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HollySys Automation Technologies (NASDAQ:HOLI)

Q3 2013 Earnings Call

May 16, 2013 9:00 pm ET

Executives

Jennifer Zhang - IR Director

Changli Wang - Chairman and Chief Executive Officer

Herriet Qu - Chief Financial Officer and Treasurer

Analysts

Chapman Deng - JP Morgan Chase & Co, Research Division

Saiyi He - Macquarie Research

James Winchester

Alex Chang - Citigroup Inc, Research Division

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Hollysys Automation Technologies Fiscal Year 2013 Third Quarter Ended March 31, 2013 Earnings Conference Call. [Operator Instructions] Please be advised that this conference is being recorded today, May 17, 2013.

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

Jennifer Zhang

Hello, everyone, and thank you for joining us. Today, our speakers will be Dr. Changli Wang, CEO and Chairman of HollySys Automation Technologies; Ms. Herriet Qu, CFO of Hollysys, and myself the IR Director of HollySys. On today's call, Changli will provide a general overview of our business, including some highlights for the quarter, and Herriet will discuss our performance from financial perspective, and a financial outlook for fiscal year 2013. Both Changli and Herriet will answer questions after their remarks.

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 future product introductions, the mix of products in future periods and future operating results. Such forward-looking statements, based upon the kind of beliefs and 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 those set forth in 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; decisions or changes in government incentive programs; potential trade barriers affecting international expansion; fluctuations in customer demand; management of revenue growth and transition 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 market acceptance of a 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. Please note that all amounts noted in this conference call will be in U.S. dollars, unless otherwise noted.

I'd now like to turn the call over to Dr. Changli Wang. Please go ahead, Dr. Wang.

Changli Wang

Thank you, Jennifer, and greetings to everyone. I would like to take this opportunity to address some key wins during this quarter. In the industrial automation, we unswervingly executed our originally set of strategies to further intensify our marketing efforts to expand sales and service network across China and enhance our market position. We are glad to see that the gradual recovery on new orders increase of industrial automation businesses, which we believe will bring solid financial performance in the upcoming quarters. New product lines including 5th Generation DCS, the Distributed Control System; SIS, Safety Instrumentation system; Batch; and other advanced control systems are gradually contributing more to the revenue growth, as these new products are supplementing our total solution, providing and building up recognition from the customers.

New businesses, like coal mining, safety solutions and machinery level control devices, are well in track for solid growth. Even though economic downturn still extends negative impact to our industrial automation businesses, and we continue to outperform market growth. However, we are not satisfied with the results achieved. Our efforts is to intensifying marketing efforts to enhance market position in low-middle end market and augmenting professional teams to tackle high-end markets will gradually reflect on the revenue and net income growth. Besides income, we believe that the intention to reduce labor costs and energy consumption, protect the environment, improve efficiency, will be the major trends and will bring us tremendous business opportunities.

With our R&D -- solid R&D capability and profound industrial knowledge, we believe HollySys is in a superior position as we pursue further growth in industrial automation market. The high-speed rail business recovery is much slower than we expected, but it will undoubtedly recover to its normal construction pace, as China is adhering to the 12th 5-Year Plan for the high-speed rail construction, given China strong demand for rail transportation.

In this quarter, we signed a contract to provide the Train Control Center and a Temporary Speed Restriction Server to Chongqing-Lichuan high-speed rail line, valued at approximately 5 -- or $6.54 million. Besides our effort in adversely penetrating domestic high-speed rail and subway markets, we were also exploring the overseas high-speed rail and subway opportunities, which we believe will be fruitful results for the yield in the future.

More excitingly, on April of this year, we successfully completed the acquisition of 100% ownership of our Singapore headquartered company, Bond Corporation Pte. Ltd., and is a group of companies to further establish our strong foothold in Southeast Asia. Bond provides complete mechanical and electrical solutions to a wide array of industries, including factories, data centers, banks, airports, commercial book centers, residential buildings and the infrastructure works, with a strong presence in Singapore and Malaysia. We are very pleased with this highly accretive and complementary acquisition, which will assist HollySys in penetrating to the fast-growing Southeast Asia area. We are also excited to be able to retain a team of seasoned professionals through this acquisition, which will form the foundation of our international team to greatly enhance HollySys'' capability to tackle the international market.

Going into the future, HollySys will leverage its strong proprietary technology and its capabilities accumulated from its leading position in China's rail and in the industrial segment, to enter and to penetrate into the international markets, through both organic growth and accretive acquisitions to maximize our customers -- our shareholder's value.

With that, I'd like to turn the call over to Jennifer Zhang, who will read the financial results, on behalf of the CFO, Ms. Qu. Okay, Ms. Zhang?

Operator

Ladies and gentlemen, your speaker is currently experiencing some technical difficulties with their lines. [Operator Instructions]

[Technical Difficulty]

Jennifer Zhang

Total revenues decreased by 8.7% to $60.4 million from $66.1 million for the same period in the prior year. Of the total revenues, revenue from integrated contracts decreased by 8.6% to $56.4 million, as compared to $61.8 million for the same period of the prior year. Revenue from product sales decreased by 10.9% to $4 million, as compared to $4.4 million for the same period of the prior year. The company's total revenue by segment was as follows: industrial automation, $38.5 million; Rail Transportation, $17.5 million; miscellaneous, $4.4 million.

As a percentage of total revenues, overall gross margin was 43.8% for this quarter, as compared to 39.3% for the same period of the prior year. The gross margin for integrated contracts and the product sales were 42.5% and 62.1% for this quarter, as compared to 37.9% and 59.9% for the same period of the prior year, respectively. The gross margin fluctuation was mainly due to the different revenue mix with different margin.

For this quarter, selling expenses were $5.3 million compared to $6.1 million for the same quarter of last year, representing a decrease of $0.8 million or 12.5% year-over-year. As a percentage of total revenues, selling expenses were 8.9% and 9.2% for the 3 months ended March 31, 2013, and 2012, respectively.

General and administrative expenses, excluding noncash stock-based compensation expense, were $6.4 million for this quarter, representing an increase of $1.4 million, or 29%, as compared to $4.9 million for the same period of the prior year, mainly due to an increase of $1.1 million of bad debt allowance.

As a percentage of total revenues, general expenses were 10.5% and 7.5% for the 3 months ended March 31, 2013, and 2012, respectively. Including the noncash stock-based compensation cost recorded on a GAAP basis, general expenses were $6.9 million and $5 million for the 3 months ended March 31, 2013, and 2012, respectively.

Research and development expenses were $7.4 million for this quarter compared to $5.6 million for the same quarter of the last year, representing a year-over-year increase of $1.8 million or 31.7%. The increase was mainly due to the company's increased R&D activities. As a percentage of total revenues, R&D expenses were 12.2% and 8.4% for the quarter ended March 31, 2013, and 2012, respectively.

The VAT refunds and the government subsidies amounted to $3.6 million for the quarter, as compared to $2.5 million for the same period in the prior year, representing an increase of $1.1 million. The income tax credit was $1.2 million for the quarter as compared to income tax expense of $2.5 million for the same period of the prior year.

During this quarter, Beijing HollySys, one of our subsidiaries, was certified as a Key Software Enterprise for calendar year 2011 and 2012, and applied to a preferential income tax rate of 10% retroactively from January 2011 to December 2012. The company, thus, recognize an income tax credit of $2.7 million during this quarter. Excluding this impact, the income tax expense and the effective tax rate were $1.5 million and 14.5% for the 3 months ended March 31, 2013.

The non-GAAP net income attributable to Hollysys, excluding noncash stock-based compensation expenses for this quarter, was $11.7 million or $0.21 per diluted share based on 56.4 million shares outstanding. This represents a slight increase of $0.1 million, or 0.6%, over the $11.6 million, or $0.21 per share based on 56 million shares outstanding, reported in the prior year period.

On a GAAP basis, net income attributable to Hollysys was $11.2 million, or $0.2 per diluted share, representing a decrease of $0.3 million or 3% over the $11.5 million or $0.21 per diluted share reported in the prior-year period.

HollySys' backlog as of March 31, 2013, was $374 million, representing an increase of 4% compared to $359.6 million as of December 31, 2012, and a decrease of 6.9% compared to $401.8 million as of March 31, 2012. The detailed breakdown of the backlog by segment was as follows: industrial automation, $146.3 million; Rail Transportation, $202.9 million; miscellaneous, $24.8 million.

The net cash provided by operating activity was $13.4 million for the 3 months ended March 31, 2013. Including investing and financing activities, the total net cash outflows for this quarter was $14.9 million, mainly due to a $12 million deposited in banks from current accounts to time deposits with maturities between 6 months to 1 year, and a $16.4 million prepaid for the acquisition of Bond Group.

The total amount of cash and cash equivalents and time deposits with original maturities over 3 months were $128.9 million, $133.5 million and $126.2 million as of March 31, 2013, December 31, 2012, and March 31, 2012, respectively. Of the total $128.9 million as of March 31, 2013, cash and cash equivalents were $110.4 million, and time deposits with original maturities over 3 months, were $18.5 million.

For this quarter, days sales outstanding was 250 days as compared to 160 days year-over-year and a 161 days quarter-over-quarter. The inventory turnover was 78 days as compared to 68 days year-over-year and a 42 days quarter-over-quarter. The increase of DSO in this quarter was mainly due to the decrease of a total revenue compared with last quarter.

The accounts receivables as of March 31, 2013, only increased $0.1 million, as compared to the end of last quarter. Due to the unexpected delay of high-speed rail orders and a weak macro economy's impact, we are revising our previously communicated fiscal year 2013 revenue guidance of $385 million to $410 million, down to $335 million to $355 million and non-GAAP net income guidance of $63 million to $67 million, down to $57 million to $60 million.

Going into the future, we believe with the recovery of the high-speed rail construction, further penetration into the industrial automation and the revenue supplement from overseas market, HollySys is well-positioned for stable and sustainable growth, leveraging its leading proprietary technology, strong innovation and execution capabilities to create a long-term value for our shareholders.

At this time, we'd 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. [Chinese] Operator, please?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Chapman Deng from JPMorgan.

Chapman Deng - JP Morgan Chase & Co, Research Division

I have 3 questions. The first question is on the -- I noticed that you recorded very strong new order rebound in industrial automation, may I know what's the reason and also, which sector do you see the highest growth? And also, I want to know the new order outlook in the coming quarter? That's the first question. The second question is regarding -- despite dissolved revenue this quarter, however, I noticed that the GP margin actually were a historical high, may I know the reason behind? And also, on an apples to apples basis, what's the GP margin trend, both Q-on-Q and on year-on-year trend? That's the second question. And the third question is on your -- based on your updated net profit guidance for FY '13, basically, you are expecting a very strong rebound in Q4 net profit, around USD 17 million to USD 20 million. May I know where do you see the growth above, basically from which segment?

Changli Wang

Okay. Thank you, Chapman. And I would like to answer those questions. For the first one, as I just mentioned that for the industrial segment, the industrial automation segment, new orders began to rebound again, but not that significantly but is still faster than before, better than before. And considering the execution time period of the industrial projects, I think the real effect in revenue and the net profit will be shown later, not in the next quarter. So the main reason is, as I said last time in the conference call, that we, before in the last year, the whole last year, we're really sorry that we underestimated the condition in China, I mean in the industrial automation area. So we just carried the original policy but we didn't [Chinese] the sales force and especially the high-end market. But since the result of last year is not very good, I mean, the last calendar year is not very good, not satisfactory. So at the end of last year and early this year, we started to analyze the economy and also, the market situation. So but the result, we set up the new strategy. First of all, we strengthened the sales force in the lower end -- the medium-end market by taking much share still more. And secondly, we set up a dedicated force for the high-end market, to penetrate the high-end market. The high-end market now is showing some impact now, but in the market -- but the real result in the revenue and the profit will be shown later. But I'm pleased to see that our actions has shown some effect, this I want to [indiscernible]. For the second question, the gross margin of this quarter is high. I think it's mainly because the business mix is a little bit different from last quarter. As I mentioned before, in HollySys, we cannot judge every quarter for the gross margin, because sometimes, if we had a very big project for the high-end, high-margin project got finished, then in that quarter, the margin will be highly affected. But if there is no good project executed at that quarter and we have more medium and the lower margin projects finished, then the margin in that quarter will be slower -- will be lower. So generally, we give the margin in a yearly basis is around reasonable. So you just asked the question, whether in the next few quarters, the margin will remain at that high level, I cannot guarantee. You see -- we will see HollySys, we will try to guarantee that we maintain the gross margin in a yearly basis, as every year. We do not sacrifice our margin for market share, but we cannot say that we can increase, or maintain a very high margin in this very competitive market. Okay, Chapman? And the third one, the third question is for the net income guidance is the -- we feel -- I've been feeling very depressed, I mean, these few months since we did not beat the market. And I really feel very sorry for that, and we have been working on this. So -- but when we study the next quarter, because it's only 1 -- a little more than 1 month left in this quarter, so we do not want to give a very optimistic guidance for this year. And we should say that if there is no very big events, negative events happens to our company, we will try to, I mean, to beat the guidance. So that's why we do not want to put a higher guidance, and then we miss again. Okay, Chapman. Thank you.

Operator

Your next question comes from the line of Saiyi He from Macquarie Capital.

Saiyi He - Macquarie Research

I have a question on the gross profit margin. Can you -- is the Railway Transportation segment margin relatively stable and also, for our overseas business, can you just give us guidance how the margins there in terms of the overseas project you're seeing? That's my first question. And my second question is, if you can ask Ms. Qu to give us estimate, the amount of VAT refund we're going to receive for the full calendar year.

Changli Wang

Okay, okay. So for the first question, I'll answer the first question, and Ms. Qu will answer the second question, okay? The first question, I'm very pleased to see that so far, our high-speed rail business margin has remained, because although, I mean the railway authorities have changed a lot, but still since there is a highly critical safety system, so they cannot sacrifice the price for, I mean, for safety. So in that case, we have maintained the margin for that. And for the overseas projects, so far, we have different projects and different areas. Urole [ph], the project in the Middle East, tend to have a higher margins and also, for the Rail businesses, the margins are very good for the subway projects, the margins are very good. But on commercial projects, which we are not doing very much, the margin tend to be lower, because now in -- as you see, the Singapore economy is not very active. So we have been concentrating on the Middle East and also, on the bigger projects like the subway and tunnel, this kind of big projects sponsored by the government, okay. For the second question, I'll turn to Qu then. Okay.

Saiyi He - Macquarie Research

Sorry, Mr. Wang, but can you just clarify in terms of overseas business how is it relative to the domestic business in terms -- if can you give us a range?

Changli Wang

You mean the margin?

Saiyi He - Macquarie Research

Yes.

Changli Wang

I think it's -- on average, it's a little bit lower than the Chinese market, because we have a higher end market in there. It's similar to industrial automation, I should say. Thank you. Okay, Ms. Qu, you answer now the question, okay?

Herriet Qu

[Chinese]

Jennifer Zhang

Okay. Currently, there's no change about the VAT policy.

Herriet Qu

[Chinese]

Jennifer Zhang

Although it's now more for our cash received. Does that answer your question, or any more questions?

Saiyi He - Macquarie Research

Yes. So percentage wise, it would be similar to your previous years then?

Jennifer Zhang

[Chinese]

Herriet Qu

[Chinese]

Jennifer Zhang

Okay. There's no positive change because of the VAT refund from the policy. So in the absolute value, we are getting the similar amount of VAT refund for this calendar year.

Operator

Your next question comes from the line of James Winchester from QVP.

James Winchester

Dr. Wang, I have a question about your guidance. You have given a guidance of revenue for 2013 of $335 million to $355 million, which implies $100 million in the fourth quarter and it was -- I don't know if this question was asked before, but how much of this would be coming from the Bond acquisition?

Changli Wang

Okay. I would like Qu then to answer this question, okay?

Jennifer Zhang

[Chinese]

Herriet Qu

[Chinese]

Jennifer Zhang

Less than 10%.

James Winchester

Less than 10%? Okay. So basically, you're suggesting about $10 million from Bond, is that correct?

Jennifer Zhang

Around $10 million from Bond.

James Winchester

Yes. Okay. And to follow that up, how do Bond's margins compare with HollySys'?

Changli Wang

As I just said...

Herriet Qu

[Chinese]

Changli Wang

Okay, I'll answer this question, okay. So far, historical, through historical data, we'll see the Bond margin is just around HollySys industrial automation part, a little less than that. Some projects are higher, some projects are less, just around industrial automation part.

James Winchester

Okay, all right. Finally, when do you expect to give -- well, actually, I was very impressed with the amount of cash that you had at the end of the quarter, even after making a significant payment towards the Bond acquisition. My question is, do you have any other acquisitions like Bond or a possibly, other things that you have on the plate that you think are opportunities in the next, say, 6 months or so? 3 to 6 months?

Changli Wang

Thank you, a very good question. In fact, I'll be asking myself all the time. In fact, really there's 2 of that, we still reserve quite a lot of cash in our pocket. Just, first of all, we were very conservative company so far, and because we have seen some companies crash because of run out of cash, so we have been very conservative in that way. But secondly, we are still looking forward to -- if we find some good opportunities to acquire, we will do that. So we will not acquire for acquisition, but if we -- we will not stop doing that kind of work, okay?

James Winchester

All right. And have you provided 2014 guidance yet?

Changli Wang

Not yet. We will, yearly, we will provide guidance in the -- in our fiscal year announcement.

Operator

We have a question from the line of Alex Chang from Citigroup.

Alex Chang - Citigroup Inc, Research Division

I mean, Dr. Wang, Ms. Qu and Jennifer, I'm Alex from Citigroup, and I will cover HollySys going forward. So my question is -- first, is some follow-up questions about the [indiscernible]. The first is regarding to the new orders from the industrial automation, can you give some details for example, is it a split between the low-end and the high-end orders, I mean we have some new products coming for the past quarter maybe, how much is the contribution from the new products? And the second question has to do about the GP margin. And I know that the margin for the industrial automation will depend, maybe it depends on the single project, but is it very different for the different industries and -- sorry, which industry will have high margin among the industry automation? And the third one is about our R&D expense, and I noticed that the R&D expense percentage increased a lot in the third quarter. Is this will be maintained going forward?

Changli Wang

Okay. Thank you very much, very good questions. But I do not want to answer them, in fact. For the first question, for the new orders, how much from low end, how much from high end, and how much from the new markets. I will say, we will try to rebound from all these sides, and for the new products, I want to elaborate just a little bit. Our SIS system has been demonstrated in the field, so far, so good, and our 5th Generation DCS now is proven to be very good, and not only by our customers, but also by some other parties but I will not mention the names. And so we are very confident in the future for our new products. And for the lower end and the higher end, I do not want to mention the specific data, because this is quite sensitive. I do not want to attract too many competition in this area, okay. And for the margin as well, we do have some products with very high margins, especially some products we tailor-made for some customers, and in this kind of products we really enjoy a very good high margin and also, because that product has experienced expertise in that kind of products built-in. So really, the customer has no choice, they have to buy our products in some areas. And we do have some lower margin areas with very fierce competition. For example, power industry for example. Power industry, the power industry has been -- the market has been decreasing all these few years and we have been gaining market share all these years and now we will be the largest market shareholder now in China, and we are sure of that in the power they are recovering in the future, the power market. But inside -- even inside the power industry, we have some products with a higher margin, we have some products with a lower margin. So that's why we have been balancing Hollysys overall margin gross margin mostly all these years, okay. And the third question, for the R&D expenditure, this quarter is very high, I noticed that as well, it's not because we spent much more in this quarter for new projects, but because we have designed a lot of safety systems, the sales force [ph] safety systems. And quite a lot of them got certified in this last 2 quarters. So the payment of this certification fee is concentrated and mainly in this quarter, so just to make it extremely high compared to the previous quarters. But it's Hollysys policy to maintain a reasonable high investment in R&D but not too high. So I'm sure we will evaluate all the R&D expenditure in more detail, more systemically in the future. So we will try to maintain, I think, 6% to 8% of our revenue is normal.

Jennifer Zhang

Okay. Thank you, everyone for joining us on the call today. Due to time constraints, if you haven't got the chance to raise your questions, we'll be very pleased to answer them through follow-up contacts. We look forward to speaking with you again in the near future. Thank you. [Chinese]

Changli Wang

Thank you very much.

Operator

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

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