Friday, February 14, 2020

Hollysys Automation Technologies (HOLI)

Hollysys Automation Technologies Ltd. (HOLI, the company) is a leading provider of automation and systems solutions in China, with overseas operations in eight other countries throughout Asia. The majority of its business is done in the industrial automation (IA) and rail transportation sectors, though it has low-margin operations in mechanical & electrical (M&E) and medical solutions as well. A miniscule debt-to-equity ratio, healthy historical cash flows, promising growth based on planned expansion in relevant sectors, and the Great Wall of China doubling as an economic moat all suggest taking a long position while the stock price hovers near its 52-week low.

Business Profile
Founded in 1993 and listed on NASDAQ since 2008, HOLI has grown from research team specializing in automation control in the power industry to a multinational company with customers in sectors including power, petrochemical, high-speed rail, and urban rail. In IA, HOLI provides automation hardware, software, and services spanning field devices, control systems, enterprise manufacturing management and cloud-based applications. In rail transportation, it provides advanced signaling control and supervisory control and data acquisition (SCADA) systems for high-speed rail and urban rail.

HOLI designs and manufactures all its products in-house at its facilities in Beijing and Hangzhou. Its core hardware is a printed circuit board, manufactured and assembled at the two Chinese facilities. Raw materials include bare printed circuit boards and various electronic components needed for assembly.

Approximately 82% of the company’s total consolidated revenues are derived from integrated solutions contracts won through the bid process. The remainder of revenue is generated through sales of spare parts, maintenance, and training services after the warranty period from the contracts has ended.

Ok, I kind of get it. So why should I be interested?
  1. A Strong Balance Sheet: After paying off its 20M convertible bond in Q1 of FY20, the company has total debt of only 2.5M. That’s good for a D/E ratio of 0.003, quite a bit lower than the 0.557 average of its competitors. It’s average OCF margin over the last three years is 19%, well above industry averages, and its average CFO/NI ratio over the same period is 0.99.
  2. Urbanization: Rapid industrialization and warped demographics has manifested in dramatic urbanization and economic integration, which in turn creates a critical need for infrastructure. Grand infrastructure goals are what a planned economy like China does best. While the world awaits the details of the PRC’s 14th Five Year Plan, you can bet HOLI will be busy servicing Chinese needs for high-speed rail and subway transit.
  3. Limited Domestic Competition: While large multinationals account for the majority of global automation market share, to the extent this is true in China does not extend to the verticals in which Hollysys makes most of its profits. Specifically, the high barriers to entry for servicing nuclear power plants and high-speed rail gives the company an enviable moat around a significant portion of its revenue share.
Valuation
Currently, HOLI’s sustainable competitive advantage comes from its specialized offerings of high-speed rail signaling systems to ensure the safety of passenger train movement. The China Train Control System (CTCS) is a country specific high-speed rail standard and therefore is different from international standards propounded by European organizations or Japan. This barrier to entry makes HOLI the largest provider in a growing market. In fact, their 39% market share from 2015-2018 for total automatic train protection (ATP) sets sold made them the largest Chinese company in the domestic automation market. 

Rail is also the division in which the company has its highest profit margins.
HOLI’s revenue comes from three main offerings: IA, Rail, and M&E. Historically, the revenue share between the three divisions has been very stable: 40%, 36%, and 23%, respectively. In 2019 and 2018, the company had a GP% of 37% and 38%. Over those two years, IA posted a GP% of 41% and 40% while Rail posted a GP% of 48% and 52%. M&E were by far its lowest margin operations with a GP% of 13% both years. The company does not provide revenue figures by geographical area for each division, but it does break out total revenues by geographical area. We can infer from this breakout and from other financial and marketing materials that almost all IA and Rail revenue is derived from business in the PRC while M&E revenue is generated from its foreign subsidiaries in Singapore, Malaysia, and the Middle East.

China’s high-speed railway operating mileage, currently the largest in the world, has grown from 19,000km in 2016 to 32,000km at the end of 2019, covering 80% of China’s major cities and surpassing the 30,000km goal by 2020 laid out under the 13th Five Year Plan. Though the details of infrastructure goals won’t be released until the next five year plan in 2021, high-speed rail is expected to be at least a $4.4 billion industry by 2023, with maintenance and replacement accounting for a rapidly growing share of expenditures. Higher growth is expected in the urban rail transit sector, which is expected to grow from 5,500km to 9,276km by 2023. In general, infrastructure needs are driven by the rapid urbanization and regional economic integration and is supported by ambitious policies such as the five year plans, Eight Horizontal and Eight Vertical High-speed Railway Corridors project, and the Belt and Road Initiatives. With its leading market share in these industries, HOLI is well positioned to take advantage of this growth. ­

China’s industrial automation market is similarly poised for accelerated growth. Total contract amount from industrial automation in China grew at a 4.9% compound annual growth rate (CAGR) from 2014 to 2018 and reached a total value of $30.1 billion. The market is estimated to accelerate that growth to 11.1% CAGR from 2018 to 2023 and reach $50.6 billion. Over that same time, petrochemicals and power are expected to grow at CAGRs of 14.5% and 5.8%, respectively. While competition in the industrial automation market is stiffer, HOLI’s roots in automation for power and petrochemicals, growing name brand recognition in China, advanced technology, and cash-rich position give it a good position to increase its market share. Importantly, HOLI has a unique advantage when it comes to nuclear power.

The 2011 Fukushima nuclear disaster threw a major wrench into China’s plans for nuclear power. To reassure the population that the country was not a risk of a similar catastrophe, the PRC placed a moratorium on the construction of new power plants. After lifting that ban in 2019, the country has 47 nuclear reactors in commercial operation, with twelve more under constructions and more on the way. The impetus for nuclear power in China has increased due to air pollution from coal-fired plants and as a result the country has subsidized nuclear power with an aim to match and surpass the world average of 15% for total electricity generated by nuclear power (currently at 4.75%). HOLI is the only qualified local automation and control product provider to the non-safety control for nuclear power stations. In the nuclear automation segment, HOLI competes with multi-national corporations such as Siemens, Areva, and Invensys, but with the abnormal glut in demand created by the Fukushima disaster HOLI has a prime opportunity to increase its market share.

The M&E division offers solutions through Concord and Bond Groups, two subsidiaries acquired by HOLI in 2011 and 2013, respectively, in Southeast Asia, the Middle East, and Hong Kong. While this division has the lowest revenue and profit margins in relation to the company’s other operations, it also offers its greatest opportunity for business expansion and diversification. A 2019 partnering with the London engineering consulting firm Arup signals a willingness to expand the M&E offerings, potentially through more acquisitions. While profitable, the revenues generated by this division do not significantly affect our valuation of the company. Barring any interesting acquisitions, the only growth we forecast for M&E is over the long-term.

An important measure in our valuation comes from HOLI’s dedication to research and development. Historically, the company spends 6-7% of revenue on R&D, and 40%, or 1,500 employees, of the 3,200 person company work in R&D. Their proprietary technology is at the center of their rail and power offerings – as of June 30, 2019, HOLI held 221 software copyrights, 126 authorized patents, 64 pending patent applications, and 44 registered trademarks. The Chairman and CEO, Shao Baiqing, has been with the company for more than 25 years starting as one of the founding engineers, and “is widely regarded as an industry leader with significant influence in China.”

Despite the fact that EBITDA has grown over 60% since FY17, HOLI has an EV/EBITDA 3.5x. This is both well below the historical multiple for the company and far below its competitors. Taking into account the growing industrial automation and high-speed transit sectors in China, while accounting for some slowdown in infrastructure spending in the current year as the window of the 12th Five Year Plan is closing having already surpassed expected rail mileage, a conservative estimate of future 5% revenue growth rate YoY is appropriate. I see no reason for net income growth to lag behind this rate. Using consistent conservative estimates I arrive at a fair value of $25 per share, close to a 60% discount rate.

Risks
  • Corona virus may mutate and spread, slowing business and further depressing Chinese stock values for an unknown amount of time.
  • Escalations by either the U.S. or China in their trade war could negatively affect trade relations or may cause further slowdowns in Chinese economic growth and depreciation of the RMB. This has the potential to adversely impact HOLI’s supply chain for its products and stifle the demand for capital projects and domestic investment in China.
  • The Beijing and Hangzhou subsidiaries of Hollysys are recognized as high and new technology enterprises, or HNTEs, by the PRC government, which entitle each of them to a reduced income tax rate of 15% (compared to the statutory income tax rate of 25%). Additionally, HOLI received VAT refunds and government subsidies of $33 million in FY2019. If the HNTE status is not renewed for those subsidiaries, or the PRC stops recognizing HOLI as a qualified research and development enterprise deserving of VAT refunds, the result could have a material adverse effect on future operations.  

Edit 02/14/2020: In response to a reproduction of this report I posted on r/securityanalysis, I received a comment asking if I had any thoughts on this 2011 post and have reproduced my response below:

A few. After tumbling down the rabbit hole of Australian fund managers, I've come away with the impression that the author, John Hempton, is known for his loud and well-timed shorts – it's worth noting that Bronte Capital's most popular fund posts solid returns while billing itself as both a long-short investment vehicle. The benefit to calling BS on a company's stock is that you get to claim you're right even when you're wrong – search for "Tesla short" and drink every time you read the word "cult." The downside is the time factor in the value equation has a much heavier weighting.  The stock price fell to $5.43 in November of 2011 and didn't permanently get back above Hempton's price of ~$8.80 until August of the next year (coinciding with -25% decline in the Shanghai Composite). The stock then rose ~100% percent over the next two years and since its $25 peak in January of 2015 has only dipped below $15 for one month (Oct. '19). So, was he right?

To quickly address his three core arguments:
  • His accusation that – for whatever reason – Hollysys was fudging their PP&E figures was based on assumptions as misguided then as they are today.  The company has never claimed to manufacture its circuit boards; as previously stated, they outsource manufacturing and assemble their boards in their Beijing and Hangzhou facilities.  Based on an albeit limited knowledge of Chinese labor practices, I’m going to assume the opposite: the boards are assembled by hand, not by machine. 
  • I’m going to do myself a favor and not pour over ten year-old balance sheets. Here’s a comment on the post that I agree with: https://imgur.com/a/Nioip3M
  • His point on BDO Hong Kong and general corruption in the PRC is well-received.  For what it’s worth, HOLI’s independent auditor for the FY19 20F was Ernst & Young Hua Ming LLP.  Though I doubt the PCAOB, or whatever Chinese version of an independent accounting investigatory body on public reporting, will be dive-bombing Chinese small-caps any time soon, a Big 4 firm is generally going to have more public audit experience than a BDO.  In response to general corruption, I can see how a reading of my HOLI report could be considered credulous.  To be frank, I assume a certain level of corruption in any bid process regardless of the country.  Certainly, a planned economy will have a higher level of corruption when it comes to infrastructure projects.  My modest proposal was that the share price is undervalued based on historical EV/EBITDA multiples and conservative projections of future revenue.  
I don’t fault anyone who’d rather stay away from Chinese small-caps.  You assume a level of risk that should be built into your fair value projections and portfolio management.  But thanks for bringing Hempton’s oeuvre to my attention – I’ll be sure to keep a close eye on his shorts from now on.

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