This article is the second installment (see Part I) of an analysis of Hollysys (NASDAQ:HOLI), the No. 1 domestic provider of industrial automation and control technology, and one of the top 2 providers of high-speed rail signaling systems in China. The previous article provides a qualitative discussion of the positive growth trend HOLI should enjoy in the near- and long-term future. This article will attempt to establish how much HOLI is worth by dissecting its earnings numbers.
HOLI has a healthy balance sheet and cash flow. It has a current ratio of 1.78 and debt ratio of 0.43 for the first 9 months of 2014 (HOLI's fiscal year ends in June). It has also been generating positive cash from operations since 2011 every quarter, except three during China's high-speed rail buildout slowdown and last year's cash crunch. For those three quarters, the deficits were relatively small (< USD$10 million). Therefore, I will focus on the income statements for this analysis.
Below is a composition of HOLI's sales for the trailing 12 months:
According to management, Mechanical & Engineering and Misc should not see much growth in the future, so Industrial Automation and Railroad will hold the keys to the future. We will try to determine growth rates to use for these segments.
For both segments, HOLI has demonstrated generally positive trends quarter-over-quarter in revenue and backlog for the trailing 12 months. The growth rate of the Industrial Automation segment was approximately 10% year-over-year for revenue, 13% for backlog. Railroad segment revenue was up 77%, but that was mainly due to the investment slump in Chinese railroads in 2012 and early 2013 caused by the corruption investigation of China's railroads regulatory body.
For FY2015, management is predicting a 10-15% growth in industrial automation revenue. In comparison, China's industrial automation market is forecast to grow by 10.3%. (Source: GongKong China). Various research institutes generally puts CAGR for the industry at high single digit till 2020.
Management did not provide any growth guidance for the railroad segment, and reliable data on country level does not exist because government policy and funding are uncertain. The only piece of information I could glean is that a total of 664 billion yuan were invested by the government in railroads in 2013, and for 2014 the target is to spend 800 billion yuan. This represents a 20% growth rate. However, while this growth rate may be possible in the next few years before China finishes the majority of its high-speed rail construction, I do feel a 20% long-term growth rate is not sustainable, so I will use 20% for FY2015 (note HOLI's fiscal year starts in June), and 10% for years after.
There are two controversial expense items on HOLI's income statements: VAT refunds & government subsidies, and Acquisition-related incentive share contingent consideration fair value adjustments. The first one shows up as a negative expense which means income on income statement. VAT refunds is a national policy adopted by the Chinese government to promote its IT industry. Eligible companies and products get refunds for any portion of VAT it paid that exceeds 3% of its sales price. This policy essentially promotes high value-add products and services. Currently, this VAT refund amounts to about 5% of sales for HOLI.
While I do not expect the Chinese government to scrap this policy any time soon, this income is not part of the company's core earning power, so I will exclude this item from my valuation. Note this is a pre-tax item, so its impact on net income will be adjusted for after-tax.
The second item, Acquisition-related incentive share contingent consideration fair value adjustments, accounted for almost USD$7 million for the first 9 months of FY2014. This is a consequence of the stock portion of the Bond acquisition in 2013. HOLI committed to pay approximately 3 million of its shares to Bond shareholders in a 3-year installment. During these three years, if HOLI's stock price goes up, the increased price is required by SFAS rule to reflect as an expense. While I recognize this cost is as legitimate as Bond's revenues, I decided not to include this item in my long-term projection because 1) this item will go away after 2016, and 2) this item is difficult to forecast.
With these adjustments, the net income for the trailing 12 months will be $45.7 million, and diluted EPS will be USD$0.78. The net margin is 9.6%.
Assuming there will be 60 million weighted average shares outstanding after full vest of Bond acquisition, here is the forecast up to 2020.
This scenario projects a forward PE of 26.9, implying a return of 3.7%. Given that 10-year treasury rate is at 2.65%, and the average S&P return is 2%-2.5% above 10-year treasury, this stock at current price is not a strong bargain.
On a more optimistic tone, it is not far-fetched to assume a higher growth rate for industrial automation, such as 15%, and higher net margin, 11% (close to GAAP net margin without VAT refund and government subsidies). The results will look like this:
This rosier scenario provides a 23 PE, or 4.3% return.
In conclusion, while HOLI is not a strong bargain at current price of $22-$23, it should still provide a good long-term return because I believe it has a high probability to grow yet low risk to fail.
Disclosure: The author is long HOLI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.