Incidents: On October 28, 2023, Lianhua Technology released its three-quarter report for 2023. The company's operating income for the first three quarters was 5.018 billion yuan, down 14.97% year on year; net profit was -75 million yuan, down 122.00% year on year; net profit after deducting non-net profit was 021 million yuan, down 94.51% year on year. The corresponding company's 3Q23 operating income was 1,353 billion yuan, down 20.79% from the previous month; net profit was -100 million yuan, down 399.81% from the previous month.

The declining cycle of the plant protection industry is dragging down the company's performance. The company's sales expense ratio for the first three quarters was 0.50%, up 0.24pcts year on year; management expense ratio was 10.84%, up 0.79pcts year on year; financial expense ratio was 0.85%, down 0.58pcts year on year; R&D expense ratio was 6.48%, up 1.84pcts year on year. Looking at gross margin, 2Q23's overall gross margin was 21.75%, and 3Q23's overall gross margin was 21.61%, down 0.14pcts from the previous month. The main reason for this is that the plant protection industry is still in a downward cycle, which is dragging down the company's overall performance.

The company's various net cash flows changed significantly in the first three quarters. Net cash flow from operating activities was $853 million, up 52.76% year on year; net cash flow from investment activities was -929 million yuan, up 31.84% year on year; and net cash flow from fund-raising activities was $300 million, down 70.70% year on year. The balance of cash and cash equivalents at the end of the period was $705 million, up 0.93% year on year. Accounts receivable decreased by 26.13% year over year, and the turnover ratio of accounts receivable declined, from 4.07 in the same period in 2022 to 3.82.

Inventories rose 4.30% year over year, and the inventory turnover ratio declined from 1.80 times in the same period in 2022 to 1.41 times.

The plant protection industry cycle is declining, the industry removes inventory, and the company's performance is under pressure in the short term. According to the original drug data of Zhongnong Lihua, on October 29, 2023, the price index of Zhongnong Lihua's raw materials was reported at 86.69 points, a sharp drop of 36.6% from last year and a decrease of 0.72% from the previous month. Of the hundreds of products tracked, 93% of products fell compared to last year; compared to September, most products remained flat, and 18% products fell. Judging from historical prices, most of the hundreds of products tracked are at historically low levels. We believe that in the short term, with the release of pesticide production capacity in Inner Mongolia, Ningxia, and Gansu, the domestic pesticide supply is relaxed; from the inventory point of view, the global plant protection market is still in the de-inventory stage. Short-term pesticide market supply and demand are unbalanced, pesticide product prices are under pressure, and the pesticide market still needs time to exchange space, and it still needs to be recovered. Looking at the medium to long term, the rigid demand situation in the food market requires the plant protection industry to improve grain production and quality through innovative chemical and engineering solutions. Pesticides are essential to the global planting industry. In the future, pesticide demand is rigid and will continue, and the global plant protection market is expected to gradually recover as stocks are removed. The company's agrochemical business mainly focuses 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 overcome the current difficulties, the company relies on products within the patent period in the product pipeline to minimize the impact of insufficient orders in the external market on the company. At the same time, the company actively promoted new product cooperation with major global companies in the front-end pipeline and CDMO business based on technological innovation, established early R&D partnerships with many international customers, identified a number of products with conditions for listing and commercialization within 3-5 years, laying the foundation for the company's long-term development. We believe that the plant protection industry cycle continues, the industry removes inventory, and the company's performance is under pressure in the short term, but considering the gradual recovery of the plant protection market over the medium to long term and the continuous increase in long-term demand, we are still waiting for the company's plant protection sector business to recover.

The pharmaceutical CDMO industry is expected to maintain a high growth rate, and the company's CDMO business continues to advance. In order to further improve R&D efficiency and optimize cost control for pharmaceutical companies, the CDMO model has gradually become mainstream. 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 in 2025 and US$231 billion in 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 success of new drug development in the pharmaceutical industry have also brought new opportunities for domestic pharmaceutical CDMO companies. The company has in-depth cooperation with global pharmaceutical companies such as Novartis, AstraZeneca, BI and other global pharmaceutical companies on CDMO projects. The company's pharmaceutical CRO business has also officially started. We believe that the CRO business has a limited short-term contribution to revenue and profit, mainly because it can better serve customers and enhance customer stickiness.

The company announcement revealed that Taizhou Lianhua, a subsidiary of the company, underwent a cGMP on-site inspection by the US FDA from July 31, 2023 to August 4, 2023. This inspection is a GMP supervisory inspection triggered by 2 APIs and 1 advanced intermediate and a pre-registration approval inspection. Field Inspection Report (EIR) results are 0-483 (zero defects). 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 passage of the US FDA audit will have a positive effect on the company's pharmaceutical CDMO business. The pharmaceutical CDMO business is expected to gradually expand and has the potential for rapid development.

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 mainly focus on personal care and cosmetics, battery chemicals, and new energy. The company's functional chemicals department continues to invest in R&D to develop new products with potential. The company's commercial production plant construction and trial production of 20,000 tons of lithium hexafluorophosphate and 10,000 tons of lithium bifluorosulfonimide continued in 1H23. According to the company's investor relations notes on September 19, 2023, the company's new energy business, lithium hexafluorophosphate and lithium bifluorosulfonimide, all carried out in an orderly manner according to the plan. Among them, lithium hexafluorophosphate has already further communicated with relevant customers and is being audited by customers. In the future, the company will continue to do a good job in building a quality system, stabilizing production, and climbing production capacity. We believe that as the company's pipeline products gradually pass verification and new construction projects are gradually put into operation, the functional chemicals sector is expected to become the company's new revenue growth curve.

Investment suggestions: We expect Lianhua Technology's revenue for 2023-2025 to be 68.87/79.74/9.537 billion yuan, a year-on-year increase of -12.44%/15.79%/19.59%, and net profit of 0.04/2.86/731 billion yuan, a year-on-year change of -99.46%/7430.73%/155.58%, corresponding EPS of 0.004/0.31/0.79 yuan, respectively. Based on the company's closing price on October 30, the corresponding PE is 1913/25/10 times, and the corresponding PB is 1.1/1.0/0.9 times, respectively. Based on the following four aspects, 1) In the context of the gradual recovery of the plant protection market and continuous growth in long-term demand, the company's plant protection sector business is expected to gradually recover. 2) 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 pipeline products in the functional chemicals sector gradually pass verification and new construction projects are gradually put into operation, we expect the functional chemicals sector to open up a new revenue growth curve for the company. Although short-term performance is under pressure, it has been pulled back to 1.1 times PB in the short term. Considering the medium- to long-term growth of the company's pesticide and pharmaceutical CDMO business in the future, the “buy” rating is maintained.

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