HollySys Automation Technologies' (HOLI) CEO Baiqing Shao on Q2 2016 Results - Earnings Call Transcript

| About: HollySys Automation (HOLI)
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HollySys Automation Technologies, Ltd. (NASDAQ:HOLI) Q2 2016 Earnings Conference Call February 3, 2016 8:00 PM ET

Executives

Arden Xia - IR

Baiqing Shao - CEO

Herriet Qu - CFO

Analysts

Alex Chang - Citigroup

Jacqueline Du - Goldman Sachs

Boyong Liu - JPMorgan

Peter Halesworth - Heng Ren Investments

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the HollySys Automation Technologies' Fiscal Year 2016 Second Quarter Ended on December 31, 2015 Earnings Conference Call.

[Operator Instructions] Please be advised that this conference is being recorded today, February 3rd, 2016.

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

Arden Xia

Hello everyone and thank you for joining us. Today our speakers will be Mr. Baiqing Shao, CEO of HollySys Automation Technologies; Ms. Herriet Qu, CFO of HollySys; and myself, Arden Xia, from the Investor Relations of HollySys.

On today's call Mr. Shao will provide a general overview of our business, including some highlights for the quarter, and Ms. Qu will discuss our performance from a financial perspective and financial outlook for the second quarter of fiscal year 2016. And the whole senior management will answer questions afterwards.

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 current 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; 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 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 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 in its filings.

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

And now I'd like to turn the call over to Mr. Baiqing Shao. Please go ahead, Mr. Shao.

Baiqing Shao

Thank you, Arden. And greetings to everyone. I would like to discuss some of the events during this quarter.

During this quarter, industrial automation business has been affected by weak external environment, with particular impacts on process control sector that we have not seen the recovery sign from the market. However, despite of the challenging conditions, our strategy of developing aftersales and services is proving successful which continuously take larger percentage of our revenue. Besides, giving the new construction projects in the near future would be lack of sustainable, we have already focused on reconstruction or upgrading opportunities as supplement through signed maintenance and service contracts to lock potential customers, helping them to improve efficiency and saving the costs.

Breaking down in the industries, power is maintaining stable. We have taken several numbers of high-level generator units and signed large contracts such as Jiujiang Shenhua 2-gigawatt power units which was the highest level units in coal-fired power industry, while petrochemical is still weak, the same as metallurgy and building materials.

Overall speaking, we have to say that external environment brings large impact for our industrial automation business, but we will adjust ourselves through better internal management and control such as to insist keeping gross margin for long-term health development within industrial automation to better cope with this situation and try our best to gradually recover the business.

In high-speed railway, we signed a large contract to provide Automatic Train Protection equipment and system to China Railways Corporation. We are quite confident of the steady high-speed rail revenue and backlog performance. As China is continuously investing a certain scale on supporting high-speed railway sector for the next five years, we will still benefit from the policy of 13th five-year-plan. Furthermore, we are also working to expand our rail new products and technologies such as track circuit which would make potential revenue contribution in the near future.

For subway business, we have signed quite a few SCADA contracts in the recent quarters and seeking opportunities to work with more local transportation bureaus. We will continue to deliver quality works and work closely with subway authorities in the future to build up our SCADA and subway signaling businesses both in China and abroad.

In the mechanical and electrical solution segment, seasonal lumpiness affected the sector's performance in the short term. However, we are unshakable to penetrate the Southeast Asia and Middle East markets and make progress on delayed projects. We also actively communicate with the local customers to discuss new project opportunities and even seek business partners for business cooperation.

At last, for extending international business, we have recruited local engineers to support our overseas team. With our proprietary technologies and products, industrial expertise and customer resources, we will continue to make exciting development and achievements in both industrial and rail transportation fields, and creating value for our shareholders.

With that, I'd like to turn the call over to Arden Xia who will lea the financial results analysis on behalf of our CFO Ms. Herriet Qu. Arden?

Arden Xia

Thank you, Mr. Shao. I'd like to share some highlights for the second quarter of fiscal year 2016 ended December 31, 2015.

Comparing to the second quarter of the prior fiscal year, the total revenues for the three months ended December 31, 2015 increased from $130.3 million to $152.8 million, representing an increase of 17.3%. Broken down by the revenue types, integrated contracts revenue increased by 12.7% to $134.2 million, product sales revenue increased by 49.4% to $15.4 million, and services revenue increased by 229.3% to $3.2 million.

The Company's total revenues can also be presented in segments as shown in the following chart. Industrial automation $54.2 million. Railway transportation $63.8 million. Mechanical and electrical solutions $29.7 million. Miscellaneous $4.9 million. Total $152.7 million.

Overall gross margin excluding non-cash amortization of acquired intangibles was 39.8% for the three months ended December 31, 2015, as compared to 38.3% for the same period of the prior year. The non-GAAP gross margin for integrated contracts, product sales and services rendered were 37.2%, 57.4% and 65.2% for the three months ended December 31, 2015, as compared to 35.7%, 63.7% and 80.4% for the same period of the 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 non-cash amortization of acquired intangibles, was 39.7% for the three months ended December 31, 2015, as compared to 37.1% for the same period of the prior year. The GAAP gross margin for integrated contracts, product sales and service rendered were 37%, 57.4% and 65.2% for the three months ended December 31, 2015, as compared to 34.4%, 63.7% and 80.5% for the same period of the prior year, respectively.

Selling expenses were $7.1 million for the second quarter, 2015, representing a decrease of $0.1 million or 1.5% compared to $7.2 million for the same quarter of the prior year. Presented as a percentage of total revenues, selling expenses were 4.6% and 5.5% for the three months ended December 31, 2015 and 2014, respectively.

G&A expenses, excluding non-cash share-based compensation expenses, were $10.8 million for the quarter ended December 31, 2015, representing a decrease of $4.6 million or 29.9%, as compared to $15.5 million for the same period of the prior year. The decrease was mainly due to the decrease of $2.1 million in bad debt expenses. Presented as a percentage of total revenues, non-GAAP G&A expenses were 7.1% and 11.9% for quarters ended December 31, 2015 and 2014, respectively. The GAAP G&A expenses, which include the non-cash share-based compensation expenses, were $12.1 million and $15.9 million for the three months ended December 31, 2015 and 2014, respectively.

Research and development expenses were $11.9 million for the three months ended December 31, 2015, an increase of $1.8 million or 17.6% compared to $10.1 million for the same quarter of the prior year. Presented as a percentage of total revenues, R&D expenses were 7.8% and 7.8% for the quarter ended December 31, 2015 and 2014, respectively.

The VAT refunds and government subsidies were $10.7 million for the second quarter, as compared to $5 million for the same period in the prior year, representing a $5.7 million or 112.7% increase, which is primarily due to the increase of the VAT refunds of $6.1 million.

The income tax expenses and the effective tax rate were $5.1 million and 13.2% for the second quarter, as compared to a net of $0.3 million and net of 1.5% for comparable prior-year period. When excluding the impact of non-GAAP adjustments on the income before income taxes, the effective tax rate would have been 12% for the current quarter and net of 1.2% for the comparable prior-year period.

During the second quarter ended December 31, 2014, Beijing HollySys and Hangzhou HollySys were certified as high-end new tech company effective for three years from January 1, 2014 to December 31, 2016, and are applied to preferential income tax rate of 15%; and Beijing HollySys and Hangzhou HollySys accordingly recalculated the tax expenses accrual for calendar year 2014 based on the newly applied EIT rate of 15% instead of 25%. Excluding the impact of the accrual adjustment, the effective tax rate for the three months ended December 31, 2014 was 15.2%.

The non-GAAP net income attributable to HollySys, which excludes non-cash share-based compensation expenses, amortization of acquired intangibles and acquisition-related consideration fair value adjustments, was $36.8 million or $0.61 per diluted share based on 60.6 million shares outstanding for the three months ended December 31, 2015. This represents a 56% increase over the $23.6 million or $0.4 per share based on 59.2 million shares outstanding reported in the comparable prior-year period.

On a GAAP basis, net income attributable to HollySys was $32.9 million or $0.55 per diluted share, representing an increase of 72.4% over the $19.1 million or $0.32 per diluted share reported in the comparable prior-year period.

Integrated contract backlog highlights. HollySys' backlog for integrated contracts as of December 31, 2015 was $527 million, representing an increase of 7.5% compared to $490.4 million as of September 30, 2015, and an increase of 21.5% compared to $433.7 million as of December 31, 2014.

The detailed breakdown of backlog for integrated contract by segment is shown below. Industrial automation $105.8 million. Rail transportation $301.5 million. Mechanical and electrical solutions $119.6 million. Total $526.9 million.

Cash flow highlights. Cash flow for the three months ended December 31, 2015, the total net cash outflow was $1.8 million. The net cash provided by operating activities was $46.7 million. The net cash used in investing activities was $45.5 million, mainly consisted of $47.2 million placed as time deposits with original maturities over three months in banks. The net cash provided by financing activities was $0.4 million.

Balance sheet highlights. The total amount of cash and cash equivalents and time deposits with original maturities over three months were $275.6 million, $234.9 million and $215.8 million as of December 31, September 30, 2015 and December 31, 2014, respectively. As of December 31, 2015, the Company held $188.7 million in cash and cash equivalents and $86.9 million in time deposits with original maturities over three months.

For the three months ended December 31, 2015, Days Sales Outstanding was 138 days, as compared to 206 days for the comparable prior-year period and 179 days for the last quarter. And inventory turnover was 34 days, as compared to 52 days for the comparable prior-year period and 42 days for the last quarter.

Outlook for fiscal year 2016. Given our strong backlog currently on-hand and sales pipeline envisioned so far, we reiterate our guidance for fiscal year 2016 with revenue in the range of $565 million to $600 million and non-GAAP net income in the range of $110 million to $120 million.

At this time we'd like to open up for Q&A session. Please note that the Chinese-speaking participants, we can do Q&A in Mandarin and we will provide translation.

[Chinese language spoken]

Operator, please.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions]

Our first question today comes from Alex Chang from Citigroup. Please go ahead.

Alex Chang - Citigroup

[Chinese language spoken]

Unidentified Company Representative

Hello.

Baiqing Shao

Hi, Alan

Alex Chang - Citigroup

[Chinese language spoken]

Arden Xia

The first two questions from Alex. First, about the ATP orders last time and we saw the price goes down, what about this order to affect the gross margin? And also, what about the future gross margin for the high-speed rail segment?

The second question is about the G&A expense. And this quarter we found $2.1 million reduced, so, compared last year, compared last year the same quarter. And what about in the future, about G&A expense in rail segment and also industrial segment, which part will affect the [inaudible] goes down?

Herriet Qu

[Chinese language spoken]

Arden Xia

About the first question, answer is ATP [inaudible] order, the price goes down. And we -- but we also have very special procurement and cost control internally. So for the order itself, the gross margin is going down. But for long term and the whole segment of high-speed rail, the gross margin we think will maintain between 40% to 50%. And also inside of this percentage, I said, it will go down a little bit, but still in this level.

Herriet Qu

[Chinese language spoken]

Alex Chang - Citigroup

Xie-xie.

Arden Xia

And the second question answer is about the better provision we focused on -- comes mainly from IA, industrial automation. And this quarter goes down because several quarters before, our management team internally controlled the contract, so we reviewed our customers' performance to control this part. That's why we have already take enough better provision. In the future it will -- still goes down from our perspective.

Alex Chang - Citigroup

[Chinese language spoken]

Herriet Qu

Xie-xie.

Unidentified Company Representative

Xie-xie, Alex.

Operator

Our next question comes from Jacqueline Du from Goldman Sachs. Please go ahead.

Jacqueline Du - Goldman Sachs

[Chinese language spoken]

Arden Xia

The first question is about the industrial automation backlog and the revenue and also new order goes down, and what about the trend in the future? And also please mention about -- talk about the contract size and even gross margin, something in the project of Jiujiang Shenhua 1 gigawatt power station project.

Second question is about Concord and Bond. MIE, mechanical, electrical installation services, their business, what about the cost structure? Which part, spare parts for example, or components, comes from abroad, and which part produce by themselves?

Herriet Qu

[Chinese language spoken]

Baiqing Shao

[Chinese language spoken]

Arden Xia

About the industrial automation, the revenue backlog and also new order is going down. But I want to mention, in the backlog, this is just including the integrated contract. Not already excluding the service render and the aftersales spare parts sales, so, along with our aftersales revenue goes up, like service rendered, you could see, and also spare parts is growing, so in future we will try our best to increase our industrial automation business.

And also about the Jiujiang Shenhua project, it's 1 gigawatt power station. And the contract signed generally speaking is we cannot disclose in here, but just let you know, within the industrial automation, most of our contracts are constructed by the small size and we have a lot of number of projects.

Herriet Qu

[Chinese language spoken]

Jacqueline Du - Goldman Sachs

[Chinese language spoken]

Herriet Qu

[Chinese language spoken]

Jacqueline Du - Goldman Sachs

[Chinese language spoken]

Herriet Qu

[Chinese language spoken]

Arden Xia

Actually Jacqueline is concerned about the exchange rate will affect MIE part or even the whole business of HollySys.

And CFO answered that exchange rate, it will affect -- it will affect very little in our business. Actually we are -- we have local account money -- I mean, for the local settlement, for the business, and this is not a factor on our P&L. But because a lot of components or business already did it [ph] in local area, and also we, right now, our business, based on a lot of localization providers, suppliers, and -- but the exchange rate will affect the translation. For example, we have a whole asset translation in the balance sheet. So this is will affect. But each company will meet the same situation.

Herriet Qu

[Chinese language spoken]

Jacqueline Du - Goldman Sachs

[Chinese language spoken]

Arden Xia

Xie-xie, Jacqueline.

Operator

Our next question comes from Boyong Liu from JPMorgan. Please go ahead.

Boyong Liu - JPMorgan

[Chinese language spoken]

Arden Xia

The first question is about the industrial automation. The industrial automation gross margin is going down, so, what about the future trend?

Second question is about C3, the 300 kilometers per hour ATP. The price of that [ph] order is going down, so it reflect -- when is it going to reflect to the net income? And why, because this order -- the price was goes down very large, so why you could also control the high-speed rail gross margin between 40% to 50%?

And the last question is down to the second quarter railway revenue, goes up very quickly. So, which main reasons, I mean which part of products contribution to this sector?

Herriet Qu

[Chinese language spoken]

Arden Xia

For industrial automation, gross margin goes down. It has a lot of factors for the changes. And in future, it will continue goes down a little bit.

But why compare this year and last year, because last year, the gross margin, they're high, because internally the nuclear power contract we have actual [ph] from CNNC [ph], that that project affected the overall gross margin for industrial automation. But we don't think in the future we will continue to get the contract from that side. So, generally speaking, it's really based on the project internal of the industrial automation structure. But the trend, it will go down a little bit, but still maintain 35% to 40% from we announced at first time.

Herriet Qu

[Chinese language spoken]

Arden Xia

About the reflection, that contract to the net income, based on the percentage of completion of our project, and along with its finished project, we will continually to make the recognition of the revenue. And some part of -- already entranced to this quarter, and some part will go to the next fiscal year.

Herriet Qu

[Chinese language spoken]

Arden Xia

And about last question, I want to emphasize here, the 40% to 50% is the overall high-speed rail signaling part gross margin. If based on the single order of last time, the gross margin is lower than that. But from our structure of internal control of the cost and procurement, we still have confidence to achieve 40% to 50% generally for the high-speed rail whole segment.

Herriet Qu

[Chinese language spoken]

Boyong Liu - JPMorgan

[Chinese language spoken]

Herriet Qu

[Chinese language spoken]

Arden Xia

About the question, is the SCADA gross margin is very low compared to high-speed rail, so what about the overall for railway transportation segment?

The answer is about because the high-speed rail revenue right now still takes a very large percentage of the whole rail transportation segment, so we still could control very well with the sector gross margin.

Boyong Liu - JPMorgan

[Chinese language spoken]

Herriet Qu

Xie-xie.

Arden Xia

And due to the time constraint, we will now take one last question from the queue.

Operator

Thank you. Our final question today comes from Peter Halesworth from Heng Ren Investments. Please go ahead.

Peter Halesworth - Heng Ren Investments

Thank you. This is for Mr. Shao. I want to address an important issue for HollySys and shareholders, and that's the rising pile of cash on the balance sheet, and ask for a regular dividend to be paid to shareholders. Our analysis at Heng Ren, which we'll share with management and shareholders, shows HollySys could easily pay shareholders a minimum $50 million annual dividend now and through fiscal year 2019. And HollySys would comfortably be able to cover its CapEx and debt service as well.

The $250 million net cash pile doesn't really need to grow anymore. HollySys' valuation needs to grow. And we believe it's a great opportunity now to do just that. If HollySys made a commitment to a regular dividend, we believe it would win many more shareholders and a valuation premium which we believe HollySys deserves. And with Chinese stocks being so volatile, a predictable growing stream of income from HollySys for shareholders would stand out and we believe be rewarded with a premium valuation, instead of the stock trading in single digits in terms of P/E.

Also, embarking on M&A with the cash at such a low valuation would be counterproductive.

So my question for CEO Shao is, would you pledge tonight to implement a regular dividend to increase greater value for all shareholders? And I also would be curious to know what other shareholders think of this proposal, which we'll share shortly. Thank you.

Arden Xia

Thank you, Peter.

[Chinese language spoken]

Baiqing Shao

[Chinese language spoken]

Arden Xia

Thank you, Peter, for the question. Generally speaking, because the macroeconomic slowing down and a lot of uncertainty, so we still want to hold the cash relatively in a large base because in Chinese word we have, if winter come, we need more clothes [ph]. So that's why we hold a lot of cash on hand. And also we are a very small company in such environment.

But for the dividend you're suggesting, we will consider it very seriously. Actually last fiscal year we already paid a dividend, but that's just one time. In future, we are in the discussions right now for the management team and we will consider your suggestion very seriously. Thank you.

Arden Xia

Thank you everyone for joining us on the call today. If you haven't got the chance to raise your questions, we will be pleased to answer them through follow-up contacts. We look forward to speaking with you again in the near future. Thank you.

Herriet Qu

Thank you.

Baiqing Shao

Xie-xie. Thank you.

Operator

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

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