Hollysys Automation Technologies Ltd (HOLI) 2011 Q3 法說會逐字稿

Thank you for standing by, and welcome to the Hollysys Automation fiscal 2011 third quarter ended March 31, 2011, earnings conference call. (Operator Instructions). Please be advised that this conference is being recorded today, May 10, 2011.

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

Good day to everyone and thank you for joining us. Our speakers for 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 expected growth of Hollysys's future product introductions, the mix of products in future periods, and future operating results.

Certain forward-looking statements based upon current beliefs and expectations of Hollysys management are subject to risks and uncertainties which could cause actual results to differ from forward-looking statements. The following factors, among others, could cause actual results to differ from those expressed in these statements, such as the conditions in China and in Southeast Asia; continued compliance with government regulations, legislation, or regulatory environments; requirements for changes adversely affecting the businesses in which Hollysys is engaged; decision or changes in government incentive programs; potential [treaties] affecting international sanctions; broad divergence in customer demand; management of [existing] and transition to new markets; capacity of competitions down or introduction of new and superior products by other providers' automation and control systems technology; timing approval and market acceptance of new product introductions; general economic conditions, geopolitical events, and rapidly changes, as well as other relevant risks in Hollysys's filings with the Securities and Exchange Commission.

The information set forth herein to be granted in light of such risks. Hollysys does not assume any obligation to update the information discussed in this conference call or in 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 with regard to 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 U.S. dollars unless otherwise noted. And now, I'll turn the call over to Dr. Changli Wang. Please go ahead.

Thank you, Jennifer, and hello to everyone.

We are pleased to report another stellar quarter with solid financial and operational performance. I would like to take this opportunity to discuss some of the key events that took place during this quarter.

In our industrial automation business, we achieved a significant breakthrough in successful commissioning of our proprietary DCS on our Guohua Taishan thermal power plants. This is the first-ever successful application of a China-made large-scale DCS for [lank heed] was actual super-critical thermal power stations in China. The milestone success we reference were further widen of opportunities in high underthermal power market segment. We will continue to leverage our proprietary technology to provide vital [whiteoak] to our customers in high-end markets.

We are increasing our footprints and courage in low-end and the medium-end markets to strive to be the market leader in China's burgeoning industrial automation market.

Our high-speed rail business also showed strong momentum in signing a $24.3 million 200 km to 250 km power ATP contract in April. Excluding this newly-awarded contract of $24.3 million, our high-speed rail backlog was reported at a high level of $103 million as of March 31, 2011, which we believe would be mostly realized during the next 12 to 15 months.

To put this backlog balance in perspective, our reported high-speed rail backlog was fluctuating in the range of $42 million to $68 million between June 30, 2008, and September 30, 2010.

With approximately 17,000 km of high-speed rail tracks and construction and a newly-announced budget of RMB2.8 trillion for the next five years, China is still investing heavily in building its high-speed rail network for the next five years. So the next five years [plan body] represents significant increase compared to the actual spending of approximately RMB1.9 trillion for the past five years.

Ministry of China rail is planning to invest RMB0.745 trillion in building rail network for 2011, and we'll have 45,000 km high-speed rail network in operation by the end of 2015.

We believe this deal has huge potential in high-speed rail signaling market for leading players like Hollysys to capture going forward.

Driven by low carbon emissions initiatives internationally, we are also [hiding] international opportunities to further increase our rail technology and the products for [print]. Hollysys will continuously execute on its [well-thought] strategy in real automation market, both national and metro, to strive to be the leading player in this field.

In our nuclear business, we were encouraged to see the continuous flow of new orders from China Guangdong Nuclear Power Holding Co. to our 50% nuclear JV for automation and control-related services of number three and number four reactors of Yangjiang Nuclear Power Station, of which conventional [islands] are based on control system is designed to be based on Hollysys's progress or a Hollysys end platform.

This new order brought our nuclear JV's backlog to aggregated 14 reactors, which we believe will continuously flow to Hollysys within the next 24 months. Giving the recent incident in Japan, the management believes that China will have rely -- have to rely on nuclear as a clean, economical power source compared to traditional coal-fired energy, and the heightened safety consciousness will benefit China's nuclear industry in the long run.

With a 50% holding JV in place with the multi-leading nuclear station builder and operator in China, Hollysys will continue to enjoy its prevailing position in China's nuclear automation and control market.

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's financial and operational results for fiscal third quarter ended March 31, 2011, the Company reported a solid quarterly result.

Total revenues increased by 67% to $55.8 million from $33.4 million year over year. Integrated contracts revenue increased by 67.7% to $52.4 million compared to $31.3 million year over year.

On a segment breakdown basis of integrated contract revenue, industrial automation generated 47.4%, or $24.9 million, representing a 51.4% growth year over year. High-speed rail revenue generated 27.7% of the total revenue, or $14.5 million, representing a 246% year-over-year growth. Subway generated 22.5% of total revenue, or $11.8 million, representing a 47.5% year-over-year growth. Nuclear generated 2.4% of the revenue, or $1.2 million.

The Company gross margin was 40.3% for the quarter, as compared to 37.2% year over year. The gross margin for integrated contracts were 38.8%, as compared to 33.8% year over year. The gross margin increase was mainly due to higher gross margin in rail and subway businesses as a result of the fewer -- a few higher-margin projects or portion of projects being recognized during the quarter.

Selling expenses were $5.3 million, compared to $5.4 million quarter over quarter and $2.7 million year over year. The increase was mainly due to the Company's expanded sales network and the increased sales staffs. As a percentage of total revenue, selling expenses were 9.5% for the quarter, as compared to 8.2% year over year.

On a nine-month cumulative basis, selling expenses were $14.3 million, or 7.5% of the total revenue, which is in line with our historical pattern.

G&A expenses, excluding non-cash stock-based comp, were $4.9 million for the quarter, compared to $4.7 million quarter over quarter and $2.4 million year over year. As a percentage of total revenue, G&A expenses were 8.8% for the quarter, compared to 7.3% year over year.

On a nine-month cumulative basis, Q&A -- G&A expenses were $13.4 million and 7% of the total revenue, which is in line with our historical pattern.

R&D expenses were $3.9 million for the quarter, compared to $3 million year over year, mainly due to the Company's increased R&D activities. As a percentage of total revenue, R&D expenses were 6.9% for the quarter, as compared to 8.9% year over year. On a nine-month cumulative basis, R&D expenses were $14.6 million, or 7.7% of the total revenue.

The share of net gains from equity [investment activities] were $0.4 million for the quarter, of which $0.3 million from our 50% holding nuclear JV with China Guangdong Nuclear Power Corp..

The income tax expenses were $0.2 million for the quarter, as compared to the same amount year over year. We still believe the overall effective tax rate will remain as high as 10% for the whole fiscal year.

The non-GAAP net income, excluding non-cash stock-based comp, was $9.6 million, or $0.17 per diluted share based on 15 million shares outstanding. This represents a year-over-year growth rate of 83.6%.

On a GAAP basis, net income was $9.5 million, or $0.17 per diluted share. Our backlog balance for the quarter was reported at $281 million, compared to $289 million quarter over quarter and $242 million year over year.

In backlog segment breakdown, both industrial automation and nuclear automation backlog set an historical high in Hollysys's history. And the industrial automation backlog achieved a 46% growth year over year and 12% growth quarter over quarter.

The high-speed rail backlog remained at high -- at near historical high levels at $103 million, excluding the newly-awarded $24 million 200 km to 250 km ATP contract.

The net cash used in operating activities was $3.9 million for the quarter, mainly due to increased inventories which was built up for one material high-speed rail project to enable the Company to meet the required delivery deadline. This project is expected to be completed delivery in June quarter.

Including investing and financing activities, the total net cash inflow for this quarter was $0.9 million. We remain optimistic to bring the operating cash flow to positive territory in the last quarter of the fiscal year and return to cash-generating situation going forward.

Our cash levels were $96 million, compared to $95 million quarter over quarter. DSO for this quarter is 156 days, as compared to 192 days year over year and 104 days quarter over quarter. Inventory turnover is 101 days for the quarter, as compared to 94 days for the prior-year period.

All in all, the management is very pleased to have delivered an outstanding financial performance for fiscal nine-month period ended March 31, 2011. Given our strong financial performance to date and backlog currently on hand, we are again revising up our fiscal 2011 revenue guidance from $243 million to $247 million to $255 million to $259 million, and net income guidance from $39 million to $41 million to $41 million to $42 million, respectively. It's worth noting that this is the second time in a row that management has to revise up the previously provided fiscal-year guidance.

The management has taken note of recent pressure on Company's stock price due to market conditions caused by misconceptions and overreactions, and we firmly believe that our stock price will eventually reflect our intrinsic value over the longer term. Hollysys will continue to leverage on its core pillar foundations of its proprietary technology and strategic alliance with leading organizations to penetrate and increase its market share in its respective high-growth end markets.

Under the right conditions, Hollysys will also rely on M&A to accelerate its growth pace and penetrate into the new market to create long-term value for our shareholders. Thank you.

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

(Operator Instructions). Mark Tobin, ROTH Capital Partners.

Peter, thanks for taking my question. First, on gross margins, very strong for the quarter despite having a higher mix of your core industrial automation business. Can you give us a sense of what you expect from gross margins going forward?

Yes, management is very pleased to see a quarterly gross margin reaching very high level, a 40-plus level.

And also, we noticed that high-speed rail revenue took out a higher percentage compared to prior-year period. But as I mentioned earlier in a speech, that the higher margin for the quarter was mainly due to a few higher-margin contracts being recognized from high-speed rail and subway businesses. And hopefully, over the longer term, we will see the margin expansion, but as a fast-growth company, Hollysys is more focused in growing the market share and trying to be the market leader in its high-growth end markets going forward.

That's helpful. And I guess looking at your pipeline, and given the changeover at the Ministry of Rail, can you give us some commentary on what you're seeing from an order flow standpoint on the high-speed rail side? And also, what's your sense of how far are we through the signaling and automation contracts within the rail sector. Are we nearing a halfway point?

Yes, as Dr. Wang mentioned in his speech earlier, high-speed rail in China doesn't lay still in the height of its buildout process.

As Mr. Wang mentioned, China is still investing heavily in high-speed rail network. It's planning to spend RMB2.8 trillion for the next five years. Even though market is a little bit discouraged by the decreased size of spending from RMB3.5 trillion to RMB2.8 trillion for the next five years, but still it represents a significant increase compared with the last five years' actual spending of RMB1.9 trillion in high-speed rail buildout.

From our point of view, we think the current uncertainties or doubts surrounding the size, surrounding the determination of China's high-speed rail buildout is temporary, and 17,000 km of high-speed rail tracks in construction, with the current plan of having 40,000 km of high-speed rail network in operation by the end of 2015, we definitely still see a huge market potential for the leading players, such as Hollysys, to capture going forward.

I don't think we are halfway through the buildout process because Hollysys' product nature, regardless it's high-speed rail, nuclear, industrial automation, or subway, it's very much backend-loaded. So it's almost the last piece of equipment to be installed before the whole line goes for operational.

So, we definitely hope we can continue to enjoy the privileged leading positions in these areas and we'll continue to win the contracts as the leading player in this field.

Okay. That's helpful. And when we look at that budget decrease from RMB3.5 trillion to RMB2.8 trillion, do you have insight into what that decrease related to? My understanding that a lot of that decrease related to operations as far as decreasing the running speed to some of the trains and so forth. Do you have any insight into that, you or Dr. Wang?

Yes, absolutely. Let me answer your question first. Dr. Wang may add some more colors on it.

You are right. I think the decrease in terms of the spending size for the next five years mainly due to some lines in terms of the traveling speed, cutting down from 300 km to 350 km power to 200 km to 250 km power, and also, the new ministers have the philosophy of making high-speed rail more cost-friendly to the normal Chinese populations, and (multiple speakers) because 300 km to 350 km power segment line from the construction point of view is more expensive than 200 km to 250 km line.

So even though with the five-year high-speed rail budget being cut, but still, the size of the buildout in terms of the kilometers of the tracks hasn't changed, so we are still as the leading player in 200 km to 250 km power segment, especially for Hollysys. We are holding roughly about 70% of 200 km to 250 km ATP market. We think it actually will benefit Hollysys over the next few years.

Jacob Schori, Credit Suisse.

Could you tell me if you are participating in any international contracts?

Not currently. But I think you raised a very good question.

I think following the -- China's high-speed rail buildout, it actually ignited a strong interest internationally from U.S. government to countries in the developing world to Russia. We are seeing large state-owned Chinese enterprises going overseas to bid for those contracts and to form strategic alliance with local leading organizations.

We definitely like to have into that channel to go into international market following or piggybacking on the Chinese state-owned enterprise efforts. At the same time, we are also looking individually at the international market opportunities, and we believe, given the environmental concerns and the low-carbon emission policy or awareness in the international community, high-speed rail or regular rail buildout will definitely continue for the next five to eight years. And Hollysys is definitely on the basis of a strong track record accumulated from Chinese high-speed rail buildout, while trying to tap into that fast-growing market internationally.

But is the reason that you're not doing it or you haven't been doing it an issue of capacity, that you have so much to do domestically that you are really not looking outside?

We are looking at outside. We actually are talking to some of the leading players, mostly Chinese state-owned enterprises, for providing our high-speed rail signaling products to some of the contracts they currently play in the role, like the general contractor. We are also exploring opportunities to go overseas on our own.

But definitely, we are making encouraging progress in this area, and we will report that achievement or progress to the market once we have some signed contracts in our hands.

(Operator Instructions). [Andrew Lone], Piper Jaffray.

Congratulations for the good results. I've got a couple of questions. The first one is regarding your ATP C-3. May I know how many percent of your business is now in the C-3 in respect to the C-2, and what do you think about the prospect of C-3 business? As you have already mentioned, the government is now slowing down its speed and there will be only limited lines running at 300 km to 350 km. Can you give me some guidance on that particular part of the business?

My second question is regarding to your subway business backlog. I see that decreasing trend. May I know how many subway lines you are now working on and what -- are you expecting to get more bids in getting more subway lines?

My last question is about the gross margin. When I'm doing some backward [texting] about your gross margin, it seems to me your high-speed railway business is having a 40%-plus gross margin, as you mentioned before. Industrial automation is also having a really impressive 40-plus gross margin. I remember you gave us a guidance about 35% to 40%. Is this still within this range forward or just particularly this quarter having a very great month? Thank you very much for your answers.

Thank you, Andrew. Let me answer your questions first. Dr. Wang may add more colors.

With respect to the revenue split between C-3 ATP and C-2 ATPs within our revenue, as you know, we have been leading -- playing the leading position in 200 km to 250 km power segment in the ATP market. We are currently roughly holding about 17% market share. We definitely enjoy this leading position going forward.

In the C-3 areas, in 300 km to 350 km power segment, we also announced a sizable contract towards the end of last year for roughly about $30 million-plus, and as one of the only two authorized 300 km to 350 km ATP product providers to China's high-speed rail buildout, we definitely will continue to play a major role in that area.

But comparatively speaking, Hollysys is having a relatively stronger marketing positioning in 200 km to 250 km ATP market. Also please keep in mind that the two key components of high-speed rail signaling systems, ATP and TCC, the TCC, the onboard control TCC really correlates with the number of kilometers of high-speed rail tracks in operation. And the number of ATP units naturally correlates with the number of passenger trains put into operation. So these two product lines are basically driven by different parameters of the high-speed rail buildout.

So we believe with the whole high-speed rail network in operation, with the increasing of ridership, there will be an exponential growth rate of high-speed rail trains to be put into operation, and then there will be a huge demand for our ATP products going forward. I think that's the part one of your question.

The part two of your question, with respect to our subway backlog balance, really, if you'll take a look at the backlog over past numerous quarters since we reported, you can see easily our backlog for subway was fluctuating between $66 million to $50 million between the time period of June 30, 2008, and September 30, 2009.

At the end of 2009, we announced a significant contract win in subway signaling area for roughly about $48 million, and also coupled with the factor of a few subway contracts got delayed during that period. So, the subway backlog balance [guards] abnormally build up to a very high level, $115 million for the quarter end March 31, 2010.

Since then, our revenue recognition and project implementation started to be normalized. So we are really seeing a regression trend to the norm over the past few quarters, and at the same time, we are working on developing more proprietary products for subway businesses, especially in subway signaling part, and we are trying to obtain more contracts with more proprietary components instead of going after the size of the contracts.

So, with respect to your third part of your question, with respect to the gross margin part, as I said earlier in my speech, the gross margin increase for the quarter was mainly due to a higher margin contributed from high-speed rail and subway businesses.

We communicated with you the industrial automation gross margin is still in the range of 30% to 35%. This is still the case for the quarter. We still believe it will be the case for the next few quarters. We will update you once we see a trend of margin expansion in this area.

The reason of high-speed rail and subway business revenue margin increase was really due to a few higher-margin contracts or portion of contracts being recognized during the quarter. So, going forward for the next few quarters, we believe the margin will come down a little bit to the normal level, but still, over the longer four- to six-quarter trend, we'll see a margin expansion probably by 50 basis points or 75 basis points.

I would like just to add one comment about the gross margin. Originally, Hollysys's main business was comprised of several segments, with high-speed rail, as just Andrew mentioned, with a higher margin and industrial automation is just in the middle. And subway systems, previously the margin is quite low. It's much lower compared with the other two segments.

But for these two couple of years, we have spent a lot of effort in R&D, not only in high-speed rail systems and automation systems, but also in the subway area as well. We have enlarged quite a large part of our systems so that we will use more proprietary systems, replace the integrated parts from the other vendors so that we will increase the gross margin of this business as well.

So that's why, at this time of the being, we spend a lot of time in trying the new systems in the field, so I think, just as Peter mentioned, the gross margin, we -- Hollysys is now not only trying to increase our business volume, but at the same time, we are trying to increase our [kernel] capabilities so that we are guaranteed our gross margin in a kind of reasonable volume. So, I think that's my attitude, just a few comments on Peter's answer. Is that okay, Andrew?

Yes. That's great. That's very helpful. So, is it reasonable to expect the high gross margin for subway business will continue?

For the current gross margin of 40%-plus, I think, like I mentioned many times in the previous earnings calls, definitely you will see the quarterly lumpiness in terms of the margin, and we like to maintain a margin expansion over a four- to six-quarter trendline instead of looking at single individual quarters.

So, yes, like Dr. Wang mentioned earlier, we are striving to obtain higher business volume and, at the same time, maintain a higher margin. But also, you have to understand the -- due to this -- the size of contracts we recognize for the reporting period, it could create some kind of margin lumpiness here. For this quarter, definitely you are seeing a positive lumpiness of the gross margin, and we would encourage you to view our margin from a four- to six-quarter trendline perspective.

(Operator Instructions).

Okay. Thank you, everyone, for joining us on the call today. If we haven't got a chance to read your questions, we'll be pleased to answer them through follow-up contacts. We look forward to speaking with you again in the near future. Thank you. (Spoken in Chinese).

Thank you.

Thanks. Bye-bye.

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