E-cigarette sales exploded in the second half of 2019. The annual revenue of Chinese flavors and fragrances rose 43.2% year-on-year to 1.641 billion yuan in 2019, exceeding our expectations. In the second half of 2019, the company's revenue increased by 71.0% year-on-year, significantly accelerating, mainly because e-cigarette revenue exploded by 343.1% year-on-year to 538 million yuan, making it the company's most important source of revenue. In 2019, the company's gross profit margin fell 4.8 percentage points year-on-year to 46.5%, mainly due to the relatively low gross profit margin of e-cigarettes. Excluding one-time gains and losses, the company's adjusted operating profit increased by 23.9% year-on-year, exceeding our expectations. However, due to the impact of one-off projects and a higher share of profits attributable to minority equity, the net profit of shareholders of Chinese flavors and fragrances fell 6.3 per cent year-on-year to 119 million yuan in 2019.

The regulation of e-cigarettes at home and abroad brings uncertainty, but the long-term growth of the industry is still improving. FDA has banned the sale of fruit-flavored e-cigarettes in the United States, while China has banned the sale of e-cigarettes online, heralding stronger regulation of e-cigarettes. The outbreak of COVID-19 has begun to affect global e-cigarette sales. However, we believe that the long-term growth of e-cigarettes is still good, because it can meet the diversified needs of consumers. China's traditional tobacco industry also continues to grow, which is good for the company's flavor enhancer business.

Due to the good revenue growth and high profitability of Chinese flavors and fragrances, we think the company's current valuation is attractive. But the company's revenue is likely to be generated more through non-wholly-owned subsidiaries, and permanent subprime convertible securities are expected to continue to dilute the company's earnings per share, and its shareholders may not fully receive an increased dividend. As a result, we maintain our "buy" rating but lower our target price to HK $1.80, which is equivalent to 8.4 times / 7.5 times / 6.5 times 2020 / 2021 / 2022.