The HollySys (HOLI) story is no less frustrating than it was a quarter ago, as the company posted mixed fiscal second quarter results, but also appeared to continue to gain share in China’s process automation market. Margins may well remain under pressure for some time, as the company continues to show a willingness to trade margins for market share in automation and as it continues to reinvest in R&D in both the automation and rail businesses.
As for the shares, they continue to look undervalued, with the stock at a five-year low in terms of price/book and EV/EBITDA. This is a profitable business that consistently generates solid free cash flow and sports a healthy balance sheet. Still, it is not particularly well-followed, it’s not particularly large, and the company’s performance has been erratic (and communication with investors has been far less than perfect). Investors attracted to the story and low apparent valuation would do well to at least be aware of the “value trap” risk here, even though the company is leveraged to some attractive trends, including a growing emphasis on self-sufficiency within China’s automation market.
A Mixed Set Of Results
HollySys didn’t post poor numbers for the second quarter (calendar fourth quarter), but they were perhaps noisier than investors would like. Revenue was solid relative to expectations, but gross margins were weaker, while ongoing R&D projects and lower government subsidies impacted the operating line.
Revenue rose 14%, the strongest result in a while, with both of the major units growing by double-digits. Industrial Automation revenue rose more than 15%, while Rail revenue rose about 24%. The small M&E business saw a 40% decline.
Gross margin declined 190bp, due in part to mix, but also due to what I believe is a willingness on the company’s part to trade margin for market share in the automation business. Lower VAT refunds impacted operating income, leading to a 20% decline and a nearly nine-point reduction in margin. Excluding items like VAT refunds, operating income would have been flat, with the lower gross margin accounting for most of the operating margin compression.
Order Numbers Show Some Encouraging Signs
HollySys reported mixed order numbers, but I believe the underlying results are a little stronger than they may first appear, particularly in the context of a still-challenging Chinese market.
Industrial Automation orders rose 58% and HollySys had a better-than-average quarter from a book-to-bill perspective – while the company’s quarter-to-quarter results are volatile, this tends to be a weaker quarter for IA. Rail orders were down 40% from the year-ago level, but quintupled the prior quarter’s number and came in more than 40% above the trailing four-quarter average as the company saw procurements pick up. M&E orders were down 67%, with management noting that they’re prioritizing risk control over growth at this point; from a strategic viewpoint, I believe management is trying to learn from past mistakes and restructure this business in a more sustainable direction.
Looking at the backlog, IA grew 16% and can support more than two and a half quarters of revenue at this quarter’s run-rate. In the rail business, backlog declined 7% but can support almost a full year’s worth of revenue at this quarter’s run-rate.
Progress On Multiple Fronts
HollySys is maintaining its strong traditional position in automation and controls for China’s thermal (coal-fired) power industry, but is increasingly winning business in growth verticals like petrochemicals – the company signed an EPC contract in December as a general contractor for a chemical plant project. HollySys is also continuing to expand its total solutions offerings (versus discrete products), a process that hurts margins in the short term, but expands its addressable market over the long term.
HollySys also noted a win with CNOOC (CEO) for a control solution for the central equipment platform for a domestic oil field. HollySys has been picking up business with CNOOC, and this is the first time that CNOOC has used a domestic supplier for this type of product. While I can’t confirm whom HollySys displaced, given past business and contract announcements, I think it’s likely that ABB (ABB) was the loser here, and that would be/is a pretty significant mark of progress for the company.
For the rail business, HollySys is leveraged both to growth opportunities in intelligent HSR signaling and upgrade projects for older HSR lines. Many significant high-speed lines are at or near their 10-year mark, including the Wuhan-Guangzhou line, and will need upgraded control systems. I’d also note that is year is the end of a five-year investment plan, and orders and procurements should improve in the coming quarters as remaining funds. One important “but” is the impact of the Covid-19 outbreak, which is likely to delay procurements in the short term.
The Outlook
Given the uncertainties tied to Covid-19, management declined to offer much in the way of guidance, and I believe that’s a reasonable approach to a still-developing situation. HollySys appears to be doing better than almost any of its automation peers/rivals in the Chinese market, helped I’m sure by increasing import substitution, and HollySys also has the benefit of relatively little exposure to pressured segments like autos. Still, the Chinese economy is not in great shape and it remains to be seen if there are further shoes to drop with the virus outbreak.
I’ve lowered my fiscal 2020 revenue estimate by 5%, more out of a desire for caution/conservatism than any real fundamental issues. There’s no real impact to my long-term outlook, though, as I believe business lost in 2020 will likely be picked up later. Long-term, I still expect mid-single-digit growth in both revenue and FCF margin, with FCF margins in the mid-teens.
Discounting those cash flows back, I believe HollySys shares are significantly undervalued even with a 13% discount rate. The shares also trade at a substantial discount to what would otherwise appear “fair” on an EV/EBITDA basis given the company’s margins and returns (ROIC, et al). Some discount is certainly fair given the elevated risk and volatility here, but this level of discount seems excessive to me.
The Bottom Line
What will it take for HollySys shares to start performing better? A prompt end to the Covid-19 outbreak would certainly help, as would a general improvement/recovery in the Chinese economy. Unfortunately, the clockwork quarter-by-quarter growth in revenue and orders that investors love is likely to continue to be quite challenging for HollySys, particularly in the rail business given the nature of orders/procurement. Still, I do think HollySys has logged some meaningful wins in the IA space and remains competitive in the rail signaling market. This is a high-risk proposition, but the valuation is increasingly making that look like a risk worth taking for more aggressive investors.
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.
