Hollysys Automation Technologies Ltd (NASDAQ:HOLI) Q2 2021 Earnings Conference Call February 4, 2021 8:00 PM ET

Company Participants

Arden Xia – Investor Relations Director

Colin Sung – Chief Executive Officer

Steven Wang – Chief Financial Officer

Lei Fang – Chief Operating Officer, Rail business

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 Second Quarter Ended December 31, 2020. At time all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. [Operator Instructions] Please be advised that this conference is being recorded today, March 05, 2020, Beijing time.

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

Arden Xia

Hello, everyone, and thank you for joining us. Today, our attendees are CEO, Mr. Colin Sung; CFO, Mr. Steven Wang; CSO, Mr. Yi Ma; COO, Mr. Yue Xu and Mr. Lei Fang, who are in charge of IA and Rail business, respectively and myself the IR Director of Hollysys Group, one of the company's subsidiary; and myself, IR Director of Hollysys.

On today's call, Mr. Sung will provide a general overview of our business, including some highlights for the second quarter and the fiscal half 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 may contain forward-looking statements within the meaning of Private Securities Litigation Reform Act of 1995. Forward-looking 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 these statements.

Business conditions in China and in Southeast Asia; continued compliance with government regulations; legislation or 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 transition to new markets; intensity of competition from or introduction of new and superior products by other providers of automation 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' filing with the Securities and Exchange Commission.

The information set forth herein should be raised 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 in U.S. dollars, unless otherwise noted.

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

Colin Sung

Thank you, Arden, and greeting to everyone. The industrial automation, or IA business, finished the second quarter with revenue and new contracts at $92.9 million and $71.4 million, achieving 34.1% and 2.7% year-on-year growth. For the first half of the fiscal year, IA revenue and contract grew 30.5% and 16.8% year-on-year, respectively.

In power sector, we maintained our market position. Highlights of the quarter include, won a bid for 1 600 megawatt power units DCS replacement project, and the bid for 2 600 megawatt power units DCS replacement project for two high profile clients. Both clients are switching from an overseas solution to a domestic solution for these two projects, and we expect these recent wins to be indications of further cooperation of this kind in the future.

In chemical and petro-chemical sector, we continued penetrating into different verticals by winning key projects and solid execution. In addition, we are building our extensive capacity through our R&D efforts and collaboration with external parties along the value chain. With our consistent high-quality project delivery, we are recognized as a market leader by our clients and continued to enhance our reputation within the industry.

Sector highlights of the past quarter include, launching our new versatile I/O solution, specifically designed for clients in the chemical and petro-chemical sector with sizable production sites. Our solution aims to optimize the signal transmission section of the entire control solution in the field, and then will lead to increased transmission reliability, as well as a substantial reduction in cable consumption and the space required for equipment cabinet layout. Petro-chemical clients will gain increased delivery efficiency and benefit from reduced project costs. We expect our solution to drive further penetration in the sector.

Won the bid for DCS and ESD, emergency shutdown device, solution for a gas field platform project. The largest platform project for the Company to date in terms of contract value and SIS control points, demonstrating meaningful progress for Hollysys in these verticals. Signed a comprehensive control solution contract with a client on its phenolic resin project. The contract covers both basic and advanced control solutions and the first time the Company has applied its solution to this specific chemical process, marking another breakthrough for the company in this fine chemical vertical.

Successfully delivered our DCS, GDS and SIS solution for a client on its oil refining capacity expansion project. The client's production capacity is expected to increase to 10 million tons per year level and it is the first time this client has adopted a domestic control solution for an oil refining project with this level of production capacity. Successfully delivered an APC solution for a client on its organosilicone project. The value provided by our solution was greatly appreciated by the client. Our client has seen distinct improvement in terms of increase in the equipment self-control level, decrease in input consumption both steam, electricity and an increase in production capacity, creating a substantial economic benefit.

In aftersales service, we continued to leverage on our national service network to capture market opportunities from our existing client bases, responding to various services and replacement demands in order to safeguard their productions. Our consistent high-quality delivery continues to be well regarded. We successfully completed a DCS replacement and upgrade project for existing clients for its 5 million tons per year oil refining capacity. The project encompassed software and hardware upgrades, information security deployment, delivering improved system performance and reliability.

In the smart factory business, we continue to actively engage potential clients through our various marketing events, gaining an in-depth understanding of market demand. Hollysys continues to develop and improve its value creating solution driving economic benefits and improved operational safety. Highlights of the past quarter include established a cooperative relationship with a client from the chemical sector which the company and the client aim to collaborate promote future smart factory upgrades for other clients in the region.

Won a smart factory contract for a client from the chemical sector for its organosilicone project. The project covers a comprehensive DCS, SIS, GDS, AMS, ODS control solution as well as the construction of an integrated data platform as the foundation for further digital upgrade initiatives. Won a smart factory contract of existing clients from the power sector on its two 1,000 megawatt power units. The project will cover control level solution such as smart control, equipment diagnosis, smart alarm and the production management level solutions.

Rail business finished the quarter with revenue and contract at $81.3 million and $99.9 million, recording 3.1% year-on-year growth and 4.2% year-on-year decrease. For the first half of the fiscal year, Rail revenue and contract achieved 10.9% and 0.9% year-on-year decrease, respectively. In high-speed rail, HSR sector, with the rail-road construction progress, we continued to sign new contracts, deliver on existing projects, maintaining our position in existing product lines and exploring opportunities in the new market lines. We have also been devoting consistent R&D resources to key technologies with the intention of expanding our solution capabilities and to drive our future performance.

Highlights of the quarter includes, won the bid for 50 sets, out of the total package of 166 sets, of ATP for C3 350 kilometer China Standard High-speed train during the quarter, completed the delivery of several projects where the company provided on-ground solutions such as Train Control Center, TCC, Radio Block Center, RBC, and Temporary Speed Restriction, TSRS, and our high quality engineering continues to be recognized by our clients. Some of the completed projects include Weifang-laixi high-speed rail, Taiyuan-Jiaozuo session of Zhengzhou-Taiyuan high-speed rail and Shaanxi session of the Xi 'an-Yinchuan high-speed rail.

Signed a regular speed track circuit contract for the Xingguo-Quanzhou railway Ninghua-Quanzhou session, the railway connects Jiangxi and Fujian Provinces. The contract marks another step forward for the Company in the regular speed track circuit market. In subway sector, the Company provided several lines to which SCADA solution was put into operation in the quarter, including Phase 3 of Shenzhen Subway line 2, Phase 1 of Shenzhen Subway line 8 and line 2 of Hohhot Subway. Our role in those projects covered product provision, system integration, debugging, and our delivery quality continued to be trusted by our clients.

In aftersales business, we continued to strengthen local service network, to expand service solution and to develop technology-and-service-centered services for better differentiation. In HSR sector, we continued to respond to demand including advanced maintenance, system and software upgrade, part component sales, as well as total replacement. Our service capability continued to be highly recognized by our clients.

Following the breakthrough contract of smart highway solution in the previous quarter, we continued to get actively involved in marketing events for further market opportunities. Meanwhile, as an experienced and responsible player in the railway industry, we took part in the national initiatives on industry-education integration, and we jointly established Hollysys Institute of Railway Industry with a local vocational technical institute from Nanjing city this quarter. We expect to join hands with more railway transit schools in the future and, leveraging on our market experience, we hope to contribute more to the talent raising of the industry as well as deeper industry-education collaboration.

Mechanical and Electrical Solutions, M&E business finished the quarter with revenue and contract at $21.2 million and $22.3 million, recording 3.8% year-on-year decrease and 86.7% year-on-year increase respectively. For the first half of the fiscal year, M&E revenue and contract achieved 11.1% year-on-year growth and 24% year-on-year decrease. COVID-19 remains a challenge to M&E and overseas business. We will keep monitoring the impact on this sector and risk control remains to be the key focus.

With that I would like to turn the call to Steven Wang, our CFO, who will provide a financial result analysis. Steven?

Steven Wang

Thank you, Mr. Sung. I'd like to share some financial highlights for the quarter ended December 31, 2020. Comparing to the second quarter of the prior fiscal year, the total revenues for the second quarter ended December 31, 2020 increased from $170.1 million to $195.3 million, an increase of 14.8%. Integrated contracts revenue increased by 9.9% to $142.5 million, products sales revenue increased by 29.3% to $8.5 million, and service revenue increased by 31% to $44.4 million.

The Company's total revenues by segments are as follows. For Q2 of fiscal year 2021 industrial automation revenue $92.9 million, rail transportation automation revenue $81.3 million, mechanical and electrical solution revenue $21.2 million, total revenue $195.3 million. Overall non-GAAP gross margin was 37.7% for the Q2 of fiscal year 2021 as compared to 36.3% for the same period of last year. The non-GAAP gross margin for integrated contract, product sales and services vendors were 28%, 85.6% and 59.3% for the second quarter as compared to 28%, 66.4% and 62.6% for the same period of the prior year, respectively. The gross margin fluctuation was mainly due to the different revenue mix with different margins.

Selling expenses were $10.3 million for the second quarter a decrease of $0.1 million or 1.3% compared to $10.4 million for the second quarter of last year. Presented as a percentage of total revenues, selling expenses were 5.3% and 6.1% for the three months ended December 31, 2020 and 2019 respectively. Non-GAAP G&A expenses were $13.6 million for the second quarter, represented an increase of $3.1 million or 28.8% compared to $10.6 million for the same quarter of last year. Presented as a percentage of total revenues, the non-GAAP G&A expenses were 7% and 6.2% for quarters ended December 31, 2020 and 2019, respectively.

R&D expenses were $18.6 million for the second quarter, an increase of $4.8 million or 34.9% compared to $13.8 million for the same quarter of prior year, R&D expenses were 9.5% and 8.1% for the quarter ended December 31, 2020 and 2019, respectively. The VAT refunds and government subsidies were $3.1 million for the second quarter as compared to $6.3 million for the same period in the last year, represented a $3.2 million or 50.4% decrease, which was primarily due to the decrease and delays of VAT refunds.

The income tax expenses and the effective tax rate were $5.9 million and 15.9% for the second quarter as compared to $6.8 million and 16.7% for the comparable prior year period. The effective tax rate fluctuation was mainly due to the different pre-tax income mix with different tax rates, as the company's subsidiaries are subject to different tax rates in various jurisdictions.

The non-GAAP net income attributable to Hollysys was $32.2 million or $0.53 per share based on 60.9 million diluted shares outstanding for the second quarter of 2021. This represents a 5.7% decrease over $34.2 million or $0.56 per share in the second quarter of last year. On a GAAP basis, net income attributable to Hollysys was $31.4 million or $0.51 per share, a decrease of 7.9% over $34.1 million or $0.56 per diluted share in the comparable prior year period.

Contracts and backlog highlights, the backlog as of December 31, 2020 was $601.3 million. The detailed breakdown of new contracts and backlogs as follows. New contracts for Q2 of 2021, Industrial Automation $71.4 million, Rail Transportation $99.9 million, Mechanical and Electrical Solutions $22.3 million. Backlog as of December 31, 2020, Industrial Automation backlog $234.2 million, Rail Transportation $273.3 million, Mechanical and Electrical Solution backlog at the end of the last quarter will be $93.7 million.

Cash flow highlights, for the second quarter of fiscal year 2021, total net cash inflows was $33.6 million. The net cash provided by operating activities was $33.4 million. The investing cash flow was $0.4 million and mainly consisted of $2.8 million purchases of property, plant and equipment, and $35.9 million purchases of short-term investments, which were partially offset by $39.1 million of matured short-term investments. The financial cash flow was $12.1 million and mainly consisted of $12.1 million payment of dividends.

Balance sheet highlight, the total amount of cash and cash equivalents is $356.9 million, $321.6 million, and $403.9 million as of December 31, 2020, September 30, 2020 and December 31, 2019, respectively. For the second quarter of fiscal year 2021, DSO was 142 days, as compared to 137 days for the comparable year period and 185 days for the last quarter; the inventory turnover was 40 days, as compared to 39 days for the second quarter of last year and 58 days for the last quarter.

Arden please go ahead.

Question-and-Answer Session

A - Arden Xia

At this we would like to open up for Q&A session. Please note that for Chinese speaking participants, we can also do the Q&A in Madrid and will provide translation. [Foreign Language] Operator, please.

Operator

Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] And your first question comes from Kevin Luo [Morgan Stanley]. Your line is now open. Please ask your question.

Kevin Luo

Hi.

Colin Sung

Hi, Kevin.

Kevin Luo

[Foreign Language]

Arden Xia

Okay, thank you. The first question comes from the Kevin, Morgan Stanley and three questions. One is for the privatization and offers. The company always will be focused by the other group for the offer and what about the company's attitude? And whether the company expected to see this kind of offer? The second one is about the revenue and the gross margin, the current half year still okay, but the operating expenses is growing relatively fast, especially the R&D expenses. What are the key behind for example like the employer numbers is growing for the other reasons? And what about the trend for the operating expense in the next moment? And the third question is for the industrial automation sector, the revenue growing relatively faster, but the new order we could see a little bit slower than the revenue. And what about the trend for the new contract in the coming moment?

Colin Sung

Hi, Kevin. This is Colin here. So I will respond the first quarter and then our CFO will respond to the second question. And then the last question, I will leave to our COO to respond. So for the first question, recalling this privatization offer, first of all, we only received a two unsolicited offers from the [indiscernible]. So we do not receive numerous offers. That's the first statement I want to make correction.

And then regarding the first offer the board approved through the discussion and review with that. And then on the second one, and that basically our board director issued a press release stating the board [indiscernible] of duty and then it's consultation with our independent financial and legal advisor and the color is still kept under review and then evaluate the revised proposal receipt. I mean, that review process still is ongoing, and then we will provide more update when a determination has to be made. At this point, we have no further update nor any announcement related to this offer. Okay. I think the second question, Steven you may answer recalling our expenses related to R&D increase.

Steven Wang

Sure.

Colin Sung

And Kevin also asked the question, is there any additional substantial people headcount increase related to those R&D. So go ahead, Steven.

Steven Wang

Right. Okay. Look at a quarterly basis, for the second quarter our R&D expenses increased 35%. On this first half of the year, we increased about 25.7%. So you can see a quite amount of an increase of our R&D expenses. And there were various reasons. We'll see the number of people increased. We also see the labor costs rising. For the detailed investment in different sectors, I will leave that to Mr. Fang and Mr. Xu to give a more detailed color on the IA and the rail industry.

Arden Xia

Sorry, by the way, this is Arden. And I also want to add some colors about the R&D respect. And actually, we are focused on developing a lot of new technology and products currently for the IA, for example, like the smart factory solution, new DCS platform, and also this new DCS based on the massive supply chain. And also in the rail sector like the infrastructure platform for the rail smart products and also C4 signaling system, those stuffs like that. So this is also the other reasons for the rising R&D expenses. Okay, go ahead Mr. Fang.

Lei Fang

[Foreign Language]

Arden Xia

And Mr. Fang also emphasize that two things within the R&D. One is the next generation DCS product and also focused on the intelligence smart manufacturing plant. And also second one is focused on the – because domestic customer also focus on the localization supply chain. So that's why we also develop our product based on the supply chain changing.

Lei Fang

[Foreign Language]

Arden Xia

Okay. And so the Rail Transportation Minister Mr. Sheng also mentioned about it in the rail sector we focused on several things. One is the intelligence business platform. For examples [indiscernible] is the product like the – the engine controller and that this is kind of a new product that also launching within the city line and the national lines. And right now we are investing that’s more into these new product and technology. And the other side is so focused on the high speed rail signaling; this is the kind of combination interlocking system combined with the train control signaling the other technology together and also develop the C4 technology.

And this year we are doing the experimental design and also the trial within the project. This is a kind of centralized the investment at the – at this stage, we keep the pace with the China Rail Corporation. I mean, our climb the speed and that the R&D expenses not like this term, and will continue very keep high investment from the rail – high-speed rail sector because right now it's the beginning. So we centralized to investment even more. And this is also depends on the China Railway Corporation and customers demand.

Yes. The last question is for the IA take part…[Foreign Language].

Lei Fang

[Foreign Language] Okay, the Industrial Automation the revenue compare increase, and this is normal, if we talk about the contract, right now it is relatively slower, but it’s because of COVID-19 influence. Because the COVID-19 the contract, that process is sometimes the reason is changing by distributed by different process. So right now it just the process is normal, but the final signed contract that may delay a little bit. So from the distributor to say the trend for the new contract that you still very steady and we could see the steady contribution in a coming moment. Thank you, Kevin.

Kevin Luo

Thank you very much.

Operator

Thank you. [Operator Instructions] The next question is from the line of Lingxin Kong from CICC. Please ask your question.

Lingxin Kong

[Foreign Language]

Arden Xia

Okay. The question from CICC, Mr. Lingxin, three questions, one is for the business outlook and what about the outlook for the second and half fiscal year performance? Especially IA and Rail and IA, is it a possible to keep the momentum like the revenue growth at this point? And also the second question is in January, we had a press release about the share buyback of the management team, what the procedure – right now the procedure could update to us. The third question is related to the factory automation and at this part Colin, CEO said we won the orders and made it a progress. Can you talk a little bit more about that this quick and shall affected automation progress and what kind of project, and also new – is there any new customers. Thank you.

Colin Sung

Steve?

Steven Wang

Yes. I’ll take the first question. Yes, well, I think we are going to see a healthy steady growth trend for industrial automation business for the coming two quarters. In other words, the second half of fiscal year 2021, we’re going to see still the same train for railway business, rail business, because this is a longer-term – have a longer–term cycle for the contract to be realized to be a revenue. So we’re going to see a slow stellar gross for railway business, the similar trend I’m passing with fall in the first half of the fiscal year.

Colin Sung

Yes. The second question regarding the management share buyback, company implement a corporate governance review in May last year and continuing the first – sorry late 2019 and continued the first half of 2017. And then one of those policy are implemented is a recall the company inside the training policy. It obviously the announcement announced for the management to share buyback up for the $15 million over the six-month period giving the codes window at the time make the announcement. And then they will not able to purchase from the open market for the period of time until today.

So once the window is open in the next 24 hours, and a management team will be making the purchase, which will be an additional six months from the date of opening. And then there is any progress or any update will company will update the shareholder as well as the Street. So at the current stage, they pushes program installed, but not in the share is being purchased from the open market yet.

Lingxin Kong

[Foreign Language]

Arden Xia

For the factory automation right now that may contract is still coming from the existing customer based on the process control area, because this part to currently have very good demand and we have a lot of customer base that based on the process control and also I want to emphasize this kinds of customer, a very good customer, no matter from the margin by Hollysys or the technology maturity to say it’s much easier and visible to launching the factory [indiscernible] control system, then the single factory automation customers. So that’s why right now are focusing is to tackle the factory automation a combination of PA and a process control and factory automation together, and also help them to optimize the management related the demand.

Lingxin Kong

Okay. Thank you. [Foreign Language]

Arden Xia

Okay. Thank you. Thank you, everyone for 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 near future. Thank you.

Colin Sung

Thank you.

Steven Wang

Bye-bye.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you all for participating. You may now disconnect.