As a value investor, one of the things I look out for is a catalyst for price realisation. After all, even if a stock is criminally undervalued, if it does not have something in its future that will cause other people to wake up to its value, it could stay undervalued forever. Today I’m going to talk about a company that has a very clear catalyst which the value, as well as price of the stock, hinges upon. If the catalyst is positive, the upside is enormous, with the stock possibly doubling or tripling almost overnight.
It all started about 6 months ago when I decided to analyse automation. The coming 4th Industrial Revolution will see human-performed tasks being done by robots, and companies that provide these automation services could do very well indeed. After a quick screen, Hollysys Automation Technologies immediately jumped out at me: the company presented itself with spectacular financials characterized by high liquidity; low debt; steadily growing FCF/revenue/net income over the decade; consistent book value; an average ROE of 15% over a decade, ROCE 13%, a stock price trading at a 30-50% discount compared to competitors, and DCF models estimating a value of $30-40 (currently trading about $11). In other words, the dream of any value investor.
I will be the first to admit I don’t have as much knowledge in the automation industry as I’d like – and that’s something I’ve been working on over the past few months. So, after a quick look at their impressive financial statements, our next step was to talk to the IR of the various Hollysys competitors to better understand the competitive environment that Hollysys were operating in, and whether they could preserve their impressive return ratios over the long term.
As a quick overview of the company, Hollysys operates in two segments: industrial automation and railway automation. In industrial, most of the company’s revenue comes from automating fossil fuel energy plants. It would not be unfair to compare it to a defence company or a public contractor, since the Chinese Communist Party controls the state railways and owns a 75% stake in SINOPEC, China's largest and most important oil company. In addition, the company also has a dominant market position in safety systems for nuclear power plants in China, a sector that is growing with a CAGR of 17%, bringing the number of reactors in the country from 16 in 2012 to 56 in 2020. As the only certified provider of nuclear automation services in the country, Hollysys has a monopoly in this subsector.
In the railway sector they hold a 30% market share, and they do not expect further increases in market share. Long-term organic revenue growth is likely to be 5%, primarily coming from after-sale services. However, they are actively researching new products such as CBTC (Communications-based train control) in subways, smart systems on highways, etc. If these products gain traction, which they should, then growth will be higher. Also, the company proved to have a great competitive advantage in the high-speed railway field as they are 1 of the 3 approved providers in 300-350km/h segment and 200-250km/h and the largest company in terms of ATP (on board equipment) sets.
In their ‘Smart factories’ sub-segment, they provide solutions to accelerate product development cycles for large white goods companies like Haier. They provide integrated data collection products like SCADA (Supervisory Control And Data Acquisition), data utilisation and analysing services to understand the application situations, designing the system architecture, data management and so on, being the largest company in terms of Supervisory Control and Data Acquisition. Another example of this sub-segment of industrial automation would be their contract with Diaobignshan where they used to collect data to build a factory virtually and rapidly iterated designs to optimise efficiencies at low cost. They provide after-build services such as combustion optimization, equipment monitoring and maintenance, etc. This segment generates real tangible returns for customers, with higher production efficiencies and lower cost. However, it’s worth noting that some of their revenue in this segment comes from fossil fuel companies as well, so a surge in renewable builds could see revenue dropping even more than it would appear at first glance.
All the segments that Hollysys operates in have been growing impressively for the past few years, at a rate above even the high growth of the general Chinese economy. To fuel their supply-side based growth, fossil fuel plants have been opening across China at an unprecedented rate, while China’s high-speed railway network has gone from virtually non-existent 15 years ago to being 2/3rds of the entire world’s track length. As Chinese wages rise, the pressure on factory owners to automate is also increasing to stave off price competition from South-East Asian competitors.
So far, the situation all looks good from a high-level company view. But when you either zoom out to look at the macro environment, or in to look at the specifics of the business, cracks begin showing.
The situation with the Chinese government is tricky – and not for the reason you might think. Despite the fact that most of Hollysys’s revenue comes from state-owned entities, and it’s monopolistic market position also dependent on the government, we do not see the government introducing competition to the market to drive down prices as a big threat. China has applied a protect-and-nurture strategy for domestic companies in every sector you could think of very successfully, creating such behemoths as Tencent and Alibaba. You prevent superior foreign competition from entering the market, and choose a winner for each sector, allowing it to take monopolistic profits to accelerate the rate of innovation and shorten the timeline that it needs to compete with foreign companies. From the past decade, Hollysys is the chosen winner for the sectors that it competes in, and that the threat of increased competition due to the Chinese government is virtually non-existent. Companies like Siemens or ABB still have objectively superior products and will likely continue to do so for the foreseeable future. Until HOLI catches up with them and can compete in a global free market, the handholding from the government will not end.
However, while the Chinese government will not introduce competition to the markets that Hollysys competes in, whether it will continue to incentivise those markets is another question entirely. In a recent Chinese government conference, China firmly stated that it would become carbon neutral by 2060 (pay attention: NET carbon emissions will be equal to 0, and not TOTAL emissions, which is quite different). I have no doubt that this will happen – the largest benefit of a single-party state is that these long-term plans can be set in stone and executed upon decades in advance, something which China has been doing since the ways of Deng. And quite obviously, there is consequently a very real threat to the heavily polluting fossil fuel-based power plants that Hollysys derives a lot of its revenue from. Banning the construction of new fossil fuel plants is an obvious way to reach this target, but whether China chooses to do this or to find alternative methods of cutting net emissions is less obvious. I would like to remind you that coal consumption, which fell from 2013 to 2017, driven in part by China's willingness to significantly improve air quality, has started to rise again in more recent years as the economy suffered a severe backlash forcing the government to stimulate industrial growth. Although the government has not released some specifics regarding how these emissions will be reduced, it is thought that this was strongly desired to allow the Communist Party to have the flexibility necessary in the short term to support the economic recovery following the pandemic. Renewables cannot as yet compete with fossil fuels in lifetime cost of operation, and building more fossil plants is a tried-and-true method of giving the economy a shot in the arm, something that any economy could do with right now.
At the same time, future constructions of railways are also uncertain. Most of the tracks laid in recent years is economically unviable, with low demand and a poor populace in these tier-3 cities laying a cap on ticket prices. However, the government views high-speed rail as a socially beneficial alternative to coaches and planes for the hundreds of millions of migrant workers that travel between large cities and the country every holiday, and thus heavily subsidies losses and encouraged more construction in the last 5-year plan. Whether continued construction in both railways and fossil fuel power plants will happen is up in the air and something that we will see in the next 5-year plan, due in March 2021.
A natural response to the threat to fossil fuel power generation automation would be to ask whether Hollysys could simply transition to automating the renewable power generation sector. My research indicates that this is not realistic. The various wind turbines, solar panels, dams, etc. they do not require a complex level of automation like that used in a refinery plan. The latter are huge power plants that occupy hundreds of meter squares which require automated processes to obtain the greatest result with the least effort.
While as regards the structures and machines used for renewable energy, they do not require complicate automated processes such as those used in oil and petrochemical plants; the entire process is enclosed within the turbine itself (as far as wind energy is concerned), so that it becomes almost impossible to state that these types of energy require any automation processes. In the image below I have shown you what the inside of a wind turbine looks like, which differs drastically from the previous image of the refinery plant.
A field of application, which is very different from the one discussed above, could be to offer automation processes for the companies that produce the different solar panels, wind turbines and so on. This, however, has nothing to do with the automation processes used in oil and petrochemical businesses; here we are dealing with real industrial processes which cannot be connected to the former since they are completely different fields.
The problem is that we are not sure if Hollysys can provide such solutions and even if it is able, we do not know the time needed for this transition. One of Hollysys' strengths was its vast knowledge in the oil industry, which allowed it to keep various competitors away, but this advantage will not be reflected in the renewable sector since they have no knowledge in this field and, and from what I’ve seen, the company has not shown any interest in this sector, neither from the various conference calls held in the past nor from the annual or quarterly reports, which suggests management is either unaware of the threat or incapable of addressing it. The fact that management accounts for some fossil fuel plant automation revenue in ‘smart factories’ suggests the latter, and that they’re trying to make it look less serious than it is.
We are not saying that the company is in danger of failure, since it still has two other revenue streams to rely on, but we will certainly see a decrease in revenues (in 2019, 41% of revenues derive from automation sector, of those 41%, 40% are from oil industries) and a deterioration in the relationship with the Chinese government.
Overall, the conclusion can be drawn that if the coming 5-year plan is unfavorable to Hollysys, the company will face serious setbacks to its short and long-term prospects as the market is pricing in, while a positive 5-year plan that encourages construction of both fossil fuel plants and railways would be hugely accretive to the value of the company. My personal stance is to wait and see what the 5-year plan says – with a small-cap Chinese stock like this, the market is unlikely to immediately react and fully reprice Hollysys on positive news, allowing me a chance to get in after the future is secure even if I miss out some gains. The uncertainty regarding the possible downside to a company is something I hate, although if you have more stomach for risk and think the 5-year plan will be friendly to Hollysys, you could jump in now.
If you are positive enough to jump in now you may find interesting that in my positive-scenario-model, I therefore attribute to the automation sector a CAGR of about 5% for the next 10 years, the railway sector a CAGR of 5-6% (assuming continued construction in the next 5-year plan) and attribute to the nuclear sector a CAGR of 12-15% given the enormous progress made in this particular sector in the last 10 years. The final stock price would be something between $25-30 but only if Hollysys starts to be valued with the same multiples of its peers and Chinese government postpones its good intentions to reduce their carbon impact on the rest of the world in order to sustain Chinese’s economy recovery.
Other important facts concerning the company:
About 3 months ago the ex-CEO Baiqing Shao was changed, who has held the role for more than 7 years and was one of the founders of the company, with a member of the company's directors, Mr Colin Shang. The reasons for this decision were not entirely transparent, as the company initially stated that the CEO had left office and remained on good terms with the company, but in the latest quarterly report the company states the following: "Dispute in connection with the ownership of Ace Lead Profits Limited (" Ace Lead ") may adversely impact us." We were made aware of a shareholder’s dispute regarding ownership of one of the principal shareholders. In August 2016, Mr. Changli Wang, the then sole shareholder of Ace Lead, one of our record shareholders, transferred his single share in Ace Lead to Mr. Baiqing Shao for a nominal consideration. As of the date hereof, Ace Lead owns 4,144,223 ordinary shares of our company, representing 6.9% of the outstanding shares of our company. We were recently notified that Mr. Wang indicated that, as Mr. Shao had stepped down as the chairman and chief executive officer of our company since July 2020, he should no longer be entitled to any share in Ace Lead and he should immediately transfer the share in Ace Lead to one or more persons designated by Mr. Wang. As of the date of this annual report, Mr. Shao has not transferred the share in ACE Lead to any designees of Mr. Wang. We cannot predict the outcome of the dispute. If Mr. Shao refuses to transfer the share in ACE Lead to a person designated by Mr. Wang, the dispute could escalate and litigation may ensue between Mr. Shao and Mr. Wang, and our company may become involved. Any escalation of this dispute, including potential litigation, may cause us to incur significant time, resources and cost if we were to become involved. As easily understood this does not seem a "friendly" decision by the old CEO, moreover with 7% of the shares in circulation he can do much more damage to the company by attending the shareholders' meetings, being one of the shareholders with the highest participation .
Many impairments of goodwill. The M&E refers to two companies they bought, Concord and Bond. They are based in Singapore and Malaysia. But their business spread in south east Asian and middle east. Before COVID-19, the macro-economy situation in those areas was not good, and then COVID-19 brought new challenges. Therefore, their management expects future lower profit in M&E. They also do not give guidance on the development of M&E since the company think risk control is the key focus, rather than revenue growth.
When they got asked what they thought about Trump will to delist Chinese companies from U.S. exchanges they said that they are evaluating recent issues that may potentially affect their status as a Nasdaq-listed company and it is prudent to say that they do not exclude that option. So, no real answer was given about that, which makes me think that they do not have any plan for the near future.
IR is slow to respond to investors. I sent two emails, the first of which was generally positive and the second follow-up which raised some of the issues discussed in this article. IR has not responded to the second for more than a month, which makes me very uncomfortable.
Also, I wanted to give you a feedback on what Hollysys has to say about this matter but investor relator has not replied to my email for more than 1 month, this gives you a clue on how bad their communication with investors is. On the other hand, I have scheduled another call with one of their competitors on 18 November to talk about what can be done for companies like these to keep up with the almost sure transition that China will experience in the following years.