Hong Kong Retail-Year of divergence: Luk Fook top pick; CTF down to Neutral

A year of divergence for HK retail, prefer mass market jewelers.

    We believe HK retail in 2015 may be reminiscent to Macau gaming in 2014– with strong PRC tourist arrivals, but beneath the surface lies a slowdownin high-end spending, while mass discretionary spending remains strong.

    This in turn should drive a divergence in company results. We hencedowngrade Chow Tai Fook (CTF) to Neutral from Buy, given its exposure tohigh-end gem-sets (HK$100k+ per piece). These gem-sets make up to 10%of CTF’s HK retail sales (2014), and we expect a choppy demand outlook ascustomers trade down. Luk Fook and Lifestyle are our top Buy picks withinthe sector, on lower ASPs and more exposure to mass market tourists. Wenote that Luk Fook’s gem-set ASP is close to half of CTF/CSS. Valuationwise, Luk Fook’s 9X 2015E P/E and 5% dividend yield are also the mostattractive among peers. With this note, Ricky Tsang assumes primarycoverage of CTF from Joshua Lu, who becomes secondary analyst.

    HK - becoming a “been there, done that” place for the middle class.

    Chinese visitor volume growth remains a strongly positive structural storyoverall, with just 3% of the population holding passports (38mn, as of2012). However, we expect the mix to shift more towards the Urban Masscohort (240mn people, c.US$6,000 income p.a), and away from the moreaffluent Urban Middle (150mn people, US$11,000+ income). We note thatpassport holders already represent almost one-third of the Urban Middle,and historical data indicates that most of this cohort has already visited HK.

    We see further evidence of an ongoing change in tourist mix in the neardoubling of PRC visitations to Korea and Japan in 2014, when HK hightariff hotel occupancy was falling and retailers saw high-end demand dryup. Meanwhile, a strong USD (appreciating 7% in 2H14) and anti-graftmeasures are accelerating the process, driving high spenders away fromHK. Category wise, we believe gold jewelry is less prone to divergence riskfrom tourists vs. cosmetics, given the global nature of cosmetics brands.

    The HK cosmetics market represented 9% of China’s cosmetics sales in2013, versus only 5% for jewelry. This underpins our Sell rating on Sa Sa –where we also expect margin pressure as customers trade down.

    HK retailer 2015E EPS should still grow, valuations accommodative.

    Despite a diverging trend, we expect recovering local demand and easingrents to still drive an 11% average EPS acceleration for HK retailers in 2015.

    HK retail valuations also appear accommodative overall at 13X NTM P/E,compared to Macau gaming at 15X and HK landlords at 16X.