The sweet spot is in the middle
 Another win for the mid-end segment. We maintain our
Outperform rating on Hengdeli (3389 HK) but downgrade
Emperor Watch & Jewellery (887 HK) from Outperform to
Neutral as we believe mid-end watch retailers will continue to
outperform their high-end peers. Sales momentum of
high-end luxury watches remains sluggish as consumers
scale back on spending on big-ticket items in 2H12.
Same-store sales (SSS) for Emperor continued to
underperform the market in 4Q12 but Hengdeli achieved
resilient growth throughout 2H12 thanks to its focus on
low-to-mid end watches. Oriental Watch (398 HK,
Not Rated), a mid-end operator, also saw positive SSSG for
4Q12. We believe the divergence in sales between mid-end
and luxury retailers will continue into 2013F due to cautious
spending on gifts as well as competition from overseas
markets, notably Europe.
 No material margin improvement. With no price increment
from Swiss watch suppliers in 2H12, gross margins are likely
to retreat. Hengdeli has imposed strict discount controls to
head off margin squeeze. Emperor’s tack has been to give
even more discounts, especially in 4Q12, so as to boost
sales and clear inventory. Aggressive promotions are likely to
put considerable pressure on Emperor’s gross margin for
FY12F.
 We prefer Hengdeli. We see upside for a re-rating for
Hengdeli given that: (1) the market recognizes the company’s
SSSG has bottomed-out; (2) there is good potential for
margin improvement, and (3) the company continues to trade
at an undemanding valuation of CY13F P/E of 12x, or else
below its average historical P/E. Hengdeli's low-to-mid end
segment, which contributes over 70% of group revenue,
should provide solid support for topline growth and our 18%
earnings growth projection in FY13F. We upgrade our target
CY13 P/E for Hengdeli from 9x to 13x, which is close to the
company’s mid-cycle valuation. While Hengdeli’s prospects
seem to be improving, Emperor appears to be struggling. A
re-rating catalyst for the stock is unlikely in the near term due
to downside risks after a sharp decline in Hengdeli’s gross
profit margin cost pressure caused by de-leveraging.
Emperor is likely to see more earnings downgrades from the
street, in our view. We value Emperor based on an
unchanged target discount of 20% (or a CY13F P/E of 9x)
versus Hengdeli.
 Key catalyst and risks. Swiss suppliers have hinted at price
increases in 2013 and, in our view, the impending macro
recovery should support this. Inventory risk remains the key
overhang for watch retailers and we expect inventory levels
at both Hengdeli and Emperor to remain high at over 190
days, with little improvement in FY12F.