China Consumer Sector: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. 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 coming years, we expect SSSG for jewelers to remain in the high single digits. The market will be driven by products targeting the middle class, while high-end products will continue to be dampened by the anti-graft campaign.

    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 current cycle, and see some upside potential in the current price.

    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 as the premium for its market-leading position.