Hollysys Automation Technologies Ltd (NASDAQ:HOLI) Q3 2021 Earnings Conference Call May 13, 2021 9:00 PM ET

Company Participants

Arden Xia - IR Director

Colin Sung - CEO & Director

Steven Wang - CFO

Lei Fang - Co-COO

Conference Call Participants

Kevin Luo - Morgan Stanley

Lingxin Kong - CICC

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Hollysys Automation Technologies Earnings Conference Call for Fiscal Year 2021 Third Quarter ended March 31, 2021. [Operator Instructions]. Please be advised that this conference is being recorded today, May 14, 2021, Beijing Time. I would now like to hand the conference over to Mr. Arden Xia, the Investor Relations Director of Hollysys Automation Technologies. Please go ahead, Mr. Xia.

Arden Xia

Hello, everyone, and thank you for joining us. Today, our attendees will be CEO, Mr. Colin Sung; CFO, Mr. Steven Wang; Mr. Yi Ma, Chairman of the Hollysys Group, one of the company's subsidiary; Co-COO, Mr. Yue Xu and Mr. Lei Fang, who are in charge of IA and the Railway business, respectively. On today's call, Mr. Sung will provide a general overview of our business, including some highlights for the third quarter and the first 9 months of fiscal year 2021. Mr. Steven Wang will discuss our performance from financial perspective, and all management team will answer questions afterwards.

Before getting started, I would like to remind everyone that this conference call will contain forward-looking statements within the meaning of Private Securities Litigation Reform Act of 1995. Forward-looking statements are the statements that are not historical facts, including statements relating to the expected growth of Hollysys' future product introductions, the mix of products in the 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 these statements: business conditions in China and in Southeast Asia; continued compliance with government regulations; legislationor regulatory environments; requirements or changes adversely affecting the business in which Hollysys is engaged; cessation or changes in government incentive programs; potential trade barriers affecting international expansion; fluctuation 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 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 the conference call or in its filings. Please note that all amounts noted in this conference call will be in U.S. dollars, unless otherwise noted.

And now I'd like to turn the call to Mr. Colin Sung. Please go ahead, Mr. Sung.

Colin Sung

Thank you, Arden, and greeting to everyone. Industrial Automation, IA, business finished the third quarter with revenue and new contract at $67.5 million and $106.7 million, representing 97.1% and 68.7% year-on-year growth. For the first 9 months of the 2021 fiscal year, IA revenue and new contract achieved 44.1% and 34% year-on-year growth, respectively.

In the power sector, we employed sustainable development tactics in order to address the needs of former customers. By offering these various upgrade products and wider range of services, we were able to increase market share.

Highlights of the quarter. Signed 2 600-megawatt power plant replacement contracts. This repeat business demonstrated industry recognition of Hollysys for quality system replacement, product offering depth and reliable engineering services. Signed service contract for digital upgrade for Distributed Control Systems, DCS, of 2 1,000 megawatt units for a power plant. We increased the number of digital projects year-over-year, increasing our sales of construction of digitally optimized factories for existing customers.

In the chemical and the petrochemical sector, we continued to win mid- and high-profile projects through effective marketing and promotion coupled with our strong customer relationships. Highlights of the quarter include: the Zhong'an United Coal Co., Ltd. project gained industry recognition for both economic and social benefits and was awarded the Special Award on Science and Technology of 2019 to 2020 for Chinese Petroleum and Chemical Automation; signed a polycarbonate project contract in Pingdingshan, Henan Province, establishing new foothold in polycarbonate field. This important project highlights Hollysys' capability, positioning the company to win more mid- and high-profile contracts.

Signed a contract with China National Offshore Oil Corporation, CNOOC, for their Sanya gas field upgrade project. An integrated control system with upgraded products will be implemented and demonstrated in this project. The installation of Hollysys' control system for CNOOC's offshore greenfield, zero discharge and low carbon project was successfully completed. This pilot green oilfield program was the first domestic control system adopted by CNOOC. Hollysys' integrated control system successfully achieved efficiency improvement and cost reduction while promoting low carbon and zero discharge management of offshore oil production. The company will participate in future exploration, construction and development on green oilfield projects. Hollysys' offering will contribute to realize the national goal of reducing carbon dioxide emission and becoming carbon neutral.

In the food and beverage and pharmaceutical sector, we are driving technological innovation by providing high-quality engineering in partnership with our key customers. In this quarter, a contract was signed with a Shandong pharmaceutical company to provide instruments, DCS and a Safety System for the production of 2,800 tons per year of active pharmaceutical ingredients. In addition, the company continues to pursue cooperation agreement with other leader in pharmaceutical industry. A significant contract was signed with one of the subsidiary of Sino Biopharmaceutical Ltd., establishing a solid foundation for the future work with the client.

In the smart factory business, we are promoting solution upgrade and staying attuned to market demand while helping clients develop technology innovative factories with digitized solution for production and management. Highlights of the quarter include: signed a contract to provide our smart factory solution for a Tangshan chemical company after winning the bid for a silicone smart factory project last quarter. Smart solution for DCS, SIS, MES, BATCH and IODS were included in the offering, which marks another advancement for the company in the fine chemical smart factory space. Hollysys will construct a data integrated platform which will achieve seamless information flow between the operation and management levels, creating the foundation of the client's digital transformation.

A contract was signed to provide smart power solution for a client's 2 125-megawatt power plant along with a DCS. Hollysys leveraging existing skills and experience to pioneer the implementation of a smart industrial platform, customized smart solution to meet the comprehensive needs of customers across verticals, such as power and fine chemicals.

A contract covering the production of approximately 500,000 tons of paper goods was signed with a large paper manufacturer. We offer a solution with DCS, Intelligent Operational Data System and instruments. This project representing the largest contract amount and production scale that Hollysys had won in the paper industry. It will boost Hollysys' industry credibility, creating a platform for the company to further penetrate the market.

Aftersales business of IA is keeping a healthy pace. Under our big automation initiative, we continued to strengthen customer relationship management and improve our capability for wider range of solutions. Under the influence of COVID-19 pandemic, the company launched Fangcun [indiscernible] smart services APP through which users can purchase spare parts, submit service requirements and participate in remote professional courses. The APP is also an e-commerce platform of industrial products for existing customers or partners to further enhance customer stickiness and boost future business development.

Rail business finished the quarter with revenue and new contract at $30.7 million and $15.7 million, recording a 7% year-on-year growth and 215.2% year-on-year growth. For the first 9 months of 2021 fiscal year, rail business revenue and new contracts showed a 7.5% year-on-year decrease and a 10.2% year-on-year growth, respectively.

In the high-speed rail, HSR, sector, we continue to deliver on existing projects while maintaining our market position in existing product lines plus exploring opportunity in new markets. Hollysys continue to apply smart and upgraded solution designed to meet the emerging needs of the market. Highlights of the quarter include: offering Automation Train Operation, ATO, to Beijing-Xiong'an railroad and offer Automation Train Protection, ATP, to Beijing-Harbin railroad. Our efforts are aligned with the established national rail strategies, and our strong operation performance has been recognized by our clients.

Applying the track circuit in Sichuan-Tibet railroad resulted in winning the first place Progress Prize in Science awarded by China Communications and Transportation Association. The application marks our entry in the track circuit field and contribution to the construction and development of a railway network in Southwest China.

In the subway sector, we continue our efforts in upgrading technologies and refining our solutions. We provide the complete system of CBTC and integrated with subsidiary system for the first time. The system has entered its pilot operation in Kunming Changshui Airport Express successfully. In addition, our smart metro station upgrading solution implemented in Shenzhen Subway Line 11 is helping clients establish a safer, more efficient, ecofriendly station. Hollysys' track record on SCADA, active automation improvement on existing products and integration of cloud computing, big data, AI, allow us to meet the needs of an increasingly demanding marketplace.

With the guidelines of the 14th 5-year plan of China, Hollysys is making great strides in the area of modernization and digitalization of infrastructure construction. Our Weather Effect Monitoring solution was widely recognized and was granted with Innovation Award of Excellent Products of Highway Industry of 2020.

Mechanical and Electrical Solutions, M&E, business finished the quarter with revenue and new contract at $11.8 million and $19.6 million, recording a 34.1% and a 1.2% year-on-year decrease. For the first 9 months of 2021 fiscal year, M&E revenue and new contract recorded 3.9% and 16.4% year-on-year decrease, respectively. COVID-19 remains a challenge to M&E and overseas business. We will keep monitoring the impact on this sector, and risk control remain a key focus.

With that, I would like to turn the call over to Steven Wang, our company's CFO, who will provide a financial results analysis. Steven?

Steven Wang

Yes. Thank you, Mr. Sung. I would like to share some financial highlights for the third quarter ended March 31, 2021. Comparing to the third quarter of the prior fiscal year, the total revenues for the 3 months ended March 31, 2021, increased from $80.8 million to $109.9 million, an increase of 36.1%. Broken down by the revenue types, integrated contracts revenue increased by 26.7% to $85.8 million, product sales revenue increased by 82.4% to $6.5 million and service revenue increased by 85.1% to $17.6 million.

The company's total revenue can also be presented in segments as follows. For the third quarter, Industrial Automation revenue achieved $67.5 million; Rail Transportation Automation revenue, $30.7 million; Mechanical and Electrical Solution revenue, $11.8 million. For the 9 months ended March 31, 2021, Industrial Automation revenue achieved $242.3 million; Rail Transportation Automation revenue, $140.6 million; M&E Solution revenue, $51.8 million.

The overall non-GAAP gross margin was 37.5% for the 3 months ended March 31, 2021, as compared to 30.8% for the same period of the prior year. The non-GAAP gross margin for integrated contracts, product sales and services rendered were 25.9%, 81.2% and 77.4% for the 3 months ended March 31, 2021, as compared to 22.3%, 71.3% and 75.3% for the same period of prior year, respectively. The gross margin fluctuated mainly due to the different revenue mix with different margins during the period.

Selling expenses were $7.2 million for the 3 months ended March 31, 2021, representing an increase of $1 million or 16.1% compared to $6.2 million for the same quarter of the prior year. Presented as a percentage of our total revenues, selling expenses were 6.5% and 7.6% for the 3 months ended March 31, 2021 and 2020, respectively.

The non-GAAP G&A expenses were $12.2 million for the quarter ended March 31, 2021, an increase of $3.3 million or 36.5% compared to $8.9 million for the same quarter of the prior year. Presented as a percentage of total revenues, the non-GAAP G&A expenses were 11.1% and 11.1% for the quarters ended March 31, 2021 and 2020, respectively.

The R&D expenses were $13.2 million for the 3 months ended March 31, 2021, representing an increase of $2.9 million or 28.7% compared to $10.2 million for the same quarter of prior year, mainly due to the increased research and development activities. Presented as a percentage of total revenue, R&D expenses were 12% and 12.7% for the quarter ended March 31, 2021 and 2020, respectively.

The VAT refunds and government subsidies were $11.6 million for the 3 months ended March 31, 2021, as compared to $12 million for the same period in the prior fiscal year, representing $0.4 million or 3.8% decrease. Income tax expenses and effective tax rate were $3.6 million and 18.5% for the 3 months ended March 31, 2021, respectively, as compared to $2.4 million and 14.8% for the comparable prior year period, respectively.

The non-GAAP net income attributable to Hollysys was $18.7 million or $0.31 per diluted share based on 60.6 million shares outstanding for the 3 months ended March 31, 2021. This represented a 34% increase from $13.9 million or $0.23 per share reported in the prior year period.

Contracts and backlog highlights. Hollysys achieved a total of $142 million of new contracts for the 3 months ended March 31, 2021. Backlog as of March 31, 2021 was $617.7 million. The detailed breakdown of new contracts and backlog by segment are as follows: new contracts achieved for the third quarter, Industrial Automation achieved new contracts of $106.7 million; Rail Transportation achieved $15.7 million; M&E business, $19.6 million. Backlog as of the end of Q3: Industrial Automation backlog, 263 -- excuse me, $262.3 million; Rail Transportation, $256.4 million; M&E business, $98.9 million.

Now the cash flow highlights. For the 3 months ended March 31, 2021, the total net cash inflow was $109 million. The operating cash outflows was $6.4 million. The investing cash flow was $112.7 million and mainly consisted of $163.8 million of matured short-term investments, partially offset by $45.7 million investment of an equity investee; $4.9 million purchase of property, plant and equipment; and $1.3 million purchase of a short-term investment.

Now the balance sheet highlights. The total amount of cash and cash equivalents were $466.1 million, $356.9 million and $366.4 million as of March 31, 2021, December 31, 2020 and March 31, 2020, respectively. For the 3 months ended March 31, 2021, DSO was 279 days as compared to 266 days for the comparable prior year period and 142 days for the last quarter. The inventory turnover was 58 days as compared to 71 days for the comparable prior year period and 40 days for the last quarter.

With that, I pass the call to Arden Xia.

Arden Xia

At this time, we'd like to open up for the QA session. Operator, please.

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question comes from Kevin Luo of Morgan Stanley.

Kevin Luo

[Foreign Language]

Arden Xia

Okay. Thank you, Kevin. The question is from Kevin, a Morgan Stanley analyst, and also company with the -- along with the company for -- focus on company for a long time, several years. And the first question is about the third quarter and the first 9 months about the Industrial Automation. No matter from the new contract or revenue or compare increase very fast, and for right now, we could see the revenue already doubled compared year-on-year growth. And what about the next quarter and the next fiscal year 2022, the guidance for the IA?

And the second question is about the -- we know about Hollysys have a lot of investment joint venture company, and like we provide the equipment system to the Haidilao. And also in the medical area, we also have a Chinese producer medicine company. And what about this company current revenue and the net income performance because I can saw from the financials that the equity investee compare decrease and this time is record a loss. So how about performance behind?

And the third question is about the dividend. Right now, we could see the cash and cash equivalents, plus the time deposits already are close to USD 700 million, and also Hollysys always have strong operating cash flow. So are you thinking about to raise the dividend payout ratio?

Colin Sung

The Industrial Automation right now performance compare increased and very strong, and we think it can keep this trend even in the coming years. And it's mainly because of two reasons. One is, currently, the market is recovering and especially domestic market is relatively strong. And we -- our performance could over the growth of the market growth itself. And the second one is about the business adjustment. We focus on the chemical, petrochemical area. And also compare to traditional power sector, even right now, power is also very good. But we reinforce our chemical, petrochemical penetration and also the medical food beverage area and especially focused on the upgrading for the [indiscernible] of the digitalization and also intellectual smart manufacturing.

Colin Sung

Okay. And the second question regarding the performance of our subsidiary. The couple of two major our subsidiary, one is regarding the nuclear operation and the other one is regarding the smart or intelligent services for Haidilao. At the current stage, those two companies just went through a reorganization, and we do see a certain cost increase for the quarter. And in relation to the third question regarding the dividend increase for the company, I think this is also the plan. Company will have a discussion with analysts as well as individual shareholders in the coming days and weeks. And it is part of the company's overall M&A strategy as well as the user policy or user capital to have more in-depth discussion with the shareholders in the coming days.

Kevin Luo

Can I have a follow-up question regarding the joint venture? You mentioned that this year, this fiscal year, some of the JVs that are happening, some of the organization. But may I know the revenue, the lovely revenue number? And how about the revenue outlook and the profitability in the next fiscal year?

Colin Sung

I think at this stage, we still is not a majority shareholder, and we do not give any guidance or any particular figures regarding those revenue. I think company in the process to reorganize along with the management team of subsidiary. In the near future, once company made the decision, I think we will give you more insight to those figures, Kevin.

Arden Xia

Okay. Thank you, Kevin.

Steven Wang

You're probably looking at the line of share of net income loss of equity investees. You see a fluctuation. Again, that's really a fluctuation. We're actually expecting for the total fiscal year for that line to actually increase compared to last year. So that's probably a fluctuation for this quarter.

Operator

Your next question comes from Lingxin Kong of CICC.

Lingxin Kong

[Foreign Language]

Arden Xia

Okay. Thank you. The first question about the Industrial Automation. And I also saw from the press release that you're already launching Fangcun [indiscernible] smart service APP and this is based on the cloud service and also the users can purchase spare parts, submit service requirements like -- stuff like that. And my question is about this kind of platform is just to focus on Hollysys' own after sales spare parts or it can also service the other like competitors, ABB, Schneider, for example? And also beyond that, a lot of Japanese company also focus on this area like to do the MRO, the industrial automation spare parts, those industry are already success. So what about your consideration from this stack?

And the second question is about the Rail Transportation, and we saw you won a CBTC system in Kunming and congratulations. And can you give more colors about background, how long your -- from your participated the bidding and to win the contract? And also, is there any other new opportunity for the coming year to have the CBTC contracts? And the third question about the production business itself. No matter, IA or Rail Transportation, we are all provide a control system. However, right now, spread across the whole world that the chips is lack of supply and also the raw material cost is growing. And have you ever meet any issue in this area? Especially, do you have enough chips to support the production for the business?

Lei Fang

About the first question, I want to emphasize that to be -- that relate to the Industrial Automation are different with the customer side. And naturally, we want to do it. The purpose is to provide high-quality services and also very quick response time to our customer. So that's why the current Fangcun [indiscernible] smart service APP is just to focus on Hollysys' after sale. And it's a combination of our supply and also -- upside or downside supply chain and also focus on the customer together to provide better services.

The CBTC, we won the contract in Kunming Changshui Airport line and right now is in operating. And we've made -- we've been made recognition by the experts within the industry and also recognition by the customer. So right now, this is a good demonstration that we could have capability to provide CBTC system to the other cities. So that's why right now, we also focus several potential targets, and right now it's under the discussion. And then this is including the local government and even the subway operating company. Maybe we could use the way to set up joint venture with them to better explain our platform within the subway sector.

And also, Mr. Kong Lingxin asked a supplement about the joint venture. You mean to cooperate with the local government or the local private sector companies. And the answer is more close to the government because the government have the policy to do the innovation and the upgrading for the whole industry. So they want to import the good entrepreneur and the company to join this area. So that's why this is also a few chance. Thank you.

Lei Fang

The third question also answered by Mr. Fang, the IA COO. Actually, you mentioned that the chips already started from last year to now, and we could see a lot of company be influenced by that. However, this is not influenced by our production because 2 years ago, we already got to start to prepare this kind of situation. So we have several ways. One is for the short-term chips. We have enough preparing in the -- in our backlog. And the second one is about the long-term chips. We are focused on the replacement -- I mean, the -- to find the other available supplier to instead of the situation.

The third way is for develop the next new generation DCS and also the other automation system, and right now, we already close to the end. I mean for the second half of this calendar year, we will provide our new generation DCS, including a lot of the other new products that based on to solve the supply chain and that they are our own IP and we could easy to solve the supply chain issue.

Operator

Your next question comes from Joseph Gu [ph] of JPMorgan.

Unidentified Analyst

[Foreign Language]

Arden Xia

Okay. Thank you. Two questions. One is about the chips and the raw material cost is growing, and what about the influence for the gross margin. And I also saw about your inventory and also cash flow, especially in freight compare increased a lot. So is this because of the -- of your pre-procurement of the raw material and chips? And the second question about IA. The IA revenue, could you give me a breaking down by industry niche market revenue or percentage? And for example, like the chemical, petrochemical and the pharmaceutical, food beverage right now compare increase relatively good, you mentioned. So what about the percentage contribution within IA right now? Thank you.

Lei Fang

The first question about the cost. And we also know about, for example, like the copper, like the chips are increased the cost right now. But for us, we -- this has not too much influence about our gross margin and still within the healthy range. And you said right, the inventory increased because we also have the preparing for those raw materials.

And the second one about IA proportion with the industry, because I cannot give you a number right now, but I can say from another stack. For example, like the petrochemical plus chemical, right now, the revenue contribution are already over the -- sorry, over the power sector. And the pharmaceutical, food beverage area right now is already reached to 2 [indiscernible] contribution by the IA revenue and grow relatively very fast. So it's already be the third large contribution niche market.

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

Colin Sung

Thank you.

Operator

That does conclude today's conference call. Thank you for participating. You may all disconnect.