Hollysys Automation Technologies Ltd (HOLI) 2011 Q2 法說會逐字稿

Thank you for standing by, and welcome to the Hollysys Automation fiscal 2011 second quarter ended December 31, 2010 earnings conference call. At this time, all participants are in a listen-only mode. There will be a presentation, followed by a question-and-answer session (Operator Instructions). Please be advised that this conference is being recorded today, February 17, 2011.

I would now like to hand the conference over to Ms. Jennifer Zhang, the Investor Relations Manager of Hollysys Automation Technologies. Thank you. Please go ahead, Ms. Zhang.

Good day to everyone, and thank you for joining us. Our speakers today will be Dr. Changli Wang, CEO and Chairman of Hollysys Automation Technologies; Mr. Peter Li, CFO of Hollysys; and myself, the IR Manager of Hollysys.

Before we get started, I would like to remind everyone that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that are not historical facts, including statements relating to the (inaudible) growth of Hollysys' future product introductions, the mix of products in future periods and future operating results.

Such forward-looking statements are based upon the current beliefs and expectations of Hollysys' management and are subject to risks and uncertainties, which could cause actual results to differ from the forward-looking statements.

The following factors, among others, could cause actual results to differ from those set forth in these statements -- business conditions in China and in Southeast Asia; continued compliance with government regulations; legislation or regulatory environments -- requirements or changes adversely affecting the businesses in which Hollysys is in engaged; [decision] or changes in government incentive programs; potential trade barriers affecting international expansion; fluctuations in customer demand; management of rapid growth and transitions to new markets; intensity of competition from or introduction (technical difficulty) superior products by other providers of automation and control system technology; timing, approval and market acceptance of new product introductions; general economic conditions; geopolitical events and regulatory changes, as well as other relevant risks detailed in Hollysys' filings with the Securities and Exchange Commission.

The information set forth herein should be read in light of such risks. Hollysys does not assume any obligation to update the information discussed in this conference call or its filings.

On today's call, the CEO and Chairman of Hollysys, Dr. Changli Wang, will provide a general overview of our business, including some highlights of the quarter. And then the CFO of Hollysys, Mr. Peter Li, will discuss our quarterly performance from a financial perspective and a financial outlook of the rest of fiscal year 2011. Both Changli and Peter will be available for the Q&A session afterwards.

Please note that all amounts noted in this conference call will be in US dollars, unless otherwise noted. Now I would like to turn the call over to Dr. Changli Wang. Please go ahead, Dr. Wang.

Thank you, Jennifer, and greetings to everyone. We are very pleased to report another stellar quarter, with solid financial and operational performance. Our financials were significantly improved on a year-on-year basis, and our operational status and the backlog continued upward trend. I would like to discuss some of the key events that took place during this quarter.

In this quarter, amid robust growth from all business lines, our high-speed rail business had another quarterly high from not only revenue, but also backlog perspective. Specifically, I would like to mention two of our significant contract wins in this quarter. Hollysys signed a $30.45 million 300- to 350-kilometer per hour ATPs contract during the quarter. This contract win is a testament that Hollysys will continue to play a leading role in China's 300- to 350-kilometer per hour high speed rail market, following our great success in the 200 to 250 kilometer per hour segment.

Also in this quarter, we signed another $33.63 million TCC contract to supply ground-based signaling system to Beijing-Shijiazhuang-Wuhan high-speed rail line, with a designated traveling speed of 350 kilometers per hour and 1200 kilometers in total length.

This line is the northern portion of Beijing-Guangzhou line high-speed rail, one of the main lines of China's national high-speed rail network. This significant contract win further strengthens our key position in China's high-speed rail signaling market.

Furthermore, Hollysys showcased its proprietary ATP and TCC products on the world stage at the seventh world conference on high-speed rail held in Beijing in December. As many countries in the world having already formulated high-speed rail buildout plans, Hollysys will leverage on its expertise and technology accumulated in this round of China's high-speed rail buildout to enter international markets.

With that, I would like to turn the call over to our CFO, Peter Li, who will discuss in great details our financial results. Okay, Peter.

Thank you, Dr. Wang, and hello to everyone. In a nutshell, Hollysys' financial and operational results for fiscal second quarter ended December 31, 2010, the Company reported a strong quarterly result. For the quarter ended December 31, 2010, total revenues increased by 61.1% to $74.4 million from $46.2 million in the same period of last year. Revenue from integrated contracts increased by 61.9% to $71.2 million year-over-year.

The breakdown of Companies integrated contract revenue by segment was as followings. $34.4 million or 48.3% from Industrial Automation, representing a 16.3% segment revenue growth year-over-year. Rail and Subway was $35.1 million or 49.3%, representing a 229.2% increase year over year, of which $22.8 million or 32% from High-Speed Rail and $12.3 million or 17.3% from Subway. And $1.7 million or 2.4% from Nuclear and miscellaneous compared to $3.7 million year-over-year.

While I am very pleased to report this historical high quarterly revenue, I (technical difficulty) remind everyone of the nature of our quarterly revenue lumpiness, due to the large size of individual contracts in High-Speed Rail and Subway, which would have rendered our quarterly revenue lumpy because of some external factors out of our control.

The overall corporate gross margin was 36% for the quarter as compared to 31.2% year-over-year. The gross margin for integrated contracts and product sales were 35.7% and 42.1% for the quarter, as compared to 31% and 35.7% for the same period of last year, respectively.

The quarterly selling expenses were $5.4 million compared to $3.6 million year-over-year, increased by $1.8 million or 50.7%, which was mainly due to the Company's expanded sales network and the increased sales staff. As a percentage of total revenues, selling expenses were 7.2% for the quarter as compared to 7.7% year-over-year.

The quarterly G&A expenses, excluding non-cash stock-based comp, were $4.8 million, representing an increase of $0.7 million or 16.9%, as compared to $4.1 million year-over-year. As a percentage of total revenues, G&A expenses were 6.5% for the quarter as compared to 9.0% year-over-year. Including the non-cash stock-based comp of $131,019, G&A expenses were $5 million for the quarter as compared to $4.3 million year-over-year.

The quarterly R&D expenses were $6.4 million compared to $3.4 million year-over-year, representing an increase of $3 million or 89.9%, mainly due to the Company's increased R&D activities. As a percentage of total revenues, R&D expenses were 8.7% for the quarter as compared to 7.4% year-over-year.

The quarterly share of net gains from equity investees were $2.3 million, of which $2.1 million from our 50%-held nuclear subsidiary in partnership with China Guangdong Nuclear Power Corp.

The quarterly income tax expenses were $1.7 million compared to $0.1 million year-over-year. The quarterly effective tax rate was 10.3% as compared to 1.1% year-over-year. The large increase of tax expenses was mainly due to lower than normal tax expenses for the same period of last year, caused by tax expense clawback upon successful obtaining High Technology Enterprise tax certificate by our Hangzhou subsidiary.

The quarterly non-GAAP net income, excluding non-cash stock-based comp, was $15 million or $0.27 per diluted share, based on 55 million shares outstanding. This represents an increase of $6.9 million or 85.4% over the $8.1 million or $0.16 per share, based on 51 million shares outstanding reported in the prior-year period.

Hollysys' backlog for the quarter hit another record high at $288.5 million, representing an increase of 13% quarter-over-quarter and an increase of 31.4% year-over-year. It is worth noting that this is the fifth quarter in a row for the Company to have maintained the upward trend of backlog balance since December quarter of 2009.

Historically, our backlog balance tends to be lumpy, but with a general upward trend. Having said this, I will not be surprised to see our quarterly backlog balance would decrease from this historical high in one of the upcoming quarters. Again, I would encourage you to view our backlog from a quarterly trend perspective, not from single quarterly balance perspective.

The net cash used in operating activities was $3.5 million for the quarter, mainly due to increased accounts receivables. Including investing and financing activities, the total net cash outflow for the quarter was $15.3 million, mainly due to the usage of $12.1 million to repay the three-year period bonds.

We have noticed our operating cash outflow for two quarters in a row now totaling to $5.3 million for the first fiscal half-year. We are working on remedying the operating cash outflow situation to maintain our operating activities in a cash-generating condition on fiscal year basis.

As of December 31, 2010, Hollysys' cash and cash equivalents were $95 million compared to $110.2 million on September 30, 2010. The quarterly DSO was 104 days as compared to 137 days year-over-year and 111 days quarter-over-quarter.

Given our strong financial performance to date and historical record high backlog balance, we'd like to revise our fiscal 2011 revenues guidance from the previous level to the range of $243 million to $247 million, and the net income guidance from the previous level to the range of $39 million to $41 million, respectively.

All in all, Hollysys has delivered a quite successful performance for the first half of our fiscal year, while we have aggressively increased investment in sales network expansion and R&D activities. We feel that we are doing a good job in balancing between the corporate long-term growth objective and short-term financial performance. We will continue to strive to create long-term value for our shareholders. Thank you.

Thank you, Peter. At this time, we would like to open up for the Q&A session. Please note that for Chinese-speaking participants, we can also do the Q&A in Mandarin and we will provide translation. (Spoken in Chinese). Operator, please.

(Operator Instructions) Mark Tobin, Roth Capital Partners.

Good evening. Thanks for taking my question. Could you give us some additional insight -- obviously, the investment in sales, as well as R&D, we started to see that ramp up during the quarter. Can you give us some insight into the return that you expect from that as far as what types of products and what types of markets that you're looking to penetrate?

Sure. That is a very good question. As you know, Hollysys achieved its market-leading position through its proprietary technology and product offerings, leveraging on its strong internal R&D capabilities. We are benefitting all of our business lines from increased R&D activities started from February 2009, with more proprietary products pushed out to the marketplace, helping our market positioning as total solution providers, which in turn increased our growth rate and market penetration in different market verticals.

We are currently conducting roughly about 40 R&D projects across Industrial Automation, High-Speed Rail and Subway. Industrial Automation, our main R&D products, is really concentrated in safety products together in other products. Especially for the safety products for Industrial Automation, it needs to go through the most stringent European certification, which is both time-consuming and monetary costly.

In High-Speed Rail, one of the main areas we conduct R&D is unified platform of interlocking system with signaling system, and also together with 300- to 350-kilometer-per-hour proprietary ATP development and its certification. In Subway, it is the signaling system.

So all in all, we think we will pretty much maintain the current R&D spending level for the rest of the fiscal year.

With respect to the sales/marketing expenditures and activities, as you know, Hollysys achieved 10.6% of DCS market share in China, really from scratch, 15 years ago, against both multinational corps and local companies through providing solutions and products with better value for money for our customers.

Over the past 15 years, we have entered and dominated low-end to mid-end market of industrial DCS market in China, while multinationals still dominate the high end of this market.

Our sales strategy is really twofold going forward. One is that we will continue to chase multinational companies to the high end of the market by beefing up our total solution capability and consulting ability. Number two is that we will aggressively expanding our sales network nationwide to cover both geographic niche market and the vertical niche market, leveraging on our brand name, total solution positioning, quality of our products and customization capabilities.

To fulfill our niche market coverage, we are expanding our sales offices nationwide and adding sales staff. We have already set up sales and support offices in 29 cities to date, with sales staff the Industrial Automation line of the business increased from previous level of 180 to 500 people now, just over the past six months. We will maintain this level sales force for the rest of the fiscal year, while we are still adding more offices to cover more extensive geographical regions.

We plan to quickly increase our sales office locations from current 29 cities to 50 to 60 cities in about half year to nine months timeframe. So we will pretty much, more or less, maintain the current quarterly selling expenditure level for the rest of the fiscal year.

That's helpful. Thank you. And I guess as far as when we start to see the impact of these investments on your financial results, what kind of timing do you expect? How quickly can we start seeing some of that return?

Definitely, as I mentioned earlier, we are benefiting from the earlier R&D investments, decisions we made back to February 2009. I think with respect to sales network expansion and sales staff increase, we probably should give it to six months to nine months ramp-up period of time, and then I think we will feel tangible results on the P&L side.

Okay. That's helpful. I'll jump back in the queue. Thank you, Peter.

Alex Potter, Piper Jaffray.

Very good quarter. I was wondering if you could comment here on the backlog trends. I know that there is lumpiness from quarter to quarter, and it doesn't always make sense to look at it on a sequential basis. Obviously, High-Speed Rail was up huge because of the contract you signed at the end of last year. But backlog trends in the other three segments seem to have come down on a quarter-over-quarter basis. I was just wondering if you could comment on some of the trends there, specifically in Nuclear and Industrial Automation.

Like I said earlier in my speech, backlog balance historically used to be lumpy quarter-to-quarter, but with a general upward trend. Over the past five quarters, I think, which is very unique pattern we see, is that we have been achieving a general trend quarter-over-quarter for the past five quarters in a row now.

Of course, for the segment balances of backlog, you will see the lumpiness, because of the timing of the contract signing and the timing of the contract revenue recognition in each of those sub-segments. So we feel that this kind of lumpiness of backlog balance is normal.

And if you look at Industrial Automation backlog balances, it used to be fluctuating between $55 million to $63 million, $65 million about 1.5 years ago. But recently, over the past three quarters, it has been fluctuating over a high level of $85 million. For this quarter, it came down a bit to $82 million. So we think this trend line generally reflects the future revenue level [inherently].

And the same goes with Nuclear. Nuclear backlog balances used to be lumpy, between $4 million to $6 million on a quarterly basis. Over the past few quarters, the backlog balances of Nuclear and Miscellaneous now trend up to between $10 million to $12 million to $13 million on a quarterly basis.

So in these two areas, it really indicates our stronger revenue going forward.

Okay, great. That's helpful. And I had one other question here on backlog in revenue recognition. Obviously, it makes sense that your High-Speed Rail backlog came up as high as it did, given the two very large contracts that you signed recently. Was somewhat surprised to see the revenue contribution come up from High-Speed Rail so quickly. Is this because you've already started recognizing revenue from some of those contracts?

No, not yet. We have to recognize revenue on the basis of signed contracts. And as we mentioned before in the previous earnings calls, we are seeing shorter and shorter project implementation cycle for high-speed rail due to expedited high-speed rail buildout in China.

He asking whether the recognition of (inaudible) coming up, going up. Have we recognized some of the revenues from these two new contracts. But I think we haven't yet.

We haven't recognized -- thanks, Changli, for clarifying the question. We haven't recognized much of the revenue from those two newly-signed contracts yet.

Okay. Thanks very much. That's helpful. I'll jump back in queue.

Anderson Chow, Macquarie Capital.

Good evening, Mr. Wang and Peter. I have two questions. Firstly, you mentioned -- Peter mentioned during the results presentation that you think in the coming quarters, the Railway side of the order backlog may start to see a bit of a slowdown. And to some extent, I kind of share that view, because the whole railway development plan in terms of the target is now pretty much five years earlier than originally expected.

But can I interpret that as saying probably beyond the end of 2011, we could start to see a decline in terms of your order backlog for Railway Automation?

And also, are you able to sell the more sort of traditional railway signaling products? Is there -- is that a potential business that Hollysys is already certified to do that? That is the first question.

Second question, just regarding your sales and marketing effort, broadening sales force from 29 cities to about 50 to 60 cities in six or nine months, I just want to get a better sense -- I mean, all these people -- are all the salespeople you are going to put into those 20 or 30 cities, are they purely marketing people? Or are they technical people working with sales or are they technical people having the ability to sell? I just want to get a better sense. And what you think is holding Hollysys back from moving up into the higher-end industrial automation market that is currently dominated by the foreign players? Thank you.

That's a good question, Anderson. I think for the first question, I have to clarify one point I made earlier in my speech. What I meant by lumpiness in the backlog balance, I didn't mean to refer to any specific segment. I really meant the general backlog balances could be lumpy going forward.

What I (technical difficulty) -- why I said that is I just don't want you guys to get used to this kind of trendline quarter-over-quarter. The general overall backlog balance could come down at one quarter in the future. That is really a cautious note to investors of Hollysys.

With respect to your comment on high-speed rail buildout and the possible slowing down of this business, really, from the management point of view, we don't see that yet. As you know, Chinese government has already placed high-speed rail of China as the top priority of strategic, of national industries to be developed into the future.

Actually, what we see is high-speed rail buildout in China has been further expanded from the previous ambitious level to even more ambitious level in the 12th five-year government plan. As you probably noticed in the public media, China now is planning to build high-speed rail to the neighboring countries -- to Iran, to Turkey, to Russia, or even to Singapore, all the way through Malaysia, Thailand to Singapore.

So really, we feel the Chinese government is beefing up the whole plan. And we currently don't really see the slowing point in the next two to three years yet. We probably will come to that by the time we reach the end of the 12th five-year plan.

I think with respect to the second question of yours, I think Dr. Wang would like to give you more color on that.

Anderson, thank you for the question. I think for the sales force increasing of Hollysys, we have been planning this for quite a long time now, and now we just execute this plan. In fact, we found that doing these years of our people selling in the field, we found that we found a very big potential market for us.

First of all, there are a lot of small and medium projects we have omitted before, and now with the increase of sales force, especially in the localized areas, we can penetrate -- we can occupy more industrial automation markets from very easy way -- in a very easy way.

So for the personnel we increased, we are mainly -- can be break into three segments, mainly. One is the technical support people we have trained, who have the experience of engineering background. The second is we have (inaudible) a lot of people from the field. That means we have a lot of people from our customer side like who understand the applications, who are expertise -- who can supply the customers with expertise of the process of control. And the third part of these personnel are purely salespeople who can go in to the customers and selling the products.

So with these organized forces, we are planning -- we are looking forward for the big increase in our Industrial Automation segment. Because during these years, we have -- although the Industrial Automation part has been growing, but with a speed we are not satisfied. So with this increase in the sales force, hopefully, we can increase that part of the business as well, in addition to the High-Speed Rail.

As for the high-end penetration, in fact, we are preparing this for many, many years. First of all, Industrial Automation can be a segment into several areas, like the power plant control systems. Now in the (inaudible) power plants, we have penetrated the highest end of the power plant. We have just to finish the installation and attachment of 1000-megawatt power plant, which is the top level of a power plant's control systems. And we supply the customer with the whole system.

And with that system completed, I am sure -- which will give us a very powerful demonstration for our ability, so later on, in the power area, there is no holdback for us in the high end.

And for the chemical process, which is another very big area, and we have done several big projects in these couple of years. And we have got projects completed and especially as we have updated our systems, so that we can fully service this kind of process. And after this, I am sure we will show our capabilities in the high-end market penetration.

And also for the R&D, as just Peter that mentioned for the Industrial Automation, he said that we spent quite a lot of money in the designing of our own proprietary safety systems for the industrial process. In fact, this is a new trend. Before, safety issue is not a big problem for the industrial, although we have installed quite a lot of systems for some of the key process. But many industrial process, they do not require this safety system certification.

But now, with this safety concern of all the industries, people now require more and more safety systems, especially for the emergency shutdown and also for the equipment protection systems at the power plant -- the generator protection and also for the chemical process safety process.

So with this (inaudible) especially, we are planning to finish this system designing within the middle of next year, 2012. And after that -- because other systems need to be certified in Europe. So after that, I'm sure our competition level will being raised to another level, because in the whole world, there are not many companies can supply whole systems, including the safety part.

So with that part of the functionalities, Hollysys has risen to a higher rank of this competition. Does that answer your question, Anderson?

Thank you very much. Can I just ask two follow-up questions? Just coming back to the high-speed rail, I wonder -- the Chinese government's target to 2012 is basically to have 13,000 kilometers built and in operation. Does Hollysys have a number that says how many kilometer of that 13,000 kilometer have already installed or tender out the signaling requirements? So that is the first question.

And the second question is, in terms -- I wonder within your Industrial Automation order backlog, is it possible to give us a breakdown of -- a further breakdown of how much of the Industrial Automation is DCS systems and how much is the PLC?

Anderson, yes, you are right. I mean, for the previous high-speed rail buildout plan of China, it used to be the 13,000 high-speed rail tracks by the end of 2012. But now, as you know, the new 12th five-year plan has increased its number to 40,000 kilometers of high-speed rail tracks by the end of 2015. I really don't have the exact number of lines which have already granted a signaling contract.

With respect to your second question of breakdown of our Industrial Automation backlog, I think that has to be going hand-in-hand with our revenue breakdown. So going forward, if our PLC revenue is reaching a meaningful portion of Industrial Automation, we will break down from the revenue perspective, and then of course we will break it down in the backlog level.

Okay, thank you.

(Operator Instructions) Katya Voronchuk, Rodman & Renshaw.

Good evening, Peter. Good evening, Dr. Wang. Just a couple of follow-up questions. So I see that your Subway backlog has been on the decline since the third quarter of 2010. Are you seeing a slowdown in new orders or a general slowdown in the spending on subway projects in China?

No, I wouldn't draw that conclusion of subway spending the slowing down. Having said that, there is an occurrence in the marketplace that some second-tier, third-tier cities are having some financing issues in funding their municipal subway buildout.

But as you know, Hollysys' subway market is mainly concentrated in the major city centers, such as Beijing, Guangzhou and Shenzhen. So we are not seeing that kind of slowing down in the first-tier cities for now.

And with respect to the backlog balances decreasing for the Subway segment, my answer to that is really the Subway backlog balance used to be abnormally high over the past few quarters, especially reached the height of balance in March quarter of 2010 at the highest point of $115 million.

The reason being that is really twofold. One is we kept signing the new contract for Subway businesses. At the same time, some of the contracts we were implementing were being postponed. So that is why historically up to March 31, 2010, you've seen our quarterly Subway backlog balances from $60 million from June 30, 2009 increase to $64 million in September quarter of 2009 and the further increase to $108 million in December quarter of 2009, and finally reaching the height of $115 million in March quarter of 2010.

Since March quarter of 2010, we are seeing this backlog balance has been steadily decreasing. And I think this trend will probably reverse in the next few quarters, given the newly-signed contracts going forward.

Okay, thank you. Also, a follow-up question on your Railway segment revenue recognition. I assume this quarter, the revenues for the Railway segment were so high because of the delivery on Qinhuangdao-Shenyang contract at the end of 2010.

So looking forward at the next two quarters, do you think recognized revenues for the High-Speed Railway segment will go down to approximately $10 million level?

I'm not commenting on exact numbers for the future quarters, especially for the subsegment of our revenue. You are right -- over the past two quarters of our fiscal year, we do have a couple of significant high-speed rail lines going into commercial operation in -- like you mentioned, Qinhuangdao-Shenyang line and also Changchun to Jilin lines.

Going forward, I think for the second half of our fiscal year, we will start shipping the product for those contracts announced in the last quarter, especially those two significant contracts of 300- to 350-kilometer power ATP contract, and also the Beijing-Shijiazhuang-Wuhan 300, 350-kilometer power line. And we will continue to announce contract wins for the second half of this fiscal year, so stay tuned.

Okay. And just the last question, on your tax rate, I believe in one of the previous calls you've mentioned that you expected relatively high tax rate in this quarter and next quarter, and then lower tax rate in the fourth quarter. But it seems like this quarter you have 10.3% effective tax rate. So for the remaining two quarters, is this the tax rate that you expect to see?

Like I communicated with you, our tax rate will be maintained at roughly about 10% to 12%.

Okay. Thank you very much.

(Operator Instructions) Ole Hui, Daiwa Capital.

Good evening, Dr. Wang and Peter. I have one question regarding the Industrial Automation business. From your conversation earlier, you mentioned you are going into safety systems in industrial automation, and from what I understand, that is also targeting the petrochemical industry. Will that product be a competing product to a product from Invensys, the Triconex? Are we talking about similar type of product? Can you give me some indication?

Yes, good question. In fact, it is our -- we have holding this for quite a long time, and now we can announce this, because our progress in the (inaudible) is quite fast. And yes, you are right. We are preparing to penetrating that part of the business, both for the power and for the petrochemical process. Because we are designing the proprietary safety system.

I'm not sure whether it's similar or not to the Triconex system, but effectively, they are going to perform the same functionalities.

Okay, I see. One of -- another listed company in Hong Kong is China Automation Group. They are a distributor of Triconex in China, and they have a very high market share in China. So I guess with your new product, they will be -- you know, you will be computing or become quite an important competitor for them.

Well, I don't know. I mean, we will see. Anyway, I think the customers, they are not pleased with one [monopoly] anyway. So they want more competitors in the field. We got encouragement from the customers.

Thank you.

Thank you, everyone, for joining us on the call today. If you haven't got a chance to raise your questions, we will be pleased to answer them through follow-up contact. We look forward to speaking with you again in the near future. Thank you.

That does conclude our conference for today. Thank you for participating. You may all disconnect.