Hollysys Automation: Catch the Train Before It Leaves the Station

| About: HollySys Automation (HOLI)
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Using its proprietary technologies, China has joined the ranks of the powerhouse elite in high-speed trains, a select list that includes France, Germany and Japan.

With up to 30,000 kilometers of high-speed railways expected to be built around the globe by 2020, China recently burnished its chances for a share of the market when it set a world record of 486.1 kilometers an hour in a test run on the new Beijing-Shanghai line on Nov 3. The 1,300-kilometer line is expected to begin full operations in October next year with five times the current passenger capacity. It will shorten the travel time to less than five hours.

China’s international high speed plans already in the works include a high-speed line in neighboring Laos and Thailand and a joint venture with industrial giant General Electric Co (NYSE:GE) for production in the United States.

Hollysys Automation Technologies Ltd (Nasdaq: HOLI) designs and manufactures automation and control systems and has been listed on the NASDAQ since 2007. Founded in 1993, it currently has approximately 2,100 employees with operations in 21 cities in China.

HOLI has three major business segments: industrial, railway & subway, and nuclear. Industrial is its major segment, generating about 55% of total revenue. The company is the only domestic nuclear power plant automation system provider, is also one of five train control system providers in the 200–250km/h high-speed rail segment and is one of two authorized providers in the 350km/h segment in China.

Business Segment Breakdown

Industrial automation

The major business segment, generating 55% of the company revenue in 2009. Provides plant automation and control with focus on the thermal power industry, chemical and petrochemical industry.

Railway signal system

Provides signalling systems and train protection systems in the railway & subway segment. It is one of the five qualified train control centre providers in the 200km/h rail segment and one of the two qualified providers in the 300–350km/h segment.

Subway automation

Provides a subway supervisory control and data acquisition integrated platform. Acts as the EPC contractor for the subway signal system.

Nuclear automation

It's the only certified domestic supplier of the conventional island automation system for nuclear power plants. It has set up a 50:50 JV with the China’s largest nuclear station operator China Guangdong Nuclear Power Holdings Corporation, which has 60% of market share in China nuclear power market.

The company has evolved from a key developer of the Chinese industrial automation system provider to a niche control system provider for the Chinese railway industry.

Investment Thesis

  1. The company is currently benefiting from the strong demand from Chinese railway development in both track length as well as the rail vehicle fleet expansion. It has a strong R&D capability internally to develop new products for the metropolitan subway control system and nuclear power control system.
  2. It is also gaining international recognition for its railway signalling product quality with certification from the International Electro-technical Commission in Europe. This would allow the company to expand into the international railway signalling market, which is worth about US$10bn globally.
  3. Nuclear power development in China will likely provide the next phase of earnings growth for the company beyond 2012 as China looks to increase greener energy generation and reduce reliance on coal-fired electricity generation.

China’s nuclear power capacity is targeted to increase from the current 9GWe to about 60GWe by 2020. This would entail significant construction activity and the start-up of on average up to 5GWe of reactor capacity a year over the course of a decade. This would bring China’s nuclear power capacity in 2020 to a level similar to Japan’s target. There is a liklihood that China may extend the development to 2030; with a 2007 NDRC target of 160GWe by 2030. This may eventually be increased, but the potential construction and start-up pipeline is already huge – 100GWe in reactors over the course of a decade, or 10GWe per year ie. 10x 1GWe-scale reactors every year.

  1. The company already has the ability to produce control system for conventional thermal power and will tap into the nuclear power control system through its 50:50 JV with China Guangdong Nuclear Power, which is one of the largest nuclear power operators in China with about 60% of current market share.


The company grew its revenue from $121 million in 2008 to $174 million in 2Q2010. Due to heavy spending on R&D, the company had negative income of -$1.7 millionin 2008 but successfully turned around and achiveved $25 million net income in FY 2010.

More importantly, the company successfully turned negative operating cash flow in 2008 to positive $30 million in June 2010.

As the large equipment supplier, the company has stable account receivable and healthy debt ratio. With $385 million total assets and only $172 million total debt.

Although this company is a reverse merger stock, it has won many large instutions’s interest. In January, Fidelity purchased more than 10% stake of this company. On the institution investors list, we can find lots of big names such as Fidelity, Wellington, TCW, HSBC, etc. One of the largest investors worth noting is GE. Actually, GE’s automation department is competing with HOLI directly. So I believe GE knows the capability of HOLI, otherwise, it won’t invest.

The stock performed very well in the past year. Different to other China small caps, which were extremely volatile, this stock had very steady performance and enjoys relative high valuation.

Yesterday, HOLI reported its most recent earnings.

Financial Highlights

  • Record-breaking quarterly revenues of $74.4 million, representing an increase of 61.1% compared with $46.2 million year-over-year
  • Gross margin at 36.0%, compared with 31.2% year-over-year, and 34.8% quarter-over-quarter
  • Non-GAAP net income attributable to Hollysys of $15.0 million, compared with $8.1 million and a 85.4% increase year-over-year
  • Diluted EPS at $0.27 reported for the quarter
  • Record-breaking backlog balance at $288.5 million as of December 31, 2010, a 31.4% increase compared to $219.6 million year-over-year
  • Quarterly DSO of 104 days, as compared to 137 days year-over-year and 111 days quarter-over-quarter

Source: Company 10Q

If we incorporate its growth of earnings and current price, I believe its forward 12 month P/E is actually around15-18X. The company’s fair value I believe is at least $21-$24 given the average 21-24X industry average PE ratio. Considering its position in China’s fast growing high speed railway and nuclear power segments, an even higher PE is reasonable.

However, HOLI’s share price tanked after a 10% jump in early morning trading due to an analyst’s downgrade. I personally don’t think this downgrade makes any sense as the analyst obviously compares HOLI to other small cap Chinese companies, which normally have lower than 15x PE. But if you look at other established names such as MR, EDU, Ctip.com (NASDAQ:CTRP), HMIN etc, all of which have much higher valuation. If anybody has basic knowledge of China’s automation and signaling control industry, HOLI is a brand. It is one of very few Chinese companies that can compete directly with Siemens(SI), GE, ABB etc.

Another reason for the recent selloff is that the head of China’s railway ministry was arrested due to corruption. The market speculates the Chinese government may cut spending on high speed railway. This is not an issue actually. The development plan of high speed railway is part of the 12th 5 year program. The plan has been approved by the central government. It is impossible that the whole plan will significantly change only because of a corrupt official.

Overall, I am very positive on HOLI and plan to hold it for long term.

Disclosure: I am long HOLI.