In 3Q23, the cosmetics business revenue exceeded expectations with personnel adjustments settled, and turning points in operations and business coverage have both arrived. Against the backdrop of consumer demand falling under pressure, Rellet and Dr.Alva achieved quarterly growth of 44% and 34%, respectively, along with a significant improvement in gross profit margin (GPM). For the pharmaceutical business, Lushang Freda has been expanding its sales channels, enhancing R&D, and gradually launching new products to drive incremental growth; the quarterly revenue pressure may have reflected the impact of the crackdown on healthcare corruption. The raw material business has been continuously optimized by focusing on high-value raw materials, expanding product categories, and entering new fields. With the Company's core business refocused, personnel adjustments finalized, and teams and personnel optimized, we expect its operational efficiency to continue to improve, enhancing long-term growth visibility. We maintain our target price at Rmb13 and reiterate the "BUY" rating. Reporting steady growth and optimized profitability after adjusting for the disposal of real estate assets. p 3Q23 report overview: In 1-3Q23, Lushang Freda achieved operating revenue of Rmb3.395bn (-60.20% YoY or +15.42% YoY on a comparable basis), a GPM of 47.08% (+21.00ppts YoY or +3.42ppts on a comparable basis), attributable net profit (ANP) of Rmb238mn (+54.79% YoY), and a net profit margin (NPM) of 7.01% (+4.83ppts YoY), while its ex-one-off net profit reached Rmb108mn (-33.17% YoY), implying an ex-one-off NPM of 3.17% (+1.28ppts YoY). In 3Q23 alone, the Company achieved operating revenue of Rmb922mn (-75.05% YoY or +18.24% YoY on a comparable basis), a GPM of 54.91% (+35.13ppts YoY or +6.32ppts YoY on a comparable basis), ANP of Rmb47.61mn and an NPM of 4.85%, while its ex-one-off net profit stood at Rmb44.71mn, leaving the ex-one-off NPM at 4.85%. p After adjusting for the disposal of real estate assets: In 1-3Q23, Freida Pharmaceutical Group, the entity that holds the majority of the cosmetic, pharmaceutical and raw material businesses after excluding the real estate business, achieved operating revenue of Rmb2.159bn (+15.95% YoY), net profit of Rmb156mn (+24.89% YoY), and an NPM of 7.23% (+0.51ppts YoY). In 3Q23 alone, Freida Pharmaceutical Group achieved operating revenue of Rmb690mn (+19.58% YoY), net profit of Rmb37mn (+85.00% YoY), and an NPM of 5.36% (+1.90ppts YoY). p Adjusted performance: During the reporting period, the Company's revenue and net profit declined along with cost optimization, affected by the divestment of its real estate business. However, when considering comparable revenue figures for the cosmetics, pharmaceutical, and raw material segments, the Company has shown a trajectory of steady growth, with a significant improvement in GPM. Cosmetics: Rellet and Dr.Alva delivered strong growth in 3Q23, aided by a boost to the GPM thanks to an optimized product structure. In 1-3Q23, the Company's cosmetics business achieved operating revenue of Rmb1.654bn (+15.75% YoY) along with a GPM of 62.08% (+3.52ppts YoY). In 3Q23 alone, the cosmetics business achieved operating revenue of Rmb548mn (+31.41% YoY) with the GPM at 60.14% (+6.80ppts YoY). 1) Rellet witnessed substantial growth in 3Q23 on the back of a ramp-up in new product sales and channel optimization. The Rellet brand achieved operating revenue of Rmb612mn (+13.33% YoY) in 1-3Q23 and Rmb220mn (+44.32% YoY) in 3Q23 alone. During the reporting period, Rellet's spray sales soared by 406% YoY, and new products such as moisturizing cream and mask powder performed well. As the Company optimized its sales channels, Rellet's self-operated online sales surged by 129.38% in 1-3Q23. 2) Dr.Alva maintained rapid growth and launched new mid-to-high-end products. The Dr.Alva brand achieved operating revenue of Rmb893mn (+19.87% YoY) in 1-3Q23 and Rmb295mn (+33.95% YoY) in 3Q23 alone. During the reporting period, Dr.Alva upgraded its probiotic face mask to 2.0 and introduced a new moisturizer to improve its mid-to-high-end product lineup. As of the end of 3Q23, it had sold 160k bottles of the new moisturizer. It also introduced new products such as wake-up essence and anti-acne essence to boost the brand's growth and efficiency. 3) The comprehensive "4+N" brand matrix addresses segmented consumer demand, contributing to the Company's overall growth backed by a multi-brand portfolio. Other brands achieved operating revenue of Rmb149mn (+3.47% YoY) in 1-3Q23 and Rmb33mn (-26.67% YoY) in 3Q23 alone. 4) Lushang Freda is accelerating its entry into the medical aesthetics market, with the collagen production line already in place. The Company is advancing medical aesthetic equipment production and technology development and has completed the construction of collagen raw material and Class II & Class III medical equipment production lines. In terms of products, the Company has obtained a medical device registration certificate for its hyaluronic acid sodium solution (Class II). through enhanced R&D. Raw materials: Focusing on new product development and expanding application scenarios. 1) The pharmaceutical business continued to expand channels and strengthen R&D efforts. In 1-3Q23, the Company's pharmaceutical business achieved operating revenue of Rmb399mn (+18.48% YoY) with a GPM of 54.42% (+2.10ppts YoY). In 3Q23 alone, the pharmaceutical business achieved operating revenue of Rmb108mn (-14.29% YoY) with a GPM of 49.41% (+0.07ppts YoY). The revenue pressure in 3Q23 may have been influenced by anti-corruption measures in the pharmaceutical sector, but a return to normal levels looks imminent. In terms of sales channels, the Company's pharmaceutical business has continued to expand into above-county-level and higher-level hospitals, grassroots medical institutions, and pharmaceutical chains, while also accelerating the ecommerce sales of supplementary over-the-counter (OTC) drugs. On the R&D front, the Company has established a contract development and manufacturing organization (CDMO) platform for drug pilot testing and production conversion. It is also accelerating R&D innovation and has obtained a drug registration certificate for Tadalafil tablets, which are now available for sale, during the reporting period. 2) The raw material business is actively pushing for registrations, launching new products and enhancing synergies. In 1-3Q23, the Company's raw material business achieved operating revenue of Rmb253mn (+9.13% YoY) with a GPM of 36.01% (+3.54ppts YoY). In 3Q23 alone, the raw material business achieved revenue of Rmb83mn (+1.22% YoY) with a GPM of 36.97% (+5.58ppts YoY). The Company has continued to advance the registration of domestic and foreign active pharmaceutical ingredients (APIs) and develop new raw materials. During the reporting period, the focus has been on Freda's sodium hyaluronate API for eye drops, which has obtained the "In Progress" registration number from the Center for Drug Evaluation (CDE) of the National Medical Products Administration (NMPA). Freda Biotechnology's ectoine has received the FDA's Drug Master File (DMF) registration, and three new cosmetic raw materials have been introduced. In addition, the Company is continuously strengthening synergy in the raw material business, advancing cooperation on materials such as hyaluronic acid and natamycin and further expanding the application scenarios of hyaluronic acid, polyglutamic acid, and ectoine raw materials. With the divestiture of real estate assets, the Company's expense ratio is aligning with the average of the cosmetics industry, with financial expenses significantly optimized and aggressive R&D spending driving research in pharmaceuticals, raw materials, and cosmetics. 1) The Company's selling and administrative expense ratios have increased significantly, approaching the average of the cosmetic industry. In 1-3Q23, the Company's selling expense ratio was 32.04% (+20.68ppts YoY), and the administrative expense ratio was 4.63% (+1.98ppts YoY). In 3Q23 alone, the selling expense ratio was 40.06% (+31.88ppts YoY), and the administrative expense ratio was 5.24% (+2.95ppts YoY). 2) The Company has consistently adjust its debt structure, significantly optimizing its debt costs. In 1-3Q23, the Company's financial expense ratio was 1.19% (-1.35ppts YoY), and in 3Q23 alone, the financial expense ratio was -2.46% (-4.65ppts YoY). The Company has consistently optimized its debt structure. In 1Q23, the Company received net cash of Rmb1.38bn from the disposal of subsidiaries. In 2Q23, it repaid Rmb1.817bn debt in cash and obtained loans of Rmb317mn. In 3Q23, it repaid Rmb192mn debt and obtained loans of Rmb137mn. Through this debt structure adjustment, the Company's interest rate on liabilities in 1-3Q23 reached 1.22% (-1.88ppts YoY), resulting in significant optimization of debt costs. 3) The Company has continued to maintain a high level of R&D spend. In 1-3Q23, the R&D expense ratio was 2.96% (+2.03ppts YoY), and in 3Q23 alone, the R&D expense ratio was 3.87% (+3.22ppts YoY). The Company is committed to high R&D spending, focusing on pharmaceutical and cosmetic raw materials. The Company's controlling shareholder has pledged 70mn shares to issue convertible corporate bonds. In Jun 2023, Shandong Commercial Group, the Company's controlling shareholder, announced the plan to issue convertible corporate bonds in 2023 (the first tranche), with the issuance capped at Rmb500mn, and pledged 70mn shares, equivalent to approximately 6.89% of the total shares of the Company. Previously, Shandong Commercial Group issued convertible corporate bonds in Apr 2021, with the total amount not exceeding Rmb1.5bn. To provide guarantees for the convertible bonds, Shandong Commercial Group pledged 20mn shares in the first tranche in Sep 2021 (approximately 1.97% of the total shares) and pledged 35mn shares in the second tranche in Dec 2021 (approximately 3.44% of the total shares). Potential risks: Industry regulation tightening; underperformance in the Company's cosmetics business; increased competition in the raw material business; unexpected drops in pharmaceutical product prices; uncertainty in pharmaceutical industry policies and the Company's technology R&D in the pharmaceutical business; underperformance of the functional raw material market; related guarantee risks. Investment recommendation: In 3Q23, the cosmetics business revenue exceeded expectations with personnel adjustments settled, and turning points in operations and business coverage have both arrived. Against the backdrop of consumer demand falling under pressure, Rellet and Dr.Alva achieved quarterly growth of 44% and 34%, respectively, along with a significant improvement in gross profit margin (GPM). For the pharmaceutical business, Lushang Freda has been expanding its sales channels, enhancing R&D, and gradually launching new products to drive incremental growth; the quarterly revenue pressure may have reflected the impact of the crackdown on healthcare corruption. The raw material business has been continuously optimized by focusing on high-value raw materials, expanding product categories, and entering new fields. With the Company's core business refocused, personnel adjustments finalized, and teams and personnel optimized, we expect its operational efficiency to continue to improve, enhancing long-term growth visibility. We maintain our 2023E/24E/25E revenue forecast at Rmb4.207bn/5.350bn/6.504bn and ANP forecast at Rmb386mn/498mn/610mn, corresponding to EPS forecast of Rmb0.38/0.49/0.60. With the valuation of comparable peers in the cosmetic and raw material industries as a reference, with Proya (603605.SH), Bloomage Biotech (688363.SH), and Marubi (603983.SH) trading at 34x 2023E PE on average based on Wind consensus estimates, we assign 34x 2023E PE to keep our target price unchanged at Rmb13 and reiterate the "BUY" rating.
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