China Consumer Sector

January 4, 2018 Hong Kong Jewelers: Leading Position Unchallenged Initiate Chow Sang Sang and Luk Fook with a BUY Rating Top-down: Jewellery Market Recovering Gradually, Supported by Structural Growth in China Luxury Sector China. We are long-term bullish on the Mainland China market, as it is undergoing a consumption upgrade. The core of our investment thesis is that more consumers outside major cities can afford more luxury products, creating sustainable growth for jewellery retailers. In the Last Price TP coming years, we expect SSSG for jewelers to remain in the high single digits. The market will Company Ticker Rating (HK$) (HK$) be driven by products targeting the middle class, while high-end products will continue to be CTF 1929 HK 8.65 9.20 HOLD dampened by the anti-graft campaign. Luk Fook 590 HK 33.90 39.30 BUY CSS 116 HK 18.70 23.00 BUY For Hong Kong, we expect demand from Mainland Chinese tourists to become lukewarm as tourists now prefer to shop elsewhere, although local demand is picking up. We forecast that overall SSSG will be in the high single digits in the near term, and then stabilize to mid-single digits as the wealth effect continues. We expect an important theme for HK to be rental cost reductions, which could last until 2019.

Hong Kong Jewelers Are Well-Positioned for China’s Consumption Upgrade. We are positive on the performance of the three leading Hong Kong jewellery retailers, namely CTF, Luk Fook and CSS. In general, we consider Hong Kong brands to be better positioned to capture the mid- to high-end market in Mainland China (e.g. product position, marketing strategy), and we expect Hong Kong brands to continue to maintain a leading position in the growing Mainland market.

The focus will be expanding the POS network in Mainland China. For example, Luk Fook has revised up its POS net addition to 100 in FY18. E-commerce may be an engine of growth, but it may take some time for profit to be visible due to increasing SG&A and capex in the near term.

Bottom-up: Luk Fook could outperform in the current cycle. Our stock pick for the sector rests on the critical assumption that China's luxury market is recovering healthily, as consumption upgrade demand from the middle class supports sustainable growth. We note that Hong Kong-based jewellers have been more aggressive in expanding their POS, which we believe will be helpful for their earnings. However, we believe Luk Fook could be the best performer in this cycle, because its SSSG is likely to outperform, based on experience in previous cycles.

Our order of preference is: CSS (+23.0%) >LF (+15.9%) >CTF (+6.4%), based on our TP upside. We believe the valuation of CSS is the most attractive, while its expansion in Mainland China could reap more visible output due to the low-base effect.

LF is no longer very undervalued, but we are still positive on the Company’s expansion in the Tony Li, CFA—Analyst current cycle, and see some upside potential in the current price.

(852) 3698 6392 Although CTF should continue to be the leader in the China jewelry market, and its cost-cutting efforts in HK are more visible, we believe the valuation already reflects the fundamentals, as well [email protected] as the premium for its market-leading position. Valuation of the sector Wong Chi Man, CFA—Head of Research Company Ticker Rating Price PER(x) EPS Growth (%) 3-Year PBR(x) HK$ FY0 FY1 FY2 FY1 FY2 CAGR (%) FY1 FY2 (852) 3698 6317 Chow Tai Fook Jew ellery 1929 HK HOLD 8.65 28.27 21.08 18.84 34.12 11.89 10.28 2.85 2.64

Luk Fook Holdings Intl Ltd 590 HK BUY 33.90 19.60 17.52 15.10 11.83 16.03 17.26 2.07 1.88 [email protected] Chow Sang Sang Hldg 116 HK BUY 18.70 17.06 15.09 12.38 13.06 21.94 18.16 1.33 1.25 1 Sources: Bloomberg, CGIS Research estimates

Summary of Our Views

Chow Sang Sang [BUY, TP:HK$23.00]. We initiate coverage on Chow Sang Sang (CSS) with a BUY rating. Even though the scale of the Company is the smallest of the three leading jewelers in Hong Kong, we expect its growth in the current recovery cycle to be more visible than for some bigger players. We expect that with the net addition of 50 POS in Mainland China in FY2017E, as well as the emergence of e-commerce, revenue growth in FY2018E could accelerate to +10.5% in FY2018E (2017E: +6.1%). Also, with rental expense control, we expect to see margin improvement. NPM is forecast to expand from 4.9% in FY2016 to 5.8% in FY2019E. We therefore forecast that its EPS growth for FY2017E to FY2019E could reach +13.1%/+21.9%/+14.2%, respectively. The current valuation of CSS is undemanding in our view, as it is the cheapest of the big 3 jewellers in Hong Kong. Our TP of HK$23.00 is based on 16x FY2018E PER. CSS’s financial position is also healthy, taking into account its nearly HK$600m in net cash on hand and a steady dividend payout ratio.

Luk Fook [BUY; TP:HK$39.30]. We initiate coverage on Luk Fook Holdings with a BUY rating, as we believe the Company is likely to be an outperformer in the gradually recovering China luxury market. Luk Fook expanded rapidly with its franchisee model, but we expect the contribution from self-operated stores and e- commerce to become more visible: the contribution from Mainland China’s self- operated stores will be up from 12% in FY2016 to 18% in FY2020E, while e- commerce’s contribution to its Mainland China’s retail sales will exceed the current 15%. These channels are more profitable and could lift overall revenue and profit in the current cycle, in our view. We also expect there to be a margin expansion in the next few years as the product mix improves. Above all, when looking at data like SSSG, Luk Fook is more sensitive to the industry cycle, so we expect its growth to outperform that of its peers. We therefore expect its EPS to grow +11.8%, +16.0%, +18.3% in FY2018- FY2020E, respectively. Although its current valuation is at a multi-year high, we believe the re-rating will continue if earnings growth is considered. Our TP of HK$39.30 is based on 17.5x FY2019E PER. Luk Fook has a healthy financial position, and we believe increasing the dividend payout ratio could be a potential catalyst.

Chow Tai Fook [HOLD, TP:HK$9.20]. Chow Tai Fook Jewellery (CTF) has been a market leader in the Chinese jewellery market, and we expect it to maintain its leading position in the future. We expect the continuous addition of POS in smaller cities in Mainland China, as well as the development of mass market-friendly brands and e- commerce, could help the Company reach the mass market. CTF is also more proac- tive in reducing its POS network in Hong Kong, which will help margin enhancement. We therefore expect its FY2018E EPS to grow 34% YoY to HK$0.41. However, CTF’s financial position is no longer attractive, as it has turned from a net cash position to a net debt position, and its dividend payout will revert to the normal level. We also expect the Company’s EPS growth for FY2019E and FY2020E to revert to a slower pace of +12% and +9%, respectively. We believe the current valuation already reflects the fundamentals and the premium for its leading position. We initiate with a HOLD rating. Our TP of HK$9.20 is based on 20x FY2019E PER, which is close to its histori- cal valuation average.

Sector Comparison and Valuation

Figure 1: Summary of Three Listed Companies CTF [1929.HK] Luk Fook [590.HK] CSS [116.HK] Overview Year Ended 31 March 31 March 31 December Forecast Period FY2018E FY2018E FY2017E Revenue (HK$m) 57,068 14,365 17,068 Net Profit (HK$m) 4,104 1,137 839 Gross Profit Margin 29.0% 24.8% 24.5% ROE 13.9% 11.9% 8.8% Net Debt to Equity 21.0% (Net Cash) (Net Cash)

Total POS 2,521 1,602 522 - Hong Kong & Others 125 68 98 - Mainland China 2,396 1,534 424 % of Self-operated POS 65% 14% 100% E-commerce's Contribution to Mainland China Business: Revenue (HK$m, latest 621 137 525 interim figures) as % of retail revenue 5.4% 14.8% 13.0% Product Mix: Gold 91% 77% ~90% Gem-set 9% 23% ~10%

Sources: Company, CGIS Research estimates

Figure 2: Sector Peer Comparison Company Ticker Trading Price Mkt Cap PER(x) PBR(x) ROE(%) Div YIeld(%) Currency US$m FY0 FY1 FY2 FY0 FY1 FY2 FY0 FY1 FY2 FY0 FY1 FY2 Our Coverage Chow Tai Fook Jew ellery 1929 HK HKD 8.65 11,066 28.27 21.08 18.84 2.61 2.85 2.64 11.32 13.88 14.45 2.54 2.85 2.65 Luk Fook Holdings Intl Ltd 590 HK HKD 33.90 2,546 19.60 17.52 15.10 2.13 2.07 1.88 12.37 11.94 12.60 3.39 3.39 3.39 Chow Sang Sang Hldg 116 HK HKD 18.70 1,619 17.06 15.09 12.38 1.35 1.33 1.25 8.38 8.81 10.27 2.35 2.52 3.07 Simple Average 21.64 17.90 15.44 2.03 2.08 1.92 10.69 11.54 12.44 2.76 2.92 3.04

Peers Listed in Hong Kong Emperor Watch & Jew ellery 887 HK HKD 0.36 317 57.56 - - 0.59 - - 1.02 - - 0.47 1.39 1.67 Hengdeli Holdings Ltd 3389 HK HKD 0.38 225 - - - 0.27 - - -10.40 - - - - - Oriental Watch Holdings 398 HK HKD 1.78 130 17.49 - - 0.46 - - 2.67 - - 1.35 - - Tse Sui Luen Jew ellery Intl 417 HK HKD 2.24 71 19.05 - - 0.52 - - 2.80 - - 2.37 - - Simple Average 31.36 - - 0.46 - - -0.98 - - 1.40 1.39 1.67

Peers Listed in A-share Lao Feng Xiang Co Ltd-A 600612 CH RMB 42.23 2,826 19.19 17.48 15.38 4.08 3.75 3.15 22.53 22.29 21.51 2.37 2.33 2.27 Shanghai Yuyuan Tourist-A 600655 CH RMB 11.09 2,453 29.93 23.60 21.00 1.45 1.54 1.45 5.10 6.43 6.85 0.90 1.11 1.24 Eastern Gold Jade Co Ltd-A 600086 CH RMB 10.82 2,247 52.00 - - 4.53 - - 9.06 - - 0.20 - - Chow Tai Seng Jew ellery Co-A 002867 CH RMB 27.97 2,056 26.39 25.78 22.20 6.96 - - 28.09 25.10 23.70 2.15 - - Guangdong Chj Industry Co-A 002345 CH RMB 10.75 1,498 33.76 33.70 29.05 2.88 2.95 2.73 8.98 8.39 9.16 0.93 0.37 0.43 Zhejiang Ming Jew elry Co-A 002574 CH RMB 7.59 617 53.78 42.17 58.38 1.28 1.28 1.26 2.40 3.06 2.12 0.66 0.92 0.66 Simple Average 35.84 28.54 29.21 3.53 2.38 2.15 12.69 13.05 12.67 1.20 1.18 1.15

International Peers LVMH Moet Hennessy MC FP EUR 242.35 147,677 27.75 24.97 22.46 4.54 4.25 3.84 17.04 17.76 18.03 1.73 1.91 2.12 Cie Financiere Richemont CFR SW CHF 88.22 51,955 25.83 24.56 22.14 2.94 2.64 2.50 11.21 10.86 11.68 2.04 2.40 2.61 Tiffany & Co TIF US USD 106.43 13,227 27.21 26.31 24.09 4.19 4.04 3.76 15.37 16.46 15.98 1.88 1.86 1.96 Signet Jew elers Ltd SIG US USD 55.29 3,346 8.78 8.78 8.54 1.58 1.52 1.36 19.89 14.93 12.28 2.24 2.21 2.31 Simple Average 22.39 21.16 19.30 3.31 3.11 2.86 15.88 15.00 14.49 1.97 2.09 2.25

Sources: Bloomberg, CGIS Research estimates for covered stocks 3

Sources: Bloomberg, CGIS Research estimates for covered companies

Jewelry Market Overview

Mainland China: The Rise of the Mass Market

We are long-term bullish on the consumer market in Mainland China. As the average income of Chinese residents continues to increase along with the Chinese economy, we expect this to trigger an ongoing consumption upgrade. Spending on discretionary items will increase and catch up to the level of developed countries. Luxuries, especially jewellery, will face rising demand from Chinese families who are getting richer.

The core of our investment thesis is that more consumers outside major cities can afford luxury items, creating sustainable growth for jewellery retailers. As income rises, and wealth spills over from the richest cities to lower-tier cities, retailers will need to open more points of sale (POS) to capture the growth potential.

Since the income level for these cities is still lower than that of Demand will tilt towards the mass developed countries, we expect demand for lower-priced products to be much stronger market than for high-end products. In other words, we expect the growth opportunities to be mass-driven.

Signs of Recovery According to Official Data

According to data from the National Bureau of Statistics of China (NBS), China's retail market has been growing steadily, with a YoY growth rate of around 10% in recent months. In 2016, total retail sales of consumer goods in China reached RMB33.23 China’s consumer market may trillion, up 10.40% YoY. If this momentum can be sustained, then we estimate that retail reach RMB48.65 trillion by 2020 sales in China could reach RMB48.65 trillion in 2020. As Chinese consumers become wealthier, we argue that a significant portion of this increase will be related to purchas- ing discretionary items (jewellery included).

Figure 3: Retail Sales in China Growing Steadily

35,000 25

30,000 20

25,000

20,000 15

15,000 10 10,000 5 5,000

0 0 2011-01 2012-01 2013-01 2014-01 2015-01 2016-01 2017-01

Total Retail Sales of Consumer Goods, YTD (LHS, RMB billion) YoY Change (RHS, %)

Sources: National Bureau of Statistics, CGIS Research 4

For jewelry retailers, we believe there will be plentiful opportunities in the current market landscape, despite the big shift in market structure and sentiment.

As official data up to Oct 2017 suggests, overall retail sales of companies above NBS's designated size (e.g. retailers with annual sales of RMB5m) are growing at a high sin- Signs of jewelry retail sales gle digit rate (~8% in 2H 2017). For the category applicable to jewelry retailers, the stabilizing growth rate has been picking up since 2H 2017 and is approaching high single digit growth as well (above 6% in Oct 2017). While the growth rate for this category has been bumpy, there have been signs of stabilization.

Figure 4: Retail Sales of Larger Companies Still Growing, Despite the Impact from E- commerce and SMEs

16,000 30

14,000 25 12,000 20 10,000 8,000 15 6,000 10 4,000 5 2,000

0 0 2011-01 2012-01 2013-01 2014-01 2015-01 2016-01 2017-01 Total Retail Sales of the Wholesale and Retail Enterprises above Designated Size, YTD (LHS, RMB billion) YoY Change (RHS, %) Sources: National Bureau of Statistics, CGIS Research

Figure 5: Sales of Bullion and Jewelry of Larger Companies Recovering in China

350 70

300 60

50 250 40 200 30 150 20 100 10 50 0 0 (10) 2011-01 2012-01 2013-01 2014-01 2015-01 2016-01 2017-01 Total Retail Sales of Gold, Silver and Jewelry, YTD (LHS, RMB billion)

YoY Change (RHS, %)

Sources: National Bureau of Statistics, CGIS Research

Mainland China Market Growth Outlook

Impact from Anti-graft Campaign Still Lingers, But High Single-Digit Growth Still Possible

We assume SSSG could remain In our investment thesis, we estimate that the overall growth in sales of gold products in the high single digits and jewellery in China will remain in the high single digits for the next few years. This lays the foundation of our same store sales growth (SSSG) forecast for jewellery retailers. Our argument is based the following points:

(1) Product Offerings Will Be More Mass-Market Oriented

ASP expected to fall We emphasize that the mass market will be the backbone for the growth of overall luxury products. On the demand side, rising income of Chinese families will create more demand for gold and jewellery products. On the supply side, we expect jewellery retailers to offer more products with lower ticket prices to cope with demand among emerging middle class and millennials (see later in this report for a detailed explanation).

As we foresee more jewellery products being more affordable to Chinese mass consumers, we expect the overall growth in sales of gold and jewellery products to resemble the growth of overall retail sales in China, as these products have become more mass market-oriented and accessible to more consumers. With the rise of e- commerce, we see jewellery retailers have successfully captured demand from millennials, who seek products with lower ticket prices and faster product cycles.

(2) Anti-graft Campaign Could Have a Long-lasting Impact on High- End Products

In the early 2010s, gold and jewellery products experienced explosive growth (more than 50% in 2011), but growth has significantly deteriorated since the start of 2014. The anti-graft campaign has reached new heights since Chairman Xi Jinping took over more top positions in 2013. Since then, there has been a massive cut in lavish spending and gift giving, resulting in a sharp decline in high-end luxury product sales.

High-end products could still grow, but at a slower pace We expect the anti-graft campaign to continue even though it may be lower profile, and it could have a long-lasting impact on the overall luxury market. In the past, a substantial portion of the demand was driven by gift giving, but now we continue to expect this part of demand to be muted. However, we still expect there to be growth in sales of high-end products, albeit slower, as wealth accumulation in China will create more demand from the high net worth individuals (HNWs).

Figure 6: YoY Growth of Retail Sales: Gold and Jewellery Were More Volatile Than the Overall Retail Market

70.0% 70.0%

60.0% 60.0% 50.0% 50.0% 40.0% 40.0% 30.0% 30.0% 20.0% 20.0%

10.0% 10.0% 0.0% 0.0% -10.0% -10.0%

Gold, Silver and Jewelry, YTD All Categories, YTD Sources: National Bureau of Statistics, CGIS Research

(3) Gold-rush May Be Non-recurrent as Consumers Now More

Experienced

We expect the market to be more The "gold-rush" in 2013 created an unexpected surge in demand for gold products, which surprised the market, but such an unusual sharp rise in demand may not recur in stable the future, in our view. In other words, we expect demand to be less volatile.

In retrospect, the 2013 gold rush was triggered by speculative demand from Chinese consumers. The gold price fell considerably (>10%) within a short period of time, as global investors were less worried about inflation created by central banks, and the risk of a European Sovereign Debt Crisis had faded. Chinese consumers believed it was an opportunity to buy the dip. However, the gold price continued to sink, and some gold buyers during the "gold-rush" experienced losses.

As the global market has stabilized and Chinese consumers become more experienced, we believe such a sudden surge in speculative demand for gold products will be unlikely to happen again. We therefore are more confident in a steadier expansion of the overall gold and jewellery market.

Hong Kong: Tourists Still Matter, But to a Lesser Degree

SSSG for HK will follow the pattern We believe the Hong Kong market is also recovering moderately, driven by two factors: of Mainland China (1) the rising spending power of Mainland Chinese tourists, and (2) stable demand from local residents. The integration of Mainland-Hong Kong economic activity will also drive the overall growth of luxury products, as well as our SSSG forecasts. We forecast that overall SSSG may be in the high single digits in the near term due to the low base effect. Then it will stabilize to mid-single digits, as we expect the wealth effect in Hong Kong to continue.

Hong Kong is still an important destination for Chinese consumers to shop for luxury products, although we note that Hong Kong's attractiveness has been fading some- what. For Hong Kong-based jewellery retailers, Hong Kong still provides a solid revenue and profit contribution to the overall group, even though their expansion focus is on Mainland China.

The HK retail market has been driv- In a nutshell, Hong Kong's retail market has been driven by Mainland Chinese tourists since 2003, when Mainland China started to relax the visa policy. The value of retail en by tourists sales (VaRS) has been increasing since 2003, synchronized with the growth of Chi- nese tourists. Jewellery and gold product sales experienced robust growth during the period, as there were fewer POS in Mainland China selling Hong Kong brand products. However, as the anti-graft campaign intensified in 2014, Hong Kong also suffered.

Figure 7: Value of Retail Sales (VaRS) in Hong Kong by Year - Figure 8: Value of Retail Sales (VaRS) in Hong Kong by Year - Jewelry, All Categories Watches and Clocks, as well as Valuable Gifts

30% 50% 120,000 500,000 25% 40% 100,000 30% 400,000 20% 20% 15% 80,000 300,000 10% 10% 60,000 0% 200,000 5% 40,000 -10% 0% 20,000 100,000 -20% -5% 0 -30% 0 -10% 2001 2005 2009 2013 2017 2001 2005 2009 2013 2017 Jewelery, Watches and Clocks, as well as Valuable Gifts (HKS, HK$m) VaRS - All Retailer Categories (LHS, HK$m) YoY Change (RHS) YoY Change (RHS)

Sources: Hong Kong Census and Statistics Department, Sources: Hong Kong Census and Statistics Department, CGIS Research estimates CGIS Research estimates

Figure 9: Number of Tourist Arrivals in Hong Kong by Year Figure 10: Number of Mainland Chinese Tourist Arrivals in Hong Kong by Year

50% 50,000,000 90% 60,000,000 45,000,000 80% 40% 40,000,000 50,000,000 35,000,000 70% 30% 40,000,000 30,000,000 25,000,000 60% 20% 30,000,000 20,000,000 50% 15,000,000 20,000,000 10% 10,000,000 40% 10,000,000 0% 5,000,000 0 30% 0 -10% 2001 2005 2009 2013 2017 2001 2005 2009 2013 2017 Visitor Arrivals from Mainland China (LHS, persons) Visitor Arrivals (LHS, persons) YoY Change (RHS) as % of Total Visitor Arrivals (RHS)

Sources: Hong Kong Tourism Board, CGIS Research estimates Sources: Hong Kong Tourism Board, CGIS Research estimates

More recently, spending from local residents in Hong Kong has shown resiliency, driv- ing the recovery of local luxury market. Since mid-2017, the Hong Kong market has turned more positive, and the overall growth rate for retail sales and jewellery sales has turned positive again after dropping for nearly three years.

Figure 11: Value of Retail Sales (VaRS) in Hong Kong by Year (Jan Figure 12: Value of Retail Sales (VaRS) in Hong Kong (Jan 2016 to 2016 to Oct 2017) - All Categories Oct 2017) - Jewelry, Watches and Clocks, as well as Valuable Gifts

50,000 10.0% 9,000 20.0% 45,000 8,000 5.0% 10.0% 40,000 7,000 0.0% 35,000 6,000 0.0% 30,000 -5.0% 5,000 25,000 -10.0% -10.0% 4,000 20,000 3,000 -20.0% 15,000 -15.0% 10,000 2,000 -20.0% -30.0% 5,000 1,000

0 -25.0% 0 -40.0% Jan-2016 May-2016 Sep-2016 Jan-2017 May-2017 Sep-2017 Jan-2016 May-2016 Sep-2016 Jan-2017 May-2017 Sep-2017 Value of Retail Sales: All Retailer Categories (LHS, HK$m) Jewelery, Watches and Clocks, as well as Valuable Gifts (LHS, HK$m) YoY Change (RHS) YoY Change (RHS)

Sources: Hong Kong Census and Statistics Department, Sources: Hong Kong Census and Statistics Department, CGIS Research CGIS Research

Hong Kong Market Growth Outlook

Positive Despite the Dichotomy

We are less bullish on the outlook for the Hong Kong market than we are for the Main- The HK market should see a mod- land market, but we still expect the market to see a moderate recovery in the coming erate recovery years. This implies that we expect the local market to grow at least in the mid-single digits, or high-single digits if the market turns more favourable.

Our core view is that Mainland Chinese consumers are less likely to shop in Hong Kong, as Hong Kong is no longer an exclusive location to shop for authentic, high qual- ity jewellery. This is evident from a few facts:

(1) The increase in POS in Mainland China by Hong Kong-based retailers saves consumers' time travelling to Hong Kong.

(2) There are more potential shopping destinations for Chinese spenders, as more countries have opened up their visa policy for Mainland Chinese passport holders.

(3) There is an increasing reliance on e-commerce for Hong Kong-based retailers.

(4) The rise in the number of local jewellery brands and boutiques has captured different consumer segments.

The data shown by Chow Tai Fook (CTF) in Figure 13 demonstrates this situation. Be- tween July and Sept 2015, 57% of the Company's Hong Kong retail sales was trans- acted by China UnionPay or RMB. This figure can serve as a proxy for the revenue contribution from Mainland Chinese tourists in Hong Kong. The ratio dropped to 41% between the period from July to Sept 2017, showing the recent recovery is driven mainly by local shoppers.

Figure 13: Proportion of Hong Kong Retail Sales Paid by China UnionPay / RMB in Chow Tai Fook 60% 57% 55%

51% 50% 49% 47% 45% 45% 45% 43% 41% 40% 40%

35% 07/01/2015 - 10/01/2015 - 01/01/2016 - 04/01/2016 - 07/01/2016 - 10/01/2016 - 01/01/2017 - 04/01/2017 - 07/01/2017 - 09/30/2015 12/31/2015 03/31/2016 06/30/2016 09/30/2016 12/31/2016 03/31/2017 06/30/2017 09/30/2017

Paid by China UnionPay / RMB Sources: Company, CGIS Research 10

We continue to expect the contribution from Mainland Chinese tourists to decline gradually, but they will remain a pillar of the local retail market. While the number of Main- land Chinese tourists has stabilized, their per-capita spending has been falling since the start of anti-graft campaign. In 2016, we estimate that the per-capita spending of Mainland tourists was HK$5,228 in 2016, which is considerably lower than HK$6,094 in 2013 and even lower than the HK$5,349 in 2009. One of the reasons for the drop in More affordable items + shopping per-capita spending is that since the anti-graft campaign began, there have been fewer experience = support from Main- consumers buying high-ticket items in Hong Kong. The high-end segment suffered land tourists even more as lavish spending has been discouraged. However, as retailers have started offering more affordable items, it is expected that they can still capture the demand from ordinary tourists, who prefer the shopping experience in Hong Kong.

Figure 14: Tourist Spending Per Capita in Hong Kong (HK$)

6,400 6,172 6,200 6,094

5,952 6,000 5,890 5,908

5,800

5,600 5,554

5,400 5,349 5,228 5,200

5,000

4,800

4,600 2009 2010 2011 2012 2013 2014 2015 2016

Per capita spending (HK$)

Sources: Hong Kong Tourism Board, CGIS Research estimates

On the other hand, as Hong Kong continues to reap the fruits of economic benefits brought by Mainland-Hong Kong integration, the spending power of local residents continues to rise. This could offset the impact of lower spending by Mainland Chinese tourists.

Theme: Relocation and Rental Cost Savings

Unsurprisingly, Hong Kong jewellery retailers have place more emphasis on local spenders, as they have driven the recent recovery of the retail jewellery market. A key strategy deployed by Hong Kong-based jewellery retailers is rebalancing their POS by closing down POS in tourist areas and opening up stores in residential areas.

Figure 15: Recent Trend of POS Movement of Hong Kong Jewellery Retailers Area Examples Change in POS Mongkok, Causeway Bay, Touristic Area: Net Closing Tsim Sha Tsui Residential Area: Yuen Long, Tsuen Wan Net Opening Sources: CGIS Research

We estimate rental expenses could We believe such relocations are necessary and critical for the earnings growth of Hong be 7-9% of retail revenue in HK Kong-based jewellery retailers. In general, we estimate that the current rental expenses could account for 7-9% of the retail revenue generated Hong Kong for the three listed companies. While this figure may not sound significant, we believe the ratio could be managed to decrease further.

Shutting Down Non-performing Stores

While the overall rental expense ratio of the listed jewellery retailers is still under control, some POS operated by the retailers are actually loss-making. This is particularly the case for street-level POS in tourist areas. The boom before 2014 drew retailers to set up POS in popular tourist areas such as Nathan Road. However, we believe there is an oversupply and over-saturation of jewellery retailers in certain areas. It is not uncommon to have a dozen of jewellery shops in the same street in Hong Kong, which could lead to destructive competition.

We expect the rental reduction As retailers realize these facts, they have shut down these non-performing POS. Land- lords also face pressure as the rental contracts have started to expire. In general, the phase to continue until at least rental reversion in these tourist areas could be up to 30 to 40%. As rental contracts 2019 usually last for 3-5 years, and the cycle peaked in 2014, we expect the rental reduction to continue until at least 2019.

Figure 16: Distribution of Jewellery Retailers in Nathan Road - Cannibalization May Be Less Severe after Retailer Optimization (Retrieved in December 2017)

Sources: Google Map, CGIS Research

As a reference, rental levels in Hong Kong have moderated in general, especially in Kowloon District, which has more tourist areas. According to the Hong Kong Rental and Valuation Department, average rents in Kowloon were HK$1,301/sqm in Q3 2017, 20% lower than in Q3 2013, which is more significant than Hong Kong District (-6%) and the New Territories (+4.5%).

Figure 17: Average Rents of Private Retail Properties in Hong Kong - by District (Unit: HK$/sqm) 1,800 1,700

1,600

1,500

1,400

1,300

1,200

1,100

1,000

900

800 2010-03 2011-03 2012-03 2013-03 2014-03 2015-03 2016-03 2017-03

Hong Kong Kowloon New Territories Sources: Hong Kong Rating and Valuation Department, CGIS Research

Overview of Hong Kong Jewellery Retailers Well-Positioned in China's Consumption Upgrade

We are positive on the performance of the three leading Hong Kong jewellery retailers, Chow Tai Fook, Luk Fook and Chow Sang Sang. As China continues to develop as the We expect CTF, CSS and Luk Fook largest luxury market in the globe, its consumers are becoming more sophisticated. We to maintain their market-leading believe these three Hong Kong-based retailers are well-positioned to offer the right position products at the right price, suiting the needs of the emerging middle class and millennials. Even with the rise of local brands and boutiques, we expect Hong Kong brands to maintain their leading position in the Mainland China market.

Fundamentally Differentiated Branding

While many leading jewellery brands in China have decades of operating history, Hong Kong-based brands have accumulated more experience in more mature markets inter- nationally. This has led to differentiated branding and product designs, making them pioneers in providing world-class jewellery with Chinese characteristics. As the Chinese luxury market become more mature and diversified we believe the Hong Kong-based jewellers will provide products that satisfy the demand of both the mass market and the high-end market.

In general, we consider Hong Kong brands, especially the three companies under our HK-based jewelers could capture coverage (Chow Tai Fook, Luk Fook and Chow Sang Sang), to be better positioned to capture the mid- to high-end market in China. Global luxury giants such as Tiffany, the mid to high-end market LVMH and Richemont have been unchallenged in the high-end spectrum of the mar- demand ket, thanks to their international brand recognition, unique product offerings and con- siderable marketing efforts. Hong Kong brands nonetheless can still offer products with relatively high ticket prices and establish differentiated branding in Mainland China.

These qualities will be helpful in expanding their market share, in our view.

Figure 18: General Positioning of Jewellery Retailers in China

Overall Positioning Related Listed Companies High-end Tiffany, LVMH, Richemont

Mid to High-end Chow Tai Fook, Chow Sang Sang, Luk Fook

Lao Feng Xiang, Chow Tai Seng, Yuyuan Mass Market to Mid-End Tourist Mart, Ming Jewelry, Guangdong CHJ

Sources: CGIS Research

Therefore, Hong Kong brands have been highly ranked among Chi- Four HK-based retailers had a na’s jewellery retailers and have a significant market share 15.1% market share in Mainland in Mainland China. According to the China Jewelry Index, a joint project of the Gems & China in 2015 Jewelry Trade Association of China and the Luohu People's Government in Shenzhen, Chow Tai Fook was the leading brand in China with an 8.5% market share in 2015, and the other three major Hong Kong brands, Chow Sang Sang, Luk Fook and 3D Gold, 14 together had a 6.6% market share.

Figure 19: Market Share of China Jewellery Retailers in 2015

Chow Tai Fook 8.5%

Lao Feng Xiang 5.8%

Chow Tai Seng 4.3%

Yuyuan Tourist Mart 3.1%

Chow Sang Sang 2.3%

Luk Fook 2.2%

3D Gold 2.1%

Zhejiang Ming Jewelry 0.9%

Shenyang Cuihua 0.5%

GuangDong CHJ 0.4%

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%

Sources: China-Jewelry Index (http://www.cnjindex.org)

We expect Hong Kong brands to continue to maintain their leading position in the growing Mainland market, thanks to their mid-high-end positioning. As the data from the China-Jewelry Index suggests, some Mainland Chinese brands, such as Chow Tai Seng, have been rising quickly, but these local brands usually target the mass market, or lower-tier cities.

The ASP of HK retailers in general Using the ASP of gem sets sold by the leading retailers as an example, Chow Sang is higher Sang and Chow Tai Fook have been selling pricier products (HK$11,916 and HK$6,200, respectively) than Chow Tai Seng. Even the ASP of Luk Fook, which offers more affordable products, at HK$3,000 is still higher than the ASP of products sold in Chow Tai Seng's franchised stores, which is their major distribution channel.

Figure 20: ASP of Gem Sets Sold by Selective Listed Jewellery Retailers in 2016 (Unit: HK$)

14,000 11,916 12,000

10,000

8,000 6,200 6,000 3,842 4,000 3,000 1,978 2,000

- CSS CTF Chow Tai Seng Luk Fook Chow Tai Seng (self-operated) (franchisee) Sources: Company, CGIS Research 15

Distribution Channel: Still A Game of Scale

We expect the focus of Hong Kong brands to be on increasing their POS in Mainland China for the foreseeable future. While we are bullish on the overall luxury market in China, we note that competition between retailers has intensified. The rise of the middle class outside major cities, combined with the lingering effect of the anti-graft campaign, has transformed the market landscape. As we believe the growth driver More POS will be opened in tilts towards the mass market side, retailers have to ramp up their distribution channels lower-tier cities in less developed cities to capture the potential, in our view. This is especially the case for CTF, since its exposure outside Tier 1 & 2 cities is lower (32.7% vs 51.2% for Luk Fook).

Hong Kong brands still lead the market in terms of revenue, but we expect them to be under the pressure to set up more POS in Mainland China. In the past, a small number of POS in Hong Kong could generate much higher revenue per store thanks to the high influx of tourists. However, as we suggested previously, Mainland Chinese consumers now have more choices in shopping locations. Mainland China is now more attractive for jewellery retailers to set up POS, as the Chinese government has introduced more favourable policies.

Figure 21: Number of POS for Hong Kong Jewellers CTF Luk Fook CSS As at: Sept 30 2017 Sept 30 2017 Jun 30 2017 Hong Kong & Macau 95 58 71 Mainland China 2,358 1,507 395

Other Location 35 11 25 Total 2,488 1,576 491

Sources: Company, CGIS Research

The number of POS of HK retailers It should be noted that the number of POS of Hong Kong brands is falling behind some of the leading local brands, such as Lao Feng Xiang and Chow Tai Seng. These local is still behind some leading local brands have been expanding aggressively with the help of the franchising model, brands which has been more successful in Tier 3-4 cities, as the market there is usually more concentrated. Local business partners can often secure better rental terms and logistics arrangements.

Figure 22: Number of Mainland China POS by Major Jewellery Retailer CTF Luk Fook CSS TSL Lao Feng Xiang Chow Tai Seng Yuyuan Ticker 1929.HK 590.HK 116.HK 417.HK 600612.CH 002867.CH 600655.CH As at: Sept 30 2017 Sept 30 2017 Jun 30 2017 Aug 31 2017 Jun 30 2017 Jun 30 2017 Jun 30 2017 POS 2,358 1,507 395 349 3,058 2,505 1,904

Sources: Company, CGIS Research

There have been two extremes among Hong Kong jewellers. Unsurprisingly, Luk Fook has been experiencing much quicker growth than its peers, as it has adopted an aggressive franchising model targeting Tier 3-4 cities. In 1H FY2017, Luk Fook had 1,355 franchised POS, accounting for 90% of its total POS. In contrast, CSS adopted the self-operated-only model, so its overall expansion has been slower.

Figure 23: Hong Kong Jewellers' Operating Model CTF Luk Fook CSS As at: Sept 30 2017 Sept 30 2017 Jun 30 2017 Self-operated 1,493 152 395 Franchised 865 1,355 0 Total 2,358 1,507 395

Sources: Company, CGIS Research

Figure 24: Hong Kong Jewellers' POS Distribution CTF Luk Fook As at: Sept 30 2017 Sept 30 2017 Tier 1 273 242 Tier 2 1,234 494 Tier 3 and Below 733 771 2,240 1,507 Sources: Company, CGIS Research

E-commerce: Not Falling Behind

We believe jewellers are less exposed to the threat of e-commerce or online boutiques, but establishing an online channel is essential for retailers to capture the growth in consumption power. With the rise of e-commerce, consumption patterns in China have fundamentally changed. Although shopping for jewellery is still heavily experience-driven, Chinese consumers are now more willing to shop for lower-priced products, or afforda- Consumers are now willing to buy ble luxury, through online channels. low-priced luxury products online

Hong Kong-based jewellery retailers also realize the potential of e-commerce and have already made certain achievements in the field of e-commerce. To illustrate, the e- commerce channels of the three leading Hong Kong jewellers already account for a significant portion of retail revenue in Mainland China. For Luk Fook and Chow Sang The e-commerce contribution Sang, the revenue contribution has already reached beyond 13%. Recent YoY growth of their online sales could be more than 100% in 2017. could be >13% of Mainland China sales For Chow Tai Fook, although the revenue from online sales in 1H FY2018 accounted for only 5.4% of its Mainland retail revenue, the scale was already HK$621m, the highest of three Hong Kong retailers. E-commerce accounted for a notable 13.4% of Chow Tai Fook's sales volume in Mainland China.

Figure 25: E-commerce Performance of the Three Retailers CTF Luk Fook CSS As at: Sept 30 2017 Sept 30 2017 Jun 30 2017 Contribution to Mainland China Business: Revenue (HK$m, latest interim figures) 621 137 525 as % of retail revenue 5.4% 14.8% 13.0% Product Mix: Gold 91% 77% ~90% Gem-set 9% 23% ~10%

Sources: Company, CGIS Research estimates

Fact: The ASP for products sold The case of Chow Sang Sang illustrates that jewellers’ online channels usually sell online is much lower products with lower ticket prices. The ASP for gold and jewellery products sold online in 2016 was RMB1,280 and RMB2,800, respectively, 47% and 73% lower than the ASP of products sold in its physical stores. A quick check on Tmall shows that the best-selling products are those with a ticket price below RMB1,000/unit, and some even below RMB500.

The product positioning of these products is more towards the mass market, so retailers often find e-commerce to be a good tool to supplement their existing channels. Accord- ing to Chow Sang Sang, approximately 30% of its online sales originate from locations not covered by the Company's physical stores. This illustrates that retailers can capture 18 the demand of the middle class in smaller cities with no physical store exposure.

Figure 26: ASP of Chow Sang Sang's Different Product Categories (2016, RMB/unit) 12,000 10,200 10,000

8,000

6,000

4,000 2,800 2,400

2,000 1,280

- China e-shop - Gold China - Gold - Exclude China e-shop - China - Jewellery - e-shop Jewellery Exclude e-shop Sources: Company, CGIS Research

Figure 27: Hong Kong Jewellers' Best Selling Products on Tmall

Sources: Tmall, CGIS Research

Nonetheless, we expect e-commerce to take years to become a major profit driver for jewellers, despite its growing contribution to top-line growth. Other than the problem of considerably lower ticket prices, we expect intensifying competition among retailers to be increasingly expensive in the next few years. These expenses could come from:

(1) Increasing SG&A expenses for online platforms. Online platforms established by internet giants such as Tmall, JD.com and VIP Shop are still the major platforms for Hong Kong jewellers, and they could account for up to 90% of online sales. Given the increasing competition, online platforms often offer promotions to customers at the expense of retailers or brand owners.

(2) Increasing capex in the near term. Although the growth of online sales has been explosive, retailers have to fill customer orders in accordance to the requirements set by the online platforms. Often jewellers have to build comprehensive logistics facilities to deliver the goods to the platforms' warehouse or direct to consumers. Some retailers, like Chow Sang Sang, have been seen large capex on logistics facilities, and we expect the depreciation and operating costs involved to be a drag on the performance of the jewellers' e-commerce segment in the near term. 19

Bottom-Up: Luk Fook Could Shine

Our stock pick for the sector rests on the critical assumption that China's luxury market is recovering healthily, as mass market demand supports sustainable growth. There- fore, we believe in this business cycle, those who are more aggressive in expansion We expect Luk Fook to will deliver more growth for investors. Hong Kong-based jewellers have been more outperform in terms of SSSG aggressive in expanding their POS, which we believe will be helpful to their earnings. However, we believe Luk Fook will be a better performer in this cycle, because its SSSG likely to outperform thanks to its better positioning in the mass market.

SSSG: Luk Fook Likely to Outperform In the Recovery

With reference to the retailers' SSSG performance, we believe Luk Fook will outperform CTF and CSS in the near term. In the previous cycles, each usually lasting three years, Luk Fook's SSSG was more volatile. That is, when the market experienced an expansionary cycle before 2014, the SSSG of Luk Fook was visibly higher than that of CTF and CSS. Then in the retail recession from 2014 to early 2017, Luk Fook experienced more contraction in SSSG than its two peers. This case was applicable to SSSG in both Hong Kong and Mainland China.

Figure 28: SSSG in Mainland China of the Three Retailers 01/01/13 - 04/01/13 - 07/01/13 - 10/01/13 - 01/01/14 - 04/01/14 - 07/01/14 - 10/01/14 - 01/01/15 - 04/01/15 - 07/01/15 - 10/01/15 - 01/01/16 - 04/01/16 - 07/01/16 - 10/01/16 - 01/01/17 - 04/01/17 - 07/01/17 - 03/31/13 06/30/13 09/30/13 12/31/13 03/31/14 06/30/14 09/30/14 12/31/14 03/31/15 06/30/15 09/30/15 12/31/15 03/31/16 06/30/16 09/30/16 12/31/16 03/31/17 06/30/17 09/30/17 CTF -8% 32% 12% 14% 15% -28% -2% -15% -9% -7% 6% -6% -25% -17% -22% 4% 12% 11% 9% LF 14% 115% 33% 6% 1% -52% -20% -6% -5% 0% 2% -10% -19% -24% -23% 5% 11% 23% 11% CSS 31% 9% -20% -4% 5% 7% -5% -3% 8%

Sources: Company, CGIS Research estimates for Chow Sang Sang

Figure 29: SSSG in Mainland China of the Three Retailers

120% 120%

100% 100%

80% 80%

60% 60% 40% 40%

20% 20%

0% 0%

-20% -20%

-40% -40%

-60% -60% 01/01/13 - 10/01/13 - 07/01/14 - 04/01/15 - 01/01/16 - 10/01/16 - 07/01/17 - 03/31/13 12/31/13 09/30/14 06/30/15 03/31/16 12/31/16 09/30/17

CTF CSS LF

Sources: Company, CGIS Research estimates for Chow Sang Sang 20

Figure 30: Hong Kong & Macau SSSG of the Three Retailers

01/01/13 - 04/01/13 - 07/01/13 - 10/01/13 - 01/01/14 - 04/01/14 - 07/01/14 - 10/01/14 - 01/01/15 - 04/01/15 - 07/01/15 - 10/01/15 - 01/01/16 - 04/01/16 - 07/01/16 - 10/01/16 - 01/01/17 - 04/01/17 - 07/01/17 - 03/31/13 06/30/13 09/30/13 12/31/13 03/31/14 06/30/14 09/30/14 12/31/14 03/31/15 06/30/15 09/30/15 12/31/15 03/31/16 06/30/16 09/30/16 12/31/16 03/31/17 06/30/17 09/30/17 CTF 4% 68% 26% 7% -9% -50% -20% -21% -26% -24% -13% -23% -27% -20% -30% -2% 4% 5% 13% LF 29% 86% 66% 36% -12% -54% -30% -11% -22% -19% -7% -26% -28% -24% -39% -11% 1% 3% 18% CSS 50% 16% -32% -14% -12% -10% -26% -24% -3%

Sources: Company, CGIS Research estimates for Chow Sang Sang

Figure 31: Hong Kong & Macau SSSG of the Three Retailers

100% 100%

80% 80%

60% 60%

40% 40%

20% 20%

0% 0%

-20% -20%

-40% -40%

-60% -60% 01/01/13 - 10/01/13 - 07/01/14 - 04/01/15 - 01/01/16 - 10/01/16 - 07/01/17 - 03/31/13 12/31/13 09/30/14 06/30/15 03/31/16 12/31/16 09/30/17

CTF CSS LF

Sources: Company, CGIS Research estimates for Chow Sang Sang

As the jewellery market entered a recovery in the second half of 2017, we expect Luk Fook to demonstrate its resiliency in the coming cycle with better SSSG than that of its

peers. Other than the low base effect, we believe Luk Fook's positioning, which leans more towards the mass market (e.g. lower ASP and >50% POS located in Tier 3 or lower cities) than its two Hong Kong-based peers, is likely to capture more mass market demand.

For CTF and CSS, we are also positive on their future SSSG, as the overall industry is recovering. We also note that these two jewellers have been offering more mass market-oriented products, especially through their e-commerce channels. For example, CTF launched "MONOLOGUE" and "SOINLOVE", which target younger consumers in Mainland China.

POS: Expanding in the Mainland; Consolidating in Hong Kong

Mainland China: more sales growth The number of POS still matters to Hong Kong-based jewellery retailers, especially in HK: lower SG&A Mainland China, although they can no longer expand like it was the blue ocean. In a nutshell, retailers will still expand in Mainland China and consolidate their POS in Hong Kong. We believe this will have two positive effects in the current cycle: (1) organic growth in Mainland China revenue, and (2) lower SG&A in Hong Kong thanks to rental savings.

Mainland China: All three retailers are going to expand their POS network in 2018, and their latest expansion plans are aggressive. CTF has opened the most POS recently, and it aims to open 140-150 POS in Mainland China in FY2018E. Luk Fook has been more ambitious as it revised up its Mainland China POS net addition plan to 100 for FY2018E.

CSS will see a more visible As CSS has adopted the self-operated model only, it plans to have a net addition of 50 contribution from POS addition POS in Mainland China in FY2017E. However, since the base for CSS is lower, we expect the addition of 50 POS to have a more visible contribution than for its two peers.

Figure 32: Point-of-sales (POS) Movement and Forecast Year ended 31 March FY2015 FY2016 FY2017 FY2018E CTF 2,257 2,319 2,381 2,516 Mainland China 2,124 2,179 2,246 2,386 Hong Kong & Macau 93 89 83 78 Others 40 51 52 52

Luk Fook 1,383 1,428 1,496 1,597

Mainland China 1,319 1,365 1,429 1,529 Hong Kong & Macau 58 57 57 58 Others 6 6 10 10

Year ended 31 Dec FY2014 FY2015 FY2016 FY2017E

CSS 405 441 472 522 Mainland China 322 343 374 424 Hong Kong & Macau 61 75 74 74

Others 22 23 24 24

Sources: Company, CGIS Research estimates

Hong Kong: We expect CTF to be more active in optimizing its POS network in Hong CTF will have the largest net reduc- Kong, resulting in more visible rental reductions. As there has been a saturation of tion of POS in Hong Kong POS in tourist areas, the retailers have been attempting to reduce the number of POS there. Luk Fook and CSS may maintain a stable number of POS overall, but they have been relocating their POS to locations with lower rent levels or smaller store sizes. The overall rental reductions will therefore be less visible. 22

Hedging: An Important Tool for Stabilizing Gross Profit Margin

Hedging now serves an important function for jewellery retailers. As gold products account for a substantial portion of inventory, fluctuation in gold prices can impact the gross profit margin. For instance, gold products in Mainland China are usually priced daily according to the gold price fixed in the Shanghai Gold Exchange. The difference between the selling price and the material cost, which is fixed, could vary greatly in the case of market volatility.

Therefore, the retailers have set up a hedging policy to hedge against this risk to smoothen their GPM. The common hedging tools for retailers include: (1) gold loans, where retailers borrow bullion from lenders, so that changes in gold prices impact the liability side of the retailers, offsetting the changes in inventory value, and (2) buying gold futures.

Figure 33: Latest Hedging Policy of the Three Retailers Retailers Policy a floating ratio of 20-50% 100% hedged for seasonal inventory & consigned inventory CTF (short-term, volatile in nature and thinner margins) 0% hedged for base inventory

(considered as long-term cost of capital) Luk Fook approximately 40% of the total gold inventories

CSS 20-25% of the total gold inventories

Sources: Company, CGIS Research

Only CTF changed its hedging policy recently

The 2008 financial crisis triggered the volatile fluctuation of gold prices for a few years, which created problems for jewellery retailers in the past. However, as the market stabilized after global central banks intervened, gold prices have been largely range-

Figure 34: Gold Prices in Recent Years Have Been Range-bound

16,000

14,000 bound since

12,000 2013. While the retailers review their 10,000 hedging policy from 8,000 time to time, it is only

6,000 CTF that changed its hedging policy radi- 4,000 cally.

RMB per oz HKD per oz

Sources: Bloomberg, CGIS Research 23

Case Study: Chow Tai Fook's New Hedging Policy

CTF adopted a new hedging policy in FY2017. In the past, CTF adopted a fixed hedging policy, with 70% of its gold inventory hedged. Now it has a floating hedging ratio of around 20-50%. The range is based on two parts: (i) 100% hedged for seasonal inventory and consigned inventory, and (ii) 0% hedged for base inventory.

The Company listed several reasons for the shift in its hedging policy:

1.) Higher reliance on Mainland China operations, where seasonality is more dominant;

2.) A higher proportion of consigned inventory after the introduction of its inventory ownership unification programme (as at the end of 1H FY2018, 647 franchised POS, or 75% of CTF's franchises, had joined the programme). These franchises held inventory worth HK$2,980m, or 8.3% of total inventory of CTF; and

3.) Relatively low gold prices in recent years.

CTF expects the GPM to be more stable and finance costs to be lower, as there will be less need for gold loans used for hedging.

Our take: We believe CTF has better capability to adopt this strategy because of its CTF’s GPM will be more stable un- large scale. We also expect the GPM for CTF's gold products to be more stable. It der normal circumstances could also capture the benefits of rising gold prices, as most of its inventory is un- hedged. Of course, in the unlikely event of continuously falling gold prices, CTF will underperform its peers, as its GPM may contract more.

In addition, of the three retailers, we believe the overall GPM will be more affected by the performance of gem sets because (1) gem sets usually have a higher GPM (40- But we expect GPM to be driven 50% vs. mid-20% for gold products); (2) gem sets have a higher ticket price; and more by gem sets (3) the contribution from gem sets is rising.

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Besides, the analyst confirms that neither the analyst nor his/her associates (as defined in the code of conduct issued by The Hong Kong Securities and Futures Commission) (1) have dealt in or traded in the securities covered in this research report within 30 calendar days prior to the date of issue of this report; (2) will deal in or trade in the securities covered in this research report three business days after the date of issue of this report; (3) serve as an officer of any of the Hong Kong-listed companies covered in this report; and (4) have any financial interests in the Hong Kong-listed companies covered in this report. Explanation on Equity Ratings BUY : share price will increase by >20% within 12 months in absolute terms SELL : share price will decrease by >20% within 12 months in absolute terms HOLD : no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL

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