Is Now the Time to Buy Jewelry Stocks in China?

 | Apr 10, 2017 | 11:00 AM EDT
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Is the worst over for the beleaguered luxury retailers in Hong Kong and China? Some of the signs say so, meaning this is the time to stock up not just on a Rolex, but also their shares.

Jewelers and gold merchants have had a terrible time of late. Many have closed their doors amid a slump in spending and mainland tourism. Retail sales in Hong Kong hit a 17-year low for 2016, down 8% over the previous year to HK$436.6 billion ($56 billion).

Frankly, I have little sympathy. There are too many luxury stores here. Do we really need 11 Cartier "boutiques"? But I need to set aside my feelings when thinking about the investment play.

In late 2014, I spent quite a bit of time at the encampments of the Occupy Central movement that closed much of downtown Hong Kong. Looking around one afternoon on Nathan Road, the main artery, in Mong Kok, one of the most densely packed places on earth, I counted eight jewelry stores within my sight.

And that was within the space of a handful of blocks. Why are there so many outlets selling non-essential items? "Who is really occupying Hong Kong?" I thought to myself. 

At the time, it was mainland tourists, visiting the city in droves and spending more per capita even than U.S. tourists, previously the fattest cats. But those days are over.

China's crackdown on corruption and conspicuous consumption has meant the number of Chinese visitors to Hong Kong has fallen since 2014. Resentment from locals over mainland "locusts" flashing the cash and stripping the city's stores bare of daily necessities has only exacerbated the situation.

The Hong Kong dollar is also pegged to its U.S. counterpart and has shared in the greenback's gains. The stronger currency and a maturing Chinese public, keen to explore pastures new in Japan, South Korea and Europe, have also diminished Hong Kong's popularity.

Visitor numbers from the mainland shrank 6.7% for 2016, to 42.8 million warm bodies, dragging the overall figure down by 4.5%, to 56.7 million visitors. That still means, though, that mainlanders account for three in every four people passing through immigration. Taiwan, South Korea, the United States and Japan are, in that order, the next-biggest sources of visitors to Hong Kong.

The tide seems to have turned, with mainland visitation up 1.1% for the first two months of this year. Overall tourism is up 1.4%, with exceptional growth of more than 20% from Indonesia and India. Those two markets are small in terms of tourism here, but on many an investment wish list for private equity funds, real-estate managers and their kin. So it's interesting to see their citizens traveling more, flush with extra cash. 

Chow Tai Fook Jewellery Group (CJEWY) is the industry leader in Hong Kong, commanding 18.1% of the market here. It is also the biggest jewelry retailer in mainland China, although the highly-fragmented nature of the industry there means it only has a 4.2% market share.

Chow Sang Sang Holdings International HK:0116 is next in size in Hong Kong. It has 10.4% of the market, although it is a relatively big player in the mainland. Luk Fook Holdings HK:0590 is third in Hong Kong, with a 9.1% share.

All three are expanding their presence in China, where the investment bank Nomura Holdings (NMR) thinks they stand to steal business from mainland competitors in a market that has few branded names. They each target opening around 50 stores on the mainland this year, focusing on smallish Tier 3 and Tier 4 cities.

Small is a very relative term -- this is China after all, where more than 100 cities have populations of at least 1 million. While Chow Sang Sang will own all its own stores, Chow Tai Fook and Luk Fook will likely have a 50-50 split between self-run and franchise stores.

China's jewelry market has grown at an annual rate of 12.8% over the last decade, hitting $43.5 billion in size last year -- but with plenty of room to grow. Per-capita jewelry consumption, at $32 per head according to Euromonitor, is 79% below the levels found in developed nations. 

Chow Tai Fook already operates an amazing 103 stores in Hong Kong, one for every 70,000 or so residents. While the other two companies will probably maintain a static store count in this city, Nomura expects Chow Tai Fook to shut another five under-performing stores this fiscal year, running through March 2018, giving margins a slight boost.

Tse Sui Luen Jewellery International HK:0417 is another stock worth considering, its 2.2% market share in Hong Kong good enough for fourth place.

China's market is so incredibly fractured that the top 10 players only command 15% of the market, combined. The largest mainland players are Lao Feng Xiang SH:600612, Shanghai Yuyuan Tourist Mart SH:600655, Hengdeli Holdings (HENGY) , Fiyta Holdings SZ:200026 and Kering (PPRUY) .

This is a propitious year to be married, according to feng shui forecasts, meaning business should be booming. The mainland jewelry market bottomed in March 2016, with a steady recovery over the rest of the year and 5.1% growth for the first two months of 2017.

Tastes appear to be shifting for Chinese consumers. Younger couples are favoring gem-set couples' rings and engagement rings, trading up from traditional gold. Average sales prices are roughly double for gem sets, which is leading to better same-store sales and profit margins.

There's always a real-estate component in this, the most-expensive of cities globally for store space. Rents in Hong Kong for luxury retailers are down between 20% and 40%, meaning operations get an immediate boost when leases come up for renewal or renegotiation. Nomura's top pick is Chow Tai Fook, which the bank forecasts will generate rental savings of 12.8% this fiscal year in Hong Kong. That compares with rent cuts of around 5% for its two largest competitors. 

Chow Tai Fook also has the highest share of sales from gem sets of the Hong Kong retailers, as well as having a greater percentage (59.7% of sales) of its overall business coming from China, with its higher growth. To reinforce that message, international retailers such as Richemont (CFRUY) , Tiffany (TIF) and Pandora (PANDY) all report strong growth in Asia as well, largely from China, Korea and, with Pandora, Australia.

Beyond jewelry, Samsonite International (SMSEY) is another tourism-related play worth considering. The world's largest luggage company now has its financial headquarters in Hong Kong. Its stock debuted here in 2011 after acquisition by the private-equity group CVC Capital Partners. 

Its sales fell 16% in the first half of last year. But that pace of decline slowed to a 7% fall in the final six months of 2016, and the company said the market had shown "early signs of stabilizing."

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