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Full Report_Silver

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Full Report_Silver

  1. 1. The University of Hong Kong Faculty of Business and Economics ACCT 3114 2016-2017 Valuation using Financial Statements Instructed by: Dr. Li Jing A Valuation of Luk Fook Holdings (International) Limited Silver Name UID Yaxuan CHEN 3035084902 Xue SUN 3035140811 Huixin WANG 3035085267 Zhixin WANG 3035085944 Ziyong WANG 3035028166
  2. 2. Table of Contents Executive Summary 1. Introduction 1 1.1 Company Overview – Luk Fook (“LF”) 1.2 Industry Overview & Competitive Landscape 2. Basic Valuation 2 2.1 Assumptions 2.2 Non-accounting Based Valuation 2.2.1 Comparable Method 2.2.2 Discounted Dividend Model 2.3 Accounting Based Methods 2.3.1 Residual Income Model and Abnormal Earnings Growth Model 2.3.2. Building Block Analysis 3. Business Drivers Analysis 4 4. Growth and Profitability Analysis 5 5. ReOI Model 5 6. Conclusion & Recommendation 6 Appendices 7
  3. 3. 2016-2017 Semester 1 ACCT3114 Report-Silver 1 Executive Summary In this report, we apply various accounting based and non-accounting based models to value our research target – Luk Fook (“LF”), a Hong Kong (“HK”)- China jewlery retailer. We first conduct research on LF’s business nature and recent trends in HK-China jewelry industry to generate our assumptions for the basic valuation using Comparables Method, Discounted Dividend Model, Residual Income Model and Abnormal Earnings Growth Model. During the valuation process, we make our own justifications on LF’s long-term growth rate due to the limited base of consensus forecasts. We further reformulate LF’s financial statements and utilize common size analysis, profitability analysis and growth analysis to identify LF’s primary business drivers. Based on our understanding of LF’s future prospects, we derive full information forecasting. After adopting Residual Operating Income model and making corresponding adjustments on non-GAAP items, we consider our valuation results from different models collectively and arrive at our target price of HK$16.93. 1. Introduction 1.1 Company Overview – Luk Fook Established in 1991, Luk Fook is one of the major Hong Kong (“HK”)-China jewelry retailers. Primarily operated in HK, Macau, and mainland China, LF engages in the sourcing, designing, wholesaling, trademark licensing and retailing of all its jewelry products. Retailing is LF’s major line of business, accounting for 78% of sales revenue and 55.5% of profits. LF was listed in HKSE in 1997, and now is traded at $22.15 per share and 14.08x P/E (Fig 1). LF’s product line ranges from gold, platinum to gem-set jewelry. While gold and platinum account for 60.9% of the sales, gem-set contributed to 61.9% of the gross profit. In June 2014, LF acquired 50% of CGS with HK$245 million. CGS is a wholly- owned subsidiary of HK Resources Holdings Limited, and engaged in the retailing and franchising operations of gold and jewellery products in HK, Macau and Mainland China under the brand name “3D-GOLD”. 1.2 Industry Overview & Competitive Landscape HK jewelry industry saw a progressive decline in 2014 & 15. Despite the large base formulated by the surging growth in 2013, the massive political protests and adjustments in policy of visitor visa policy, together with the unfavorable exchange rate have damaged visitors’ desire to travel. Thus, despite the slowing economic growth, China still sees a GDP growth amongst those at the top globally, and has been regarded as the next strategic focus of HK-China jewelry retailers. Chow Tai Fook (“CTF”) and Chow Sang Sang (“CSS”), another 2 major HK-China jewelry retailers with market share over 10%, are direct competitors of LF (Fig 2). CTF, with the largest share of HK-China jewelry market and similar business models and products, is chosen for comparative analysis with LF.
  4. 4. 2016-2017 Semester 1 ACCT3114 Report-Silver 2 2. Basic Valuation 2.1 Assumptions Key assumptions used in valuations are shown in Fig 3, mainly based on: 1) adjusted analyst forecasts; 2) academic research; 3) our own forecasts. Important assumptions adjusted include long-term growth rate and dividend payout ratio. Consensus forecast for 5Y long-term growth rate currently has jumped from 6.06% to 15.10%1 from 1 year ago till now. Although it can be justified by LF’s obvious competitive advantage over its HK peers in mainland China as shown in Fig 4, we remain conservative in the estimation given an unfavourable perspective in the local market, and use the lowest of analyst forecasts, 10.2% for further valuation. With the justified increase in 5Y long-term growth rate, a stable dividend payout ratio has been maintained in 2012-2015, but jumped to 67.5% in 2016. Considering the significant cut in earnings in 2016, it is reasonable to believe the special dividend paid is for the purpose of matching with previous DPS. By excluding this transitory manipulation of payout ratio, we use the average of 2012-2015, 40.1% as our forecasted future dividend payout ratio. 2.2 Non-accounting Based Valuation 2.2.1 Comparable Method Comparable method is a relative valuation approach and it estimates firm’s value by examining the value of comparable companies. We select two local peers as our targeted comparables, namely CSS and CTF, mainly out of the consideration that these three companies share common ground in market shares, firm size and operational activities (Global and China Jewelry Industry Report, 2014). Three multiples - P/S, P/E and P/B ratios - are selected to determine the relative value of LF. Fig 5 presents P/S, P/E and P/B ratios for CTF and CSS, which are derived by dividing each firm’s market capitalization by its sales revenue, net income and book value respectively. The averages of their P/S, P/E and P/B ratios should serve as proxies for LF’s corresponding multiples since their market shares are quite alike. Through applying the averages to LF’s relevant measures, we can estimate LF’s market capitalization. Further dividing the estimated market capitalization by outstanding shares, we arrive at LF’s estimated value, which is $18.1 by P/S, $25.49 by P/E and $19.17 by P/B. Particularly, the estimated value by P/B is very close to LF’s current price. We realize that this is driven by jewelry companies’ identical normal P/B ratios in recent years (Fig 6) 2.2.2 Discounted Dividend Model The average DPS growth rate is 12.99% over past 5 years, which far exceed the presumed discount rate of 10.99%. Therefore, it is more justifiable to adopt two-stage 1 Extracted from consensus opinion on at October 7, 2016.
  5. 5. 2016-2017 Semester 1 ACCT3114 Report-Silver 3 growth model to estimate LF’s intrinsic value. During the first five years, namely 2016 to 2021, LF’s dividend growth rate will follow its historical trajectory of 12.99%. Starting from 2022, LF’s dividend growth rate will drop down, suggesting that the firm will enter into a mature and stable growth phase. Here we take HK GDP growth rate - 3%, as the proxy for LF’s second stage dividend growth rate. The final value we derive from this two-stage growth model is $21. 32, which is slightly higher than its current stock price. 2.3 Accounting Based Methods 2.3.1 Residual Income Model and Abnormal Earnings Growth Model Residual income model and abnormal earnings growth model have intrinsic similarities despite of different arrangement of inputs. While residual income emphasizes on the extra return on book value, abnormal earnings growth intends to associate the value with capitalized earnings. Considering the brand-name effect but weak financial performance of LF, it is more reasonable to assume constant residual income after years 2020, or rather, no abnormal earnings growth. Under such circumstance, the intrinsic value will be priced at $17.14 (Table 1). In this sensitivity testing, the difference in residual income model between the highest and the lowest value insignificant partly results from the low absolute value of residual income in our projected years. Moreover, the P/B ratio of LF is close to one, implying the critical influence of book value in deciding its intrinsic value. Nevertheless, AEG model is more sensitive to discount rate. The possible rationalization is the crucial impact of discount rate on capitalization of earnings. 2.3.2. Building Block Analysis To challenge on the market price, we anchor on book value from known and short-term forecast of which we are reasonably confident. To begin, we establish the no-growth valuation by reverse engineering. Three-level blocks breakdown of the market price include book value, value from short-term accounting and value from long-term growth. Book value has been ascertained as $14.94. To derive the value from short-term accounting, we calculate the present value of residual earnings of both 2016 and 2017. The result showed that in the short term, market expects the share price will go down $0.09. Meanwhile, in the long-term, market is placing $4.23 on the speculative growth. To further determine the reasonableness of market price, we also can solve for growth in residual earnings valuation model. Based on current market price $19.08, we convert the residual earning growth rate to EPS growth rate and find the expected EPS growth rate of market is 10.2%. If the analyst forecasts growth rates are below 10.2%, it implies that LF was overpriced at current market price. As we have mentioned in the first part, this 10.2% long-term forecast was based on analysts’ good knowledge of business, and they believe the rebound on gold price and company’s competitive advantage will support this growth. While remaining skeptical of prices, as investor we may also reflect on ourselves to avoid over-pessimism.
  6. 6. 2016-2017 Semester 1 ACCT3114 Report-Silver 4 Exclusive information, which is beyond our knowledge, may exist, thus supporting the higher expectation within market. 3. Business Drivers Analysis Through examining reformulated balance sheet, we realize that LF is a NOA firm and at the same time, a NFA firm. Among operating assets, inventory is the largest component and accounts for around 80%. This high percentage not only is contributed by LF’s inventory’s inherent fair value, but also is inflated by gold price decline in recent years. As presented in Fig 7, gold price has dropped substantially over 20% during 2013 to 2014. The massive depreciation offered LF an incentive to increase inventory level and speculate for a future bounce in gold price. The targeted gold price provided by Goldman Sachs is US$1300 for the next year. However, given the great intensity and uncertainty shock for current economic environment, together with LF’s declining sales under HK bleak economic conditions, we expect LF’s future inventory level to be relatively stable with moderate increase. We further examine the effect of gold price on LF’s sales performance and find a moderate negative correlation (-0.54) between change in gold price and sales growth where sales growth is measured by same stone sales growth (“SSSG”) (Fig 8). Considering the great volatility in gold price, this factor is not taken into consideration for sales prediction purpose. Breaking down revenue by market, business line and product respectively, we discover 1) Proportion of sales from mainland China has been growing, which brings new growth opportunity and more exposure to exchange rate risk (Fig 9); 2) HK will still be the main source of sales in short term. Since the growth of visitor arrivals have been stabilizing after over 12 months of consecutive decline, it is likely there would be a rebound in SSSG (Fig 10); 3) Business and product revenue structure remain stable, with over 75% revenue coming from retail and 60% from gold & platinum. In terms of expense structure (Fig 11), staff cost takes the largest proportion against LF’ s sales revenue, so does CTF. As increasing staff cost is an inevitable trend in this industry, LF’s lower staff cost proportion compared to CTF can be explained by a larger part of revenue from franchise and licensing business. The second largest item in the expense structure is lease expense. The soaring HK property rental in the past few years consumed LF more proportion of rental expense than CTF with its larger HK based business. Downward course is expected as HK property rental price has started to decline since this year, and LF is switching its focus to mainland China. 4. Growth and Profitability Analysis To analyse the profitability and growth of LF, return on common share equities(“ROCE”) is the most direct reflection. ROCE of the company reached a peak in year 2013 and has been decreasing ever since, especially dropped by 11.31% in 2015. This inevitable
  7. 7. 2016-2017 Semester 1 ACCT3114 Report-Silver 5 change is a result of the slow-down economy in mainland China and the decrease of tourists to HK. When we further decompose ROCE to investigate the impact of leverages, it is not surprised to observe that those effects are relatively insignificant since LF has a very small proportion of liabilities [Fig 11]. Change of financial leverage(“FLEV”) remains stable and merely adds on small increase as 0.33%. Instead, return on net operating assets(“RNOA”) and return on operating assets(“ROOA”) are the major drivers of ROCE. Consequently, breaking down RNOA and ROOA are crucial to look for value drivers. When it comes to RNOA, profit margin and asset turnover are decisive components, particularly driven by core business. Within LF’s 13.37% decrease of RNOA in 2015, drop from core income from sales takes up 11.66%. Decomposing profit margin, we observe that the sales profit margin of the company is relatively stable, even slightly increased in recent two years, probably caused by the rising sales of gem-set (Fig 12). However, since the growing selling and administration costs, the bad performance of the associate and the loss in hedging instruments, the profit margin of the most recent year drops in year 2015 compared to a relatively stable rate at around 9.7% in previous years (Fig 13). Further investigation into core income from sales shows that decrease in core profit margins and asset turnover contribute 6.54% and 5.11% respectively. In other words, assets used to generate same amount of core operating sales are rising year by year, mostly caused by the climbing inventory turnover, which closely related to the the number of visitors to HK and gold price (Fig14). Besides, if breaking down RNOA to investigate the impact of ROOA, operating liability leverage (“OLLEV”) and operating liability spread(“OLSPREAD”), ROOA is also the dominant factor in determining RNOA (Fig 15). For one thing, operating income decrease drives down the return. For the other thing, the rise in operating assets enlarges the base. More specifically, the financial drag from associate accounts for the growing amount in “interests in associates”, “loans to associates” and “amount due from associates” which recorded as assets on the balance sheet of LF. Consequently, the combination effect of both operating income and operating asset results in consecutive decline of ROOA in recent years. Residual earnings growth is also driven by the change in common share equity(“CSE”), which can be explained by two components which are change in net operating assets(“NOA”) and change in NFA. In 2015, growth of NOA turned negative after a two- year increase. Previous analysis breaking down into profit margin and asset turnover explained the change in sales growth that affect NOA. Moreover, it is also caused by decrease of long-term investment and inventory. On the other hand, the growth of NFA turned positive attributed to the sharp reduction on bank borrowing in 2015. In addition, we further compare some key indicators with other well-known jewelry brands in the world. In terms of gross profit margin, jewelry brands such as Pandora and Tiffany that rely more on gem-sets are higher than brands like LF and CTF whose main focus is gold products. Also, the high selling expenses which includes marketing expenses are also high for these two brands, probably also contributes to a higher margin (Fig 16).
  8. 8. 2016-2017 Semester 1 ACCT3114 Report-Silver 6 5. ReOI Model Residual operating income (ReOI) model is a modified model for RIM. Using CAPM, we calculate cost of equity to be 10.99% and WACC to be 12 57%. Corresponding to three cases in RIM, the continuing value of residual operating income model also has three forms and when we apply scenario 2, the intrinsic value of LF is $17.16 (Table 2). Specially, in simple forecasting scenario 3, growth rate in residual operating income is -13.94%, which is not representative for the growth trend of residual operating income. So we use the average growth rate of ReOI in past three years, 26%, to generate enterprise value. Valuation grid is made to indicate what combination of return on net operating assets (RNOA) and growth in net operating assets (NOA) can justify current market price of LF. For instance, current market price $19.08 can be legitimized by forecasting a 16% RNOA and 2.5% growth rate in NOA, or alternatively, 15% RNOA and 5.5% growth rate in NOA. However, since we estimate the long term growth rate in NOA to be 1%, LF needs to maintain at least 16.55% RNOA to explain its market price, while its current RNOA is only 14.56%. FFull information forecasting of ReOI model is conducted based on analysts’ forecast and historical data. Analysts forecast there will be a sharp drop of sales, leading to -8.31% growth in sales in 2016. After 2016, the sales tend to grow relative steadily so we assume long term sales growth rate to be 1%. As far as asset turnover, ATO declines and analysts’ forecast for 2016 ATO is 1.815. We assume ATO continues to decline until 1.215 in 2018 and remains constant after then, and we have NOA grow at 1% after 2017. As for non-GAAP items adjustments, LF does not issue any share options and its design fees cannot be capitalized as R&D expense. We therefore adjust LF’s ReOI by capitalizing operating lease commitments. Detailed calculation please refer to excel appendix. Since LF has relative small amount of lease contingent commitments, adjusting operating lease does not bring a significant difference on LF’s valuation. 6. Conclusion & Recommendation: Sell Based on our analysis of valuation results above, our initial investment recommendation would be sell at target price of $17.14. The most suitable model would be residual income model, as the industrial P/B ratio is close to one, therefore our analysis on book value may give us reasonably expectation on stock price. Our valuation results from all models are listed in Fig 17. We take average of the valuation results given by both RIM (Case 2) model and ReOI (Case 2) model after non- GAAP adjustments, which gives a target price of $16.93. This price is within the company’s 52w price range and 11.27% below the current market price, and our final opinion is to sell.
  9. 9. 2016-2017 Semester 1 ACCT3114 Report-Silver 7 Appendices Fig 1: Market Information of LF Source: Google Finance Fig 2: LBN Brand Shares of Jewelry: % of Value 2011-2014 Source: Euromonitor, February 2016
  10. 10. 2016-2017 Semester 1 ACCT3114 Report-Silver 8 Fig 3: China Gem-set SSSG LF vs CTF Source: LF and CTF’s Annual Report Fig 4: Assumptions FY16 FY15 FY14 FY13 FY12 Basic EPS 1.63 2.74 3.17 2.11 2.43 DPS 1.10 1.10 1.27 0.86 0.96 Payout ratio 67.5% 40.1% 40.1% 40.8% 39.5% Notes: We extract the forecasts for 5Y long-term growth rate and EPS in the next 2 years from Reuters, as well as the firm beta and industry beta. We use the firm beta, which is quite close to the industry beta, and US 10Y T-bill yield as our risk free rate to get the discount rate of LF. The market risk premium is from NYU source. More on 5Y long-term growth rate: Appreciation of gold at the beginning of 2016 might be a justification for the jump. Earnings lift is likely to come from GP margins as inventory purchased at a lower cost is sold at a higher spot value, but any impact from rebounce of gold price with high volatility is likely temporary given the 3-month inventory cycle. However, the volatility in gold price cannot support a sustained positive impact. A more reasonable explanation is the visibility of LF’s obvious competitive advantage over its HK peers in mainland China. LF has outperformed CTF in China gem-set SSSG continuously for 15 months, and remained a positive growth. Fig 5: Comparable model: Sales Net Income Market cap (ttm) (ttm) (msq) CSS 17,630 765.2 9,078 9,600 0.54 12.55 1.06 LF 7,300 379.26 4,607.38 7,082 0.97 18.67 1.54 LF 14,030 958.69 8,674 P/S P/E P/B Calculated as below (in Millions) Book value (mrq) Notes: LF’s value by P/S: 0.76*14,030=10,625.36/587.11= $18.2 -30% -20% -10% 0% 10% 20% Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Luk Fook CTF
  11. 11. 2016-2017 Semester 1 ACCT3114 Report-Silver 9 LF’s value by P/E: 15.61*958.69=14,964.65/587.11= $25.49 LF’s value by P/B: 1.3*8,674=11,252.78/587.11= $19.17 Figure 6: CTF, CSS & LF’s P/B ratio Table 1: RIM and AEG Model Results Case 1 Case 2 Case 3 RIM 15.48 17.14 17.83 AEG Model 17.14 21.26 22.97 Sensitivity test of RIM
  12. 12. 2016-2017 Semester 1 ACCT3114 Report-Silver 10 Sensitivity test of AEG Model Fig 7: Gold Price and Inventory Level Fig 8: Gold price change and SSSG correlation
  13. 13. 2016-2017 Semester 1 ACCT3114 Report-Silver 11 Fig 9 Profits breakdown by market Source: LF’s Annual Report Fig 10: Visitors Arrival of Hong Kong by Country Source: Census and Statistics Department, HKSAR, September 2016 0% 20% 40% 60% 80% 100% 2012 2013 2014 2015 Mainland China HK, Macau & Overseas -30.0% -20.0% -10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 0 1 000 000 2 000 000 3 000 000 4 000 000 5 000 000 6 000 000 7 000 000 2012-1 2012-3 2012-5 2012-7 2012-9 2012-11 2013-1 2013-3 2013-5 2013-7 2013-9 2013-11 2014-1 2014-3 2014-5 2014-7 2014-9 2014-11 2015-1 2015-3 2015-5 2015-7 2015-9 2015-11 2016-1 2016-3 2016-5 2016-7 2016-9 Africa The Americas Australia mainland China Other areas of Asia Europe & Middle East % Change of mainland China
  14. 14. 2016-2017 Semester 1 ACCT3114 Report-Silver 12 Fig 11: Common Size Analysis of Operating Assets & Operating expenses 20152014201320122011 Others 780,115 815,128 682,680 547,286 241,815 Long-term Equity Investments 154,531 245,934 7,046 7,303 8,161 PPE 603,878 618,012 566,321 516,172 395,160 Inventories 6,344,728 7,394,696 6,225,280 4,955,374 4,330,499 Trade Receivables 214,534 200,759 225,938 316,629 162,516 Working Cash 140,313 159,227 192,149 37,213 23,397 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Common Size Analysis of Operating Assets
  15. 15. 2016-2017 Semester 1 ACCT3114 Report-Silver 13 2015201420132012 Other operating expenses 2.52%2.62%2.93%2.86% Loss on disposal of PP&E 0.01%0.00%0.01%0.01% Share of results of associates 0.06%0.14%0.00%0.01% Credit card commission expense 0.79%0.82%0.87%0.84% D&A 0.96%0.98%0.64%0.75% Currency translation difference 1.09%0.11%0.04%0.00% Lease payment 4.59%3.66%2.46%2.11% Staff cost 5.08%4.66%3.81%4.17% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Common Size Analysis of Operating Expenses Fig 12: Change of ROCE Trend 23.22% 28.91% 20.80% 9.49% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 2012 2013 2014 2015
  16. 16. 2016-2017 Semester 1 ACCT3114 Report-Silver 14 Fig 13.1: Sales Profit Margin Trend Fig 13.2: Profit Margin Trend Fig 14: 1/ATO Trend 21.42% 22.13% 24.62% 23.57% 21.00% 21.50% 22.00% 22.50% 23.00% 23.50% 24.00% 24.50% 25.00% 2012 2013 2014 2015 10.47% 10.24% 8.91% 3.60% 9.69% 9.67% 9.83% 5.62% 3.00% 5.00% 7.00% 9.00% 11.00% 2012 2013 2014 2015 Chow Tai Fook Lok Fook 0.597 0.404 0.708 0.825 0.302 0.275 0.410 0.584 0.020 0.120 0.220 0.320 0.420 0.520 0.620 0.720 0.820 0.920 2012 2013 2014 2015 Chow Tai Fook Lok Fook
  17. 17. 2016-2017 Semester 1 ACCT3114 Report-Silver 15 Fig 15: Components of ROOA Fig 16: Comparison of Jewelry Industry *Blue – Pandora, Yellow – Tiffany, Orange – CTF, Green – LF Source: Annual Reports from companies Table 2: Simple forecasting – ReOI Case 1 Case 2 Case 3 Value $14.94 $17.16 $13.14 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 2012 2013 2014 2015 ROOA OLLEV x OLSPREAD 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% GrossProfit Margin Selling, marketing and administration expenses proportion
  18. 18. 2016-2017 Semester 1 ACCT3114 Report-Silver 16 Sensitivity analysis Fig 17: Valuation Results *(as of 2016 October 7) 18.10 25.49 19.17 21.32 15.48 17.1417.8317.14 21.26 22.97 14.94 16.9716.71 13.26 16.93 23.85 12.80 19.08 -13.00 -8.00 -3.00 2.00 7.00 12.00 17.00 22.00 27.00 Valuation Results Results Gap with Current Market Price RNOA $13.14 13.0% 14.0% 15.0% 16.0% 16.55% 0.0% 15.35 16.31 17.27 18.23 18.76 0.5% 15.37 16.37 17.37 18.37 18.92 Growth in NOA 1.0% 15.39 16.43 17.48 18.52 19.09 1.5% 15.41 16.50 17.59 18.68 19.28 2.0% 15.43 16.57 17.72 18.86 19.49 2.5% 15.46 16.66 17.86 19.05 19.71 3.0% 15.48 16.75 18.01 19.27 19.96 3.5% 15.51 16.85 18.18 19.51 20.24 4.0% 15.55 16.96 18.37 19.78 20.55 4.5% 15.59 17.08 18.58 20.08 20.90 5.5% 15.68 17.39 19.09 20.80 21.74

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