Incident: On August 25, 2023, Lianhua Technology released its 2023 annual report. The company's total revenue for 1H23 was 3,665 million yuan, down 1.01% year on year; net profit for return was 225 million yuan, down 87.97% year on year; net profit after deducting non-net profit was 130 million yuan, down 38.60% year on year. The corresponding company's total revenue for 2Q23 was 1,708 billion yuan, down 15.01% year on year and 12.74% month on month; net profit for return was -20 million yuan, down 115.35% year on year, and 144.85% month on month.

Revenue from the plant protection and functional chemicals sector declined significantly, dragging down overall revenue. The company's revenue in the pharmaceutical/plant protection/functional chemicals sector in 1H23 was 812/24.76/86 million yuan, YoY was 5.90%/-7.57%/-26.73%, gross margin was 36.38%/16.93%/17.40%, respectively, and -0.03/-6.50/-9.69pcts, respectively. Sales expenses increased 84.82% year on year, mainly due to the adjustment of some managers to the sales department due to business adjustments. The sales expenses rate was 0.45%, up 0.21 pcts year on year; management expenses fell 9.14% year on year, mainly due to management cost control cost reduction costs. The management expenses rate was 9.66%, down 0.87 pcts year on year; financial expenses fell 188.46% year on year, mainly due to fluctuations in the US dollar exchange rate in the current period and exchange earnings. The financial expense rate was -1.34%, down 2.84pcts year on year; R&D expenses were the same The year-on-year increase was 30.68%, mainly due to an increase in R&D investment in the current period compared to the same period last year. The R&D cost ratio was 6.05%, an increase of 1.47 pcts over the previous year. 1H23's net profit declined markedly. The net profit margin was 1.35%, down 4.71 pcts from the previous year. The main reason for this was the decline in gross margin in the pharmaceutical/plant protection/functional chemicals sector.

The company's net cash flows fluctuated in the first half of 2023. Net cash flow from operating activities was 652 million yuan, up 38.46% year on year, mainly due to the recovery of the subsidiary Jiangsu Lianhua Insurance; net cash flow from investment activities was -697 million yuan, up 0.02% year on year, mainly due to an increase in investment investment in the current period compared to the same period last year; net cash flow from fund-raising activities was 381 million yuan, down 30.67% year on year, mainly due to a decrease in financing inflows in the current period compared to the same period last year. The balance of cash and cash equivalents at the end of the period was $824 million, an increase of 3.10% over the previous year, mainly due to the fact that the total inflow of operating cash flow and financing cash was greater than the outflow from investment activities. Accounts receivable decreased by 8.97% year on year, and the turnover ratio of accounts receivable remained essentially the same, from 2.75 to 2.71 times. Inventory increased 20.88% year over year, and the inventory turnover ratio declined, from 1.16 times to 0.98 times.

The plant protection industry cycle is declining, the industry is removing inventory, and the company's performance is under pressure in the short term. In the short term, the supply chain of plant protection products has been impacted by various factors over the past few years, causing clients and end users to purchase ahead of time to a certain extent and stock up on a certain amount of product inventory. Interest rate hikes in major global currencies such as the US dollar have led to an increase in inventory holding costs, and a drop in the prices of bulk plant protection products outside of the patent period in the market. Therefore, since 2023, the plant protection market has always been in the “de-inventory” stage. Weak demand has further spread to the plant protection CDMO industry where the company is located, and the company's short-term performance is under pressure.

In the long run, according to the Food and Agriculture Organization of the United Nations, the global population will reach 9.7 billion in 2050, yet current global food production is insufficient to meet the needs of a growing population. The rigid demand situation in the grain market requires the plant protection industry to improve the yield and quality of grain through innovative chemical and engineering solutions to solve the problem of insufficient food supply. With the gradual recovery of the market in the later stages and the launch and mass production of products in pipelines, the company, as a leader in the plant protection industry in China, still has good prospects for business development. Relying on 5 domestic production bases and the UK base, the company is committed to providing integrated services throughout the life cycle from early R&D to commercial production. In order to break through the current difficult situation, the company relies on products within the patent period in the product pipeline to minimize the impact of insufficient external market orders on the company. At the same time, the company actively promoted new product cooperation with major global companies in front-end pipelines and CDMO business based on technological innovation, established early R&D partnerships with many international customers, identified a number of products with listing and commercialization conditions within 3-5 years, and laid the foundation for the company's long-term development. We believe that the plant protection industry cycle is declining, the industry is removing inventory, and the company's performance is under pressure in the short term, but considering the gradual recovery of the plant protection market and the continuous growth of long-term demand, we are waiting for the company's plant protection sector business to recover.

The pharmaceutical industry continues to strengthen R&D efforts, and the company's CDMO business has great potential for growth. According to the Frost & Sullivan report, the global pharmaceutical industry's R&D investment will increase from US$243.7 billion in 2022 to US$328.8 billion in 2026, at a compound annual growth rate of about 7.8%. The FDA approved 26 new drugs in the first half of 2023, an increase of about 60% over the same period last year. The pharmaceutical industry as a whole is showing a trend of rapid development. In order to further improve R&D efficiency and optimize cost control, the CDMO model is gradually becoming mainstream for pharmaceutical companies. According to Frost & Sullivan data, the global CDMO market grew from US$39.4 billion in 2017 to US$63.2 billion in 2021, with a compound growth rate of 12.5%. It is expected to reach US$124.3 billion by 2025 and US$231 billion by 2030.

China's CDMO market also increased from 5.0% in 2017 to 13.2% in 2021, and is expected to expand to one-fifth after 2025. The implementation of the domestic MAH system and the successful development of new drugs in the pharmaceutical industry have also brought new opportunities to domestic pharmaceutical CDMO companies. In the context of industry development, the company further strengthened its core capabilities and continued to advance its business pipeline. It completed 5 verification projects in the first half of 2023, laying the foundation for subsequent business development. The company strives to expand new customers by participating in new project incubation and technology integration platform strategies. In the first half of the year, it deepened R&D cooperation with two foreign pharmaceutical giants, and strived to further expand the cooperation from the CDMO module to front-end drug development. At the new business level, the company's pharmaceutical CRO business has also officially started. The team and R&D base have been built and put into use. Currently, it has established contacts with a series of domestic and foreign customers, and successfully carried out business cooperation. In terms of innovative drugs, the company actively cooperates with small and medium-sized innovative pharmaceutical companies in R&D and production, and has reserved a number of clinical phase II and III pipeline products with great commercial potential. Based on the booming development of the pharmaceutical CDMO industry, we are optimistic about the company's pipeline product reserves in the pharmaceutical CDMO business and the continuous development of the CRO business. We believe that the company's pharmaceutical CDMO business is expected to gradually expand. With the accumulation of verification projects, the pharmaceutical CDMO business has the potential to develop rapidly.

The functional chemicals sector is in a market development cycle and is expected to create a new revenue curve. The company's downstream functional chemicals products are mainly concentrated in the fields of personal care and cosmetics, battery chemicals, and new energy. During the 14th Five-Year Plan period, battery chemicals were a key development area in China, and the market scale steadily expanded. According to the “White Paper on the Development of China's Lithium-ion Battery Electrolyte Industry (2023)”, China's lithium-ion battery electrolyte shipments in the first half of 2023 were 504,000 tons, and it is estimated that China's electrolyte shipments for the full year of 2023 will reach 1,169 million tons. The company's functional chemicals department continues to invest in R&D to develop promising new products. The company currently has 2 new energy products to be commercialized in the pipeline, and has completed product verification with downstream customers. There are 4 pilot stages and 11 pilot stages. Among them, the construction and trial production of the company's 20,000 tons of lithium hexafluorophosphate and 10,000 tons of lithium bifluorosulfonimide continued to advance in 1H23. We believe that as products in the company's pipeline gradually pass verification and new projects are gradually put into operation, the functional chemicals sector is expected to become the company's new revenue growth curve.

New technologies and projects under construction continue to advance, optimizing the company's strategic layout. The company adheres to a technology-led development direction and has established a multi-level intelligent R&D platform. As of June 30, 2023, the company's various business segments have obtained 87 domestic invention patents, 55 utility model patents, and 1 European invention patent. In the plant protection sector, R&D work in the first half of 2023 mainly focused on R&D cooperation projects, while further improving R&D capabilities, continuing to research high-efficiency ligand catalysis technology, using continuous reactors such as microchannels and circuits to conduct research on reaction types such as continuous bromination, continuous oxidation, and continuous amination, and exploration of new technologies such as wastewater oxidation technology, green nitrification, and fluorination; in the pharmaceutical sector, the company promoted the implementation of many new projects related to the above technologies in the first half of the year through a number of new technologies involving continuous reactions, enzyme technology, and peptide synthesis. , gradually establishing R&D technology platforms such as PROTAC (proteolysis-targeting chimeras, protein degradation target consortium), Linker (drug connector), etc.; functional chemicals sector. This year, the company's functional chemicals division focused on the construction and trial production of 20,000 tons of lithium hexafluorophosphate and 10,000 tons of lithium bifluorosulfonimide. In the second half of the year, we will continue to do a good job of trial production, quality system construction, and production capacity climbing to achieve high-quality commercial production as soon as possible. To meet the development needs of battery chemical projects, the company simultaneously established professional teams for functional additive development, engineering technology development, electrolyte industrialization technology development, and battery chemical application technology development. We believe that the company's continuous investment in R&D will lay a good technical foundation for the long-term development of the company's various product segments.

Investment advice: We expect Lianhua Technology's revenue for 2023-2025 to be 84.15/108.03/12.757 billion yuan, respectively, up 6.99%/28.38%/18.08%, and net profit to parent to be 2.73/6.70/1,030 million yuan, with a year-on-year change of -60.81%/145.38%/53.73%, corresponding to EPS of 0.30/0.73/1.12 yuan, respectively. Combined with the company's closing price on August 25, the corresponding PE was 29/12/8 times, respectively.

Based on the following four aspects, 1) In the context of the gradual recovery of the plant protection market and the continuous growth of long-term demand, we are optimistic about the recovery of the company's plant protection sector business. 2) Based on the booming development of the pharmaceutical CDMO industry, we are optimistic about the company's pipeline product reserves in the pharmaceutical CDMO business and the continuous development of the CRO business. The pharmaceutical CDMO business is expected to gradually expand. 3) As the products in the functional chemicals sector pipeline gradually pass verification and new projects are gradually put into operation, we expect the functional chemicals sector to open up a new revenue growth curve for the company. 4) We are optimistic about the company's continued investment in R&D in various fields, which will lay a good technical foundation for the company's long-term development and maintain the “buy” rating.

Risk warning: risk of fluctuations in industry demand, environmental safety risk, risk of new project investment and construction, exchange rate risk.