Hollysys Looks Like A Name To Watch In Emerging Market Automation December 21, 2012Posted by Ishmael Chibvuri in Latest Articles!!!.
Investors do well to hold on to a thorough skepticism when it comes to small Chinese companies, but Hollysys Automation Technologies (HOLI) looks like a name that aggressive investors should get to know better. While it is a lofty goal indeed to say that Hollysys could become the next ABB (ABB), Siemens (SI), Emerson (EMR), or Rockwell (ROK), Hollysys has already shown that it can carve out a meaningful niche against these large foreign competitors in China’s fast-growing automation market.
Three Broad And Worthwhile Growth Opportunities
While virtually all of Hollysys’ business activities can be labeled as automation and control systems, a little more specificity is useful.
In recent times, more than half of the company’s revenue has come from industrial automation, where the company sells distributed control systems and programmable logic controllers (PLC) into industries like power generation.
In about 20 years of operations, Hollysys has built a high single-digit overall market share, with shares of over 10% in particular markets. That may not sound so impressive relative to the high-teens share of ABB or the low-teens shares of Honeywell (HON), Siemens, Emerson, or InvenSys (IVNSF.PK), but does make the company the largest home-grown automation player. What’s more, the company has been stretching out a bit and expanding into new markets like steel, mining and petrochemicals.
High-speed rail and subway products make up the bulk of the remainder of Hollysys’ business. Hollysys sells safety and control products like train control centers (TCC) and automatic train protection (ATP) systems, and is one of a relatively small number of companies approved by China’s Ministry of Railways to supply such systems (one of five for shorter systems, one of two for longer). Depending upon the product and the market involved, Hollysys seems to hold between 30% and 50% share.
Last and not least is the company’s small nuclear business. Hollysys is the only certified Chinese provider of automation control systems for nuclear power plants, and though this is a small business at present, China has made large commitments to build new nuclear power plants.
The China Problem
Before delving more into the business prospects and drivers for Hollysys, it’s important to address some of the risks that go with investing in smaller Chinese companies. Hollysys did arrive on Nasdaq through a back-door listing, and readers are no doubt familiar with at least some of the many examples of Chinese companies playing fast and loose with financial disclosures and basic honesty.
I cannot and will not claim that I’ve personally seen the books at Hollysys or visited the facilities. What I do know, though, is that the firm chose to switch its auditor to Ernst & Young earlier in 2012, and that major fund managers like Fidelity, Putnam and Goldman Sachs have held (or still have) sizable stakes. Moreover, contract wins with relatively high-visibility clients like Hong Kong’s MTR (the transit railway operator) would strike me as difficult to fake with impunity. Consequently, while I will not wave off all of the concerns about investing in Chinese firms (including the possibility that the government may interfere with the auditing process), I think this is a legitimate company.
How Hollysys Could Win
It’s not easy to compete with major players like ABB, Honeywell or Siemens when it comes to factory automation. Although these systems are not tremendously expensive (usually about 2% – 10% of the cost of a plant), they have to work right.
That actually is where Hollysys has been building some of its competitive advantage – automation systems require service, and many of the large multinational players in China sell and operate through agents. Hollysys has offices throughout the country, though, and can quickly respond to sales calls with actual Hollysys employees. Couple that enhanced service with a price that’s about 10%-20% lower than its large rivals, and it’s not too difficult to see that Hollysys has a viable business model.
Looking more broadly, various consulting and market research groups like Frost & Sullivan have forecast low to mid-teens growth for industrial automation in China past the middle of this decade. Given the rising labor costs within China and the need to stay competitive in fields like electronics, automobiles and pharmaceuticals, those projections seem reasonable and constitute a real long-term growth opportunity.
Looking at the sizable rail and subway business, this would seem to be a business with solid growth opportunities as well. China has spent hand-over-fist on adding rail infrastructure over the past decade, and now the spending is moving on to the trains and train systems themselves. While I expect that spending on trains (and train safety systems) will be erratic, China’s commitment to high-speed rail (and the necessity of having automated systems for high-speed trains) leads me to believe that Hollysys still has many years of 20%+ growth to look forward to in this business.
How Hollysys Can Lose
Just because there are large opportunities before Hollysys, that is no guarantee that the company will execute on those opportunities. At the risk of stating the obvious, rivals like ABB, Honeywell and Siemens are not trifling rivals in fields like distributed control systems, programmable logic, or train controls.
Along those lines, ABB, Emerson and Honeywell will all have spent more on R&D over the last 12 months than Hollysys took in in revenue. Certainly not all of that money is going to industrial/process automation, but I think the point stands that Hollysys is taking on the role of David against some rather large Goliaths. Even so, Hollysys does stand out for its abilities to develop its own proprietary technologies (with a fifth-gen DCS released this past summer).
Hollysys may also struggle to take its business on the road. If Hollysys is to really work as a long-term investment, it needs to establish itself as more than just a provider to Chinese companies in much the same way that companies like Huawei, ZTE, and Sinovel have shown that they can sell to non-Chinese customers. This process is going to cost money (both in marketing and capex) and carry risk, but it’s important for the long-term thesis.
The Bottom Line
I believe that Hollysys can grow revenue at a compound rate of 10% or more over the next decade. That’s an ambitious-looking target, but it’s lower than the anticipated growth rate in Chinese industrial automation demand (to say nothing of the growth in train infrastructure and/or nuclear power). It’s more difficult to model Hollysys’ free cash flow trajectory, as I do not believe the company can indefinitely maintain the mid-teens free cash flow margins that sell-side analysts are projecting.
The good news, though, is that even if you assume the company’s free cash flow conversation rate ultimately matches that of its larger peers, it still combines with that revenue growth rate to result in a high-single digit compound growth rate for free cash flow (or a low-to-mid teens growth rate if you use an average of the last four years’ free cash flow generation instead of the actual, elevated, 2011 number).
Taking that cash flow and discounting it back at an elevated discount rate (to account for the above-average risk) results in a fair value in the mid-teens. In summary, then, we have here a fast-growing Chinese industrial company that has established real share against well-run multinationals in an industry likely to grow at a double-digit clip for a decade. While ongoing worries about the health of the Chinese economy and the timing of a recovery may argue for caution today, I believe Hollysys is a company that investors should investigate more thoroughly with an eye toward buying.