The Growing Pains At HollySys Are Real, But The Potential Is Worthwhile

Summary

• HollySys has had a tough go since the fall of 2016 as air pockets in rail control orders have significantly undermined revenue and margins amid a downturn in industrial automation.
• HollySys is looking to self-help (internal product development) and M&A to build up its industrial automation business, while also building out a more diversified rail control business.
• This will never be an easy or safe stock to own, but if HollySys can deliver on its potential, the shares can move to $20 or higher.

Growth is seldom as smooth or easy as investors want it to be, and that has certainly been true with Chinese automation and control systems company HollySys (NASDAQ:HOLI). Competing with the likes of ABB (ABB), Honeywell (HON), and Siemens (OTCPK:SIEGY) is hard enough all on its own, but HollySys has to overcome the added burden that even other Chinese companies don't really trust domestic suppliers in industrial automation. Making matters worse, HollySys's train control business is largely tied to the unpredictable and inconsistent ordering habits of China Railways Corporation (or CRC).

HollySys shares have fallen about 15% since I last wrote about the company, as HollySys did in fact see the prolonged slowdown in automation and train controls that concerned me then. Although the market took that development badly, my long-term outlook really hasn't changed that much. I continue to believe that as HollySys matures it will deliver revenue growth around 6%-7% and double-digit FCF growth sufficient to support a fair value in the low $20s.

Industrial Automation Seeing The Turn?

Global automation rivals like ABB, Honeywell, and Rockwell (ROK) saw sentiment turn a while ago, but the Chinese market and HollySys's order book has been a little slower to swing back. Now, though, it does appear that demand for industrial and process automation equipment is recovering in China, with companies increasingly looking to automation to reduce labor costs (or offset shortages of skilled workers) and improve product quality and consistency. Orders rebounded nicely in the last quarter (the fiscal third quarter), with revenue once again growing after a protracted tough stretch.

Looking ahead, one of the best developments for HollySys will be the growing acceptance of Chinese companies as viable competitors in the market. Having followed the sector for quite a while, one thing I've noticed in recent years is that the quality surveys done by industry magazines/journals have showed a steady increase in the perceived quality and competitiveness of Chinese automation suppliers like HollySys (as well as Inovance, Siasun, and others).

Given that the survey respondents rarely have experience with more than a few suppliers' products, I take this as more of a reflection of a rising tide of the standing of these Chinese companies in the market. Haier, the large and increasingly globally competitive Chinese appliance company, has started working more closely with HollySys and this is an invaluable “seal of approval” as HollySys looks to expand beyond its traditional stronghold in the power gen market.

Still, there are limits to this trend. HollySys has meaningful share in the Chinese market for distributed control systems (or DCS), but outside of China and a few emerging markets (like Indonesia and India), they're not really a factor. Some of that is still by design; one of the advantages that HollySys looks to maximize is that it can provide a much higher level of service and customization than multinationals are able/willing to provide, and HollySys simply doesn't have the infrastructure outside of China today to replicate that model.

One of the more exciting developments to watch at HollySys is the ongoing process of building out the automation business. Although the company sold down its interest in Hollycon (a company focused on automated blending systems for markets like traditional Chinese medicine) from 51% to 30%, the company is working on internally-developed motion control products, safety controls, and expanded programmable logic controller offerings.

HollySys will have a tough row to hoe in trying to build a credible global PLC business from the ground floor (ABB recently turned to M&A to make its PLC business more competitive), but there are still plenty of worthwhile opportunities in China, including opportunities to cross-sell.

M&A is likely to be another significant part of the process. HollySys has a clean balance sheet and could leverage that liquidity to acquire product lines in areas like motion control, drives/motors, actuation, and so on. This segment of industrial automation is increasingly less popular with the multinationals like ABB and Siemens, as there is more margin and growth potential in areas like software, sensing, and control, but it is an area where HollySys could leverage its lower cost base and cross-selling opportunities to do reasonably well for itself.

Rail Is A Headache, But Too Lucrative To Ignore

HollySys's rail business, where it sells a variety of control products/systems like automatic train protection (or ATP), train control centers (or TCC), SCADA, and so on, is a major source of volatility in the company's financial performance and in investor perception. The biggest problem is that HollySys is hugely reliant upon state-owned CRC for orders, and CRC works on its own schedule when it comes to ordering equipment.

Orders weakened significantly in 2016, leading to sharp revenue declines (down 39% in fiscal Q1, down 64% in fiscal Q2, and down 38% in fiscal Q3). Given that the rail business is rather lucrative, with gross margins on high-speed products running in the 40% to 50% range, that was a significant blow to the company's profitability.

What happens from here on is almost impossible to predict with precision. I expect that the general trend in orders will continue to be positive; China needs more trains to meet demand and accommodate other goals like reducing congestion and pollution. That said, the magnitude of the growth should decline over time (trees don't grow to the sky) and the ordering patterns will remain unpredictable – HollySys should see a surge in orders later this calendar year, but after that it's hard to predict the CRC's ordering plans.

HollySys is still trying to expand and diversify this business. The company has had some success in the metro market, with its SCADA business (which monitors the power supply systems for trains), but this is a lower-margin business. HollySys is also expanding into track circuit products (a roughly $300 million/year market in China) and signaling products for metro applications, with revenue likely to start showing up in the fiscal 2018 results.

I just don't see a path out of this predictable unpredictability in the foreseeable future. HollySys has done well holding on to market share in its core ATP market(s), but a new competitor is emerging in the 350km/hr segment (China Academy of Railway Science, or CARS) and as I said before there's no reason to believe the CRC is going to settle into a clockwork ordering pattern. With that, expanding outside China looks more and more important to me. Management used to talk up the prospects of this in the past, but has gotten quieter about it over the last year or so.

Expanding its presence in emerging markets seems like a credible long-term goal (even though there will be competition from Siemens and others), but the expected growth in China's high speed rail (about 237% from 2015 to 2030) and metro markets (about 80% from 2016 to 2020) would argue that the unpredictability of quarter-to-quarter and year-to-year revenue and orders is overshadowed by the overall revenue and profit potential.

The Opportunity

I continue to believe that HollySys can outgrow the global market for industrial automation, taking advantage of China's increasing adoption of automation, leveraging its improving standing within that market, and expanding its portfolio of product and technology offerings. Success outside of China is not core to my thesis or model today, but markets like India, Indonesia, and Vietnam offer worthwhile potential. With rail, I expect growth but quite a bit of volatility.

I'm looking for long-term revenue growth around 6% to 7% from HollySys, with FCF margins expanding into the mid-teens over time. That's a bullish/aggressive outlook; HollySys has achieved FCF margins above my long-term average forecast in individual years in its past, but consistent year-to-year performance has been elusive and the nature of the rail business adds uncertainty to the model. Should HollySys manage the low-to-mid teens FCF growth that I model, a fair value in the low $20s is appropriate today.

The Bottom Line

I am eager to see what HollySys can do with internal product development and M&A to build out its industrial automation business, and I am likewise curious to see if these new product/platform offerings in rail can add a little stability to the business (even if at the cost of margins). As inconsistency and volatility are two of the biggest issues here, a stronger, more stable growth platform would likely be well-received.

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Analyst’s Disclosure: I am/we are long ABB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.