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HLS Systems International Limited (NASDAQ:HOLI)

F4Q09 (Qtr End 06/30/09) Earnings Call

August 18, 2009 9:00 am ET

Executives

Wang Changli - CEO

Peter Li - CFO

Herriet Qu - Treasurer

Analysts

Mark Tobin - Roth Capital

Michael Weisberg - Crestwood Capital

Adam Hershey - SIAR Capital

Robert Chu - Jim Cowan

Alice Ku - Broadwell Capital

Operator

[Call Starts Abruptly]

lumpy quarter-to-quarter.

Moving to the balance sheet Hollysys have maintained a strong financial position as of June 30, ‘09 Hollysys cash and cash equivalents were $128.9 million compared to $106.2 million at March 31, ‘09 and $64.3 million at beginning of the fiscal year.

Inventory turnover is 79 days for the fiscal year ended June 30, ‘09, compared to 84 days at beginning of the fiscal year. DSO for fiscal ‘09 is 147 days, significantly reduced from 167 days for the prior year.

During this quarter the long-term bank loan increased by $24.9 million this is the government subsidized loan, which is virtually a free lending to Hollysys.

In conclusion from the management perspective, we are very pleased with our performance results for fiscal '09 with substantial financial and operational improvement. Given the great prospect we see in the market segments we target and our current leadership position, we project our fiscal 2010 revenues to be in the range of $185.9 million to $192.2 million.

We expect our fiscal 2010 non-GAAP net income to be in the range of $30.3 million to $31.4 million, which will translate into EPS of $0.61 to $0.63, based on expected 50 million shares outstanding.

We are confident to continue delivering superb financial performance for the coming fiscal and creating long-term value for our shareholders.

Herriet Qu

Thank you, Peter. At this time we would like to open up the floor for questions-and-answers. Operator, please go ahead open up the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Mark Tobin with Roth Capital.

Mark Tobin - Roth Capital

The question I guess, looking for little bit more color on the 2010 guidance. Can you give us an indication of your expectations for each of the segments and how those get those to that 20% growth?

Peter Li

Sure, Mark. From the historical record of fiscal ‘09, our high margin, high growth segments, such as high-speed rail, subway and nuclear increased by approximately 100% year-over-year compared to ‘08. Our industrial core business increased roughly by about 5%.

Going forward we continue to see strong market sales pipelines in these high growth, high margin business areas. So, we expect to continue to see the percentage of high-speed rail, subway and nuclear taking a more and more percentage of the total revenues. I think with regard total revenue guidelines, we provide this range, we are confident given the current market opportunities.

Mark Tobin - Roth Capital

In following up on that, I noticed that there is more mention of subway, are you gaining traction within that segment or you looking to finally break into some higher margin projects there?

Peter Li

Yes. As you know, we increased our R&D activities from the beginning of this calendar year '09. Subway signaling system is one of the key initiatives we undertake in R&D areas. As you know, in this Subway signaling system market in China, currently mainly dominated by foreign players and currently in 10 major cities in China including Beijing, Shanghai, Guangzhou, there are altogether about 393 kilometers of subway in operation.

According to government plan by 2050, there will be 125 lines in operation with total operating kilometers reaching 2,600 kilometers. So, according to government statistics between 2009-2011 the subway lines which will be started for construction amounted to about 32 lines.

So, with such huge market, mainly driven by China's Urbanization and Economic Development and we view this market just as large as high-speed rail going forward, but with much longer timeframe in terms of government spending and market expansion.

So with our investment in this area, especially in the subway signaling system, we expect to crack through this foreign dominating market in a near future by winning the first couple contracts while definitely signaling the foothold of Hollysys in this fast expanding market.

Operator

Your next question comes from the line of Michael Weisberg with Crestwood Capital.

Michael Weisberg - Crestwood Capital

A couple of things. The rail business you did in the fourth quarter, I saw it was a little unusual than that you received in order and shifted really within the same quarter. Was that a sort of an unusual situation or is that more like what might happen in the future in the rail business?

Wang Changli

Actually it is an unusual situation. Within the month we shifted system, this is very unusual, but from this we can see that the speed of and the timeframe before, it would have take 18 months or 20 months or 24 months. Now they have tracked the time interval between the signing of the contract to the delivery of the system, but nevertheless one month is too short. We expect maybe in the future for this material market because this is a project, it's for the 250 kilometers of rail system, but this kind of material products and the material lines, we’re expecting the time interval between six months to nine maybe that's normal.

Michael Weisberg - Crestwood Capital

I see. Your level of revenues, it was a huge jump to 15 million in the quarter. Is that a sustainable level of revenues or should we expect that to drop down and then build up during the course of the year?

Peter Li

Well, Michael I think given some of the seasonality of our revenue on quarterly basis going forward, we don’t give out the quarterly guidance. I think with the annual guidance, which will really give you a good idea of where we stand on annual basis, I think that's sufficient for guiding the street.

Wang Changli

This time the whole worries on the prices, I mean of course we are quite lucky that we prepared for this before and we have made some big progress even in this kind of the hard time. For the future this deal from our backlog and from the market opportunities we're expecting, I am sure we can see, we are more certain about a one year guidance rather than quarterly because some of the opportunities maybe delayed, some of the opportunities maybe drop in, but at this time of the year we cannot really exactly same, I mean quarterly. Maybe with our business growing more steady and also with the economy become more stable I think we can give more clearer quarterly guidance.

Peter Li

Michael, just let me add a little bit more color on this. I think with Hollysys track record of delivering a solid results quarter-over-quarter, I think investors should be assured, well assured about we’ll continue to deliver strong financial results every quarter.

Michael Weisberg - Crestwood Capital

Two more if I could. The subway business, it looks like the growth potential is there. Do you see the transition in terms of margins occurring in fiscal 2010? Can we expect gross margins in the subway business to be higher in 2010 than 2009 or it maybe about the same?

Wang Changli

For the subway systems, originally we are supplying SCADA systems that's can be a little supervision big systems, and for that part of the business, although the project is quite a big, but the margin is low, not only because the margin itself is low, but also because our operational efficiency not very high because we spent a lot of time and the labor effort for the learning curve.

Now we saw improvements of the operation, even the original business we have improved a lot in the margin. From the projects we are working now, the margin definitely is more than 10%, I mean not like before, but also we have been trying to adding new features to the original business.

For example, in the SCADA system even, we are trying to add ATS which is a new functionality to be original system which is more critical for the operation. So the [IBM class] functions into the original projects, we can improve the margin to some extent. Also now we are looking very hard. We spent lot money on the effort. In fact, I'm leading the growth to transfer the technologies under the products we have designed for the high-speed rail to the subway systems, although I mean the applications maybe a little bit different because of the requirements are different.

The hardware systems virtually are similar. Most of them are the same. So for us, it's not that difficult to transfer the technology from the high-speed rail to the subway, and I believe to succeed in this, not only the volume of the products will improve dramatically but also the margin of the products will improve a lot. We're quite confident of that.

Peter Li

I'll just add more points on Changli's comments, Mike. I think back to your original question regarding the margin impact on 2010 fiscal, you definitely will see our subway business gross margin enhanced due to this new product. Because the uncertainties involving the winning the first contract and the timing of the revenue recognition and how much improvement we can make on subway in terms of the gross margin, I cannot really specify, but definitely going forward you will see a margin expansion in this segment.

Michael Weisberg - Crestwood Capital

If I can add just one more, R&D as a percentage of sales was up to 8% of sales in the last quarter. Is that all level that now is sustainable? I think it was 5% for the year. Where should we expect R&D to be as a percentage of sales?

Peter Li

I think going forward on annual basis 5% would be a good indication, especially given the government sub-fees and VAT refunds, which will be part of the byproduct of our R&D investments and we still feel very comfortable in this area.

Michael Weisberg - Crestwood Capital

Great. Good job. Thanks very much.

Operator

Your next question comes from the line of Adam Hershey with SIAR Capital.

Adam Hershey - SIAR Capital

You continue to generate strong cash from operations for the year I think it was over $40 million and your cash balances grew to over $128 million. Can you talk about some of your potential uses of this cash?

Wang Changli

Sure, Adam. With Hollysys generating operating cash flow quarter-over-quarter, we definitely have some considerations for the better usage of the cash level to increase the return of shareholders. First of all we like to look into the possibilities of merger, acquisition.

As you know Hollysys hasn’t made any material acquisitions since we became public. To accelerate the growth of Hollysys and then they definitely is one of the strategies initiatives we are working at. We also, as you everyone of you know we announced the stock buyback one month ago and which shows management commitment to starting to the public market to support the stock in case needed. We will definitely configure the similar type of initiatives along this low decline and to further increase the return on our current shareholders.

Adam Hershey - SIAR Capital

Perfect, great.

Wang Changli

In terms of M&A strategies and consideration, I think from management perspective we definitely will apply those highly complementary businesses, product lines or markets. Secondly, we definitely will seek a highly accretive acquisition targets.

Thirdly, we definitely will have to ensure the management of the target company is in line with the Hollysys. So, that the integration issue will be minimized.

Adam Hershey - SIAR Capital

Also you guys have done a good job especially in this quarter of driving down the DSOs to the 147 days versus that 167 days last year. Could you just expand a little bit on some of the things that you're doing internally related to this improvement in your collection efforts?

Peter Li

Sure. Since DSO issue in the pervious fiscal was brawling to managing attention. Management has implemented the internal systems both from performance appraisal and from commission perspective to ensure the collection metrics is building to performance appraisal formula. So, that the sales people on the field and together with business development people well definitely have a heightened attention in this area.

Also our finance team we have a designated team of financial professionals to actively pursue and collect overdue accounts. I think on both pieces of signal measurements we have been very effective and successful. Going forward AR and DSO will definitely remain as one of the key initiates among operational management.

Operator

Your next question comes from the line of Robert Chu with [Jim Cowan].

Robert Chu - Jim Cowan

Can you comment on the timeline for delivery for both the Guangzhou-Shenzhen line and Zhengzhou Xian line?

Changli Wang

For the two lines, the deadline designated by the Ministry of China Rail it owned of, for the Chengdu line at the end of this year, calendar year, December, the project should be finished by that time. For the Shenzhen-Guangzhou line, the deadline of that line is originally was designed to be June of 2010, but it seems because of the construction problems, not the signal systems, but the infrastructure construction delay, maybe the project will be delayed for a couple of months. So far that’s the information we got.

Robert Chu - Jim Cowan

Okay. For the Dacheng contract, when do you have it was for TCC, now are they actively bidding for APP and (Inaudible).

Peter Li

Only for the TCC.

Robert Chu - Jim Cowan

Only TCC.

Peter Li

Because APP was purchased by the Ministry of China Rail by [cash] not for single loan, but for the time period, for many trains.

Robert Chu - Jim Cowan

What about the on-track portion? That also purchased by the ministry as well, not by the local bureaus?

Peter Li

Yes.

Operator

Your next question comes from the line of [Alice Ku with Broadwell Capital]

Alice Ku - Broadwell Capital

Thanks for taking my question. How do you manage raw material cost? For example do you hedge? How quickly do you pass the cost to change to the enduser over large just to what level does raw material impacted revenue and the gross margin?

Wang Changli

For this, I'll take up this okay. It's a very interesting question. For Hollysys as you know, because the competition in the market especially the condition of industrial market has been becoming fierce and fierce. So, the price of the market has been going down 10% each year on average, but our margin has been kept the same all over the year. It may improve 1% or 2%.

How we got this? We have done a lot work in this. First of all, we have been trying, taking every measures to reducing the raw material cost, very specifically the manufacturing parts. For example, with the increase of the volume of the purchase from the main vendors, we have been letting them bidding each other, first of all and by this, we reducing the cost each year and also in the whole put in to process question we also increased the efficiency of that process by more than 10% each year.

So, on the general we will be reducing the manufacturing cost of all the materials including the manufacturing process, more than 10% each year and we have been keeping back for quite a few years now.

Peter Li

Alice, just few points on Wang Changli’s comment is that, we also have utilize annual contracts with well-established vendors selected through stringent criteria to get the best available price from the long-term vendors.

Wang Changli

Also someway we have redesigned some of the hardware to improve the performance at the same time reducing the cost. We just take every way to reduce the cost each year.

Alice Ku - Broadwell Capital

Okay, great. Thank you. Also on the balance sheet, follow-up on the cash usage, when will you have the option to pay down the debt?

Peter Li

For the long-term debt, we currently have two tranches, one is the three-year bond payable issued by one of the major banks, which roughly about $11 million, which will come due towards the end of next calendar year. The rest of the long-term debt is interest-free loans from the government, which will be repaid in a couple of years.

Operator

Your next question comes from the line of Mark Tobin with Roth Capital.

Mark Tobin - Roth Capital

Hi, just a follow-up on Adam’s question about the uses of cash. Can you give us a status on the new facility in the south part of Beijing that you're building and the amount of CapEx that you expect during 2010?

Peter Li

Yeah, the new facility building project is pretty much on track and we are expected to move in some time around mid of next year. With this new facility our production capacity will be increased by 200% from the current facility.

So far for the past two years, we have already incurred about US $11 million to US $12 million in the new facility building, and going forward we will have, altogether the total budget is about US $50 million, which we believe will be well covered by internally generated the cash flow.

Mark Tobin - Roth Capital

Okay. So, you expect the balance of that $50 million, so $35 million to $40 million to be expended during the first half of 2010 calendar?

Peter Li

No, it will direct all for the next two fiscal.

Mark Tobin - Roth Capital

Okay.

Peter Li

2010 and 2011.

Operator

There are no further questions at this time. Please continue.

Herriet Qu

Okay. Thank you everyone for joining us on the call today. If you have any more follow-on questions we will be happy to answer then even by phone or by e-mail through the contact e-mail provided at our website. So, we look forward to speaking with you again in the coming future. Thanks again, and have a good day.

Operator

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

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