Strong growth in e-cigarette sales led to higher revenue. The company's revenue for the first half of 2019 increased 12.5% year-on-year to RMB 613 million, mainly driven by e-cigarettes, which increased 84.8% year-on-year to RMB 201 million, which was better than our expectations. Sales of flavor enhancers and food flavors decreased 5.1% and 7.8%, respectively, but sales of daily essences increased 6.1% year over year. The company's gross margin for the first half of 2019 fell 3.9 percentage points year over year. The adjusted operating profit margin for the first half of 2019 fell only slightly by 0.9 percentage points year over year, mainly due to a lower ratio of sales and administrative expenses. Due to one-time earnings in the first half of 2018, the company's shareholders' net profit fell 11.8% year-on-year to RMB 69 million in the first half of 2019.

The upgrading of the tobacco structure and the rise of new tobacco products are the main driving forces for the company's growth. From January to July 2019, China's cigarette production increased slightly, and the tobacco industry structure continued to upgrade. In order to strengthen tobacco control efforts, taxes on cigarettes may be raised, which may not have a big impact on tobacco sales or the company's flavor enhancer business. China's e-cigarette industry has been growing rapidly in recent years, attracting more entrepreneurs and capital to pour in. The e-cigarette regulatory policy is expected to be introduced in the second half of 2019, but there is still uncertainty about the effects of the regulatory policy. It may trigger adjustments in sales channels within the industry, but it may also cause small manufacturers to withdraw from the market, benefiting large manufacturers.

Based on the low penetration rate of e-cigarettes in China, we believe that as long as the country does not adopt comprehensive containment policies, the e-cigarette industry will maintain rapid growth. Compared to peers and Yueke's valuations in the primary market, the company's valuation is attractive. As a result, we upgraded to the “buy” rating but lowered the target price to HK$2.40, which is equivalent to 13.8 times/12.1 times/10.3 times the price-earnings ratio of 2019/2020/2021.