 cities in China, Hong Kong, Macau, Taiwan and selected countries in Southeast Asia. The majority of its stores are jewelry specialty stores with the balance being watch POS. Its network is growing fast, achieving a store count CAGR of 18% between March 2008 and March 2011, or an average 179 new POS per annum. Chow Tai Fook intends to maintain a rapid pace of expansion, as it looks to add about 200 net new jewelry POS annually going forward, targeting a total store count of over 2,000 jewelry POS per year.

Chow Tai Fook – number of POS

2,600 2,378 2,400 110 2,200 2,123 106 2,000 1,879 100 1,800 1,620 1,600 92 1,361 1,400 1,183 84 1,200 965 85 2,268 1,000 821 2,017 70 1,779 800 69 1,528 1,277 600 1,098 895 400 752 200 0 FY08 FY09 FY10 FY11 FY12F FY13F FY14F FY15F China POS Hong Kong POS Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

A first mover into lower-tier cities Chow Tai Fook made an early move into lower-tier cities where market growth is phenomenal. It entered tier-3 and tier-4 cities as early as 2000 and 2002, respectively, and has already established a strong presence. 34% and 18% of its jewelry and watch POS are located in tier-3 or below cities, based on its September 2011 store count. Frost & Sullivan forecasts impressive jewelry market CAGR of 45% in lower-tier cities, versus only 32% and 37% for tier-one and tier-two cities.

Retail value of jewelry market in China with breakdown Retail value of jewelry market in China with breakdown by city tier by city tier

RMB b 100% 1,300 2010-2015F CAGR: 90% 29% 30% 1,170 Tier-1 cities = 32% 30% 31% 34% 35% 80% 37% 39% Tier-2 cities = 37% 41% 43% 1,040 551 Tier-3 cities = 45% 70% 910 60% 780 31% 382 31% 32% 33% 50% 33% 650 33% 32% 32% 31% C 31% 520 264 401 40% 390 181 294 30% 124 215 20% 40% 39% 260 38% 36% 34% 85 158 32% 31% 29% 28% 58 115 338 26% 130 35 46 82 259 10% 26 48 61 150 197 28 36 65 85 113 0 37 46 57 0% 2006 2007 2008 2009 2010 2011F 2012F 2013F 2014F 2015F 2006 2007 2008 2009 2010 2011F 2012F 2013F 2014F 2015F Tier-1 Tier-2 Tier-3 Tier-1 Tier-2 Tier-3 Source: Frost & Sullivan Source: Frost & Sullivan

Contribution from Hong Kong not Chow Tai Fook’s solid presence in China means it can be less dependent on the Hong excessive Kong market. As shown in the following chart, Chow Tai Fook derives a smaller proportion of its sales and EBIT from Hong Kong than Luk Fook or Chow Sang Sang, which suggests smaller concentration risk.

Chow Tai Fook sales from Hong Kong vs. peers Chow Tai Fook EBIT from Hong Kong vs. peers

90% 90% 83% 83% 80% 76% 73% 80%

70% 70% 58% 60% 60% 50% 49% 44% 50% 40% 40% 28% 30% 30% 25% 20% 20% 10% 10% 0% Emperor Watch Luk Fook Chow Sang Chow Tai Fook Hengdeli 0% Sang Emperor Watch Luk Fook Chow Tai Fook Hengdeli

Source: Chow Sang Sang, Chow Tai Fook, Emperor, Hengdeli and Luk Fook data Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data

Initiation on Jewelry and Watch Sector 20 April 2012

Sourcing advantages and vertical integration

Extensive involvement in every Chow Tai Fook has an effective vertically integrated business model that allows it to stage of supply chain exert significant control over procurement, design, production, marketing and sales processes. The group therefore enjoys high efficiency and cost benefits, and has ability to ensure stable and quality supplies. Key aspects of Chow Tai Fook’s vertically integrated business model and procurement strengths are worth further discussion:

 In-house diamond processing capacity. 40% of its diamond requirement is met by its three diamond cutting and polishing facilities in South Africa and Shunde, China, where rough diamonds are cut and polished.

 Strong relationships with DTC and Rio Tinto. Chow Tai Fook is a sightholder of the Diamond Trading Company (DTC) through Zlotowski’s, one of its wholly-owned subsidiaries. Another of its subsidiary, Chow Tai Fook Hong Kong, is also a DTC Sightholder. In 2009, the group became a Rio Tinto Select Diamantaire. Under the agreements with DTC and Rio Tinto, Chow Tai Fook is supplied with rough diamonds meeting pre-agreed specifications up to a stipulated value and for a specified period. DTC and Rio Tinto account for a significant portion of Chow Tai Fook’s demand for rough diamonds.

 Access to rare stones. Thanks to its reputation, Chow Tai Fook is often invited to auctions to bid for rare and unique diamonds. In 2010, Zlotowski successfully won the bid for the 507-carat Cullinan Heritage rough diamond for US$35.3m, the highest sale price on record for a rough diamond. Successful bidding in rare diamonds or gemstones enhances Chow Tai Fook’s global exposure and media publicity.

 In-house production. As at 30 September 2011, Chow Tai Fook operated a total of 12 factories consisting of nine jewelry factories and three diamond cutting and polishing facilities. The nine jewelry factories together hire over 3,500 employees, occupying a total area of over 42,000 sqm. Since 2008, the group has produced 80% of its gem-set jewelry products in-house, or about 50% if other products are included. The basic rationale behind its outsourcing is to keep its own production capacities focused on gem-set jewelry products, while using external producers for simple or low value products.

Chow Tai Fook’s production facilities

Location Number of factories Specialization Hong Kong 1 Gem-set jewelry Shenzhen, China 4 Gem-set jewelry, karat gold and gold products Shunde, China 4 Gem-set jewelry, platinum/karat gold and gold products Shunde, China 1 Diamond cutting and polishing South Africa 2 Diamond cutting and polishing Source: Company data

Initiation on Jewelry and Watch Sector 20 April 2012

Limited franchising

More use of direct retail Unlike the majority of its key competitors, Chow Tai Fook has a relatively low ratio of franchised stores in its store base. All of its outlets in Hong Kong and Macau are self-operated, whereas franchised stores, selling products exclusively supplied by Chow Tai Fook, only account for 32% of its store count in mainland China. Its franchising model is mainly employed in tier-three and tier-four cities. Chow Tai Fook has good control over its franchised stores, and does not often grant any credit terms while setting the same operational standards as its self-managed stores. We regard Chow Tai Fook’s limited franchising as a positive. Chow Tai Fook is also in the process of converting some of its franchised stores to joint-venture POS.

Chow Tai Fook – franchised POS as % of China total China’s jewelry POS by operation model 2010

100%

90% 27% 28% 29% 31% 31% 32% 33% 34% Self-operated 80% 32% 70%

60%

50%

40% 73% 71% 72% 69% 69% 68% 67% 66% 30%

20%

10% Franchsied 0% 68% FY08 FY09 FY10 FY11 FY12F FY13F FY14F FY15F Self-owned Franchised Source: Company data, CCBIS estimates Source: Frost & Sullivan

Active hedging of gold price exposure

90% of gold inventory hedged Chow Tai Fook manages commodity price risks mainly by hedging gold price fluctuations through gold loans and bullion forward contracts. Changes in the fair value of gold loans and bullion forward contracts are reflected in the company’s COGS to offset price changes in its gold inventory and, hence, provide stability to the gross margin of Chow Tai Fook’s gold products. We understand that Chow Tai Fook has one of the most active hedging policies of its peers as it hedges nearly c.90% of its exposure to gold price. For the remainder of its product mix, the company looks to pass on price increases to its customers.

Strong presence in department store channel

As oat end-September 2011, 778 out of Chow Tai Fook’s 884 self-operated POS in China were concessionaire counters located within department stores paying turnover-linked commission (i.e. rent). While alternative retail formats such as shopping malls are developing quickly in China, the department store format remains the major channel where mid-to-high end consumption takes place. Chow Tai Fook’s significant presence within department stores ensures that it maximizes its exposure to target customer segments. It also reduces operating leverage, providing greater margin stability.

Initiation on Jewelry and Watch Sector 20 April 2012

China's jewelry sales breakdown by retail channel (2010)

Others (including the Internet) Specialised markets 2% 10%

Stores in shopping malls 14%

Department stores 44%

Stand-alone branded stores 30%

Source: Frost & Sullivan

Initiation on Jewelry and Watch Sector 20 April 2012

Key earnings drivers

We forecast 25% earnings CAGR for Chow Tai Fook in FY12F-14F to be driven by the following factors:

New openings and SSSG

We estimate c.250 net new openings to be achieved per annum going forward, implying a mid-teen rate of POS growth. Our understanding is that locations have been secured or confirmed via MOU for a majority of Chow Tai Fook’s planned openings in FY13F. SSSG of 10-12% and 15-16% is assumed for FY13F and FY14F, respectively.

Chow Tai Fook – revenue projections

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F Total revenue 18,411 22,934 35,043 55,615 68,937 86,205 104,726 YoY (%) 25 53 59 24 25 21

Revenue by market Retail, China 6,758 9,355 14,595 22,327 28,424 36,075 45,061 Retail, Hong Kong, Macau and others 8,168 10,168 15,438 24,111 28,791 35,004 41,710 Wholesale, China 3,247 3,274 4,877 8,945 11,455 14,819 17,602 Wholesale, Hong Kong, Macau and others 238 137 133 232 267 307 353

Revenue growth by market (%) Retail, China – 38 56 53 27 27 25 Retail, Hong Kong, Macau and others – 24 52 56 19 22 19 Wholesale, China – 1 49 83 28 29 19 Wholesale, Hong Kong, Macau and others – (42) (3) 75 15 15 15

Revenue mix by market (%) Retail, China 36.7 40.8 41.6 40.1 41.2 41.8 43.0 Retail, Hong Kong, Macau and others 44.4 44.3 44.1 43.4 41.8 40.6 39.8 Wholesale, China 17.6 14.3 13.9 16.1 16.6 17.2 16.8 Wholesale, Hong Kong, Macau and others 1.3 0.6 0.4 0.4 0.4 0.4 0.3

Revenue by sales channel Retail 14,926 19,523 30,033 46,438 57,215 71,079 86,771 Wholesale 3,485 3,410 5,009 9,177 11,722 15,126 17,955

Revenue growth by sales channel (%) Retail 31 54 55 23 24 22 Wholesale (2) 47 83 28 29 19

Revenue mix by sales channel (%) Retail 81.1 85.1 85.7 83.5 83.0 82.5 82.9 Wholesale 18.9 14.9 14.3 16.5 17.0 17.5 17.1 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Stable gross margin

Upside from business mix Chow Tai Fook actively hedges its gold price exposure using forward contracts and improvements gold loans, and prices its gold products on a daily basis according to prevailing gold price. As a result, its gold products carry a stable gross margin of 10% in Hong Kong and 20-22% in China. Gem-set products are usually priced at a mark-up to their cost of purchase and have higher margin at 35%+. Hence, we believe Chow Tai Fook’s overall gross margin is broadly driven by product mix changes, and to a lesser extent, retail discounting level. Share of gold products in Chow Tai Fook’s sales mix has increased since FY09 which we attributed to rising gold price, which lifted ASPs and in turn stimulated demand. However, the company’s long-term strategic intention is to gradually increase the share of gem-set products in its sales mix since there is better room for consumer to trade-up within the gem-set segment. In the meantime, the mix between direct retail and wholesale in Chow Tai Fook’s sales mix is another factor determining Chow Tai Fook’s gross margin given the higher gross margin of sales of its directly-managed stores. However, we foresee the mix to be fairly stable in the foreseeable future.

Chow Tai Fook – sales mix by product Chow Tai Fook – sales mix by channel

100% 100% 6% 7% 7% 15% 14% 90% 19% 17% 17% 18% 17%

80% 80%

70% 64% 60% 64% 67% 60% 50% 85% 86% 40% 40% 81% 83% 83% 82% 83%

30%

20% 20% 30% 29% 26% 10%

0% 0% FY09 FY10 FY11 FY09 FY10 FY11 FY12F FY13F FY14F FY15F Gem-set jewelry Gold items Watches Direct retail Wholesale Source: Company data, CCBIS estimates Source: Frost & Sullivan

Chow Tai Fook – gross margin by product Chow Tai Fook – gross margin trend

52% 30.0% 47% 29.8% 45% 29.7% 29.6% 29.5% 39% 29.5%

27% 26% 29.0% 28.9%

15% 28.6% 13% 28.5% 28.3%

0% Gem-set jewelry Platinum/karat Watches Gold products 28.0% gold products FY09 FY10 FY11 FY12F FY13F FY14F FY15F

Source: Company data, CCBIS estimates Source: Frost & Sullivan

Initiation on Jewelry and Watch Sector 20 April 2012

SG&A expenses

Staff cost is modelled as an assumed percentage of turnover. Like most peers, Chow Tai Fook has a compensation scheme linking a substantial portion of staff compensation to individual store and individual member performance. Staff cost expense ratio is expected to decline in years of extremely high SSSG such as FY11 and FY12F, whereas a slower sales environment may see a stable or modestly higher ratio due to structural growth in China’s wage level.

In FY11, concessionaire fees accounted for up to 75% of Chow Tai Fook’s total rental and commission expense. This ratio should continue to increase as its China unit, which employs predominantly the department store counter store format, increases contribution to the overall business mix. We project that the average effective commission rate applicable to Chow Tai Fook’s concessionaire counters will decrease over time as a result of more openings in lower-tier markets where commission rates are lower. We therefore project slower increases in concessionaire fee per counter than SSSG in China.

Tax rate

The group’s effective tax rate is largely as function of changes in its geographic exposure. Most of its subsidiaries based in China are subject to the standard income tax rate of 25%. In Hong Kong, its businesses face a lower profit tax rate of 25.8%. From FY13F and onwards, we expect China’s business to grow faster aided by more rapid store expansion and we forecast Chow Tai Fook’s effective tax rate will rise steadily.

Initiation on Jewelry and Watch Sector 20 April 2012

Chow Tai Fook – key assumptions

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F Total POS 965 1,183 1,361 1,620 1,879 2,123 2,378 China – sub-total 895 1,098 1,277 1,528 1,779 2,017 2,268 China – self-operated jewelry POS 634 732 815 962 1,107 1,238 1,373 China – franchised jewelry POS 261 302 391 474 570 667 772 China – watch POS 0 64 71 92 102 112 123 Hong Kong/Macau – sub-total 70 85 84 92 100 106 110 Hong Kong/Macau – jewelry POS 70 81 81 88 95 100 103 Hong Kong/Macau – watch POS 0 4 3 4 5 6 7

Total POS – YoY change 144 218 178 259 259 244 255 China – sub-total 143 203 179 251 251 238 251 China – self-operated jewelry POS 87 98 83 147 145 131 134 China – franchised jewelry POS 0 64 7 21 9 10 11 China – watch POS 56 41 89 83 97 97 105 Hong Kong/Macau – sub-total 1 15 (1) 8 8 6 4 Hong Kong/Macau – jewelry POS 1 11 0 7 7 5 3 Hong Kong/Macau – watch POS 0 4 (1) 1 1 1 1

Total POS – YoY change (%) 18 23 15 19 16 13 12 China – sub-total 19 23 16 20 16 13 12 China – self-operated jewelry POS 16 15 11 18 15 12 11 China – franchised jewelry POS 27 16 29 21 20 17 16 China – watch POS – – 11 30 10 10 10 Hong Kong/Macau – sub-total 1 21 (1) 10 9 6 4 Hong Kong/Macau – jewelry POS 1 16 0 9 8 5 3 Hong Kong/Macau – watch POS 0 0 (25) 33 25 20 17

SSSG (%) China – 15.2 35.2 33.5 10.2 15.0 14.7 Hong Kong/Macau – 16.0 32.4 53.5 11.6 16.1 15.9

Average revenue per franchised store (RMB m) 12.3 10.2 12.1 17.0 17.5 18.7 18.7 YoY (%) – (17) 19 40 3 7 0

Gross margin (%) 28.9 28.6 28.3 29.5 29.6 29.7 29.8

Total staff cost as % of retail sales 7.2 6.8 6.1 5.8 5.8 5.9 5.8

Rental per retail store (HK$m) – 2.3 2.8 3.1 3.4 3.8 4.2 YoY (%) – – 21.1 12.0 10.0 11.0 10.0

Commission per concessionaire POS (HK$m) – 1.6 2.0 2.5 2.6 2.8 3.1 YoY (%) – – 26.7 26.6 3.2 6.2 13.0

Other expenses as % of retail revenue 4.5 4.7 4.2 3.9 3.8 3.7 3.6 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Chow Tai Fook – profit and loss projections

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F 1H11 2H11 1H12 2H12F Total revenue 18,411 22,934 35,043 55,615 68,937 86,205 104,726 13,315 21,728 23,875 31,741 YoY (%) – 25 53 59 24 25 21 – – 79 46

COGS (13,085) (16,379) (25,115) (39,209) (48,531) (60,602) (73,518) (9,614) (15,501) (16,734) (22,475) YoY (%) – 25 53 56 24 25 21 – – 74 45

Gross profit 5,326 6,555 9,928 16,406 20,405 25,603 31,208 3,701 6,226 7,141 9,266 YoY (%) 23 51 65 24 25 22 – – 93 49 Gross margin (%) 28.9 28.6 28.3 29.5 29.6 29.7 29.8 27.8 28.7 29.9 29.2

Other income and gains 72 98 164 260 233 273 305 66 98 166 93

Staff costs (1,076) (1,320) (1,821) (2,693) (3,318) (4,194) (5,033) (752) (1,069) (1,370) (1,324) YoY (%) 23 38 48 23 26 20 – – 82 24 As % of turnover 5.8 5.8 5.2 4.8 4.8 4.9 4.8 5.6 4.9 5.7 4.2

Depreciation (161) (226) (247) (377) (527) (676) (802) (113) (134) (154) (224) YoY (%) 41 9 53 40 28 19 – – 36 67 As % of turnover 0.9 1.0 0.7 0.7 0.8 0.8 0.8 0.8 0.6 0.6 0.7

Donation (164) (117) (122) (120) (140) (160) (180) (21) (101) (8) (112) YoY (%) (29) 4 (2) 17 14 13 – – (63) 11 As % of turnover 0.9 0.5 0.3 0.2 0.2 0.2 0.2 0.2 0.5 0.0 0.4

Rental cost and concessionaire fees (1,036) (1,370) (1,996) (2,803) (3,403) (4,111) (5,107) (832) (1,164) (1,235) (1,568) YoY (%) 32 46 40 21 21 24 – – 48 35 As % of turnover 5.6 6.0 5.7 5.0 4.9 4.8 4.9 6.3 5.4 5.2 4.9

Other expenses (671) (926) (1,249) (1,811) (2,174) (2,630) (3,124) (492) (757) (844) (967) YoY (%) 38 35 45 20 21 19 – – 72 28 As % of turnover 3.6 4.0 3.6 3.3 3.2 3.1 3.0 3.7 3.5 3.5 3.0

Total SG&A and other expenses (3,107) (3,958) (5,435) (7,805) (9,562) (11,770) (14,245) (2,210) (3,225) (3,610) (4,195) YoY (%) 27 37 44 23 23 21 – – 63 30 As % of total turnover 16.9 17.3 15.5 14.0 13.9 13.7 13.6 16.6 14.8 15.1 13.2 EBIT 2,291 2,695 4,656 8,861 11,076 14,106 17,268 1,557 3,099 3,697 5,164 YoY (%) – 18 73 90 25 27 22 – – 137 67 EBIT margin (%) 12.4 11.8 13.3 15.9 16.1 16.4 16.5 11.7 14.3 15.5 16.3

Depreciation and amortization 161 226 255 385 534 684 810 – – – – included in SG&A

EBITDA 2,130 2,469 4,402 8,475 10,541 13,422 16,458 – – – – YoY (%) 16 78 93 24 27 23 – – – – EBITDA margin (%) 11.6 10.8 12.6 15.2 15.3 15.6 15.7 – – – –

Interest income 89 77 70 96 149 176 215 35 36 38 58 Interest expense (157) (62) (102) (274) (335) (246) (228) (30) 73 (117) 158 Share of results of an associate 1 9 (5) 0 0 0 0 0 (5) 0 0

Profit before tax 2,224 2,719 4,620 8,683 10,890 14,036 17,255 1,562 3,203 3,618 5,380 YoY (%) 22 70 88 25 29 23 0 0 132 68 As % of turnover 12.1 11.9 13.2 15.6 15.8 16.3 16.5 11.7 14.7 15.2 16.9 Tax (309) (512) (947) (1,884) (2,472) (3,326) (4,193) (339) (609) (797) (1,087) Effective tax rate (%) 13.9 18.8 20.5 21.7 22.7 23.7 24.3 21.7 19.0 22.0 20.2

Minority interest (18) (68) (135) (282) (420) (583) (795) (48) (87) (129) (153)

Net profit 1,897 2,139 3,538 6,516 7,998 10,127 12,267 1,176 2,507 2,692 4,140 YoY (%) 13 65 84 23 27 21 – – 129 65 Net margin (%) 10.3 9.3 10.1 11.7 11.6 11.7 11.7 8.8 11.5 11.3 13.0 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Balance sheet and cash flow

Chow Tai Fook’s balance sheet has been significantly enhanced by its listing. We estimate its net cash position will exceed HK$8b by end-FY12F.

The company’s cash flow health is closely related to its expansion pace and the prevailing gold price. Store fitout cost is usually around HK$1-2m per new opening but working capital requirement for each opening can be as high as HK$8-10m at the current gold price. Working capital needs of existing stores also rise in tandem with higher gold price. Sharp rises in gold price during 2010 and 2011 have led to negative operating cash for Chow Tai Fook in FY11 and 1HFY12. Given our assumption of slower gold price growth in FY13 and onwards, we estimate that positive operating cash flow will resume to finance estimated capex of HK$0.9-1.2b per annum.

Chow Tai Fook – cash flow projections

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F EBIT 2,291 2,695 4,656 8,861 11,076 14,106 17,268 Depreciation and amortization 161 226 255 385 534 684 810 EBITDA 2,451 2,921 4,911 9,246 11,610 14,789 18,078 Adjustments for other non-cash items 54 473 720 900 1,050 1,200 1,300 Working capital changes: Inventory (822) (1,186) (7,508) (10,915) (2,471) (6,767) (5,253) Receivables 177 (1,069) (675) (1,037) (741) (771) (1,178) Payables (385) 490 677 1,362 622 1,166 1,183 Defined benefits paid (7) (7) (7) (7) (7) (7) (7) Gold loans 323 (355) 984 1,268 350 300 700 Pledged deposit (390) 242 68 (39) (15) (10) (20) Tax paid (366) (399) (730) (1,535) (2,253) (3,008) (3,870) Interest paid (157) (62) (102) (274) (335) (246) (228) Interest received 89 77 70 96 149 176 215 Operating cash flow 968 1,125 (1,592) (935) 7,959 6,822 10,919 Capex (485) (320) (824) (900) (1,050) (1,200) (1,200) Free cash flow 483 806 (2,416) (1,835) 6,909 5,622 9,719 Other investment cash flows 8 7 24 (19) 1 1 0 Contribution from minority shareholders 6 14 21 0 0 0 0 Share issue 5 5 2 15,500 0 0 0 Dividend paid 0 (7) (9) (4,500) (1,308) (1,727) (2,154) Advance/repayment to/from minority shareholders 25 56 75 135 70 80 60 Net cash flow 526 881 (2,304) 9,281 5,672 3,976 7,626 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Chow Tai Fook – balance sheet projections

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F 1H12 Property, plant and equipment 715 835 1,165 1,740 2,313 2,887 3,285 1,619 Prepaid lease payments 0 0 87 99 80 62 43 102 Deposits 86 51 232 150 100 50 50 211 Interest in an associate 39 48 45 45 45 45 45 49 Amounts due from related companies 30 80 0 0 0 0 0 0 Loan receivables 35 35 16 15 14 13 13 16 Non-current assets – total 905 1,049 1,546 2,049 2,552 3,057 3,437 1,996

Inventories 8,094 9,275 17,101 28,016 30,488 37,254 42,508 28,878 Trade receivables 540 1,054 1,632 2,329 2,959 3,654 4,380 1,956 Other receivables 826 1,382 1,595 1,947 2,068 2,155 2,618 1,549 Amounts due from related companies 2,135 1,782 1,278 50 0 0 0 88 Loan receivables 136 136 135 130 130 130 130 134 Convertible bonds 0 0 0 25 25 25 25 25 Derivative financial instruments 0 0 0 0 0 0 0 165 Taxation recoverable 16 0 0 0 0 0 0 0 Pledged deposit 468 226 156 195 210 220 240 187 Cash 1,290 2,107 5,605 21,400 26,122 30,598 39,224 3,205 Current assets – total 13,504 15,962 27,503 54,092 62,002 74,036 89,124 36,187

Trade payables 212 381 384 798 931 1,061 1,356 755 Other payables 603 926 1,666 2,614 3,102 4,138 5,027 2,383 Amounts due to related companies 4,727 4,640 7,833 9,000 11,000 12,500 13,500 8,459 Amounts due to minority shareholders 28 84 165 300 370 450 510 239 Taxation payable 39 131 353 702 921 1,240 1,562 757 Bank borrowings 114 160 2,881 7,000 4,000 3,000 3,000 9,022 Gold loans 2,061 2,189 3,932 6,100 7,500 9,000 11,000 4,961 Current liabilities – total 7,784 8,511 17,213 26,514 27,824 31,389 35,955 26,575

Retirement benefit obligations 184 164 163 200 220 240 260 191

Shareholders’ equity 6,343 8,157 11,307 28,779 35,442 43,814 53,901 10,927 Minority interest 99 179 366 648 1,068 1,650 2,445 490 Total equity 6,442 8,335 11,673 29,427 36,510 45,465 56,346 11,417

Total assets 14,410 17,010 29,049 56,140 64,554 77,094 92,561 38,183 Total liabilities and equities 14,410 17,010 29,049 56,140 64,554 77,094 92,561 38,183

Gross debt 2,174 2,350 6,813 13,100 11,500 12,000 14,000 13,983 Net debt 885 243 1,208 (8,300) (14,622) (18,598) (25,224) 10,777 Net gearing (%) 14 3 10 Net cash Net cash Net cash Net cash 94 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Chow Tai Fook – cash conversion cycle and working capital days

250 228 220 218 212 210 204 206 194 200 200 198 200 192

150

100

50 13 14 13 14 14 14

0 (7) (6) (6) (7) (6) (6) (50) FY10 FY11 FY12F FY13F FY14F FY15F Average inventory days Average receivable days Average payable days Cash conversion cycle (days)

Source: Company data, CCBIS estimates

Chow Tai Fook – operating cash flow, free cash flow and net cash flow projections

HK$m 13,000 10,919 11,000 9,281 9,719 7,959 9,000 7,626 6,909 6,822 7,000 5,672 5,622 5,000 3,976

3,000 968 1,125 483526 806881 1,000

(1,000) (935) (1,592) (3,000) (2,304) (1,835) (2,416) (5,000) FY09 FY10 FY11 FY12F FY13F FY14F FY15F Operating cash flow Free cash flow Net cash flow

Source: Company data, CCBIS estimates

Chow Tai Fook – key financial ratios

Year to March 2009 2010 2011 2012F 2013F 2014F 2015F ROAE (%) – 29.5 36.4 32.5 24.9 25.6 25.1 ROAA (%) – 14.0 15.9 16.0 13.9 15.1 15.4 ROIC (%) – 21.2 24.3 28.1 27.2 29.7 30.9 Average inventory days – 194 192 210 220 204 198 Average receivable days – 13 14 13 14 14 14 Average payable days – 7 6 6 7 6 6 Cash conversion cycle (days) – 200 200 218 228 212 206 Net gearing (%) 13.7 2.9 10.3 Net cash Net cash Net cash Net cash Gross gearing (%) 33.8 28.2 58.4 44.5 31.5 26.4 24.8 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Senior management and shareholding structure

Dato’ Dr. Cheng Yu-Tung – Honorary chairman and non-executive director

Dato’ Dr. Cheng Yu-Tung, age 85, is responsible for advising on overall strategic planning and management of the group. Dr. Cheng joined the group in January 1947 as a trainee and was eventually promoted to become the permanent chairman of Chow Tai Fook Hong Kong in March 1961. Dr. Cheng is the permanent chairman of Chow Tai Fook Enterprise, a sister company of Chow Tai Fook, and a director of CYT Family Holdings, CYT Family Holdings II, Chow Tai Fook Capital and Chow Tai Fook Holding.

Dr. Cheng is also the chairman and non-executive director of NWD; non-executive director of Shun Tak Holdings Limited; non-executive director of SJM Holdings Limited; chairman and executive director of Melbourne Enterprises Limited; and chairman and non-executive director of Lifestyle International.

Dr. Cheng is the father of Dr. Cheng Kar-Shun, Henry, the grandfather of Mr. Cheng Chi-Kong, Adrian and Mr. Cheng Chi-Heng, Conroy, an uncle of Mr. Cheng Kam-Biu, Wilson and Mr. Cheng Sek- Hung, Timothy and the elder brother of Mr. Cheng Yu-Wai.

Dr. Cheng Kar-Shun, Henry – Chairman and executive director

Dr. Cheng Kar-Shun, Henry, age 64, is the chairman and executive director and a member of the company’s Nomination Committee and Remuneration Committee. Dr. Cheng is responsible for the strategic direction and overall performance of Chow Tai Fook.

He joined the company in 1971 and has served as a director of Chow Tai Fook Hong Kong since May 1971 and as vice-chairman since March 2007. Dr. Cheng is also a director of CYT Family Holdings and Chow Tai Fook Holding and is the vice chairman of Chow Tai Fook Enterprise. He also holds the following positions in other companies including managing director of NWD; chairman and managing director of NWCL; chairman and executive director of NWS; chairman and non-executive director of NWDS; chairman and executive director of International Entertainment Corporation, independent non-executive director of HKR International Limited, and non-executive director of Lifestyle International. In addition, Dr. Cheng was also the chairman and executive director of Taifook Securities Group Limited up to his resignation in 2010.

Dr. Henry Cheng is the eldest son of Dato’ Dr. Chen Yu-Tung, the father of Mr. Cheng Chi Kong, Adrian, an uncle of Mr. Cheng Chi-Heng, Conroy, a cousin of Mr. Cheng Kam-Biu, Wilson, and Mr. Cheng Sek Hung, Timothy and a nephew of Mr. Cheng Yu-Wai.

Initiation on Jewelry and Watch Sector 20 April 2012

Mr. Wong Siu-Kee, Kent – Managing director

Mr. Wong Siu-Kee, Kent, age 55, is responsible for the overall management of the group. He is a member of the company’s Nomination Committee and Remuneration Committee. He joined the group in 1977, working initially as a trainee. Mr. Wong’s diverse experience in both operations and management led to his appointment as the general manager of the PRC business of the group in 1999, where he was responsible for developing the group’s market in mainland China. Since 2002, Mr. Wong has taken the position of director of Chow Tai Fook Hong Kong and Chow Tai Fook Enterprise, and in 2008 he was promoted to managing director of Chow Tai Fook Hong Kong.

Mr. Wong is a member of HKTDC Watches and Clocks Advisory Committee, director of welfare of the HK Jewellers’ & Goldsmiths’ Association, chairman of the supervising committee of the HK & Kowloon Jewellers’ & Goldsmiths’ Employees’ Association Ltd.

Mr. Cheng Chi-Kong, Adrian – Executive director

Mr. Cheng Chi-Kong, Adrian, age 31, is responsible for the marketing of the group as well as customer relationship management and branding and e-commerce operations. Adrian joined the group in 2007 as a director of Chow Tai Fook Hong Kong. Prior to joining the group in April 2007, Mr. Cheng worked at UBS AG in the Corporate Finance group from 2003 to 2006. Mr. Cheng also holds the following positions in companies listed on the Main Board of the Stock Exchange, including executive director of NWD; executive director of NWCL; executive director of NWDS; and executive director of International Entertainment Corporation. He is a director of Chow Tai Fook Holding and Chow Tai Fook Enterprise.

Mr. Cheng is a grandson of Dato’ Dr. Cheng Yu-Tung, a son of Dr. Cheng Kar-Shun, Henry, a cousin of Mr. Cheng Chi-Heng, Conroy, a nephew of Mr. Cheng Kam-Biu, Wilson and Mr. Cheng Sek-Hung, Timothy and a grandnephew of Mr. Cheng Yu-Wai.

Mr. Cheng Chi-Heng, Conroy – Executive director

Mr. Cheng Chi-Heng, Conroy, age 33, is responsible for the procurement and production of diamonds and gemstones. He has been a director of Chow Tai Fook Hong Kong since 2007. He is also an executive director of NWD and a director of Chow Tai Fook Enterprise and Chow Tai Fook Holding.

Conroy worked at Yu Ming Investment Management Ltd. from 1999 to 2000 as a corporate finance executive. He is a grandson of Dato’ Dr. Cheng Yu-Tung, a nephew of Dr. Cheng Kar-Shun, Henry, Mr. Cheng Kam-Biu, Wilson and Mr. Cheng Sek-Hung, Timothy, a cousin of Mr. Cheng Chi-Kong, Adrian and a grandnephew of Mr. Cheng Yu-Wai.

Mr. Chan Sai-Cheong – Executive director

Mr. Chan Sai-Cheong, age 49, is responsible for the group’s PRC and overseas operations. He joined the group in 1985 as a salesman and was appointed director of Chow Tai Fook Hong Kong in July 2005. Mr. Chan has over 31 years of working experience in the jewelry industry.

Initiation on Jewelry and Watch Sector 20 April 2012

Mr. Chan Hiu-Sang, Albert – Executive director

Mr. Chan Hiu-Sang, Albert, age 60, is responsible for the group’s diamond procurement and operations of the diamond department. Mr. Chan joined the group in 1977 as a member of the diamond procurement team and was appointed a director of Chow Tai Fook Hong Kong since January 2006.

Mr. Cheng Ping-Hei, Hamilton – Executive director

Mr. Cheng Ping-Hei, Hamilton, age 36, is the finance director responsible for the group’s financial management and overseeing the group’s company secretarial functions. He joined the group in 2004 as a finance manager and subsequently became the Head of Financial Management of the group in February 2011.

Mr. Suen Chi-Keung, Peter – Executive director

Mr. Suen Chi-Keung, Peter, age 46, is responsible for the Hong Kong and Macau operations. Mr. Suen joined the group in 1985 as a trainee and was appointed as the administrative manager in 2010. He served as a general manager of the Hong Kong and Macau operations since February 2011.

Chow Tai Fook’s shareholding structure

Chow Tai Fook (Holdings) Ltd. Public 89.5% 10.5%

Chow Tai Fook (1929 HK)

Source: HKEx, CCBIS research

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor Watch & Jewellery (887 HK)

Company Rating: Outperform Veni, vidi, vici (initiation)

Emperor Watch & Jewellery (Emperor) is a leading Greater China retail name carrying European-made ultra-luxury watch labels. Price: HK$1.20 Known for stocking classic brands, the company has an exceptional franchise. Its stores have become a must-go Target: HK$1.40 destination for affluent Chinese shoppers coming to Hong Kong, (initiation) while its unique investment story is being further enriched by its growing exposure to the mainland market and to jewelry products. We initiate coverage on the stock with an Outperform Trading data rating. 52-week range HK$0.72 – 1.84 Market capitalization (m) HK$8,062/US$1,039  Strong ties with suppliers. Emperor has a long-standing Shares outstanding (m) 6,719 partnership with key Swiss watch brand owners which Free float (%) 45 allows it to source a wide range of internationally renowned 3M average daily T/O (m share) 42.0 watches. This avails it of a comprehensive product and 3M average daily T/O (US$m) 6.0 brand portfolio. Emperor’s solid sales track record has helped it gain the confidence and support of brand owners. Expected return (%) – 1 year 20.6 Closing price on 18 April 2012  Jewelry business offers synergies and upside. Emperor has built a strong franchise by offering premium quality Stock price vs. HSI jewelry under its own brand. While Emperor’s jewelry HK$ business only accounts for 18% of sales, we believe this 1.85 high margin business and the cross-selling potential it entails has not been tapped. Emperor has shifted focus to 1.62 expanding this segment by opening more jewelry stores and through additional marketing. 1.39

 Synergies with sister companies and L Capital. 1.16 Emperor enjoys significant synergies availed to it by its relationship with Emperor Group and its partnership with L 0.93 Capital, especially when it comes to negotiating with suppliers and landlords. These relationships make 0.70 19-Apr-11 1-Jul-11 12-Sep-11 24-Nov-11 5-Feb-12 18-Apr-12 cross-promotional and marketing activities possible. Emperor Watch & Jewellery HSI (rebased)  Initiate with Outperform. Our target price of HK$1.40, Source: Bloomberg based on CY13F P/E of 8x, represents a 30% discount to Hengdeli.

Financial forecast Year to 31 December FY10 FY11 FY12F FY13F FY14F Revenue (HK$m) 4,095 5,862 7,607 9,987 12,355

Core net profit (HK$m) 325 636 784 1,031 1,266 Claudia Ching EPS (HK$) 0.053 0.097 0.128 0.168 0.206 (852) 2532 2528 EPS (YoY, %) 23 82 31 31 23 [email protected] P/E (x) 22.5 12.3 9.4 7.2 5.8 Yield (%) 1.5 2.3 3.0 3.9 4.8 Forrest Chan, CFA (852) 2532 6743 FCF yield (%) (5.0) (8.3) 1.8 3.5 6.8 [email protected] ROAE (%) 6.6 20.5 18.7 20.7 21.2 P/B (x) 5.7 5.2 3.6 2.1 1.8 Timothy Sun Net gearing (%) Net cash Net cash Net cash Net cash Net cash (852) 2532 6746 Source: Company data, CCBIS estimates [email protected]

Initiation on Jewelry and Watch Sector 20 April 2012

Investment highlights

Emperor is a leading Greater China name in watches and jewelry, known especially for its European-made luxury watches and in-house designed fine jewelry. The company has shops in Hong Kong, Macau and China and targets middle-to-high income earners. Having built its brand over the last 70 years, the company is now a well recognised name, known for stocking classic luxury brands in Hong Kong. Emperor has become one of the must-visit watch and jewelry shops for affluent Chinese shoppers.

Offers the finest collection of Besides its wide range of prestigious and luxury European watches, Emperor offers top-notch European-made luxury in-housed designed fine jewelry products made of diamonds, jade, pearl, 999.9K fine watches and premium fine gold and other precious stones. These are sold under its “Emperor” brand. Luxury jewelry watch sales accounted for 82% of sales in FY11, while the contribution from the jewelry segment is growing.

Emperor has the necessary qualities to capture long-term growth in China’s luxury watch segment, with store network expansion underpinning its market share gains. It operates a direct-retail business model and a dual-format store network of both multi-brand and mono-brand outlets, which we view as a vital to in its long-term success. Over the years, the company has earned strong customer recognition and loyalty, and it now enjoys long-standing relationships with renowned international watch suppliers.

Long-standing relationships with top international brands

Extensive brand mix supported Established in 1942, Emperor can claim over 70 years of experience in the watch and by its long-standing partnership jewelry business. During that time, Emperor developed long-term partnerships with with top Swiss watch brand major watch brands which now allow it to offer a wide range of internationally suppliers renowned Swiss watches. The group has a diversified brand mix, with 19 international watch labels in Hong Kong and Macau, and 32 watch brands. The business relationships with some of these watch suppliers began decades ago. For certain watch labels, the group strategically establishes boutique outlets in order to curry favour with those brands.

Emperor’s watch brand portfolio for its Hong Kong & Macau shops

A. Lange & Sohne Audemars Piguet Baume & Mercier Blancpain Breguet Cartier Chopard Frank Muller IWC Jaeger-LeCoultre Omega Panerai Parmigian Patek Philippe Piaget Rolex Tudor Vacheron Constantin Zenith Source: Company

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor’s watch brand portfolio for its China shops

A. Lange & Sohne Audemars Piguet Baume & Mercier Blancpain BULGARI Carl F. Bucherer Certina Corum Cyma Girard Perregaux Glashütte Original Gucci Hamilton IWC Jaeger-LeCoultre Longines Maurice Lacroix Mido Movado Omega Oris Panerai Piaget Rado Raymond Weil Rolex Tag Heuer Tiffany & Co. Tissot Tudor Vacheron Constantin Zenith Source: Company

Emperor has a well-earned positive reputation among Swiss brand suppliers and has close partnership with many of them. To cite just a few examples, it is cooperating on advertising campaigns with Tudor, Patek Philippe, Cartier, Audesmars Piguet, Piaget, Breguet, Panerai and Jaeger-LeCoultre. These partnerships give Emperor access to the very latest items, including limited editions and exclusive collections.

Extensive and diversified store network in prime locations

Emperor owns an extensive network of 82 retail outlets in prime locations throughout Hong Kong, Macau and China.

Retail network located in prime In its core markets of Hong Kong and Macau, Emperor operates 25 outlets occupying locations throughout Hong Kong, total floor area of over 70,686 sq ft. The majority of these stores are located in prime Macau and China shopping locations that are easily accessible and have heavy customer traffic. Most of its shops in Hong Kong are located in Central, Wanchai, Causeway Bay and Tsim Sha Tsui, all major shopping zones for tourists. Chinese visitors currently account for over 85% of Emperor’s retail sales in Hong Kong and Macau.

China is a key region of growth for the company, which established its PRC headquarters in Beijing in 2008. The group currently manages a total of 57 outlets occupying total floor area of 76,914 sq ft in first- and second-tier cities, including Beijing, Shanghai, Guangzhou, Chongqing and Tianjin.

Multi-store formats to capture a Emperor outlets operate various store formats depending on local conditions. The wider range of clientele primary format is that of a multi-brand watch and jewelry POS offering a comprehensive Swiss watch portfolio that caters to the different price sensitivities and brand preferences of its customers. There is also an increasing number of jewelry-only POS that specialize in the finest in-house designed Emperor-branded accessories. In addition to the store formats just mentioned, mono-brand watch boutiques were established to provide comprehensive and exclusive coverage of selective brands. These mono-brand POS enhance the company’s synergies with its respective international watch suppliers and foster customer loyalty with the featured brands. For example, the group operates the largest Rolex-Tudor boutique in the world and operates a Patek Philippe and Cartier boutique in Hong Kong and a Cartier and Rolex mono-brand store in Macau.

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor’s multi-brand store Emperor’s multi-brand store

Emperor’s mono-brand store Emperor’s mono-brand store

Source: Company

Direct-retail operation

Eschewing the franchising model Emperor directly operates all of its stores. Management foresees no changes to this to sustain Emperor’s high-end business model. Given its position as a top luxury or high-end watch and jewelry positioning and to minimize the retailer, Emperor believes that its long-term success depends on how well it sustains risk of brand dilution its brand name and the image of the brands it carries. Management is well aware of the potential dangers to its reputation and the operation risks that could arise from franchising.

Initiation on Jewelry and Watch Sector 20 April 2012

Upside from jewelry exposure

Expand jewelry business to Emperor is accelerating expansion of its jewelry operation. Emperor’s jewelry enhance overall profit margin business covers a full range of luxury jewelry products including diamonds, jade, pearl, performance ruby and gold with a special emphasis on diamond and jade products. The company is known for its stylish designs, high quality and detailed craftsmanship. All jewelry products sold from Emperor are done so under the Emperor label. The group does not carry other jewelry brands or items in its stores. We believe the move to increase Targets 50% of overall sales from exposure to jewelry products presents Emperor with considerable growth jewelry in the medium to long opportunities. It aims to raise its jewelry sales contribution from 18% of total sales at term present to 50% in three-to-five years. In the long term, we expect Emperor’s jewelry business to play a more central role in driving the company’s overall earnings growth. We think it will eventually enhance Emperor’s reputation as one of the leading luxury goods distributors in China.

We see four major positives in Emperor’s jewelry business:

Cross-selling potential  Emperor’s jewelry segment enjoys considerable synergies with the company’s existing watch business. There are major cross-selling opportunities to be seized by leveraging off the existing customer base of Emperor’s watch business.

Focus on non-gold jewelry items  Emperor has made the decision to focus on diamond and jade products in order to avoid competition from the to differentiate itself from the over-crowded gold-jewelry market, and thereby gold-jewelry market avoid direct competition with the likes of Chow Tai Fook, Luk Fook, Chow Sang Sang, and Tse Sui Luen, which already have high market shares and long histories within the gold-jewelry trade. Jewelry products tend to provide higher gross margins than watches or gold products. It is therefore more sensible for Emperor to concentrate on high-end diamond, pearl and jade products.

 The additional offering of jewelry products will provide an avenue for Emperor to increase its presence in China since consumption of very high-end luxury watches still tends to take place overseas. Jewelry is a more personalized product than watches and so customers are less reluctant to purchase domestically.

 The jewelry segment provides higher gross profit margin than watches, with a minimum of 10ppt difference between the two segments. Greater sales of jewelry will enhance Emperor’s overall profitability.

Enhance Emperor’s jewelry The group is planning to enhance its Emperor jewelry brand by launching direct brand recognition through the marketing events and rolling out different collections on a regular basis. The company use of different marketing is committed to maintaining a high profile at jewelry shows held each year in Hong campaigns Kong, Macau and China each year.

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor’s jewelry store in Hong Kong Emperor’s jewelry store in China

Emperor’s jewelry products Emperor’s jewelry products

Source: Company

Strategic partnership with L Capital

Unique relationship with the Emperor introduced L Capital Asia, an affiliate of the LVMH group (LVMH IM, world-renowned LVMH group Not Rated), as a passive investor as well as a strategic partner in 2010 by issuing HK$140m worth of CBs and HK$100m in warrants to L Capital with an exercise price of HK$0.54 and conversion price of about HK$1.00 for the CB. L Capital converted the CBs it held in February 2011 while the warrants are still outstanding. L Capital is now holding around 2% of Emperor’s stake, which would further increase to about 4% upon full exercise of the warrants.

Synergies Given LVMH’s established reputation and L Capital’s expertise in investing in consumer companies in Asia’s emerging markets, particularly China and India, we believe the involvement in L Capital has major positive implications for Emperor’s operation, business developments and valuations. Indeed, an MOU was signed at the time of L Capital’s investment. The agreement set out the framework for future co-operation between the two parties, stipulating that L Capital would extend professional advice to Emperor regarding sales expansion, brand building, advertising, marketing, retail operations, human resources, distribution and costs management. More specifically, L Capital would: (1) assist Emperor in establishing retail stores in China; (2) assist Emperor in expanding its product portfolio; (3) allow Emperor to launch joint promotions and marketing events with leading LVMH brands; and (4) ensure a stable and competitive diamond supply to Emperor with the support of leading LVMH brands. Most importantly, the support of L Capital stands to enhance Emperor’s creditability and, hence, its bargaining power when it comes to acquiring watch and diamond resources.

Initiation on Jewelry and Watch Sector 20 April 2012

Synergies with the Emperor Group of companies

Emperor enjoys synergies from its membership in the Emperor Group of companies. Obvious benefits include joint marketing events, the sharing of the VIP database as well as access to favourable shop locations and competitive rental rates with sister companies.

Synergies with the Emperor One-third of Emperor’s shops in Hong Kong and all stores in Macau are leased from Group properties owned by Emperor Group (163 HK, Not Rated). We believe Emperor enjoys more competitive rental rates than peers, as reflected by its rental expense to sales ratios of under 8% in FY07-10. Most importantly, the relationship with Emperor Group’s property arm provides it with access to prime retail locations.

Emperor has access to the VIP database of Emperor Entertainment Hotel (296 HK, Not Rated), which includes casino “high-rollers” and key business associates. Having these names in Emperor’s Rolodex presents tremendous cross-selling opportunities.

In addition, the entertainment businesses of Emperor Motion Pictures (EMP) and the Emperor Entertainment Group (EEG) provide strong support to Emperor’s advertising and marketing efforts, especially in China. Emperor benefits from free celebrity endorsements and media coverage of EMP/EEG’s promotional campaigns. From time to time, Emperor Watch & Jewellery sponsors various local concerts, art shows, and movies showing in Hong Kong and China. It invariably invites VIPs and other luminaries to these events. During the past few years, Emperor’s marketing cost ratio has been running at under 1% of total sales.

Key earnings drivers

We forecast a strong earnings CAGR of 27% between FY11 and FY13F.

Hong Kong and Macau

Steady SSSG Business growth in Hong Kong and Macau is expected to be underpinned by a mix of modest store openings and solid SSSG. In Hong Kong, the group has plans to add three-to-four outlets in FY12F, and one-to-two new stores in FY13F. Coupled with our SSSG estimates of 16% in FY12F and 21% in FY13F, we project annual turnover growth to be 30% in FY12F and 32% in FY13F in Hong Kong.

Macau is forecast to have a steady uptrend with turnover growth estimated at 52% in FY12F and 38% in FY13F. There are two drivers unique to Macau, namely (1) the influx of Chinese gamblers whose demand for luxury accessories is particularly high, and (2) growing cross-selling opportunities thanks to the sharing of the Emperor Entertainment Hotel’s casino VIP database. For Macau, we assume two openings in FY12F followed by one addition in FY13F.

Initiation on Jewelry and Watch Sector 20 April 2012

China

Healthy sales growth in China Despite the on-going trend of mainland consumers preferring to purchase luxury items supported by increased abroad due to price and product offering differences, we see additional room for penetration and store expansion Emperor to develop its domestic business as its current operations in China are small. We also believe having a presence in China is critical for marketing purposes and, perhaps more importantly, for positioning the company as the price differential between China and Hong Kong narrows in the long run. We project turnover growth of 17% in FY12F and 19% in FY13F in China.

The pace of Emperor’s network growth in China is forecast to be rapid and we estimate 10-12 new openings per annum in FY12F-13F. As we discussed earlier, we expect more of the openings to be for its jewelry business. Of the planned new stores, there will be openings of three mono-brand watch POS in Shanghai and Shandong in FY12F. The group will also construct a flagship store in Beijing, expected to commence in 2015.

Steady gross margin uptrend

Gross margin improvement Emperor has limited control over the gross margins it earns from selling for the Swiss mainly driven by increased watch brands as gross margins are watched over and carefully controlled by the contribution from jewelry sales Swiss watch suppliers. The implication is that watch gross margins have and will remain largely stable within the range of 23 to 25% going forward. The gemstone jewelry business earns a higher gross margin of about 34% to 35%. Critically, there is upside to jewelry’s gross margin in the long run as Emperor’s brand ownership within this segment provides flexibility for product mix upgrades and ASP increases.

Due to jewelry’s higher profitability, Emperor is planning to increase the segment’s contribution from 18% currently to a target of 50% in the medium-to-long term. That said, the change is not likely to be substantial in the coming three years. That said, we believe the group’s gross profit margin is set to grow steadily, factoring in a gradual increase in sales contribution from gemstone jewelry and gross margin improvement within the jewelry segment.

Emperor – sales mix by product Emperor – gross profit margin trend

100% 31% 12% 14% 15% 18% 29.9% 30% 29.5% 80% 29.1% 29% 28.8% 27.9% 60% 28%

27% 88% 86% 85% 40% 82% 25.8% 26% 25.6%

20% 25%

24% 0% FY08 FY09 FY10 FY11 23% Watches Gem-set jewelry FY08 FY09 FY10 FY11 FY12F FY13F FY14F Source: Company data Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

SG&A not a key concern

We see the following factors lending stability to Emperor’s key SG&A expense ratios.

No material pressure from key  Synergies with the Emperor group of companies. Emperor has access to costs in the medium term attractive retail locations at competitive rates as one-third of its stores in Hong Kong and Macau are leased from Emperor Group. We forecast rental costs to remain under 7% of total sales in FY12F and FY13F. Our earlier discussion also indicated that Emperor enjoys advertising and marketing synergies with the activities of EMP and EEG. Marketing cost ratio remained under 1% of total sales for the past few years and should remain below 1% of sales in the foreseeable future

 Turnover-linked staff compensation. A common practice of watch and jewelry retailers is to link a substantial part of their staff compensation to individual store and staff member performance. We expect staff costs to sustain at 4% of total sales in FY12F-13F.

 High SSSG. High sales growth on a same-store basis tends to offset rising costs.

Emperor – key assumptions

Year to December (HK$m) 2008 2009 2010 2011 2012F 2013F 2014F Total POS 19 40 61 80 95 110 124 Hong Kong 11 12 17 18 21 23 24 Macau 4 4 4 5 7 8 9 China 4 24 40 57 67 79 91

Total POS – YoY change 10 24 18 19 15 15 14 Hong Kong 3 4 2 1 3 2 1 Macau 3 0 0 1 2 1 1 China 4 20 16 17 10 12 12

Total POS – YoY change (%) 111 111 53 31 19 16 13 Hong Kong 38 9 42 6 17 10 4 Macau 300 0 0 25 40 14 13 China NA 500 67 43 18 18 15

SSSG (%) HK/Macau 20 15 49 32 16 21 18

Sales growth – YoY (%) Hong Kong 16 29 51 44 30 32 25 Macau 31 75 49 42 52 39 24 China NA 1393 66 35 17 19 15

Gross margin (%) 27.9 25.8 25.6 28.8 29.1 29.5 29.9

Total staff cost as % of total sales 4.4 4.3 3.8 3.9 4.2 4.3 4.4

Total lease costs as % of total sales 5.3 8.0 6.7 6.9 7.2 7.3 7.5

Other expenses as % of total sales (0.4) 0.3 1.1 1.2 1.3 1.4 1.5 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor – revenue projections

Year to December (HK$m) 2008 2009 2010 2011 2012F 2013F 2014F Total revenue 1,842 2,686 4,095 5,862 7,607 9,987 12,355 YoY (%) 18 46 52 43 30 31 24

Revenue by market Hong Kong 1,722 2,230 3,366 4,863 6,305 8,325 10,376 Macau 102 179 267 377 574 796 983 China 19 278 462 622 728 866 996

Revenue growth by market (%) Hong Kong 16 29 51 44 30 32 25 Macau 31 75 49 42 52 39 24 China NA 1,393 66 35 17 19 15

Revenue mix by market (%) Hong Kong 93 83 82 83 83 83 84 Macau 6 7 7 6 8 8 8 China 1 10 11 11 10 9 8 Source: Company data, CCBIS estimates

Emperor – profit and loss projections

Year to December (HK$m) 2008 2009 2010 2011 2012F 2013F 2014F Total revenue 1,842 2,686 4,095 5,862 7,607 9,987 12,355 YoY (%) 18 46 52 43 30 31 24

COGS (1,328) (1,993) (3,048) (4,177) (5,397) (7,045) (8,666) YoY (%) 10 50 53 37 29 31 23

Gross profit 514 694 1,048 1,686 2,210 2,942 3,688 YoY (%) 47 35 51 61 31 33 25 Gross margin 27.9 25.8 25.6 28.8 29.1 29.5 29.9

Other income and gains 0 5 10 8 8 10 12

Staff costs (81) (116) (156) (227) (319) (429) (544) YoY (%) 13 43 35 46 41 34 27 As % of turnover 4.4 4.3 3.8 3.9 4.2 4.3 4.4

Depreciation and amortization (14) (22) (42) (66) (73) (59) (55) YoY (%) 49 62 85 60 9 (18) (7) As % of turnover 0.8 0.8 1.0 1.1 1.0 0.6 0.4

Rental costs (97) (215) (273) (407) (548) (729) (927) YoY (%) 96 122 27 49 34 33 27 As % of turnover 5.3 8.0 6.7 6.9 7.2 7.3 7.5

Other costs 8 (7) (44) (71) (99) (140) (185) YoY (%) 48 (184) 542 62 39 41 33 As % of turnover (0.4) 0.3 1.1 1.2 1.3 1.4 1.5

Total SG&A and other expenses (170) (338) (472) (705) (966) (1,298) (1,656) YoY 47 99 40 49 37 34 28 As % of total turnover 9.2 12.6 11.5 12.0 12.7 13.0 13.4

EBIT 280 245 413 764 955 1,254 1,539 YoY (%) 44 (12) 68 85 25 31 23 EBIT margin (%) 15.2 9.1 10.1 13.0 12.6 12.6 12.5 (Continued on next page)

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor – profit and loss projections (continued from previous page)

Year to December (HK$m) 2008 2009 2010 2011 2012F 2013F 2014F Depreciation and amortization included in SG&A 14 22 42 66 73 59 55

EBITDA 294 268 454 831 1,027 1,313 1,593 YoY (%) 44 (9) 70 83 24 28 21 EBITDA margin (%) 15.9 10.0 11.1 14.2 13.5 13.1 12.9

Interest income 1 0 2 4 4 5 7 Interest expense (3) (2) (11) (2) (3) (3) (3) Extraordinary items (9) 0 (199) (9) 0 0 0

Profit before tax 269 243 204 757 956 1,256 1,542 YoY (%) 40 (10) (16) 271 26 31 23 As % of turnover 14.6 9.1 5.0 12.9 12.6 12.6 12.5

Tax (47) (43) (70) (130) (167) (220) (270) Effective tax rate (%) 17.5 17.7 34.5 17.2 17.5 17.5 17.5

Minority interest (0) 5 8 (0) 4 5 6

Net profit 223 196 126 627 784 1,031 1,266 YoY (%) 40 (10) (33) 368 26 31 23 Net margin (%) 12.1 7.3 3.1 10.7 10.3 10.3 10.2

Core net profit 232 196 325 636 784 1,031 1,266 YoY (%) 46 (16) 66 96 23 31 23 Core net margin (%) 12.6 7.3 7.9 10.9 10.3 10.3 10.2 Source: Company data, CCBIS estimates Balance sheet and cash flow

Lowest inventory turnover days Emperor’s inventory largely consists of finished watches and gem-set inventory, for Swiss watches in the industry including raw materials and finished goods. Inventory turnover days for Emperor surged from 207 days in FY10 to 243 days in FY11, mainly caused by the Lunar New Year stock building, and the increased proportion for jewelry stocks. Emperor has the lowest inventory turnover days for its watch segment compared with peers, with only 130-150 days by end-2011. Jewelry inventory was at over 400 days in the same period.

Going forward, with the tight control on inventory management, we believe Emperor’s inventory turnover days to maintain under 260 days level, with an average of 16-24% YoY increase p.a. Receivable and payable days were relatively stable in FY08-11 and we believe both will remain constant in FY12F-13F.

Capex spending is mainly being put towards retail network expansion, IT system upgrade and regular maintenance. We expect a sum of HK$54-56m on capex in FY12F-13F. Our estimates included an average of HK$2-2.3m starting costs for stores in Hong Kong and Macau, and HK$0.8m capex budget for China openings.

Emperor is in a net cash position (HK$464m as at end-December 2011). It is also forecast to generate annual EBITDA of over HK$1b in FY12F-13F. On top of that, Emperor had HK$340m in short-term borrowings at end-2011 to support its heavy working capital requirements. We hence expect the group to have sufficient financial and cash flow strength to support its store openings pipeline, without the immediate funding needs from capital markets in the short term.

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor – cash conversion cycle and working capital days

320 276 269 280 257 243 230 235 239 240 220 219 228 207 216 205 200 184

160

120

80 23 40 17 17 12 11 11 11 0

(40) (24) (34) (40) (35) (33) (34) (33) (80) FY08 FY09 FY10 FY11 FY12F FY13F FY14F Average inventory days Average receivable days Average payable days Cash conversion cycle (days)

Source: Company data, CCBIS estimates

Emperor – operating cash flow, free cash flow and net cash flow projections

HK$m 800 604 600 550 379 334 400 278 198 201 149 135 146 155 200 92 47 0 (63) (200) (80) (248)(272) (400) (346) (403) (600) (592) (669) (800) FY08 FY09 FY10 FY11 FY12F FY13F FY14F Operating cash flow Free cash flow Net cash flow

Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor – balance sheet projections

Year to December (HK$m) 2008 2009 2010 2011 2012F 2013F 2014F Property, plant and equipment 34 75 85 97 80 75 74 Deferred tax assets 0 0 4 6 6 6 6 Others 0 0 102 157 155 155 155 Non-current assets – total 34 75 191 260 240 236 234

Inventories 1,205 1,308 2,152 3,404 4,209 5,002 5,806 Trade receivables and other receivables 133 205 171 199 251 330 408 Tax recoverable 0 7 0 0 0 0 0 Bank balance and cash 168 252 601 804 828 979 1,335 Total current assets 1,506 1,771 2,925 4,407 5,288 6,311 7,549

Payables, deposits received and accrued charges 102 264 405 396 594 705 867 Amount due to immediate holding company 0 0 0 0 0 0 0 Amounts due to related companies 0 3 4 4 1 1 1 Amount due to a related party 0 0 45 0 0 0 0 Dividend payable 0 0 0 0 0 0 0 Taxation payable 16 6 35 68 70 70 70 Obligation under a finance lease – due within a year 0 0 0 0 0 0 0 Short-term bank loans 4 4 67 340 320 320 300 Total current liabilities 123 277 556 809 985 1,096 1,238

Bank borrowings – due after one year 13 9 0 0 0 0 0 Deferred taxation 1 0 0 0 0 0 0 Derivative financial instruments 0 0 180 0 0 0 0 Liability component of convertible bond 0 0 110 0 0 0 0 Total non-current liabilities 14 10 290 0 0 0 0

Shareholders’ equity 1,398 1,549 2,268 3,859 4,540 5,442 6,530 Minority interest 5 10 3 0 4 9 15 Total equity 1,403 1,559 2,270 3,859 4,544 5,451 6,545

Total assets 1,540 1,846 3,116 4,667 5,529 6,546 7,783 Total liabilities and equities 1,540 1,846 3,116 4,667 5,529 6,546 7,783

Gross debt 17 14 67 340 320 320 300 Net debt (150) (239) (534) (464) (508) (659) (1,035) Net gearing (%) Net cash Net cash Net cash Net cash Net cash Net cash Net cash Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Emperor – cash flow projections

Year to December (HK$m) 2008 2009 2010 2011 2012F 2013F 2014F EBIT 280 245 413 764 955 1,254 1,539 Depreciation and amortization 14 22 42 66 73 59 55 EBITDA 294 268 454 831 1,027 1,313 1,593 Adjustments for other non-cash items (10) 1 (2) 22 2 3 5 Working capital changes: Inventory (403) (105) (842) (1,255) (805) (793) (804) Receivables (44) (71) (68) (81) (52) (79) (78) Payables (32) 162 141 (8) 197 111 162 Amount due to fellow subsidiary and related companies (1) 3 1 0 (3) 0 0 Tax paid (53) (60) (40) (99) (165) (220) (270) Interest paid 3 2 11 2 3 3 3 Interest received (1) (0) (2) (4) (4) (5) (7) Operating cash flow (248) 198 (346) (592) 201 334 604 Capex (25) (63) (57) (77) (54) (55) (54) Free cash flow (272) 135 (403) (669) 146 278 550 Other investment cash flows 15 0 2 4 4 5 7 Contribution from minority shareholders 0 0 0 (3) 0 0 0 Share issue 581 0 372 800 0 0 0 Dividend paid (318) (43) (83) (149) (103) (129) (178) Advance/repayment to/from minority shareholders 143 (1) 33 (45) 0 0 0 Net cash flow 149 92 (80) (63) 47 155 379 Source: Company data, CCBIS estimates

Emperor – key financial ratios

Year to December 2008 2009 2010 2011 2012F 2013F 2014F ROAE (%) 25.3 13.3 6.6 20.5 18.7 20.7 21.2 ROAA (%) 18.2 11.6 5.1 16.1 15.4 17.1 17.7 ROIC (%) 26.2 15.7 20.8 24.4 22.2 24.3 25.4 Average inventory days 276 230 207 243 257 239 228 Average receivable days 17 23 17 12 11 11 11 Average payable days (24) (34) (40) (35) (33) (34) (33) Cash conversion cycle (days) 269 220 184 219 235 216 205 Net gearing (%) Net cash Net cash Net cash Net cash Net cash Net cash Net cash Gross gearing (%) 1.2 0.9 3.0 8.8 7.0 5.9 4.6 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Company specific risks

Connected-party transactions

Although we acknowledge that Emperor’s working relationship with sister companies under the Emperor Group brings operational advantages, the market tends to have a negative perception of any form of connected-party transactions.

Frequent fund-raising activities

Emperor has raised money from the market several times in the past three years as shown in the following table. Not all of these activities were absolutely necessary, in our view. Frequent capital market activities can be a share price overhang and EPS dilutive.

Emperor – past capital raising activities

Conversion/ Amount/principal amount Issue date completion date Type No. of shares issued (HK$m) HK$/share January 2010 N/A Placement 450,000,000 230 0.51 March 2010 N/A Top-up placement 264,810,000 143 0.54 August 2010 12 April 2013 Convertible bond to L Capital 259,300,000 140 0.54 August 2010 12 April 2013 Convertible bond to D.E.Shaw 444,400,000 240 0.54 September 2010 12 April 2013 Warrants N/A 100 0.62 April 2011 April 2011 Top-up placement 800,000,000 787 1 Source: HKEx, CCBIS research

Senior management and shareholding structure

Ms. Cindy Yeung – Executive director and Managing director

Ms Yeung joined the group in 1990. She is responsible for the group’s strategic planning, business growth and development and for overseeing different operations within the group. She became a director of Emperor Watch & Jewellery (HK) Company Limited, an operating arm of the retail outlets of the group in Hong Kong, in April 1999. The Group has been under her management since then. She obtained the qualification of Graduate Gemologist of GIA in 1988 and since then has accumulated over 20 years of experience within watch and jewelry industry. Prior to joining the group in 1990, she joined the sales department of Anju Jewelry Ltd, a US-based company engaging in trading of jewelry products. Ms. Yeung is the daughter of Dr. Yeung Sau Shing, Albert who is deemed to be a controlling shareholder of the company.

Mr. Chan Hung Ming – Executive director

Mr. Chan joined the Group in July 2005 and is now responsible for overseeing the retail outlet operations in Macau and Hong Kong. He has over 30 years of experience within the watch and jewelry industry. Prior to joining the group, he acted as general manager in charge of the retail and watch boutique outlets in Hong Kong and the PRC in the Dickson Watch & Jewellery division under Dickson Concepts (International) Limited (113 HK, Not Rated) for over 20 years.

Initiation on Jewelry and Watch Sector 20 April 2012

Mr. Wong Chi Fai – Executive director

Mr. Wong has been involved in the management of the company since November 1998. He is the Chairman of the Remuneration Committee of the company. Mr. Wong is an associate of the HKICPA. He is also a director of Emperor International Holdings Limited (163 HK, Not Rated), Emperor Entertainment Hotel Limited (296 HK, Not Rated) and New Media Group Holdings Limited (708 HK, Not Rated). Having over 20 years of management experience, Mr. Wong has diversified his experience by working in different businesses ranging from manufacturing to watch and jewelry retailing, property investment and development, hotel and hospitality as well as media and publication.

Ms. Fan Man Seung, Vanessa – Executive director

Ms. Fan has been involved in the management of the company since late-1998. She is also a director of Emperor International Holdings Limited, Emperor Entertainment Hotel Limited and New Media Group Holdings Limited. Besides having over 21 years of corporate management experience, she possesses diversified experience in different businesses, including watch and jewelry retailing, property investment and development, hotel and hospitality, financial and securities operations as well as media and publication.

Mr. Hanji Huang – Non-executive director

Mr. Huang was appointed as non-executive director of the company in August 2010. He is a member of the company’s audit committee of the company and has held senior positions in various global investments. He has over 10 years of experience in the equity capital market, particularly in private equity investment.

Emperor shareholding structure

Yeung’s Family Trust Public 53.2% 46.8%

Emperor Watch & Jewellery Limited (887 HK)

Source: Company, HKEx

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli Holdings (3389 HK)

Company Rating: Outperform Still a timeless preposition (maintained)

Hengdeli is China’s largest mid-to-high end watch retailer and wholesaler with 35% market share. Increased penetration of the mid-market segment through aggressive network expansion into Price: HK$3.43 the second- and third-tier cities will be the company’s core Target: HK$4.15 earnings driver in the coming years. Given the company’s favorable earnings outlook as well as its strengthening financial (up from HK$3.95) position, we maintain our Outperform rating on the stock. Trading data  Market leader. As the leading national mid-to-high end watch retailer with strong store brand recognition in China, 52-week range HK$2.14 – 5.15 Hengdeli is well positioned to tap the country’s burgeoning Market capitalization (m) HK$15,085/US$1,944 watch market. The company outshines its peers by virtue of Shares outstanding (m) 4,398 its strategic alliances with major Swiss watch suppliers, that Free float (%) 48 allow Hengdeli to secure and source a wider range of 3M average daily T/O (m share) 14.4 products. We see limited competition risk for the 3M average daily T/O (US$m) 6.1 foreseeable future as peers have weaker sales channels Expected return (%) – 1 year 22.8 and insufficient financial strength to adopt Hengdeli’s Closing price on 18 April 2012 multi-brand strategy or keep up with its aggressive expansion. Stock price vs. HSI  Tapping the potential of second- and third-tier cities. HK$ The booming Chinese economy has spurred the country’s 5.0 urbanization rate, leading to the emergence of a wealthy 4.6 middle-class. Hengdeli has moved ahead of its competitors in aggressively expanding into second- and third-tier cities, 4.2 and is therefore well-positioned to benefit from the 3.8 favorable market development. 3.4

 Reiterate Outperform. We fine-tune our estimates and 3.0 slightly lower our EPS estimates by 3% for FY12F-13F. Our 2.6 target price is raised from HK$3.95 to HK$4.15, now based on CY13F P/E of 12x instead of CY12F P/E of 14x. Despite 2.2 19-Apr-11 1-Jul-11 12-Sep-11 24-Nov-11 5-Feb-12 18-Apr-12 the near-term hiccup of moderating sales growth, we Hengdeli HSI (rebased) believe that the long-term prospects for the industry will Source: Bloomberg remain promising. Hengdeli’s market leadership and FY11-13F earnings CAGR of 21% should support share price performance in the medium-term.

Financial forecast Year to 31 December FY10 FY11 FY12F FY13F FY14F Revenue (RMB m) 8,216 11,375 14,155 17,019 19,729 Rev forecast change (%) – – 0.2 (1.3) –

Net profit (RMB m) 554 815 985 1,192 1,356 Claudia Ching NP forecast change (%) – – (3.4) (3.0) – (852) 2532 2528 EPS (RMB) 0.133 0.185 0.224 0.271 0.309 [email protected] EPS (YoY, %) 41 40 21 21 14 P/E (x) 25.9 18.5 15.3 12.6 11.1 Forrest Chan, CFA (852) 2532 6743 Yield (%) 1.1 1.6 1.8 2.2 2.5 [email protected] FCF yield (%) (4.3) (0.6) 12.7 3.4 11.4 ROAE (%) 14.9 16.9 18.1 19.2 19.1 Timothy Sun Net gearing (%) Net cash 6 Net cash Net cash Net cash (852) 2532 6746 Source: Company data, CCBIS estimates [email protected]

Initiation on Jewelry and Watch Sector 20 April 2012

Investment highlights

Leader in mid-to-high end Hengdeli is the largest watch retailer in China with 35% market share and the watches country’s most extensive retail network with close to 405 stores at end-2011. These feature put it in good position to capture growing demand for affordable-luxury watches .in China. Hengdeli’s strong brand recognition, well-established relationships with key suppliers, multi-brand strategy, and diverse customer base are key competitive advantages that keep the company ahead of its peers. By expanding its strong network in the affluent mid-market segment, Hengdeli stands to strengthen its strong network presence across the second- and third-tier cities.

Strategic tie-ups with world Thanks to its long standing co-operation with major Swiss watch makers over the renowned luxury brand owners years, Hengdeli now has close relationships with top Swiss watch suppliers. The Swatch Group (UHR VX, Not Rated) and LVMH Moet Hennessy Group are substantial shareholders of Hengdeli. The company’s strategic alliance with major suppliers provides unique advantages, including a more diversified and wide ranging supply of product, an extended credit line, and priority in watch supply and delivery which no other industry player in China can compare with.

Supported by its nationally recognized brand name, Hengdeli is a rare luxury watch retailer that has the financial ability and bargaining leverage to operate a multi-brand approach. With its three main brands targeting different customer segments, we believe the company is well positioned to fortify its sales channels and expand its customer pool.

Focus on developing tier two-to- Eyeing the large market potential for entry-level luxury watches, Hengdeli will three markets in China accelerate its expansion plans by adding 40-60 stores per annum in FY12F-13F in second- and third-tier cities, from a total store count of 405 at end-2011. Hengdeli is among the few luxury watch chains expanding at such a rapid pace; moreover, it is doing so in regions outside of tier-one cities. We are confident of Hengdeli’s ability to seize the opportunity to capture additional market share.

Solid sales performance over the In 4QCY11-1QCY12, when the overall retail environment in China began to soften, past six months despite Hengdeli saw some slowdown in its sales of ultra-luxury goods (over RMB50,000). In weakening consumer sentiment contrast, mid-end watch sales at Prime Time and With Time stores held up well. Overall, the quarter still saw SSSG in the mid-to-high teens. At the latest results announcement presentation, management indicated a relatively cautious sales target of over 20% YoY growth for FY12F, which we believe is achievable. Despite the near-term hiccup of moderating sales growth, we believe that the long-term prospects for the industry remain promising. Hengdeli’s market leadership and earnings CAGR of 21% between FY11-13F should support share price performance in the medium-term. Hengdeli offers an attractive investment case that will sustain over the long-term.

Market leader with exceptionally strong store brand recognition

Hengdeli was ranked first in Greater China in terms of retail sales of affordable-luxury watches, topping RMB11b in sales in FY11. As the largest player in the luxury watch segment in China with 35% market share, Hengdeli is strongly leveraged to the country’s rapidly growing demand for luxury goods, especially in the wake of rising income levels and its penetration into second- and third-tier cities. On the back of its aggressive expansion plans across China, we anticipate Hengdeli’s market share will continue to grow.

Initiation on Jewelry and Watch Sector 20 April 2012

Unmatched competitive advantages to sustain dominance

Besides being a dominant player in China, Hengdeli is the most scalable retailer among China’s national luxury watch retail chain operators. Hengdeli’s successful business model is extremely difficult for other industry players to replicate and, hence, it is unlikely others will overtake Hengdeli’s market leadership in the foreseeable future. The success of Hengdeli is supported by the following factors:

Four distinctive competitive  A well-established household name within China’s luxury watch market advantages  Strategic tie-ups with suppliers and comprehensive product offerings

 Extensive customer coverage through effective brand building

 Room to scale up through aggressive store openings A well-established household name within China’s luxury watch market

Wide recognition nationwide One of the first national luxury watch retailers in China, Hengdeli has established sound and exclusive working relationships with various internationally renowned brand owners. Tracing back to 1949 when it became a state-owned enterprise, Hengdeli began distributing Swiss watches in China. The close cooperation over the years has been unrivaled.

Experienced management team Hengdeli’s extensive history distributing luxury watches in China has given it considerable industry know-how. Run by an experienced management team (Chairman Zhang Yupin has over 25 years of experience in the high-end consumable distribution industry in China), we believe Hengdeli will continue to benefit from its management team’s expertise and experience retailing luxury watches in China.

Hengdeli is consistently viewed as a symbol of authenticity and quality assurance. With the rising awareness of product quality and originality among Chinese consumers, Hengdeli is likely to become a preferred and trusted watch retailer. Its long established reputation in China will help it gain access to more strategic shop locations, and will give it strong bargaining power when negotiating for rental rates.

Strategic tie-ups and wide ranging product offerings

In order to minimize brand image risk, international luxury brand suppliers have become extremely stringent when selecting distribution partners, especially in China. On the strength of its exclusive product offerings and years of cooperation, Hengdeli has managed to win over the trust of world-class Swiss watch brands, including the world’s largest watch distributors – Swatch Group and LVMH. Hengdeli currently distributes over 50 internationally renowned brands. Its strong ties with suppliers mean Hengdeli is able to secure a wider range of model collections as well as more favourable credit terms compared with local peers. In many cases, Hengdeli is also given priority in watch supply and delivery.

Unique shareholding structure While non-exclusive, distribution partnerships with Swatch Group and LVMH remain with suppliers as major guarded in our view, given the ownership status of the major suppliers within shareholders Hengdeli’s shareholding structure. Swatch Group owns a 9.1% stake in the company and is currently the second-largest shareholder, while LVMH is the third-largest shareholder with a 5.9% interest. Such shareholding structures clearly suggest that Hengdeli has a strong vote of confidence from its suppliers; moreover its strategic ties provide it a distinctive competitive advantage.

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli’s shareholding structure

Best Growth Swatch Group (UHR VX) LVMH Public 34.6% 9.1% 5.9% 50.4%

Hengdeli Holdings (3389 HK)

Source: Bloomberg

Hengdeli and Swatch Group have established a 50:50 JV to wholesale and retail certain watch brands in China since 2003. The JV, which plans to open and operate boutiques that focus on watches, jewelry, and other accessories of the Swatch Group, has already opened an Omega flagship shop on Huaihai Road, Shanghai and a Swatch boutique in Harbin and Qingdao.

Providing the hottest brands Leveraging its strong links with various brand owners, Hengdeli has managed to secured exclusive distribution rights for over 18 brands, including those owned by Swatch Group, LVMH, and Richemont. Its close relationship with Swatch Group and LVMH are of particular importance given that these brands are among the top-five best-selling watch brands in China (50% of the market).

Hengdeli’s brand portfolio

Exclusive brands Non-exclusive brands Swatch Group Tissot, Calvin Klein, Certina, Hamilton, Omega, Rado, Blancpain, Glashutte, Mido, Breguet, Longines Jaquet Droz Rolex Group Rolex, Tudor LVMH TAG Heuer, Zenith, Christian Dior, Fendi Richemont Jaeger-Lecoultre, Baume & Mercier Alfred Dunhill, Panerai, Cartier, Vacheron Constantin, IWC Independent Maurice Lacroix, Carl. F. Bucherer, Edox, Enicar, Carven, Ball, Gucci, Oris, Raymond Well, brands Claude Bernard Frank Muller, Hermes, Girard Perregaux, Grand Seiko, Jean Richard, MONTBLANC, Parmigiani, Ulysse Nardin, Cyma Source: Company

Extensive customer coverage through effective brand building

Three distinct store brands to Rare among luxury brand retailers, Hengdeli possesses sufficient scale to handle a capture different consumer multi-brand strategy that allows it to maximize customer exposure. Its retail network segments and expand sales can be classified under three main categories of multi-brand shops, namely: Elegant, channels Prime Time, and With Time. The company also operates several mono-brand boutiques.

The multi-brand business model is unparalleled and is a function of Hengdeli’s leadership within China’s mid-to-high end watch market. Hengdeli’s ability to source an extensive range of watch products avails it of a diverse clientele base while supporting the multi-brand operation. Most industry peers operate under single store brand due to network scale restrictions.

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli’s store brands

Elegant  Showcases the most luxurious, internationally renowned brands of top-class watches  ASP: RMB50,000 in Mainland; HK$100,000+ in Hong Kong  21 Elegant outlets, with 14 in China, six in Hong Kong and one in Taiwan Prime Time  Offers a full range of watch brands under an extensive number of internationally renowned brands targeting middle-to-high end customers  Provides one-stop-shop services to customers  Selective expansion in tier-two and tier-three cities  ASP: RMB15,000  245 Prime Time stores, with 207 in China and 38 in Taiwan With Time  The trend setter of watches, bringing fashionable and niche yet classy watches to the youngsters  ASP: RMB5,000  63 stores in China Mono-brand boutique  Jointly established brand boutiques with brand owners to demonstrate the style of brands, and providing the most comprehensive and rare portfolio. stores  74 brand image boutiques, with 48 in China, 12 in Hong Kong, one in Macau and 13 in Taiwan under various renowned brands, namely Rolex, Tissot, TAG Heuer and Cartier etc. Source: Company, CCBIS Research

Hengdeli’s Elegant store Hengdeli’s Prime Time store

Source: Company website Source: Company website

Hengdeli has committed considerable resources improving sales of its middle-to-high end brands. More than 75% of its retail outlets in China are Prime Time shops, which are positioned to sell mid-to-high end watches. Prime Time and With Time contribute nearly 80% of the company’s total retail sales in China and will remain the company’s leading store brand in the coming years. Given increasing demand for mid-to-high end watches, Hengdeli will continue to consolidate and expand its retail network in second- and third-tier cities under the Prime Time label.

Leadership by scale

An industry leader for several With its good reputation and wide product coverage, Hengdeli dominates the other years two major Hong Kong-listed luxury watch competitors in terms of sales size and market share. In FY11, Hengdeli’s sales revenue exceeded Oriental and Emperor by 2.1x and 1.9x, respectively. Its presence in China also over shadows that of its peers, with a network of approximately 332 stores compared with 57 for Emperor and 86 for Oriental at end-2011. The three players target different markets, with Hengdeli focusing on China’s second- and third-tier cities, Oriental targeting Hong Kong and Emperor focusing on China’s first-tier cities.

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli dominates China’s luxury watch industry on the strength of its reputable brand name, long history, large network, and overall sales and profitability. Given their lower sales and smaller market share, other players have insufficient finance ability to ramp up their expansion plans. Thus the threat to Hengdeli from its peers is minimal.

Faster expansion compared to peers

Captures the affluent In view of the growing spending propensity of the expanding middle class, Hengdeli is middle-income customers accelerating its store rollout plan to capture fast growing demand. Already with 332 stores in China, 18 in Hong Kong, 1 in Macau, and 54 in Taiwan at end-2011, management aims to add 40-60 annually in FY12F-13F. Hengdeli’s store portfolio should reach over 400 outlets, far exceeding other competitors.

Hengdeli – number of stores

600 539 496 500 82 453 79 405 76 400 350 73 64 300 237 204 13 457 417 200 7 377 332 286 100 197 224

0 FY08 FY09 FY10 FY11 FY12F FY13F FY14F China POS Hong Kong, Macau & Overseas POS Source: Company data, CCBIS estimates

Burgeoning middle class Second-tier city stores have fared well in the past three years, delivering increasing provides a strong sales catalyst profits the company. We believe Hengdeli’s reliance on these cities will continue to increase over time to eventually become the company’s main growth driver.

Hengdeli – China revenue mix by city tier Hengdeli – store space in China by city tier

100% 100% 5% 12% 13% 15% 90% 18% 21% 90% 27% 30% 35% 80% 80%

70% 70% 58% 60% 57% 60% 61% 61% 58% 50% 59% 50% 60% 40% 59% 40% 55% 30% 30%

20% 37% 20% 31% 26% 10% 24% 24% 20% 10% 13% 12% 10% 0% 0% 2006 2007 2008 2009 2010 2011 2009 2010 2011 Tier 1 Tier 2 Tier 3 Tier 1 Tier 2 Tier 3

Source: Company data Source: Company data

Initiation on Jewelry and Watch Sector 20 April 2012

Compared with Hengdeli, most peers have a slower rollout plan with a focus on first-tier cities. Meanwhile, Hengdeli has spotted the enormous growth potential in the mid-market segment. With the aim of extending the coverage of its mid-to-high end product line, the majority of Hengdeli’s new stores will come under the Prime Time label. Expansion will focus on tier-three and tier-four cities in the North Eastern region, such as Shenyang and Tianjin, Eastern China, like Sichuan, and Southern China regions, including Nanchong and Jiangxi.

Well-positioned to capture future As urbanization continues, we have a positive view on Hengdeli’s strategy to extend growth by penetrating China’s into second- and third-tier cities. In our view, consumers in those cities make up the second- and third-tier cities bulk of Hengdeli’s addressable market. We believe that Hengdeli’s mid-end watch offering will gain traction with the growing number of middle income consumers in these cities.

Expansion into Taiwan to complete Greater China coverage

Hoping to capture the opportunity for additional sales, Hengdeli entered Taiwan through its acquisition of 80% of Taiwan Jing Guang Timepiece for HK$48m, at 6x P/E, in 2009. Taiwan Jing Guang Timepiece owns 31 retail outlets in Taipei, Taichung, Kaohsiung, Hsinchu, and Chiayi. It specialized in selling internationally renowned watch brands. As a result of the acquisition, Hengdeli managed to establish a retail network in the major cities of Taiwan having leading market share. By doing this, Hengdeli laid a sound foundation for the long-term development of the company’s overseas business.

Benefits from surging mainlander In mid-May 2010, Hengdeli opened its Elegant flagship store in Taiwan. The new store visits sells the world’s top-ten most exclusive watch brands and serves as a grand emporium for building brand image.

Hengdeli’s expansion into Taiwan makes good business sense given that in July 2008, mainland China and Taiwan resumed regular direct flights between the two regions for the first time in six decades. As retail prices for luxury watches in Taiwan are approximately 11% cheaper than in mainland China, many mainlanders visit Taiwan in search of bargains.

Acquired Taiwan Jing Guang Considering the Taiwan market is still at a developing stage, we do not anticipate any Timepiece to strengthen foothold material contribution to the company in the near term. Nevertheless, we anticipate the in Taiwan broadened platform will be a long-term driver for Hengdeli in capturing additional market share and sales.

Initiation on Jewelry and Watch Sector 20 April 2012

Key earnings drivers

Hengdeli’s revenue is derived from three major segments, with retail business, the largest segment, accounting for over 76% of total sales, followed by the wholesale business (22%). Going forward, we expect the company to continue to rely on the retail segment, which holds greater potential for rapid growth and higher margins. We project the segment to account for 80% of total sales by 2013F.

No substantial slowdown in sales After demonstrating exceptional sales trends in FY11, with growth of 39% YoY, momentum despite the Hengdeli began to see a slowdown in sales of ultra-luxury items mainly due to the less weakening retail environment positive macro outlook. However, mid-end watch sales at Prime Time and With Time stores remained robust. Overall, Hengdeli still achieved a double digit sales growth in January and February 2012. Going further into 2012, Hengdeli’s focus on the mid-market watch segment, in our view, will provide sales resilience amidst the softer retail environment.

China retail sales

We expect the core sales drivers of Hengdeli’s China business to be high SSSG and accelerated store rollout. Currently, mature stores (defined as stores operating for more than three years) account for 30% of Hengdeli’s China store count and contribute to approximately 70% of its total China sales. We believe maturing younger stores will help drive strong overall SSSG as growth can be as high as 50-70% in new stores. We are also forecasting 40-45 new store openings or an increase of 11-13% in the store network for China in FY12F-13F. On this measure, our 21-25% YoY retail sales growth projections for China in FY12F-13F, respectively, do not appear to be demanding.

Hong Kong retail sales

Organic sales growth will be the main sales driver as we expect new openings in Hong Kong to be muted. We assume only one store per annum to be added in 2012-2013. Looking ahead, we expect Hengdeli sales in Hong Kong to rise 24% YoY in FY12F and 19% YoY in FY13F.

Wholesale business

Consistent robust sales from the Hengdeli’s China operation currently owns the distribution rights for 50 internationally wholesale business renowned, of which 18 are on an exclusive basis. Hengdeli is the largest wholesaler of affordable-luxury watches in China with over 400 customers covering approximately 1,000 stores. With its ownership of exclusive distribution rights for a number of best-selling international brands, local retailers that intend to carry these brands must source from Hengdeli.

In recent years, the wholesale business was not the fastest growth segment for Hengdeli, yet this segment remains financially important as it generates stable cash inflow and serves as a platform for maintaining close working relationships with its Swiss watch suppliers.

The wholesale business outlook is anticipated to remain sound given the healthy industry development in China. We expect sales from this segment to grow steadily by 21% in FY12F and 17% in FY13F and to contribute 21-22% to total sales in FY12F-13F.

Initiation on Jewelry and Watch Sector 20 April 2012

Uptrend in margins

Widening gross margin on rising On a like-for-like basis, Hengdeli’s gross margin has been fairly stable over the past contribution from the retail few years since Swiss watch suppliers dictate ASPs and strictly restrict retailers from business and mid-market offering excessive discounts. Nonetheless, the rising contribution from the retail products business in China supports a steady expansion in the group’s overall gross margin. Thanks to the higher gross profit margin carried by mid-end watches (34-35% for Prime Time versus 31% for Elegant), the increased sales contribution will enhance the company’s overall gross margin.

Hengdeli – gross profit margin trend

25.8% 25.4% 25.5% 25.4% 25.3% 25.1% 24.9% 25.0%

24.6%

24.2% 23.9% 23.9% 23.8%

23.4%

23.0% FY08 FY09 FY10 FY11 FY12F FY13F FY14F

Source: Company data, CCBIS estimates

SG&A expenses and other assumptions

 Rental expenses. Hengdeli’s rent structure in China is similar to most retailers, with a fixed base rental on top of a share of approximately 15% of total sales. 90% of Hengdeli’s shops are located in department stores and the rest are standalone or boutique stores. Since most new stores will be set up in tier-two and-three cities where rents are relatively lower, we model rental expenses to be well-contained within 7% of total retail sales in FY12F-13F as SSS accelerates.

Major cost components remain  Distribution expenses. Staff costs account for 5% of sales. The company has stable, and able to levy costs no direct exposure to changes in the minimum wage as it always pays its pressure through robust SSSG workers more than the minimum. Distribution costs remained stable at under 12% of sales in FY10 and FY11.

 Tax rates. The tax rate imposed to Hengdeli’s mainland operations is 25% and is expected to remain constant in FY12F-13F. Its Hong Kong business is subject to a tax rate of 17.5%. We forecast the blended effective tax rate for Hengdeli will be 24% in FY12F-13F.

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli – key assumptions

Year to December (RMB m) 2007 2008 2009 2010 2011 2012F 2013F 2014F Sales growth by product (YoY, %) China retail sales 86 36 17 38 38 27 23 18 Hong Kong retail sales 40 (3) 20 41 31 24 19 15 Wholesale revenue 41 13 (19) 25 54 21 17 14 After-sales services revenue 455 58 (6) 34 31 15 12 10

Gross profit margin (%) 22.5 23.9 23.9 24.9 25.1 25.3 25.4 25.5

Retail store numbers 84 204 237 350 405 453 496 539 China 82 197 224 286 332 377 417 457 Hong Kong 2 7 13 16 19 20 21 22 Taiwan – – – 48 54 56 58 60

Retail and after-sales service business as % of total sales 69 68 75 78 76 76 77 77 Wholesale business as % of total sales 31 30 23 20 22 22 21 21

Other assumptions Distribution expense as % of revenue 6.8 9.5 10.0 11.5 11.6 11.7 11.9 12.3 Rental expense as % of retail revenue – – – 7.3 7.3 7.2 7.3 7.4 Staff expense as % of revenue – – – 5.1 5.3 5.4 5.5 5.6 Administrative expense as % of revenue 3.4 4.6 4.1 3.4 3.2 3.1 3.1 3.2 Effective tax rate (%) 19.9 21.1 24.8 24.3 23.4 24.0 24.0 24.0 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli – profit and loss projections

Year to December (RMB m) 2007 2008 2009 2010 2011 2012F 2013F 2014F Revenue 4,579 5,516 5,899 8,216 11,375 14,155 17,019 19,729 YoY (%) 90 20 7 39 38 24 20 16

COGS (3,549) (4,197) (4,490) (6,167) (8,518) (10,580) (12,689) (14,705) Gross profit 1,030 1,319 1,409 2,049 2,857 3,575 4,330 5,024 YoY (%) 83 28 7 45 39 25 21 16 Gross margin (%) 22.5 23.9 23.9 24.9 25.1 25.3 25.4 25.5

Government grants 13 15 16 9 10 11 13 15 Investment income (Distributing JV with SWATCH) 11 16 16 19 28 32 37 42 Other income – sub-total 55 50 51 55 141 156 162 195

Distribution costs (312) (522) (590) (948) (1,325) (1,661) (2,033) (2,421) Administrative costs (156) (253) (239) (281) (369) (435) (527) (622) Total SG&A (483) (774) (831) (1,230) (1,697) (2,097) (2,560) (3,043)

Key SG&A expense ratio (%) Distribution costs 6.8 9.5 10.0 11.5 11.6 11.7 11.9 12.3 Administrative costs 3.4 4.6 4.1 3.4 3.2 3.1 3.1 3.2

EBIT 591 623 613 837 1,267 1,606 1,902 2,108 YoY (%) 97 6 (2) 37 51 27 18 11 EBIT margin (%) 12.9 11.3 10.4 10.2 11.1 11.3 11.2 10.7

D&A 30 37 44 53 75 56 41 45 EBITDA 621 660 656 890 1,342 1,661 1,943 2,154 YoY (%) 97 6 (1) 36 51 24 17 11 EBITDA margin (%) 13.6 12.0 11.1 10.8 11.8 11.7 11.4 10.9

Interest income 21 10 5 19 90 98 98 123 Effective interest rate on deposits (%) 3.3 2.6 2.6 2.6 2.0 1.8 1.8 1.8 Interest expense (60) (114) (76) (83) (178) (182) (173) (173) Effective interest rate on borrowings (%) 7.3 8.4 5.8 3.7 4.7 4.5 4.5 4.5

Profit before tax 552 619 514 816 1,198 1,460 1,768 2,013 Income tax (110) (131) (128) (198) (280) (350) (424) (483) Effective tax rate 19.9 21.1 24.8 24.3 23.4 24.0 24.0 24.0 Minority income (25) (28) (21) (63) (103) (124) (150) (171)

Net profit 418 460 365 554 815 985 1,192 1,356 YoY (%) 110 10 (21) 52 47 21 21 14 Net margin (%) 9.1 8.3 6.2 6.7 7.2 7.0 7.0 6.9 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Balance sheet and cash flow

Improved efficiency in cash Hengdeli’s operating cash flow turned negative in FY10 mainly due to rapid expansion conversion cycle during the year, which required heavy inventory support. By following a measured pace of store opening, Hengdeli has brought operating cash to positive territory, with an inflow of RMB196m in FY11. Management has implemented more stringent controls over inventory and working capital to ensure positive operating cash flow going forward. Given the expectation of a reasonable expansion pace, we anticipate Hengdeli will be able to generate positive cash flow in FY12F-13F.

Inventory management is the key to its retail business expansion with the initial batch of inventory typically accounting Hengdeli’s for about 90% of its store opening capital requirements. Despite aggressive network expansion in the past years, Hengdeli managed to improve inventory turnover in the last three years. For example, Hengdeli Healthy cash conversion cycle managed to maintain average turnover days at the FY10 level of 165 days in FY11. With the soon-to-be-implemented ERP system, we anticipate further improvements in inventory levels for FY12F. We look for inventory turnover days to remain under control at below 165 days in FY12F-14F. Average payable turnover days was kept under 75 days for the past three years. We expect payable turnover days to remain stable at 75 days in FY12F-14F.

Going forward, we anticipate the cash conversion cycle days for FY12F-13F to remain at the reasonable level of 114-115 days. A stable working capital cycle should support healthy growth in operating cash flow as well as free cash flow.

Hengdeli – cash conversion cycle and working capital days

220 197 200 179 180 166 165 165 165 164 155 146 160 136 140 115 115 115 114 120 100 80 60 40 18 24 23 25 25 25 25 20 0 (20) (40) (60) (51) (52) (80) (66) (75) (75) (75) (75) (100) FY08 FY09 FY10 FY11 FY12F FY13F FY14F Average inventory days Average receivable days Average payable days Cash conversion cycle (days) Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli – operating cash flow, free cash flow and net cash flow projections

RMB m 2,500 2,145 1,987 1,908 2,000 1,713 1,779 1,416 1,500

942 1,000 625 663 512 534 500 155 115 174 0 (94) (205) (500) (280) (310) (480) (662) (675) (1,000) FY08 FY09 FY10 FY11 FY12F FY13F FY14F Operating cash flow Free cash flow Net cash flow

Source: Company data, CCBIS estimates

Hengdeli – balance sheet projections

Year to December (RMB m) 2007 2008 2009 2010 2011 2012F 2013F 2014F Property, plant and equipment 289 529 600 664 666 750 840 925 Intangible assets 43 43 43 26 23 41 40 40 Investment properties 30 28 26 240 256 256 256 256 Investment in jointly controlled entity 28 31 36 53 56 55 54 53 Other investments 0 1 1 122 474 474 474 474 Deferred tax assets 24 40 39 52 78 78 78 78 Goodwill 213 228 243 278 297 297 297 297 Non-current assets – total 628 900 988 1,437 1,849 1,951 2,038 2,122

Inventories 1,667 2,447 2,404 3,198 4,521 5,044 6,428 6,786 Trade and other receivables 560 450 591 1,005 1,115 1,320 1,516 1,701 Asset classified held for sale 0 0 0 0 136 136 136 136 Cash and equivalents 1,071 685 1,191 3,420 3,968 5,452 5,424 6,838 Current assets – total 3,298 3,581 4,186 7,623 9,740 11,952 13,504 15,462

Bank loans and other loans 245 760 824 1,077 2,042 2,042 2,042 2,042 Trade and other payables 476 584 807 881 1,759 3,259 3,847 4,404 Current tax payables 88 70 62 97 144 346 614 933 CB and embedded financial instruments 0 0 0 0 48 48 48 48 Liabilities associated with asset classified as held for sale 0 0 0 0 28 28 28 28 Current liabilities – total 809 1,415 1,692 2,055 4,022 5,723 6,580 7,456

Long-term borrowing 995 716 322 2,317 2,202 2,000 1,800 1,800 Other NC payables 140 18 36 41 35 40 40 40 Non-current liabilities – total 1,134 734 358 2,359 2,237 2,040 1,840 1,840

Minorities 197 236 257 329 440 545 673 818 Equity 1,785 2,096 2,867 4,316 4,891 5,595 6,449 7,469

Total assets 3,926 4,481 5,174 9,059 11,589 13,903 15,542 17,583 Total liabilities and equities 3,926 4,481 5,174 9,059 11,589 13,903 15,542 17,583

Gross debt 1,240 1,476 1,146 3,394 4,244 4,042 3,842 3,842 Net debt (cash) 253 888 (5) (16) 302 (1,410) (1,582) (2,996) Net gearing (%) 14.2 42.4 Net cash Net cash 6.2 Net cash Net cash Net cash Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Hengdeli – cash flow projections

Year to December (RMB m) 2007 2008 2009 2010 2011 2012F 2013F 2014F EBIT 621 660 656 890 1,342 1,661 1,943 2,154 D&A 30 37 44 53 75 56 41 45 EBITDA 651 697 700 944 1,417 1,717 1,985 2,199 Other non-cash adjustment (58) (101) (29) (44) (102) (117) (99) (90) Operating cash flow before changes in working capital 593 595 671 900 1,316 1,600 1,885 2,109

Working capital changes: Inventory (353) (740) 42 (739) (1,281) (523) (1,383) (358) Trade and other receivables (260) 96 (105) (227) (256) (205) (196) (186) Trade and other payables 35 72 215 14 664 1,505 589 557 Total working capital changes (577) (572) 153 (951) (873) 777 (991) 13

Interest received 22 10 5 19 90 98 98 123 Interest paid (68) (82) (77) (83) (171) (182) (173) (173) Tax paid (96) (157) (128) (165) (247) (149) (156) (164) Operating cash flow (126) (205) 625 (280) 115 2,145 663 1,908

Capex for acquisition of: Property, plant and equipment (60) (274) (110) (393) (208) (140) (130) (130) Land use rights 0 0 0 0 0 0 1 1 Intangibles 0 (1) (2) (2) (2) (18) (0) (0) Total capex (60) (275) (112) (395) (209) (158) (129) (129)

Free cash flow (186) (480) 512 (675) (94) 1,987 534 1,779 Other investing cashflow 0 0 0 0 0 0 1 1 Changes in pledged deposit (7) (13) 56 30 (16) 26 0 0 Reorganization 0 0 0 0 0 0 0 0 Proceeds from issue of shares 0 (6) 526 923 5 0 0 0 Dividend paid (76) (163) (153) (123) (204) (300) (361) (364) Net cash flow (269) (662) 942 155 (310) 1,713 174 1,416 Gross cash flow (889) (1,272) (150) (907) (1,602) 1,510 (26) 1,416 Source: Company data, CCBIS estimates

Hengdeli – key financial ratios

Year to December 2007 2008 2009 2010 2011 2012F 2013F 2014F ROAE (%) 26.9 25.1 15.4 14.9 16.9 18.1 19.2 19.1 ROAA (%) 13.1 10.9 7.6 7.8 7.9 7.7 8.1 8.2 ROIC (%) 26.0 19.5 16.9 17.8 20.7 25.5 29.7 31.0 Average inventory days 151 179 197 166 165 165 165 164 Average receivable days 32 18 24 23 25 25 25 25 Average payable days 49 51 66 52 75 75 75 75 Cash conversion cycle (days) 134 146 155 136 115 115 115 114 Net gearing (%) 14.2 42.4 Net cash Net cash 6.2 Net cash Net cash Net cash Gross gearing (%) 69.4 70.4 40.0 78.6 86.8 72.2 59.6 51.4 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Company specific risks

Management shares transaction

Public filings show that the Swatch Group (UHR VX, Not Rated), the second-largest shareholder in Hengdeli, substantially raised its stake in the company, from 9.05% to 20.42%, on 21 July 2011. Chairman Zhang Yuping, with a 35.42% stake in Hengdeli, has personally pledged about 500m shares, or an 11% stake for a fixed term of three years till 2014, in return for US$100m from the Swatch Group. There is no option or obligation for the Swatch Group to acquire the shares and the chairman affirms he has no plan to sell the shares under the pledge.

The chairman explained that the funding is purely for personal investments in business ventures unrelated to Hengdeli’s operations. Management emphasized that there will be no change in Hengdeli’s board, management or operations after the change in shareholding structure. We believe the pledge arrangement, while only a private agreement between major shareholders, will be viewed cautiously by the market. The on-going corporate governance concerns held by some investors do not help.

Senior management

Board of directors

Mr. Zhang Yuping (Alia, Cheung Yu Ping) – Chairman and executive director

Mr. Zhang, who founded the company in 1999, is in charge of overall management and strategic development. He has more than 20 years of experience in the high-end consumables distribution industry for the China market.

Mr. Song Jianwen – Executive director

Mr. Song is in charge of finance and investment at Hengdeli. Mr. Song graduated from Zhongnan Finance Economics University with a Masters Degree in Economics. He joined the company in 2001 and has over 10 years of experience in finance and accounting.

Mr. Huang Yonghua – Executive director

Mr. Huang is in charge of the company’s business coordination and operational supervision. Joined the company in 2001, Mr. Huang has more than 10 years of experience as a manager China’s watch distribution industry.

Mr. Chen Sheng – Non-executive director

Mr. Chen joined the company in 2007 and is responsible for the group’s investment activities. He graduated from Fudan University in Shanghai with a Master’s Degree in Business Administration.

Initiation on Jewelry and Watch Sector 20 April 2012

Mr. Shen Zhiyuan – Non-executive director

Mr. Shen graduated from the Beijing Institute of Business (北京商学院). Later, he became General Manager of Beijing Yishang Group (北京一商集团). He is currently the Vice Chairman of the Association of PRC Enterprises (中国商业企业协会) and Chairman of the Association of Beijing Enterprises. (北京商业企业协会). Mr. Shen joined the group in 2004.

Mr. Shi Zhongyang – Non-executive director

Mr. Shi graduated from Nanjing University in China and the University of Goetting in Germany with a Master’s Degree in Law. Mr. Shi joined The Swatch Group Limited in 2000 and joined Hengdeli in 2006. He is currently legal counsel in the legal department of The Swatch Group Limited.

Mr. Cai Jianmin – Independent non-executive director

Mr. Cai joined Hengdeli in 2005. He has held senior financial positions in various companies including Shanghai Hualian (Group) (上海华联(集团)). He graduated from University of Edinburgh, Scotland with a Bachelor’s Degree and a Doctorate Degree in Electrical Engineering. Mr. Wong is currently a professor in the Department of Systems Engineering and Engineering Management at Chinese University of Hong Kong. He obtained his qualification as a Chartered Engineer (CEng) in 1991, and is now a member of the Institute of Electrical Engineers and a professional member of the Association of Computing Machinery.

Senior management

Mr. Zhuang Liming – Vice chairman of Shanghai Xinyu

After graduating from Beijing Foreign Trade College, Mr. Zhuang worked for China’s Light Industry Commodities Import and Export Company before joining Hengdeli in 2000.

Ms. Wang Lingfei – Deputy president

Ms. Wang is responsible for brand development. Before joining the company in 2005, she was General Manager of Beijing Yishang Group.

Mr. Lee Wing On, Samuel – Deputy president

Mr. Lee is responsible for retailing in Hong Kong. He joined the company in 2006 and has over 20 years of experience in the Hong Kong watch retail industry.

Mr. Stan Lee – Deputy president

Mr. Lee is responsible for retailing on the mainland. He joined Hengdeli in 2007, and has over 20 years of experience in watch manufacturing and distribution.

Initiation on Jewelry and Watch Sector 20 April 2012

Luk Fook Holdings (590 HK)

Company Rating: Neutral

Losing a bit of glitter (initiation)

Despite its shorter operating history relative to peers, Luk Fook has grown to become the third-largest gold and jewelry Price: HK$20.90 retailer in Hong Kong, where it enjoys high customer recognition and differentiates itself from Chow Tai Fook by Target: HK$21.80 having a higher turnover contribution from gem-set products. (initiation) The major shortcomings of Luk Fook stem from its franchising-driven operation in China. While valuations are Trading data compelling, significant near-term challenges arise as SSSG weakens on the back of consolidating gold price. We initiate 52-week range HK$19.2 – 46.15 coverage on this stock with a Neutral rating. Market capitalization (m) HK$12,312/US$1,586 Shares outstanding (m) 589  Wide exposure to gem-set products. Luk Fook’s sales Free float (%) 55 from gem-set items contribute to over 40% of its total 3M average daily T/O (m share) 5.5 jewelry sales. Gem-set products have more stable 3M average daily T/O (US$m) 19.5 pricing and offer higher margins than gold jewelry. Expected return (%) – 1 year 9.3  Shortcomings from China operation. Well Closing price on 18 April 2012 established and recognized in Hong Kong, Luk Fook’s major negatives arise from its China operation which is Stock price vs. HSI

predominantly franchising-driven. Another negative HK$ comes from its weak presence in China. Luk Fook only 46 owns 3% of the market in China. The intense 42

competition in the China market means it can be costly 38 and risky for its franchised store network to scale up. 34

 Major near-term challenges. On top of declining 30 SSSG, Luk Fook hedges only 20% of its gold price risk. 26 With gold price moving sideway, gross margin could be under pressure. 22 18  Initiate with Neutral. Valuations of Luk Fook are 19-Apr-11 1-Jul-11 12-Sep-11 24-Nov-11 5-Feb-12 18-Apr-12 undemanding as it trades on 8x CY13F P/E but the Luk Fook HSI (rebased) stock could further de-rate in the near term before its Source: Bloomberg SSSG troughs out and gold price regains momentum. For now, we value the counter on 8.5x CY13F P/E, a 35% discount to our target valuation for Chow Tai Fook.

Financial forecast Year to 31 March FY10 FY11 FY12F FY13F FY14F Revenue (HK$m) 5,386 8,091 11,530 13,403 15,973

Net profit (HK$m) 531 866 1,303 1,283 1,594 Claudia Ching EPS (HKD) 1.079 1.705 2.303 2.178 2.705 (852) 2532 2528 EPS (YoY, %) 93 58 35 (5) 24 [email protected] P/E (x) 19.4 12.3 9.1 9.6 7.7 Forrest Chan, CFA Yield (%) 2.1 3.3 4.5 4.4 5.2 (852) 2532 6743 FCF yield (%) 0.0 1.2 3.4 6.2 7.7 [email protected] ROAE (%) 36.5 34.1 28.1 20.1 21.0 P/B (x) 7.3 3.6 2.1 1.8 1.5 Timothy Sun Net gearing (%) 1.6 Net cash Net cash Net cash Net cash (852) 2532 6746 Source: Company data, CCBIS estimates [email protected]

Initiation on Jewelry and Watch Sector 20 April 2012

Investment highlights

A well-recognised domestic Luk Fook began with only one outlet in 1991. Since that humble beginning, it has brand in Greater China evolved into one of the most successful jewelry retail brands in Greater China. It sources, designs, retails, wholesales a variety of gold jewelry and ornaments, including gem-set jewelry and gemstones. Over the years, Luk Fook has earned high brand recognition from both domestic and mainland shoppers, who have come to appreciate its high product quality and the diversity in product offering.

Luk Fook has an extensive retail network of over 800 POS in Hong Kong, Macau and China, including directly-managed and franchised outlets. The company also runs a number of stores in overseas markets, including Singapore, Canada and the United States. In addition, it has an online business that doubles as a business-to-business trading platform among manufacturers, wholesalers and retailers globally.

Looking to increase the sales Luk Fook has expertise in gem-set products and is renowned for its exquisite designs contribution from gem-set jewelry and craftsmanship. This represents an important competitive advantage as gem-set products tend to be high-margin and their sales are less vulnerable to gold price fluctuations. With an anticipated increase in contribution from higher-margin gem-set products, we see potential upside for Luk Fook’s gross margins in the long run.

Market position of jewelers Luxury Van Cleef & Arpels Cartier

Bulgari

Tiffany Chow Tai Fook Tesiro Chow Sang Sang

Batar Jewellery

Affordable Source: Frost & Sullivan

Gold and jewelry icon in Hong Kong

Third-largest gold and jewelry With only 21 years of operating history, Luk Fook is a younger brand relative to Chow retailer in Hong Kong Tai Fook or Chow Sang Sang, both of which have been around for 70 years or more. Despite its relatively short life so far, Luk Fook has developed into a leading Hong Kong-based gold and jewelry retailer targeting middle- to upper-income customers in the market for appealing designs and a wide product range. The company has earned high praise from customers and is considered a trusted household brand in Hong Kong and China. In 2010, it accounted for the third-largest market share of 7% of Hong Kong’s jewelry retail market, exceeded only by Chow Tai Fook’s 20% and Chow Sang Sang’s 9%.

Initiation on Jewelry and Watch Sector 20 April 2012

Stores located in prime tourists Luk Fook is well-known to mainland Chinese shoppers as many of its stores are shopping areas located in prime tourist shopping destinations in Hong Kong, including Tsim Sha Tsui, Mong Kok and Causeway Bay, in short, the favoured destinations of mainland visitors to Hong Kong. It is currently ranked second among Hong Kong jewelry retailers in the UnionPay market pool, just behind market leader Chow Tai Fook. Luk Fook also won the coveted “PRC consumers most favored Hong Kong brand” for several years running. Such achievements bespeak of the high regard mainland shoppers have for Luk Fook.

Jewelry market share by retail value in China (2010)

14% 13% 12%

10% 9%

8% 7% 7% 6% 6%

4% 4% 4% 3% 3% 2% 2% 2%

0% Chow Tai Lao Feng Chow Tai Lao Miao Beijing First Asia Zhe Jiang Cartier Luk Fook Kimberlite Chow Fook Xiang Seng Caishikou Ming Diamond Sang Sang

Source: Frost & Sullivan

Jewelry market share by retail value in Hong Kong and Macau (2010)

22% 20% 20% 18% 16% 14% 12% 10% 9% 8% 7% 6% 4% 4% 3% 2% 2% 2% 2% 2% 2% 0% Chow Tai Chow Sang Luk Fook MaBelle Cartier Tiffany & King Fook Seng Feng Qeelin CSS Fook Sang Co

Source: Frost & Sullivan

Initiation on Jewelry and Watch Sector 20 April 2012

Luk Fook’s flagship store in Tsim Sha Tsui, Hong Kong Luk Fook’s shop in Beijing

Source: Company presentation Source: Company presentation

Strength in gem-set jewelry backed by reputation for authenticity, product quality and fashionable designs

Renowned for offering authentic, In an industry where product differences are generally subtle, Luk Fook has built an high quality gold and jewelry enviable reputation for offering exquisite, creative and stylish designs. Its design items excellence has been rewarded by higher-than-average sales contribution from gem-set jewelry products, which tend to provide more room for design variety versus gold jewelry. Luk Fook is a keen participant in various local and international jewelry design competitions, where it has collected more than 140 awards and special mentions at various international and local design competitions. In FY11, Luk Fook generated 41% of its sales from gem-set products, materially higher than that of its peers. Wider exposure to gem-set products is a positive, in our view, since demand is usually stickier and has less correlation with commodity price, and they offer higher margins. Finally, within the gem-set segment, there is more room for product mix upgrades to drive gross margins.

Luk Fook’s gem-set jewelry products Luk Fook’s gold products

Source: Company website Source: Company website

Initiation on Jewelry and Watch Sector 20 April 2012

Gem-set vs. other product sales split between Luk Fook, Chow Sang Sang and Chow Tai Fook

100%

90%

80% 48% 70% 59% 74% 60%

50%

40%

30% 52% 20% 41% 26% 10%

0% Luk Fook Chow Tai Fook Chow Sang Sang Gem-set jewelry Other products

Source: Company data, Chow Sang Sang, Chow Tai Fook latest financial data

Luk Fook – sales split trend

100%

90%

80% 54% 53% 55% 54% 70% 59%

60%

50%

40%

30% 46% 47% 45% 47% 20% 41%

10%

0% FY09 FY10 FY11 1H FY11 1H FY12 Gem-set jewellery Gold/platinum jewellery

Source: Company data

Increasing self-sufficiency ratio

Adding production plant capacity Luk Fook has its own gem-set jewelry manufacturing plant in Panyu, Guangdong, to support sales growth and which supplies around 50% of its gem-set jewelry. Having its own processing plant enhance margins means that Luk Fook is able to ensure high product standards for its gem-set jewelry products. This also means that cost effectiveness and production efficiency can be enhanced. The group invested approximately RMB100m in 2003 in a large-scale jewelry processing plant in Panyu, Guangdong, with a total site area of over 350,000 sqf.

Luk Fook is now expanding its production plant to increase capacity to support sales growth. The construction of the jewelry processing plant phase II, also situated in Panyu, has begun and operations are expected to commence in October 2012. Once phase II becomes fully operational, total production capacity of the group will double. The group expects to increase its in-house supply ratio for gem-set jewelry from 50% currently to 100% in the long run.

Initiation on Jewelry and Watch Sector 20 April 2012

Longest history as a listed company

Luk Fook was listed in 1997 which means it has the longest history as a public company among the four companies we cover in this report. Over the years, management has established a solid track record of achieving satisfactory business development, as shown in the following charts.

Luk Fook – turnover since FY96 Luk Fook – earnings since FY96

HK$b HKm 9 1,000 8.1 877 8 900

7 800 700 6 5.4 600 537 5 4.0 500 4 3.4 400 2.8 318 3 278 300 2.0 2.1 1.7 1.7 199 2 1.5 1.4 1.6 1.5 1.5 1.6 200 127 1.1 97 78 81 70 78 1 100 47 63 40 65 48 0 0 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 Source: Company data, Bloomberg Source: Company data, Bloomberg

Shortcomings

Relatively low presence in China Under-represented in China. Luk Fook has a strong franchise in the Hong Kong market, but its market share in China is still low. In 2010, it had market share of only 3% in China (versus 12.6% for Chow Tai Fook), and was ranked ninth by retail value. As at end-September 2011, it had 738 POS in China including 686 franchised stores and 52 directly managed outlets, compared with Chow Tai Fook’s jewelry store count of 1,505. Considering Chow Tai Fook’s market share is three times larger than Luk Fook’s, it is clear that Luk Fook’s China unit has lower store productivity than that of Chow Tai Fook. As a result of the use of franchising, China contributed only 17% of Luk Fook’s total turnover and only 6% of EBIT in FY11. Luk Fook’s underexposure to China disqualifies it as a proxy for that market. Indeed, we look at the stock as solely a proxy of the Hong Kong’s jewelry market.

Initiation on Jewelry and Watch Sector 20 April 2012

Heavy reliance on franchisees Franchising risk. Unlike Chow Tai Fook, Luk Fook pursues an asset-light expansion model in China where over 93% of its POS are franchised outlets.

Luk Fook – sales mix by channel

100% 9% 9% 8% 7% 16% 16% 11% 8% 9% 8% 8% 9% 80% 7% 8%

60%

83% 83% 84% 85% 40% 78% 76% 80%

20%

0% FY09 FY10 FY11 FY12F FY13F FY14F FY15F Direct retail Wholesale Other

Source: Company data, CCBIS estimates

Luk Fook – group’s POS breakdown

100% 12% 13% 12% 12% 12% 12% 12%

80%

60%

88% 87% 88% 88% 88% 88% 88% 40%

20%

0% FY09 FY10 FY11 FY12F FY13F FY14F FY15F Franchse Direct retail

Source: Company data, CCBIS estimates

Franchising gives Luk Fook the benefit of lower working capital requirements and faster retail network expansion. But there are also major risks and disadvantages inherent in the franchising business model, including limited access to market intelligence, difficulties in monitoring franchisee performance as well as reputation risk. Luk Fook tries to mitigate franchising risk by enforcing strict standards on its franchisees. A key requirement is that all items distributed to licensees are handled over on cash-on-delivery payment terms. New joiners also have to meet certain prerequisites laid down by Luk Fook in order to receive store opening approvals.

Initiation on Jewelry and Watch Sector 20 April 2012

Luk Fook closely monitors its licensees along the following lines:

 Quality and inventory control over jewelry products conducted by real-time POS and surveillance systems

 In-house audit team to check POS financials

 Standardized point-of-sale systems

 Mysterious shoppers

 Penalty of RMB50,000, RMB100,000 or RMB200,000 for selling inferior quality jewelry or breaking licensing rules and

 A reward of 20% on the collection of penalties to any parties who discover and report violations

Most sensitive to gold price Near-term margin pressure. Compared with Chow Tai Fook, which hedges 90% of fluctuations compared with peers its gold inventory, Luk Fook’s margin is more vulnerable to gold price changes given that the company only hedges 20% of its total gold inventory and keeps about three months of gold inventory. In the case of sharp movements in gold prices, particularly falling gold prices, Luk Fook’s gross margins suffer. Luk Fook’s gross margin also benefited from rising gold price between 2009 and 2011, suggesting that the recent consolidation in gold price could lead to gross margin contraction.

Key earnings drivers

We forecast 22% earnings CAGR for Luk Fook in FY11-13F, with FY13F likely to see an earnings decline as sales momentum weakens and gold price fluctuates.

Hong Kong and Macau

FY13F will be challenging given Luk Fook believes it is already well-represented in the Hong Kong and Macau markets weakening SSSG in its core with good store coverage in key shopping areas. The plan is to add two-to-three new markets stores in Hong Kong and one-to-two outlets in Macau per year going forward. Combined with the SSSG estimates discussed at the beginning of this report, we look for 49% turnover growth in each of Hong Kong and Macau in FY12F, but slower sales growth of only 15% in FY13F on the back of lower SSSG.

China

Luk Fook’s China operation is dominated by franchised stores which account for 686 out of its 738 POS there. Its footprint in China will continue to grow as it adds both franchised stores and directly-run retail points. We forecast 12-16% growth, or 100-102 licensed stores added annually. In addition, 10-15 self-run POS will be opened annually, mainly in tier-one or two cities. As a result, we forecast 29-41% China retail turnover growth and 22-27% overall wholesale revenue growth in FY12F-13F, with the latter representing a rough proxy for the company’s wholesale business in China given that overseas wholesale contribution is marginal.

Initiation on Jewelry and Watch Sector 20 April 2012

Gross margin dilution in the near term

Gross margin pressure in the We see potential downside risk to the gross margin of Luk Fook’s gold products in short term as gold price trades FY13F. As discussed above, Luk Fook’s margin is more vulnerable to gold price sideways changes than peers given that the company only hedges 20% of its total gold inventory and keeps about three months of gold inventory. In the event of sharp movements in gold prices, in particularly falling gold prices, Luk Fook’s gross margins could fall. We estimate Luk Fook’s gross profit margin will decline from 23.9% in FY12F to 22.4% in FY13F.

As for the gemstone jewelry business, Luk Fook is hoping to increase the segment’s contribution in the coming years given the more attractive profitability. The group’s gem-set jewelry earns a higher gross margin of about 35% to 39% versus gold/platinum jewelry with around 14% to 15%. In our view, the steady upward trend in diamond and gemstone prices should also favor Luk Fook’s operations ahead.

That said, we believe Luk Fook’s product mix changes will not vary materially in the medium term as most Chinese still prefer to buy gold jewelry as a form of wealth protection and as a status symbol. Therefore, we expect there will only be incremental adjustments in product mix over the long run.

Luk Fook gross profit margin trend

25.4% 24.9%

24.5% 24.0% 23.9% 23.7% 23.7% 23.6% 23.3%

22.7% 22.4% 22.1%

21.8%

20.9%

20.0% FY08 FY09 FY10 FY11 FY12F FY13F FY14F FY15F

Source: Company data, CCBIS estimates

Rise in key expense ratio for FY12F-13F

We expect Luk Fook to face greater operating cost pressure in FY12F-14F particularly on the rental costs front, as most of the group’s stores in Hong Kong are located in prime shopping areas. Management has indicated that rental increments for FY12F will be exceptionally high, not only because of the revision of the renewal contracts, but because the rise has also been caused by high rental rates for its new stores established in Hong Kong during the period. Nonetheless, helped by high SSSG in FY12F, we believe Luk Fook’s rental ratio will only increase by 0.1ppt, from 3.1% to 3.2% of total sales in FY12F. Going forward, we expect Luk Fook to see moderating SSSG in FY13F-14F, and with rental hikes for its stores destined to continue, we anticipate a jump in the company’s rental ratio, from 3.2% of total sales in FY12F, to 3.4% and 3.5% of total sales in FY13F-14F respectively.

Initiation on Jewelry and Watch Sector 20 April 2012

Staff costs, representing 4.7% of total sales in FY11, is not a major issue thanks to the significant variable portion of Luk Fook’s staff compensation structure. Luk Fook typically spends less than 1% of sales on advertising and promotional expenses. We do not expect a material change in A&P spending for FY12F-13F but expect it to be maintained at less than 1% of total sales.

Luk Fook – key assumptions

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F Total POS 456 557 699 817 927 1,045 1,163 China – sub-total 419 519 657 772 882 999 1,116 China – self-operated jewelry POS 19 36 39 54 64 79 94 China – franchised jewelry POS 400 483 618 718 818 920 1,022 Hong Kong/Macau – sub-total 30 31 33 34 34 35 36 Other markets – sub total 7 7 9 11 11 11 11

Total POS – YoY change 46 76 117 118 110 118 118 China – sub-total 43 75 113 115 110 117 117 China – self-operated jewelry POS 8 17 3 15 10 15 15 China – franchised jewelry POS 35 58 110 100 100 102 102 Hong Kong/Macau – sub-total 2 1 2 1 0 1 1 Other markets – sub total 1 0 2 2 0 0 0

Total POS – YoY change (%) 18 22 25 17 13 13 11 China – sub-total 19 24 27 18 14 13 12 China – self-operated jewelry POS 73 89 8 38 19 23 19 China – franchised jewelry POS 18 21 28 16 14 12 11 Hong Kong/Macau – sub-total 7 3 6 3 0 3 3 Other markets – sub total 17 0 29 22 0 0 0

SSSG (%) China 28 (12) 33 25 13 15 13 Hong Kong/Macau 9 17 30 38 10 12 13

Wholesale (supply of gem set to the licensee) 259 452 739 937 1141 1348 1549 YoY (%) 74 64 27 22 18 15 Wholesales per licensee 1 1 1 1 1 1 2 YoY (%) 44 28 11 9 7 5

Royalty income 126 154 253 338 416 487 546 YoY (%) 22 64 34 23 17 12 Royalty income per licensee 0 0 0 1 1 1 YoY (%) 1 28 15 8 4 1

Consultancy fee income 11 19 22 26 29 32 35 YoY (%) 160 73 16 21 16 12 9

Gross margin (%) 22.1 24.0 23.7 23.9 22.4 23.3 23.7

Total staff cost as % of total sales 6.0 4.9 4.7 5.1 5.2 5.3 5.3

Total lease costs as % of direct retail sales 5.3 4.8 3.9 4.1 4.4 4.6 4.6

Other expenses as % of total sales 4.6 4.1 3.4 3.5 3.7 3.8 3.9 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Luk Fook – revenue projections

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F Total revenue 3,959 5,386 8,091 11,530 13,403 15,973 19,038 YoY (%) 18 36 50 43 16 19 19

Revenue by market Retail, China 177 289 454 641 826 1,080 1,368 Retail, Hong Kong, Macau and others 2,898 3,802 5,986 8,919 10,289 12,288 14,766 Wholesale, China 259 452 739 937 1,141 1,348 1,549 Scrap of gold and platinum and gold bullion 487 671 637 669 702 737 774 Licensing (royalty fee 2-12%) 138 174 276 364 445 519 582

Revenue growth by market (%) Retail, China (90) 63 57 41 29 31 27 Retail, Hong Kong, Macau and others 12 31 57 49 15 19 20 Wholesale, China 5,991 74 64 27 22 18 15 Scrap of gold and platinum and gold bullion 38 (5) 5 5 5 5 Licensing (royalty fee 2-12%) (114) 26 59 32 22 17 12

Revenue mix by market (%) Retail, China 4 5 6 6 6 7 7 Retail, Hong Kong, Macau and others 73 71 74 77 77 77 78 Wholesale, China 7 8 9 8 9 8 8 Scrap of gold and platinum and gold bullion 12 12 8 6 5 5 4 Licensing (royalty fee 2-12%) 3 3 3 3 3 3 3

Revenue by sales channel Retail 3,076 4,091 6,440 9,560 11,114 13,369 16,134 Wholesale 259 452 739 937 1,141 1,348 1,549

Revenue growth by sales channel (%) Retail (29) 33 57 48 16 20 21 Wholesale 5,991 74 64 27 22 18 15

Revenue mix by sales channel (%) Retail 78 76 80 83 83 84 85 Wholesale 7 8 9 8 9 8 8 Others 16 16 11 9 9 8 7 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Luk Fook – profit and loss projections

Year to March (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F 1H11 2H11 1H12 2H12F Total revenue 3,959 5,386 8,091 11,530 13,403 15,973 19,038 3,264 4,827 5,511 6,019 YoY (%) 18 36 50 43 16 19 19 56 46 69 25

COGS (3,085) (4,093) (6,174) (8,780) (10,398) (12,250) (14,520) (2,497) (3,677) (4,159) (4,621) YoY (%) 122 133 151 142 118 118 119 60 45 67 26

Gross profit 874 1,294 1,917 2,751 3,005 3,723 4,518 767 1,150 1,353 1,398 YoY (%) 4 48 48 43 9 24 21 46 50 76 22 Gross margin (%) 22.1 24.0 23.7 23.9 22.4 23.3 23.7 23.5 23.8 24.5 23.2

Other income and gains 32 22 19 15 12 10 7 5 14 9 6

Staff costs (239) (264) (382) (450) (532) (648) (785) (149) (233) (211) (239) YoY (%) 5 10 45 18 18 22 21 28 58 42 3 As % of turnover 6.0 4.9 4.7 5.1 5.2 5.3 5.3 4.6 4.8 3.8 4.0

Depreciation and amortization (36) (44) (51) (52) (65) (81) (96) (24) (27) (33) (18) YoY (%) 13 21 16 1 26 25 18 23 10 (38) 32 As % of turnover 0.9 0.8 0.6 0.4 0.5 0.5 0.5 0.7 0.6 0.6 0.3

Rental costs (164) (197) (253) (369) (450) (563) (681) (120) (133) (133) (236) YoY (%) 30 20 28 46 22 25 21 31 26 11 77 As % of turnover 4.2 3.7 3.1 3.2 3.4 3.5 3.6 3.7 2.8 2.4 3.9

A&P costs (33) (33) (38) (58) (80) (96) (114) (19) (19) (23) (35) YoY (%) (7) 0 15 52 39 19 19 6 24 20 84 As % of turnover 0.8 0.6 0.5 0.5 0.6 0.6 0.6 0.6 0.4 0.4 0.6

Commission expense to credit cards (32) (43) (68) (92) (107) (128) (152) (26) (42) (46) (46) YoY (%) 25 35 59 36 16 19 19 60 59 77 10 As % of turnover 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.9 0.8 0.8

Total SG&A and other expenses (587) (680) (912) (1,221) (1,479) (1,823) (2,212) (396) (516) (520) (701) YoY 11 16 34 34 21 23 21 29 38 31 36 As % of total turnover 14.8 12.6 11.3 10.6 11.0 11.4 11.6 12.1 10.7 9.4 11.6

EBIT 318 635 1,024 1,545 1,538 1,910 2,313 377 647 842 703 YoY (%) (14) 99 61 51 (0) 24 21 64 59 124 9 EBIT margin (%) 8.0 11.8 12.7 13.4 11.5 12.0 12.2 11.5 13.4 15.3 11.7

Depreciation and amortization included in SG&A 36 44 51 52 65 81 96 24 27 33 18

EBITDA 355 679 1,075 1,597 1,603 1,991 2,409 401 674 875 721 YoY (%) (12) 91 58 49 0 24 21 61 57 118 7 EBITDA margin (%) 9.0 12.6 13.3 13.8 12.0 12.5 12.7 12.3 14.0 15.9 12.0

Interest income 5 0 9 7 9 11 14 3 6 3 4 Interest expense (8) (4) (5) 0 0 0 0 (3) (2) 0 0 Share of results of an associate 1 2 0 1 1 1 1 1 (0) 3 (2)

Profit before tax 316 634 1,029 1,553 1,547 1,922 2,328 378 651 848 705 YoY (%) (15) 101 62 51 (0) 24 21 64 61 124 8 As % of turnover 8 12 13 13 12 12 12 12 13 15 12

Tax (38) (98) (152) (233) (248) (308) (396) (54) (98) (120) (113) Effective tax rate (%) 12 15 15 15 16 16 17 14 15 14 16

Minority interest (3) (5) (11) (17) (17) (21) (25) (4) (7) (8) (9)

Net profit 275 531 866 1,303 1,283 1,594 1,907 320 546 720 583 YoY (%) (12) 93 63 50 (2) 24 20 71 59 63 125 Net margin (%) 7.0 10.0 10.8 11.4 9.7 10.1 10.1 9.9 11.5 13.2 9.8 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Balance sheet and cash flow

Net cash positioning with AMPLE The majority of Luk Fook’s planned openings will be franchised outlets and meaning cash on hand of c.HK$2.5b by that expansion will create only minimal burden to the company’s working capital. Luk FY12F Fook’s capex is mainly for openings of a small number of self-owned stores and regular maintenance. Management is setting a capex target of HK$140-160m for FY12F-13F, mainly to set up 10-15 boutiques across the PRC. These capex targets are not significant considering the company’s operating cash flow of HK$500m-plus in FY12F-13F. Moreover, Luk Fook was in a net cash position of HK$318m as at end-September, 2011. More recently, in Janurary 2012, it raised an additional amount of HK$1.3b via a top-up placement.

Luk Fook cash conversion cycle and working capital days

180 146 150 139 139 141 132 129 133 116 120 107 106 109 100 97 101 90

30 3 4444 44 0

(30) (33) (35) (36) (36) (37) (37) (37) (60) FY09 FY10 FY11 FY12F FY13F FY14F FY15F Average inventory days Average receivable days Average payable days Cash conversion cycle (days)

Source: Company data, CCBIS estimates

Luk Fook operating cash flow, free cash flow and net cash flow projections

HK$m 1,800 1,563 1,600 1,400 1,200 1,103 1,000 1,025 943 1,000 922 865 762 800 719 561 580 600 534 421 340 400 311 311 212 244 143 200 (4) 0

(200) (136) (400) FY09 FY10 FY11 FY12F FY13F FY14F FY15F Operating cash flow Free cash flow Net cash flow Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Luk Fook – balance sheet projections

Year to December (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F 1H11 1H12 Property, plant and equipment 108 380 370 459 555 634 699 336 385 Leasehold land and land use rights 17 15 15 15 14 14 13 6 40 Investment properties 0 0 81 81 81 81 81 82 90 Interests in associate 2 5 5 6 6 7 8 5 8 Trading license 1 1 1 1 1 1 1 1 1 Rental deposits 26 31 40 59 72 90 109 33 35 Deferred tax assets 14 14 19 19 19 19 19 16 31 Non-current assets – total 168 446 531 639 748 846 930 480 592

Inventory 1,219 1,736 2,631 3,775 4,159 5,145 6,098 2,208 3,927 Trade receivables 37 74 109 150 174 208 247 80 145 Deposits, prepayments and other receivables 44 46 41 58 67 80 95 47 81 Amt due from associate 6 8 5 5 5 5 5 33 0 Bank balance and cash 280 287 966 2,529 3,063 3,782 4,359 274 413 Total current assets 1,586 2,151 3,751 6,517 7,468 9,219 10,805 2,642 4,566

Trade and other payables 259 530 686 1,054 1,040 1,470 1,452 511 865 Short-term bank loans 169 314 0 0 0 0 0 0 95 Taxation payable 28 50 90 140 149 185 237 608 166 Amount due to an associate 0 0 0 0 0 0 0 79 1 Total current liabilities 456 894 777 1,193 1,188 1,654 1,689 1,198 1,127

Deferred tax liabilities 3 7 19 19 19 19 19 14 27 Employees benefit 23 12 28 31 34 37 41 12 28 Long-term bank loans 0 0 0 0 0 0 0 0 0 Total non-current liabilities 26 19 46 49 52 56 59 26 55

Shareholder equity 1,196 1,523 3,196 5,624 6,671 7,964 9,471 1,870 3,933 Minority interest 18 23 35 52 69 90 115 28 44 Proposed dividend 59 138 228 238 236 300 401 0 0 Total equity 1,273 1,683 3,458 5,914 6,976 8,355 9,986 1,897 3,977

Total assets 1,754 2,597 4,282 7,156 8,216 10,065 11,735 3,122 5,158 Total liabilities and equities 1,754 2,597 4,282 7,156 8,216 10,065 11,735 3,122 5,158

Gross debt 169 314 0 0 0 0 0 0 95 Net debt (111) 27 (966) (2,529) (3,063) (3,782) (4,359) (274) (318) Net gearing (%) Net cash 1.6 Net cash Net cash Net cash Net cash Net cash Net cash Net cash Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Luk Fook – cash flow projections

Year to December (HK$m) 2009 2010 2011 2012F 2013F 2014F 2015F EBIT 318 635 1,024 1,545 1,538 1,910 2,313 Depreciation and amortization 39 44 51 52 65 81 96 EBITDA 355 679 1,075 1,597 1,603 1,991 2,409 Adjustments for other non-cash items 25 (26) 24 (9) (1) (3) (1) Working capital changes: Inventory 29 (513) (870) (1,144) (384) (986) (953) Receivables (3) (32) (36) (58) (34) (46) (55) Payables (26) 272 156 367 (14) 430 (18) Tax paid (48) (71) (108) (184) (239) (272) (343) Interest paid 8 3 5 0 0 0 0 Interest received (0) (0) (1) (8) (9) (11) (13) Operating cash flow 340 311 244 561 922 1,103 1,025 Capex (30) (315) (101) (140) (160) (160) (160) Free cash flow 311 (4) 143 421 762 943 865 Other investment cash flows 2 2 2 8 9 11 13 Contribution from minority shareholders 0 0 0 0 0 0 1 Share issue 0 0 1,134 1,363 0 0 0 Dividend paid (101) (133) (279) (228) (238) (236) (300) Advance/repayment to/from minority shareholders 0 0 0 0 0 0 1 Net cash flow 212 (136) 1,000 1,563 534 719 580 Source: Company data, CCBIS estimates

Luk Fook – key financial ratios

Year to December 2009 2010 2011 2012F 2013F 2014F 2015F ROAE (%) 23.5 36.5 34.1 28.1 20.1 21.0 21.0 ROAA (%) 15.9 24.4 25.2 22.8 16.7 17.4 17.5 ROIC (%) 24.2 37.5 41.4 44.4 35.2 37.6 37.4 Average inventory days 146 132 129 133 139 139 141 Average receivable days 3 4 4 4 4 4 4 Average payable days 33 35 36 36 37 37 37 Cash conversion cycle (days) 116 100 97 101 107 106 109 Net gearing (%) Net cash 0.0 Net cash Net cash Net cash Net cash Net cash Gross gearing (%) 13.3 18.6 0.0 0.0 0.0 0.0 0.0 Source: Company data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

Company-specific investment risks

Share disposal risk

Luk Fook’s major shareholders and directors have a history of reducing ownership in Luk Fook, exhibited in the below table. Capital raised in the past was mainly used to raise the company’s liquidity, purchase inventory and expand. While the company’s key shareholders remain the same, we nevertheless view Luk Fook’s history of share disposals as a key risk that could trigger short-selling of the stock.

Luk Fook – past capital raising activities

Issue date Type # of shares issued Net proceeds HK$ / share December 2010 Top-up placement 42,000,000 1,134 23.15 January 2011 Top-up placement 46,600,000 1,341 29.25 Source: HKEx, CCBIS research Senior management and shareholding structure

Directors

Mr. Wong Wai Sheung – Chief Executive Officer and founder

Mr. Wong has over 43 years of experience in the Hong Kong jewelry industry and is responsible for overall strategic planning and management of the group. Mr. Wong is also the Associate Director of The Kowloon Gold Silver and Jewel Merchant’s Staff Association, a post he has held since November 1993. He has also been the Honorary Permanent Chairman of Jadeware Traders Industry & Commerce Association and Chairman of the Supervisory Committee of Kowloon Jewellers’ and Goldsmiths’ Association since 2001. In 2005 he was elected Honorary Chairman of Macau Goldsmith’s Guild and appointed Honorary Chairman of the First General Committee of Guangdong Golden Jewelry and Jade Industry’s Association in 2006. He has been a member of the Hong Kong Trade Development Council Jewellery Advisory Committee and the QTSA Governing Council (Retailer Category) and an elected member of the General Committee of the Hong Kong Brand Development Council sine 2008. Mr. Wong is the father of Mr. Wong Ho Lung, Danny and Miss Wong Lan Sze, Nancy, all directors at the company.

Mr. Tse Moon Chuen – Director, deputy general manager and co-founder

Mr. Tse has over 37 years of experience in the jewellery retailing business and is responsible for sales operations and administration of the group’s retail shops. He has been appointed to various positions over the years including as an executive committee member of the Diamond Federation of Hong Kong, China Ltd. since 2000; an alternate committee member of the Chinese Gold & Silver Exchange Society since July 2004 and Vice-Chairman of the Kowloon Pearls, Precious Stones, Jade, Gold and Silver Ornament Merchants Association since 2005.

Mr. Law Tim Fuk, Paul – Director, Company secretary and Financial controller

Mr. Lau joined the group in 1996. He is a member of the ACCA, the CIMA, the HK ICSAN. Mr. Law has over 16 years of accounting and auditing experience and over 19 years of experience in commerce. He is mainly responsible for the accounting and finance of the group. He also handles communications with institutional investors and financial reporters.

Initiation on Jewelry and Watch Sector 20 April 2012

Senior Management

Mr. Au Kwok Kau – General manager and co-founder

Mr. Au is one of the co-founders of the company and was the General Manager of the group since 1992. Since 2007 he has served as the group General Manager. Mr Au is responsible for the overall administration of Luk Fook and has over 38 years of experience in Hong Kong’s jewelry industry.

Ms. Chung Vai Ping, Icy – Senior Product Development Manager

Ms. Chung has over 20 years experience within the jewelry industry. She joined the group in 1990 and is mainly responsible for the product development, jewelry purchasing, wholesaling and retailing business of the group. Ms. Chung frequently visits jewelry exhibitions worldwide in order to explore new products and source the finest jewelry and jewelry parts. In 2001, she won the Best of Show Award with her “Flashing” design at the 2nd Hong Kong Jewellery Design Competition. She was awarded the title GIA Diamonds Graduate in 2004.

Luk Fook’s shareholding structure

Luk Fook (Control) Ltd. Public 39.8% 60.2%

Luk Fook Holdings Ltd. (590 HK)

Source: HKEx, CCBIS research

Initiation on Jewelry and Watch Sector 20 April 2012

Appendix : Peer comparison

Chow Tai Fook (1929 HK) Emperor (887 HK) Hengdeli (3389 HK) Luk Fook (590 HK) Year to March Year to December Year to December Year to March FY11 FY12F FY10 FY11 FY10 FY11 FY11 FY12F Total POS 1,361 1,620 61 80 350 405 699 817

Total POS by region China 1,277 1,528 40 57 286 332 657 772 Hong Kong, Macau & others 84 92 21 23 64 73 42 45

POS breakdown by format Direct 970 1,146 61 80 350 405 81 99 Franchised 391 474 – – – – 618 718

POS breakdown by format (%) Direct 71 71 100 100 100 100 12 12 Franchised 29 29 – – – – 88 88

Total sales (HK$m) 35,046 55,615 4,095 5,862 7,157 9,462 8,091 11,530 Direct retail 30,033 46,438 4,095 5,862 5,553 7,145 6,440 9,560 Wholesale 5,009 9,177 – – 1,447 2,122 739 937 Other – – – – 157 196 912 1,033

Sales mix – by channel (%) Direct retail 86 83 100 100 78 76 80 83 Wholesale 14 17 – – 20 22 9 8 Other – – – – 2 2 11 9

Sales mix – by region (HK$m) China 19,472 31,272 462 622 4,731 6,455 1,468 1,942 Hong Kong 15,571 24,343 3,366 4,863 2,101 2,626 5,986 8,919 Other – – 267 377 325 381 637 669

Sales mix – by region (%) China 56 56 11 11 66 68 18 17 Hong Kong 44 44 82 83 29 28 74 77 Other – – 7 6 5 4 8 6

Sales mix – by product (HK$m) Gem-set jewelry 8,963 – 633 1,030 – – 2,898 – Platinum/karat gold products 4,869 – – – – – – – Gold items 18,725 – – – – – 3,542 – Watches 2,486 – 3,461 4,832 7,157 9,462 – –

Sales mix – by product (%) Gem-set jewelry 26 – 15 18 – – 45 – Gold items 67 – – – – – 55 – Watches 7 – 85 82 100 100 – –

Gross profit margin (%) 28.3 29.5 25.6 28.8 24.9 25.1 23.7 23.9 (continued on next page)

Initiation on Jewelry and Watch Sector 20 April 2012

Appendix : Peer comparison (continued from previous page)

Chow Tai Fook (1929 HK) Emperor (887 HK) Hengdeli (3389 HK) Luk Fook (590 HK) Year to March Year to December Year to December Year to March FY11 FY12F FY10 FY11 FY10 FY11 FY11 FY12F Key SG&A expense ratio (%) Rental 5.7 5.0 6.7 6.9 5.7 5.5 3.1 3.2 Staff 5.2 4.8 3.8 3.9 5.1 5.3 4.7 5.1 Other operating expense 4.6 4.2 1.1 1.2 0.8 0.9 3.4 3.5

EBIT (HK$m) 4,656 8,861 413 764 729 1,054 1,024 1,545 EBIT margin (%) 13.3 15.9 10.1 13.0 10.2 11.1 12.7 13.4 EBITDA (HK$m) 4,402 8,475 454 831 775 1,117 1,075 1,597 EBITDA margin (%) 12.6 15.2 11.1 14.2 10.8 11.8 13.3 13.8

Net profit (HK$m) 3,538 6,516 134 627 482 678 877 1,320 Normalised net profit (HK$m) 3,538 6,516 325 636 482 678 866 1,303 Normalised net profit margin (%) 10.1 11.7 7.9 10.9 6.7 7.2 10.8 11.4

Average inventory days 192 210 207 243 166 165 129 133 Average receivable days 14 13 17 12 23 25 4 4 Average payable days 6 6 (40) (35) (52) (75) (36) (36) Cash conversion cycle (days) 200 218 184 219 136 115 97 101 Gross debt (HK$m) 6,813 13,100 67 340 2,956 3,530 0 0 Net debt (HK$m) 1,208 (8,300) (534) (464) (14) 252 (966) (2,529) Net gearing (%) 10.3 Net cash Net cash Net cash Net cash 6.2 Net cash Net cash ROAE (%) 36.4 32.5 6.6 20.5 14.9 16.9 34.1 28.1 ROAA (%) 15.9 16.0 5.1 16.1 7.8 7.9 25.2 22.8 ROIC (%) 24.3 28.1 20.8 24.4 17.8 20.7 41.4 44.4 * As % of direct retail sales Note: Hengdeli’s data was originally presented in RMB; RMB/HK$ exchange rate of 1.2 was applied to all figures Source: Chow Tai Fook, Emperor, Hengdeli and Luk Fook data, CCBIS estimates

Initiation on Jewelry and Watch Sector 20 April 2012

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