SIEGY - Better Results From HollySys But Investability Remains An Issue

Summary

• HollySys posted good second quarter results, with the company continuing to grow its automation business in the petrochemical and oil/gas markets and rail projects getting back on track.
• The Chinese government is pushing for enterprises in strategic sectors to opt for local providers when possible, and that should benefit HollySys at the expense of international automation rivals.
• Expansion of the rail network, on catching up on pandemic-delayed projects, remains a government priority, but HollySys has to prove it can drive more consistent results here.
• HollySys is not overvalued assuming mid-single-digit revenue growth and low-to-mid-teens FCF margins, but investability is an issue as investor communication and disclosure are suboptimal.

Credit where due - the return of Changli Wang to the CEO role at HollySys Automation Technologies ( HOLI ) does seem to be making a positive difference. The execution in the Industrial Automation business has improved, and while the Rail business is still consistently inconsistent, there have been some notable wins in the business. These improved results, and the end of China's zero-COVID-19 policy have not gone unnoticed, with the shares up more than a third since my last article .

Valuation was never my concern here - I thought fair value was in the $20s before, even with fairly punitive valuation metrics (a higher discount rate, a lower EBITDA multiple, et al). The issue was and is investability. Talk of forcing Chinese companies to delist from U.S. exchanges has cooled, but there are still serious ongoing issues between the U.S. and Chinese governments that could impact an investment in HollySys.

Beyond that, the company's communication was shareholders has improved to some extent, but is still far worse than what most investors in U.S., European, or Japanese companies are likely accustomed to, and I believe this is a non-trivial issue to consider. Without reliable, consistent, and detailed communication, the line between investment and speculation or gambling definitely begins to blur.

Solid Results In The Fiscal Second Quarter

HollySys results are difficult to benchmark. HOLI stock is basically uncovered by the Street now, and while large international automation players like ABB ( ABB ), Emerson ( EMR ), Honeywell ( HON ), and Siemens ( OTCPK:SIEGY ) do compete in China, the level of disclosure they offer about their automation businesses in China on a quarterly basis typically isn't enough to make definitive comparisons.

Revenue rose 13% year over year and 44% quarter over quarter, as the company saw meaningful improvement as rail projects have gotten back underway in earnest with reduced pandemic restrictions. Industrial Automation revenue improved 16% year over year and 9% quarter over quarter, while Rail improved 12% yoy and 218% qoq and Mechanical & Electrical Solutions rose 5% yoy and 15% qoq.

Gross margin improved 350bp yoy and 850bp qoq to 39.6%, helped by significantly better cost leverage in the Rail business. Operating income more than doubled from the year-ago period, with margin up 860bp yoy and almost 10 points qoq to 19.6%.

Both ABB and Emerson saw relatively soft results in China in the quarter with their automation business, with ABB reporting a "slight" slowdown and Emerson referring to its growth as "offset" by shutdowns in China (suggesting year-over-year decline to me). Siemens, on the other hand, posted 17% year-over-year growth in China on strong backlog conversion in Digital Industries, but weaker results (down 7%) in Smart infrastructure.

Leveraging Strong Government Relationships In Automation

HollySys continues to do a good job with "land and expand" business wins with Chinese state-owned enterprises including PetroChina (PCCYF) and Sinopec (SHIIY). With this, the company has continued to win new awards in the petrochemical and oil/gas market verticals for a range of products including distributed control systems, safety instrumentation systems, and manufacturing execution systems. Progress has been slower in discrete automation, though the company's sparse disclosures make it hard to monitor the businesses.

I continue to see attractive opportunities for HollySys in its home market. For starters, HollySys is willing and able to work more closely with customers in China on system design, implementation, and maintenance, allowing for more customized solutions at cost-effective prices.

Beyond this, HollySys continues to benefit from Chinese government policy to prioritize local companies for what they consider to be vital capabilities. The government has made localization of equipment and services for its power industry a key priority, and given HollySys's strong history here (it got its start with automation solutions for power plants), that only helps the company. That policy seems to be extending to other industries, and while I don't think it's accurate to say that companies like ABB, Emerson, or Siemens are being pushed out of China, there's definitely a preference for Chinese vendors when the capabilities are considered comparable.

Rail Coming Back, But Consistency Will Be Challenging

HollySys has had some challenges in its rail operations. At the time of my last write-up, the company was losing share and there were frequent disruptions to projects because of the COVID-19 pandemic. While the pandemic is still an issue, projects are advancing once again and the company is benefiting from conversion of past awards into revenue.

China definitely fell behind in its targeted rail investments during the pandemic, and I expect extensive public financing to be made available to get these projects back on track. Expansion of the rail network, particularly high-speed passenger rail, is a priority in the current five-year plan, and HollySys still enjoys a credible presence in the rail safety, signaling, and automation space.

I'd also note some progress of late in the company's subway/metro business. This has been long in coming (and largely disappointing), but a win for smart edge control for the Dalian metro system could mark an important turn in the business. I'd also note some progress in repurposing the company's core technologies - HollySys has won some awards for weather monitoring/warning systems, emergency response, and tunnel monitoring for highway projects, and this could be an important supplemental business opportunity.

The Outlook

I continue to expect mid-single-digit revenue growth from HollySys over the longer term. The company is slowly branching out from its strong core in power, petrochemicals, and oil/gas (it also recently won business from an Indonesian mining project), and I do still see attractive long-term opportunities in process automation.

I'm less bullish on the discrete and hybrid automation opportunities, largely because the company just doesn't seem to have the necessary in-house capabilities and acquiring them (particularly by acquiring a U.S. or European company) seems like a virtual non-starter. My feelings on the rail business are more along the lines of "cautious optimism" - the opportunity is definitely significant, but consistent execution has long been a challenge here.

Low-to-mid-teens free cash flow margins should be achievable, particularly if execution in the rail business becomes more consistent. The resulting cash flows can support a fair value in the mid-$20's, even with a high discount rate to reflect operating risk and inadequate (or at least unreliable) communication with investors.

The Bottom Line

In terms of core drivers, I like HollySys's leverage to the increased adoption of automation among Chinese enterprises, and certainly its leverage to a concerted "buy local" effort in industries that the Chinese government deems critical to national security (including power, chemicals, and oil/gas). I also like the leverage to ongoing investment in public transportation, specifically high-speed and local rail. All of that said, I still find this a difficult company to follow and I believe investors need to carefully weigh the prospective returns with the reality that they will never be treated as partners or co-owners in the business.

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