Hollysys Automation Technologies Ltd (HOLI) 2018 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Hollysys Automation Technologies Earnings Conference Call for the Fiscal Year 2018 Third Quarter Ended March 31, 2018. (Operator Instructions) Please be advised that this conference is being recorded today, May 15, 2018, Beijing time.

I would now like to hand the conference over to Mr. Arden Xia, the Investor Relations Director of Hollysys Automation Technologies. Thank you. Please go ahead, Mr. Xia.

Hello everyone, and thank you for joining us. Today, our speakers will be Mr. Baiqing Shao, CEO of Hollysys Technologies; and myself, the IR Director of Hollysys. On today's call, Mr. Shao will provide a general overview of our business, including some highlights for the third quarter of fiscal year 2018, and I will, on behalf of CFO Ms. Qu, discuss our performance from a financial perspective. And we will answer questions afterwards.

Before getting started, I would like to remind everyone that this conference call may contain forward-looking statements within the meaning of Private Securities Litigation Reform Act of 1995. Forward-looking statements that are not historical facts, including statements relating to the expected growth of HollySys' future product introductions, the mix of products in future periods and future operating results. Such forward-looking statements, based upon the current beliefs and the expectations of HollySys' management, 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 the 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 engaged; cessation 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 of new and superior products by other providers of automation and control system technology; timing, approval and the 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 SEC.

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 in its filings. Please note that all amounts noted in this conference call will be in U.S. dollars unless otherwise noted.

And now I would like to turn the call to Mr. Shao. Please go ahead, Mr. Shao.

Thank you, Arden, and greetings to everyone. I would like to discuss some key events during this quarter.

Industrial automation recorded a 20% year-to-year growth in quarterly revenue at $45.7 million and a 55.6% year-to-year growth in quarterly contract at $82.2 million. Management's low-to-high end market expansion strategy has led to a healthy contract growth, especially in chemical and in petrochemical.

Contracts covered a broad range of products, such as DCS, SIS, DEH, MES and AMS, et cetera. Several major contracts were signed, such as providing system for Henan Kelong Group, Shanxi Guangda Coking on their energy management project, and Zhong'an Lianhe Coalification Company on their methanol and olefin conversion project.

We are also building comprehensive capacity to address the substantial service and upgrading potential from the entire customer base. On the coal fire, while maintaining our marketing share in the high-end market, we have been actively responding to demand and environmental protection, energy saving, control optimization and information security, et cetera.

Similar, demand has also been spotted in other industries. With our widespread national service network, we are capable of communicating with and delivering to our customers from various industries regular and value-added customization services and the products they need.

In Factory automation, we adhered to our demonstration-for-further application strategy and proceeded deeper in the cooperation with our current customer base. On food and beverage, we continued to provide innovative solution to address safety and efficiency issues for Haidilao with a new project covering automatic dish serving, dipping source making and smart cleaning.

Management team will continue to seek strategic cooperation with more renowned customers to address the increasing demand from discrete automation. With productive sales and the customized solutions already being delivered for the time being, our team is also making effort to get Hollysys' production line more ready for the era of intelligent manufacturing. The R&D is currently underway for a future-oriented industrial Internet platform aiming to make better use of industrial data for a higher level of efficiency, digitalization and automation in manufacturing.

Rail business recorded a 30.9% year-to-year growth in quarterly revenue at $45.5 million, while quarterly contract declined year-to-year by 24.6% at $37.9 million. Few contracts on ATP were signed in this quarter and the visibility of CRC bidding remains to be observed.

In overseas business, we signed a maintenance contract with a Hong Kong MTR with a service duration of 3 years. In Subway, we continued to execute signed contracts, while strengthening our marketing capacity through reviewing and upgrading strategic partnership and improving local service network coverage. Management team will adhere to the diversity strategy to create the revenue stream from more new products and services and to maintain a stable and healthy growth into the future.

In oversea business, we continued to seek opportunities under the Belt and Road Initiative, signed several EPC contracts with a domestic company, including a contract with Shenhua Guohua Co., Ltd to provide DEH for 2X350 megawatt power station in Indonesia. Our effort to strengthen operating management and risk control in mechanical and electronic installation services has worked efficiently, with a quarterly revenue recorded at 59.4% year-to-year growth at $29.4 million and a 303.0% year-to-year growth of quarterly contract at $21.2 million. We will continue to address the operation, management and risk control issue and to closely follow the economic and political circumstances in Southeast Asia and the Middle East.

With that, I would like to turn the call over to Arden Xia, who will read the financial results analysis on behalf of CFO, Mr. Harry Qu.

Thank you, Mr. Shao. I would like to share some highlights for the fiscal year 2018 third quarter ended March 31, 2018.

Comparing to third quarter of the prior fiscal year, the total revenues for the third quarter increased from $91.3 million to $120.6 million, representing an increase of 32.1%. Broken down by the revenue types, integrated contracts revenue increased by 34% to $104.7 million; product sales revenue increased by 1.7% to $9.9 million; and the services revenue increased by 76.2% to $6 million.

The company's total revenues can be also presented in segment; 3 months ended March 31, industrial automation, $45.7 million; railway transportation, $45.5 million; M&E, $29.4 million; total, $120.6 million.

Non-GAAP gross margin was 66.4% for the third quarter as compared to 30.7% for the same period of prior year. The non-GAAP gross margin for integrated contracts, product sales and service rendered were 30%, 81.2% and 73.6% for the third quarter as compared to 24.4%, 65.2% and 78.8% for the same period of prior year, respectively.

The gross margin fluctuation was mainly due to the different revenue mix with different margin. The GAAP overall gross margin, which includes noncash amortization of acquired intangibles, was 36.4% for the third quarter as compared to 30.7% for the same period of prior year. The GAAP gross margin for integrated contracts, product sales and service rendered were 30%, 81.2% and 73.6% for the third quarter, as compared to 24.4%, 65.2% and 78.8% for the same period of prior year, respectively.

Selling expenses were $6.2 million for the third quarter, representing an increase of $0.2 million or 4.1% compared to $6 million for the same quarter of prior year. Presented as a percentage of total revenues, selling expenses were 5.1% and 6.5% for the third quarter of fiscal year 2018 and '17, respectively.

Non-GAAP G&A expenses were $7.6 million for the third quarter, representing a decrease of $1.2 million or 13% compared to $8.8 million for the same quarter of the prior year. The decrease was mainly due to a decrease of $2.3 million in [bad debt] provision. Presented as percentage of total revenues, non-GAAP G&A expenses were 6.3% and 9.6% for the third quarter of fiscal year 2018 and '17, respectively. The GAAP G&A expenses, which included the noncash share-based compensation expenses, were $7.9 million and $6.8 million for the third quarter of fiscal year 2018 and '17, respectively.

R&D expenses were $8.8 million for the third quarter, representing an increase of $2.7 million or 43.7% compared to $6.1 million for the same quarter of the prior year, mainly due to increased R&D activities. Presented as a percentage of total revenues, R&D expenses were 7.3% and 6.7% for the third quarter of fiscal year 2018 and '17, respectively.

The VAT refunds and government subsidies were $3.9 million for the third quarter as compared to $5.5 million for the same period in prior year, representing a $1.6 million or 29.4% decrease, which was primarily due to decrease of the government subsidy for $2.6 million.

The income tax expenses and the effective tax rate were $4.6 million and 17.2% for the third quarter as compared to $4.4 million and 22.1% for the comparable prior year period. The effective tax rate fluctuation was mainly due to the different pretax income mix with different tax rates as the company's subsidiaries apply to different tax rates.

The non-GAAP net income attributable to Hollysys, which excludes the noncash share-based compensation expenses, which is calculated based on the numbers of shares or options granted and the fair value as of the grant date, amortization of acquired intangible assets, fair value adjustments and acquisition-related consideration and the fair value adjustments of bifurcated derivative was $22.1 million or $0.36 per diluted share based on 61.3 million shares outstanding for the third quarter. This represents a 61.1% increase over the $13.7 million or $0.22 per share based on 61.2 million shares outstanding reported in the comparable prior year period.

On a GAAP basis, net income attributable to Hollysys was $21.8 million or $0.36 per diluted share representing an increase of 39.8% over the $15.6 million or $0.26 per diluted share reported in the comparable prior year period.

Hollysys achieved $141.3 new contracts for the third quarter, and the backlog as of March 31, 2018 was $578.9 million. The detailed breakdown: new contracts, industrial automation, $82.2 million; railway transportation, $37.9 million; M&E, $21.2 million; total, $141.3 million. Backlog: industrial automation, $186 million; railway transportation, $275 million; M&E, $117.5 million; total, $578.9 million.

For the third quarter, total net cash inflow was $6.9 million. The net cash provided by operating activities was $5 million. The net cash used in investing activities was $5 million, mainly consisted of $29.9 million time deposits placed with banks, which was partially offset by $26.6 million maturity of deposits. The net cash used in financing activities was $0.1 million, mainly consisted of $0.5 million pre-payment of short-term bank loans, which was partially offset by $0.4 million proceeds from short-term bank loans.

The total amount of cash and cash equivalents and time deposits with original maturities over 3 months were $385 million, $365.4 million and $268.8 million as of March 31, 2018, December 31, 2017 and March 31, 2017, respectively. As of March 31, 2018, the company held $238 million in cash and cash equivalents and $147 million in time deposits with original maturity over 3 months.

For the third quarter, DSO was 196 days as compared to 218 days for the comparable prior year period and 147 days for the last quarter. And inventory turnover was 63 days as compared to 62 days for the comparable prior year period and 48 days for the last quarter.

Based on our backlog currently on-hand and sales pipeline envisioned so far, we reiterate our guidance for fiscal year 2018 with revenue in the range of $500 million and $530 million and non-GAAP net income in the range of $100 million to $110 million.

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

(Operator Instructions) Our first question comes from Alex Chang from Citigroup.

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Thank you, Alex. The first question focused on industrial automation, and this quarter, the new contract is -- compare increased a lot. And can you say something about, for example, like the chemical, petrochemical and the proportion of this part and also the power sector for the process control? And also, I want to know exactly the process control, what about the Factory automation contributed for the new contract of IA? And also, the last one is for the upcoming period, how about the industrial automation, can maintain such level of the contribution of new contracts? And the second question is for the bidding for the CRC. And recently, we could see that the bidding pipeline is also not too much, just a few by the corporate CRC. How about the delivery of 1 project? For example, the Guangzhou-Shenzhen-Hong Kong, that line, what about the time schedule for that line in operation? And also how about the upcoming, like the fourth quarter, the pipeline from the bidding of the China Railway Corporation? The last question is about the R&D expenses. Right now it increased fast and how -- what's Hollysys' focused areas within the expenditure? And also in future, about the absolute value, we'll maintain this level or the proportion of the R&D expenses?

(Spoken in foreign language)

The first question -- answer, actually, yes, the chemical and petrochemical, we are focusing on this area and we do a lot of activity. For example, we import a lot of experts within this area to the company. And also, we participate in a lot of industry-level conference to broaden our power within this area. And right now, about the proportion for the FA and PAs, the process control takes 90% of IA and around 10% from the of FA of IA. And within the PA, the chemical, petrochemical take around 40% of the process control revenue, and the power take also like 40% of the process control revenue.

(Spoken in foreign language)

The railway transportation right now, China Railway Corporation, CRC, is under the reform of the corporate system, so a lot of top line procurement is delayed right now. So that's why we are working and focused on the maintenance service after sales, this part, as the supplement. And actually, like the Shenzhen-Guangzhou-to-Hong Kong, that line, we recently signed a contract for the maintenance service. Contract size around HKD 280 million, and we will continue to focus this area to support. And by the way, the CRC procurement is delaying and we could see it going to start bidding for the second half of this calendar year. So that is to say, for the next -- the coming fiscal year. And we think, from the revenue part, it cannot affect it too much because we recognize revenue followed by percent of completion. But from the new contracts, the upcoming fourth quarter may be still in a challenge, but we also will focus on the maintenance, the other things at the supplement.

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About the R&D expenditure, right now we focus on 2 areas. One is the high-speed rail, for example, like the C2, 200, 250 kilometer power segment. We are under the research and development for the new standard [multiple] train for the CRC. And the second part is for the digital intelligence platform. This is, right now, starts from the factory automation. But at the end, it will implementing to support other business by our side. For example, no matter PA or FA, or even the transportation also could use this platform. For the future, no matter absolute value or the proportion, we are going to maintain our stable, like the proportion, for example, between 60% to 80% and we will focus on efficiency, productivity. Thank you.

Your next question comes from Thomas Zhang from Morgan Stanley.

(Spoken in foreign language)

The first question is about the gross margin. And actually, right now gross margin is still very good. But the explanation for this kind of change is by the structure of the business tax. But naturally, from my perspective view, it's not very sharply to performance by the different structure. Can you explain more further about this area? And is it sustainable for this gross margin for the future? And the second question for the industrial automation, we could see the whole industry from 2017 to now 2018, the industry is a little recovering and good. The upcoming will maintain this momentum? Or you will do some self -- can structure to do the other business allocated resources to increase the industrial automation to maintain this level? And the third part question is about we double check for the proportion of the process control, about 40% of process control revenue contributed by chemical and petrochemical and 40% from power? And the fourth question is about the high-speed -- about the new product within the railway transportation, like the track circuit, like the subway signaling. Is there any update for this area?

(Spoken in foreign language)

The first question about the gross margin. And actually, it's not just -- it depends on the structure of the business, as everybody knows, the industrial automation roughly between 35% to 40% and the railway transportation between 40% and 50%, M&E, just around 10%. So this mix can lag the gross margin change. But also we want to emphasize another thing is that we are -- we have a lot of project within one year. For example, thousands of the project, especially within the IA. So a part of the project to [enter] the 30% of the IA, and the part of the gross margin above 35%. So this can also mix by the different projects and also we emphasize some part of the high contribute gross margin contract like the nuclear power. And also, right now the service contract is increasing very fast and also the service contract roughly above at least 50% of gross margin. So this is -- these factors will account for the changes of the gross margin. But we will maintain the gross margin between 35% to 40%, this range.

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Okay. I'll translate first. The second question for the industrial automation, actually from 2017 to 2018, the market is recovering. Even not too strong, but we also [help] construct our business and to focus on -- especially on chemical, petrochemical area. And for example, we host a lot of conferences within our factory to introduce hundreds of customers and experts together and to let them know our products, know our strengths within the chemical and new solution to the new chemical and petrochemical. So this works, and that's why this part also contributed to IA increase by our revenue. And the third question about the proportion, let me introduce the industrial automation, 90% of the industrial automation revenue from the process control. And within the process control, 40% -- roughly 40% from the chemical and the petrochemical. The other 40% is from the power. Power, by the way, includes the coal fire, new energy and thermal power. The fourth question about new product within the rail and the track circuit, we just got the regular speed license and we already gathered -- we are focusing on the high-speed rail license of track circuit there, and right now, we already got our test online. And the test line, it will start in operation at least 1 year, I mean, roughly around one year. So we could negotiate part of it after one year. So we can start the license process by CRC. And the subway signaling, right now, we are working on it. So just, we hope to bring the new information in the future.

(Spoken in foreign language)

The first question, demand for the industrial automation increase, we could hear about you are opening some -- a lot of conferences focused on the customer and also experts to introduce your product. But I think, this is most reflected by from the new contracts. However, the industrial automation revenue, I still worry about the power, especially coal fire. And this part is the drive by the history of Hollysys. So right now, can you talk a little bit, distinguish about the power and chemical? For example, like right now the revenue, the coal fire still the main drive or power is still the main drive? And also, maybe this sector, the power clients, call it, more better than the chemical, or the gross margin still have difference? This is the first question. And the second one, for the railway transportation, we can see a lot of the new maintenance service contracts. Can you introduce a little bit about this area, what kind of specific thing you are doing for the maintenance? For example, like ATP, Automatic Train Protection, if this one needed the maintenance, in my knowledge so far, it's just a replacement at the end of the lifetime. Still need any maintenance during the period before the lifetime? And the third question for the operating cash flow, in this quarter, compared decrease. Why? The first and second questions will be answered by Mr. Shao.

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The first question about the revenue compare, about the chemical, petrochemical and also power, and also we worry about the coal fire. And the answer is, naturally, this area, the differences, from the clients have no too much differences because no matter chemical, petrochemical or the coal fire or power, still have the high-quality customer and also have the small projects from this small clients. Like -- but we will focus on different level, have a different team to negotiate with the customer. And we want to emphasize the coal fire, right now, from the absolute value is maintained stable, but the proportion is declining because the other area is growing like the thermal, like the new energy. And in thermal, we emphasized on this more capacity project and this part, no matter from the local heating or local support productivity, [steam] support, those kinds of things, is growing very fast. And the gross margin is dependent on different projects and the same thing, chemical, petrochemical also have low margin, high margin. So it's based on the project matter.

And the second question for the high-speed rail maintenance, we -- in this area, we provide maintenance like the checking, like the support operating, like the training, no matter from the software or hardware. And the Hong Kong MTR project, for example, we signed a new service contract, is focused on the -- to secure within 3 years about the smooth operation of our devices and checking and also to training their people to take care of the equipment. And ATP also need maintenance. For example, the whole high-speed rail is running regular at the daytime and night is stopped for the checking, for the maintenance to support the second day in operating smooth. So that's why the maintenance is also divided by the low level and high level from 1 to 4. So this is for the maintenance.

And the last question for the operating cash flow, this quarter compares a little, not strong, but actually from the first 9 months, we could see the operating cash flow still very strong, more than USD 17 million. And we think the operating cash flow is positive, is positive, is still good, rather than a specific number. But however, by the history of Hollysys, the operating cash flow always positive and roughly around $14 million, $17 million. And right now, from 9 months, you see is still very strong, and we think the whole year, fiscal year, will maintain a good momentum.

And because of the time restraint, one more last question. Please, operator.

Your next question comes from (inaudible) from Bernstein.

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The first question about the proportion of IA and FA contributed from the net income, but I already make supplement. I said, actually, we give the proportion of former is by the revenue, not the net income. The net income partly to divide by the FA and the PA because the expenditure, we do not disclose these data. But from the revenue, just like what we said, the proportion, 90% for PA, 10% of IA of revenue supported by the factory automation. And also, the supplemental question is about the gross margin and the growth rate by the PA versus factory automation, FA. (Spoken in foreign language)

(Spoken in foreign language)

The increased rate by the PA and FA and industrial automation may be faster than the PA because the base is also smaller. And currently, still not contribute too much, it's 10% of IA revenue. But the growing speed would be more faster and we are focused in this area and we hope it can support as the key driver of IA in the upcoming years. And the gross margin, not too much difference because the industrial automation also like the project, or like the integrated contract, including the product by ourself and software and also implementing of the project, engineering. So the gross margin, just like the IA average, 35% to 40%. Maybe some particular, first, the contract for the demonstration may be lower than that, but we still focus on the gross margin within this level.

Thank you, everyone, for joining us on the call today. If you haven't got a chance to raise a question, we are pleased to answer them through follow-up contacts. We're looking forward to speaking with you again in near future. Thank you.

(Spoken in foreign language)

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