Deutsche Bank Markets Research
Rating Company Date 11 July 2016 Buy Hollysys Initiation of Coverage Asia Automation China Reuters Bloomberg Exchange Ticker Price at 8 Jul 2016 (USD) 17.63 Industrials HOLI.OQ HOLI US NAS HOLI Price target - 12mth (USD) 25.80 Manufacturing 52-week range (USD) 22.80 - 15.21
NASDAQ 100 4,528
HOLIstic solutions; initiating with Buy Sky Hong, CFA Nick Zheng, CFA Research Analyst Research Analyst (+852 ) 2203 6131 (+852 ) 2203 6198 A temporary slowdown is in the price but two emerging growth drivers are not [email protected] [email protected] Hollysys (HOLI), a leading industrial automation solution provider in China, has underperformed the NASDAQ100 by 22% in the past year. With valuations hitting three-year troughs, we believe that the market has overly priced in a Price/price relative slowdown in existing operations, but overlooked rising after-sales service and 28 new product launches. On the back of potential positive earnings surprise (DBe 24 13% EPS CAGR over FY16-18E vs. consensus’ 5%) and the start of a regular dividend, we initiate with Buy and a TP of US$25.8, with 49% upside potential. 20 16 Rising after-sales to cushion slowdown in new sales 12 As the installed base of DCS and rail signalling systems continues to grow, we 7/14 1/15 7/15 1/16 expect lucrative after-sales service revenue to build momentum. For DCS, the Hollysys Automation maintenance/repair cost makes up of c.80% of the total cost of ownership over NASDAQ 100 (Rebased) its lifespan. For rail signalling systems, we expect more high-speed trains to be Performance (%) 1m 3m 12m due for heavy maintenance in the coming years. We expect HOLI’s after-sales revenue to account for 15% of the total by FY18 vs. 9% in FY15. Margins for Absolute 0.6 -12.1 -17.6 after-sales service can typically reach 50-70% vs. 30-40% for initial sales. NASDAQ 100 0.2 1.2 4.1
Source: Deutsche Bank
Horizontal expansion gaining traction; watch out for new product launches We highlighted in our sector report that “know your products” and “know your customers” are two winning strategies in industrial automation. HOLI’s success in TCM dispensers is a perfect example as its core control technology is combined with in-depth knowledge of sector verticals. This success, in our This report accompanies our FITT view, is easily replicable in other niche verticals, as customers are increasingly research report – China Industrial looking for customised automation solutions. For rail, similarly leveraging its Automation: Dawn of the Machines core technology and existing customers, new products, such as track circuit and subway signalling systems, should be launched successfully, in our view. Valuations at multi-year lows; key risks At 8x/7x FY17E/FY18E P/E, the stock is trading at 1SD below its long-term average, which looks too pessimistic. Our TP of US$25.8 is derived based on a DCF valuation (WACC: 11.2%, TGR: 0%), corresponding to a non-GAAP P/E of 11.9x/10.2x on FY17E/FY18E, in line with its mid-cycle levels in the past five years. The possibility of a regular dividend ahead also bodes well for the stock. Key risks: an unexpected slowdown in automation capex/railway investment.
Forecasts And Ratios Year End Jun 30 2014A 2015A 2016E 2017E 2018E Sales (USDm) 521.3 531.4 536.0 566.1 613.0 EBITDA (USDm) 105.5 139.4 136.7 154.0 176.1 Reported NPAT (USDm) 69.6 96.5 107.6 119.3 139.5 Reported EPS FD(USD) 1.19 1.61 1.84 2.04 2.39 DB EPS FD(USD) 1.49 1.72 1.96 2.17 2.52 DB EPS growth (%) 45.7 15.5 14.3 10.5 16.2 PER (x) 11.6 13.2 9.0 8.1 7.0 Source: Deutsche Bank estimates, company data 1 DB EPS is fully diluted and excludes non-recurring items 2 Multiples and yields calculations use average historical prices for past years and spot prices for current and future years, except P/B which uses the year end close
______Deutsche Bank AG/Hong Kong Distributed on: 07/11/2016 15:04:19GMT Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016.
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Manufacturing Hollysys Automation
Model updated:07 July 2016 Fiscal year end 30-Jun 2013 2014 2015 2016E 2017E 2018E
Running the numbers Financial Summary Asia DB EPS (USD) 1.02 1.49 1.72 1.96 2.17 2.52 Reported EPS (USD) 0.92 1.19 1.61 1.84 2.04 2.39 China DPS (USD) 0.00 0.00 0.40 0.00 0.00 0.00 BVPS (USD) 7.2 8.5 9.9 11.4 13.4 15.8 Manufacturing Weighted average shares (m) 56 58 59 58 58 58 Hollysys Automation Technol Average market cap (USDm) 602 1,004 1,333 1,029 1,029 1,029 Enterprise value (USDm) 487 825 1,116 731 643 543 Reuters: HOLI.OQ Bloomberg: HOLI US Valuation Metrics P/E (DB) (x) 10.5 11.6 13.2 9.0 8.1 7.0 Buy P/E (Reported) (x) 11.6 14.5 14.2 9.6 8.6 7.4 Price (8 Jul 16) USD 17.63 P/BV (x) 1.69 2.83 2.42 1.55 1.31 1.12
Target Price USD 25.80 FCF Yield (%) 3.6 7.5 6.0 9.8 8.9 10.1 Dividend Yield (%) 0.0 0.0 1.8 0.0 0.0 0.0 52 Week range USD 15.21 - 22.80 EV/Sales (x) 1.4 1.6 2.1 1.4 1.1 0.9 Market Cap (m) EURm 932 EV/EBITDA (x) 7.1 7.8 8.0 5.3 4.2 3.1 EV/EBIT (x) 8.2 8.9 8.8 5.9 4.6 3.4 USDm 1,029 Income Statement (USDm) Company Profile Sales revenue 349 521 531 536 566 613 Founded in 1993 and headquartered in Beijing, HollySys Gross profit 124 176 214 204 224 248 Automation (HOLI) specializes in process automation, EBITDA 69 105 139 137 154 176 factory automation, rail automation and mechanical & Depreciation 6 7 9 9 9 10 engineering solutions. Hollysys has established itself as Amortisation 3 6 5 5 5 5 the local leading automation and IT solutions provider in EBIT 59 93 126 123 140 161 China and Southeast Asia. HollySys listed its common Net interest income(expense) 1 1 2 3 5 7 stock on NASDAQ in 2008. Associates/affiliates 0 -3 -3 6 0 0 Exceptionals/extraordinaries 0 0 0 0 0 0 Other pre-tax income/(expense) 0 0 0 0 0 0 Profit before tax 61 91 125 132 145 169 Price Performance Income tax expense 8 20 26 22 22 25 Minorities 1 2 3 3 3 4 28 Other post-tax income/(expense) 0 0 0 0 0 0 Net profit 52 70 97 108 119 139 24
DB adjustments (including dilution) 6 17 7 7 7 8 20 DB Net profit 58 87 103 115 127 147 16 Cash Flow (USDm) 12 Jul 14 Oct 14Jan 15Apr 15 Jul 15 Oct 15Jan 16Apr 16 Cash flow from operations 31 83 84 121 113 128 Net Capex -9 -7 -4 -20 -22 -24 Hollysys Automation Technol Free cash flow 22 76 80 101 91 104 NASDAQ 100 (Rebased) Equity raised/(bought back) 1 0 1 0 0 0 Margin Trends Dividends paid 0 0 -23 -23 0 0 Net inc/(dec) in borrowings -5 -8 24 -30 0 -20 32 Other investing/financing cash flows -2 -18 -36 0 0 0 28 Net cash flow 16 50 46 47 91 84 Change in working capital -37 -21 -58 3 -23 -30 24 Balance Sheet (USDm) 20 Cash and other liquid assets 112 162 208 255 346 430 16 Tangible fixed assets 92 95 92 98 105 114 13 14 15 16E 17E 18E Goodwill/intangible assets 78 73 62 62 63 63 EBITDA Margin EBIT Margin Associates/investments 41 48 67 73 73 73
Other assets 422 549 556 565 597 646 Growth & Profitability Total assets 745 927 984 1,053 1,183 1,326 Interest bearing debt 36 28 51 21 20 0 60 20 Other liabilities 293 407 347 360 368 387 50 15 Total liabilities 329 435 398 380 388 387 40 Shareholders' equity 414 488 579 663 783 922 30 10 Minorities 2 4 6 9 13 16 20 5 Total shareholders' equity 415 492 585 673 795 939 10 Net debt -76 -134 -157 -234 -326 -430 0 0 13 14 15 16E 17E 18E Key Company Metrics Sales growth (%) nm 49.4 1.9 0.9 5.6 8.3 Sales growth (LHS) ROE (RHS)
DB EPS growth (%) na 45.7 15.5 14.3 10.5 16.2 Solvency EBITDA Margin (%) 19.7 20.2 26.2 25.5 27.2 28.7 EBIT Margin (%) 17.0 17.8 23.8 23.0 24.7 26.3 0 Payout ratio (%) 0.0 0.0 24.3 0.0 0.0 0.0 -10 ROE (%) 12.6 15.4 18.1 17.3 16.5 16.4 Capex/sales (%) 2.6 1.6 0.9 3.7 3.9 3.9 -20 Capex/depreciation (x) 1.0 0.7 0.3 1.5 1.6 1.6 -30 Net debt/equity (%) -18.3 -27.3 -26.8 -34.9 -41.0 -45.8 -40 Net interest cover (x) nm nm nm nm nm nm
-50 Source: Company data, Deutsche Bank estimates 13 14 15 16E 17E 18E
Net debt/equity (LHS) Net interest cover (RHS)
Sky Hong, CFA +852 2203 6131 [email protected]
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Table of contents
Investment thesis ...... 4 Outlook ...... 4 Valuation...... 4 Risks ...... 4 Industrial automation ...... 6 Key points ...... 6 DCS – don’t overlook the potential from after-sales service ...... 6 Factory automation – leveraging on its core control technology, success will come ...... 10 Overseas expansion – benefiting from China’s One Belt One Road (OBOR) initiatives ...... 12 Rail transportation ...... 13 Key points ...... 13 A full spectrum of product offering in rail signalling control ...... 13 High-speed rail – steady growth in coming years ...... 14 New products – new growth drivers ...... 16 Upside potential from after-sale services ...... 18 Earnings, valuation and risks...... 20 Earnings forecasts – 13% CAGR over FY16-18E on revenue growth, margin expansion and falling expenses ...... 20 Valuation – DCF-based target price of US$25.8 with 49% upside potential ..... 21 Risks to our positive view on the stock ...... 24 Company basics ...... 25 Company profile, structure and history ...... 25 Product offering and how the products work ...... 27
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Investment thesis
Outlook
Hollysys Automation (HOLI) is one of China’s leading providers of industrial automation and rail automation solutions in China. Overall, we project a 13% non-GAAP EPS CAGR over FY16-18E, driven by a gradual recovery in the industrial automation segment and healthy growth in the rail transportation segment. We believe that the market may not only have been overly pessimistic on the slowdown in HOLI’s existing operations, but could also have overlooked the benefit of rising after-sales services and new product launches.
As the installed base of DCS and rail signalling systems continues to grow, we expect lucrative after-sales service revenue to build momentum. We expect HOLI’s after-sales revenue to account for 15% of the total by FY18 from 9% in FY15. Margins for after-sales services can typically reach 50-70% vs. 30-40% for initial sales.
Additionally, leveraging on its core control technology along with its in-depth knowledge on verticals, we believe HOLI’s recent success in TCM dispensers is highly replicable in other niche verticals, as customers are increasingly looking for customised automation solutions. Similarly for rail, we expect new products, such as track circuits and subway signalling systems, to be launched successfully.
Valuation
We use DCF to value HOLI, given its stable cash flow. Our target price of US$25.8 is based on a WACC of 11.2% and conservatively assumes a terminal growth assumption of 0% (given its exposure to railway business). Our cost of equity assumption incorporates a risk-free rate of 3.9%, an equity risk premium of 5.6% and a beta of 1.3x.
Our target price corresponds to a non-GAAP-based P/E of 11.9x/10.2x and a P/B of 1.9x/1.6x for FY17/FY18, largely in line with its mid-cycle levels in the past five years (including the distressed valuation period post Wenzhou HSR crash). Compared to its long-term (since 2007) mid-cycle multiples, our TP implied valuation multiples are at a 10% discount, which we think is fair, given relatively slower earnings growth ahead.
Risks
Key downside risks include: 1) an unexpected slowdown in China’s economic growth and capex spending for automation upgrades; 2) an unexpected slowdown in China’s railway investment and demand for high-speed rail trains; 3) poor execution of investments.
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15% 34% 10.6x 9M16 14.9x 57% 14% 12.8x Bank estimates. 38% 13% 2015A 1 STDEV1 67% Avg P/E Avg - 13% sale servicessale - 31% 9% 2014A Integrated contractIntegrated After 64% Bank estimates. - - year year trough 8% - GPM GPM 33% , Deutsche hit 3 2013A 6% 67% data after sales service revenue to account for for accountto revenue service sales after 1yr fwd P/E(x) fwd 1yr STDEV +1
8% 6% 4% 2% 0%
0%
16% 14% 12% 10% 80% 70% 60% 50% 40% 30% 20% 10% As % of total sales total of % As GP margin (%) margin GP
9.0 7.0
11.0 19.0 17.0 15.0 13.0 P/E (x) P/E Source: Company Source: Company data, Bloomberg Finance LP, Deutsche P/E multipleP/E We expectWe muchgenerates it andFY18 by revenue HOLI'sof 15% sales new to comparedmargin higher 18E) - 3 - CTCS 2 - Bank. Bank estimates. CTCS , Deutsche Industrial Automation Industrial transportation Rail Bond)and(Concord M&E Miscellaneous service for rail segmentlikely is to data 0
sales
800 700 600 500 400 300 200 100 - 0 trainsets
700 600 500 400 300 200 100 US$ mn US$ Source: Company After yield upsideto our forecastsas HOLI's installed base of HSR signalingsystem continuesto grow Revenue breakdown by segment (FY08A Source: Company Source: Company data, Deutsche
as % of total sales 0% 50% 40% 30% 20% 10% 60% healthy 51% 127 2018E - segment - 85% 115 High 52% 2017E speed rail speed sub As % of totalof% As 90% control Process 102 50% 2016E 96 Bank estimates. 45% 2015A rail segment rail 74 - 42% 2014A 15% GP segment withinthe rail segment - Bank estimates. Subway 36 29% 10% 2013A control Discrete 0
40 20 80 60
140 120 100 Gross profit (US$mn) profit Gross Source: Company Source: Company data, Deutsche Source: Deutsche We expectWeHOLI's rail segment to record growthin the coming years and account for halfover of its total sales by FY18E Processcontrol is the largest withinHOLI's IA segment while HSR theis largestsub
s 74% 26% 0% 2018E estimate 40%
FY18E 8% 44% 40% Industrial Automation Industrial Automation 80% 20% 4% 2017E (TCMD) 6% 1% - 50% Deutsche Bank Deutsche Miscellaneous FY17E 87% 13% 2016E 3% 3% 10% - ous - Industrial automation Industrial 100% FY16E (TCMD) Bank. Bank estimates. 6% 94% Miscellane 2015A Industrial automation (adjusted) automation Industrial Industrial automation Industrial TCMD on salesto sustain high growthaccount and TCMD Rail 36% 3% 5% 4% - - 48% 96% transportati 2014A FY15A Rail 44% : Our investment thesis in charts in thesis : investment Our 21% M&E 8% automation and rail are the largesttwo transportation 1 (Concord and Bond)and and Bond)and 0%
80% 60% 40% 20% 0%
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100% 50% 50%
(adj.) LP, Finance Bloomberg data, Company
-
Source: Company Source: Company data, Deutsche Source: Company Source: Company data, Deutsche 150% 100% yoy chg% yoy As % of total IA sales sales IA total of % As for c.1/4 for of HOLI's total adjustedIA salesby FY18E.As a result,weexpect HOLI's adjustedIA salesto bottom out in FY17E We expectWeTCMD segments,on a combined basis,accounting for 76% and 88% of HOLI's revenue and respectively GP in FY15 Industrial Figure Figure
Source: Source:
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Industrial automation
Key points
We think the market has overlooked the upside potential from HOLI’s lucrative after-sales market.
HOLI’s recent success in TCM dispensers is highly replicable in other niche verticals, as customers are increasingly looking for customised automation solutions.
HOLI’s strong balance sheet could facilitate its expansion in the factory automation field.
Figure 2: Industrial automation (IA) – Figure 3: IA revenue by control type Figure 4: DCS sales by verticals – 20- 40% of total revenue in 2015 – 90% process control 30% from thermal power
Miscellaneous Discrete Food & (TCMD) control healthcare M&E 3% 10% ~10% Thermal (Concord and power Bond) 21% Metallurgy 20-30% ~10% Industrial Automation 40% Building materials ~10%
New energy Chemical & Rail ~10% petchem transportation Process Nuclear 20-30% 36% control power 90% 5-10% Source: Company data, Deutsche Bank Source: Deutsche Bank estimates. 90% process control revenue Source: Deutsche Bank estimates. all from DCS; 10% discrete control products are mostly PLCs
DCS – don’t overlook the potential from after-sales service
Hollysys Automation (HOLI) is one of the leading providers of Distributed Control systems (DCS) in China – a mainstream automation control system primarily used in the process industries – with 13% market share in 2015 (Figure 5). Sales derived from DCS accounted for c.90% of HOLI’s total sales for the industrial automation segment.
The company is one of the two local players (another one is Supcon) that are capable of challenging MNCs’ position in China’s DCS market (Figure 6). In selective verticals, notably thermal power, HOLI has been successfully gaining market share from MNCs in recent years.
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Figure 5: China’s DCS market share by players (2015) Figure 6: HOLI and Supcon have been gaining market share (2008-15) 100% Others Supcon 90% 12% 15% Zhishen 80% 4% 70% Chint 4% 60% Siemens 50% Emerson 6% 17% 40%
Yokogawa 30% 7% 20% Invensys 10% 4% Hollysys 0% ABB 13% 2008A 2009A 2010A 2011A 2012A 2013A 2014A 2015A 9% Honeywell 9% Supcon Hollysys Other locals MNCs
Source: Gongkong, Deutsche Bank Source: Gongkong, Deutsche Bank
Import substitution and replacement demand – tailwinds for local players China’s DCS market is largely driven by new projects. It has suffered a visible slowdown in many process-heavy industries (such as petrochemical, steel etc.), with domestic DCS sales falling 11% 2015, which was the first time since 2009.
We expect China’s DCS market to remain lukewarm amid slow economic growth and the government’s initiatives on supply-side reform. Overall, we expect China’s DCS market to gradually bottom out and capture low-single digit growth in 2017-18 as the start of the replacement/upgrade cycle might help to offset some slowdown in new projects (Figure 7).
Figure 7: China’s DCS market size and growth Figure 8: China’s DCS market split between locals and (2005-18E) MNCs (2010-18E) 9,000 20% 100% 90% 8,000 15% 7,000 80% 56% 55% 10% 70% 63% 62% 59% 58% 6,000 yoy chg% 71% 69% 65% 60% 5,000 5% 50% 4,000 0%
Rmb mn Rmb 40% 3,000 -5% 30% 2,000 44% 45% 20% 37% 38% 41% 42% -10% 29% 31% 35% 1,000 10%
0 -15% 0%
2014A 2017E 2005A 2006A 2007A 2008A 2009A 2010A 2011A 2012A 2013A 2015A 2016E 2018E
China DCS Market yoy chg% Local players' market share MNCs' market share
Source: Gongkong, Deutsche Bank estimates Source: Gongkong, Deutsche Bank estimates
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Having said that, we believe leading local players such as HOLI are likely to Track record and technical capture stronger growth from import substitution. As these local majors know-how on downstream continue to build up their track record, their deeper knowledge/expertise on verticals are ranked as the top downstream verticals, along with the higher price-to-performance ratio of their two critical factors for DCS products and better after-sales services, would enable them to further gain market market share from MNCs in the mid-to-high-segments. We expect local players’ market share (on an aggregate basis) to reach 45% by 2018 from 41% in 2015 (Figure 8).
Moreover, as a typical DCS system has a designed life-span of 7-10 years, a major replacement/upgrade cycle is likely to commence in the coming years, based on previous sales. For example, in terms of existing thermal power plants, a total of 2,000 units of DCS require an upgrade and/or replacement in the next two years.
Note that, apart from upgrade/replacement demand arising from local players’ installed base, we see huge opportunities for local players to tap into DCS systems previously installed by MNCs, possibly in two ways:
Complete replacement: DCS has become a less attractive business for HOLI’s thermal power DCS MNCs post rounds of pricing wars in many recent years. Our reconstruction project in discussions with experts and relevant players revealed that some Suizhong Liaoning (previously MNCs have downsized their DCS operations, while a couple have even installed by Siemens) signed exited selective verticals (e.g., Siemens largely withdrew from the in 2014 was a great example thermal power vertical). This should present significant potential for local players when these DCS systems installed by MNCs are up for of complete replacement replacement or upgrade, as project owners are highly likely to switch to local brands on after-sale service concerns.
Partial substitution: While local players may find it difficult to replace core systems that were previously sourced from those MNCs with a solid presence in China and sticky customer relationships, we think it is possible for local players to replace sub-systems or standardised accessories. Our checks with experts also confirm that this is feasible technically. We believe successful penetration into MNCs’ installed base market along with continued import substitution should yield meaningful upside to China’s local players in the coming years.
After-sale service – a rising market should not be overlooked Due to the complexity of a DCS system and changes in customers’ control requirements, a DCS system requires maintenance and upgrade on a regular basis throughout its product life-cycle. For example, it is estimated that 5-6% of I/O modules need to be replaced per annum while field devices like process instruments also require regular replacement. This makes DCS a unique automation product that offers huge after-sales potential.
Figure 9 shows the total cost of ownership for process automation assets, which consist of DCS. Our checks with DCS providers and experts confirm that this cost structure also well applies to DCS systems.
The initial cost (i.e., acquisition, installation, system engineering, etc) only constitutes c.20% of the total cost of ownership for a DCS system, with the other 80% belonging to after-sales service over its life-span.
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Further breaking down the initial investment, system cost only accounts for c.30% while the rest is mainly engineering and configuration. This essentially means that DCS is a service-intensive market, which gives local players natural advantages, given their deeper knowledge on downstream verticals, lower cost of labour, and shorter response time in terms of services (as vs. MNCs).
Figure 9: Total cost of ownership of a Distributed Control System
System Maintenance & engineering Instrument repair 4% engineering 83% 5%
Initial investment 17%
Install and rewire 3%
System cost 5%
Source: Gongkong, Company data, Deutsche Bank
As the installed base of HOLI’s DCS systems continues to grow, we believe it’s time to take a closer look at its after-sale services potential. Indeed, HOLI’s revenue derived from after-sale services has witnessed a significant increase in recent years (Figure 10) and reached 13% in 9MFY16 vs. a mere 6% in 2013 (Figure 11). We see substantial upside from here as MNC peers like ABB and Siemens derive 20-25% of their revenues from after-sale services.
More importantly, as we pointed out in our sector report, DCS providers’ bargaining power over customers typically would strengthen after initial sales, which allows them to enjoy superior margin from after-sales service contracts (Figure 12). In this sense, a rising contribution from after-sales service also bodes well for margins. We expect HOLI’s after-sales service to make up 15% of total sales and 20% of total gross profit by FY18E.
Figure 10: HOLI’s after-sales service Figure 11: Its after-sales service now Figure 12: Its after-sales service yield revenue has been growing rapidly accounts for 13% of total revenue much higher GPM than new sales
60 120% 14% 13% 80% 110% 50 52 70% 67% 67% 50 100% 12% 64% 43 60% 57% 40 80% 10% 9% 50% 8% 38% 30 60% 8% 40% 33% 34% 31%
US$ mn US$ 21 46% chg% yoy 6% 30% 20 40% 6% 20% 10 23% 20% 4% 17% 10%
0 0% 2% 0% 2013A 2014A 2015A 9M16 2013A 2014A 2015A 9M16 After-sale service revenue yoy chg% 0% 2013A 2014A 2015A 9M16 After-sale services Integrated contract
Source: Company data, Deutsche Bank Source: Company data, Deutsche Bank Source: Company data, Deutsche Bank
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Factory automation – leveraging on its core control technology, success will come
Amid visible slowdown in China’s process automation market, HOLI has been actively looking for opportunities in the factory automation field, which offers better growth prospects, on government’s push for intelligent manufacturing.
Niche-market-focus strategy begins to bear fruit Leveraging on its core control technology and sound knowledge accumulated from various verticals, HOLI has adopted a strategy of offering customised automation solutions to niche verticals. This strategy has not only helped HOLI to avoid fierce competition and a long R&D cycle associated with individual products, but also enabled it to target demand from niche markets accurately.
The company’s initial efforts have started bearing fruit, evidenced by the success in Traditional Chinese Medicine Dispenser (TCMD). Released in 2008, TCMD is automation equipment developed by HOLI, exclusively for Traditional Chinese Medicine (TCM) pharmacies in hospitals.
Based on doctors’ prescriptions, the machine can automatically recognise and grab medicines and complete weighing, warning of the compatibility, and contraindication of medicines etc. As this machine greatly raises the efficiency and avoids human errors, the penetration in China’s hospitals has continued to rise (from ~1,000 in FY14 to ~1,500 in FY15). HOLI’s sales of TCMD (miscellaneous segment) have surged c.50% in FY15.
While the revenue contribution from TCMD was a mere 3% of the total and 6% of the industrial automation segment (adjusted, included TCMD), we see huge growth potential ahead. Although competition might intensify ahead, if the government relaxes the licensing of the distribution of single-formula-granules, more than 10,000 hospitals in China suggests great upside potential. We expect the segment’s sales to post a CAGR of >60% over FY16-18E, with the revenue contribution reaching 10% of total sales and 26% of adjusted IA sales by FY18E. We expect HOLI’s blended GPM for its whole IA segment (adjusted) to recover to 43% in FY18E from 40% in FY16E, given the higher margins associated with TCMD.
Figure 13: We expect TCMD to post Figure 14: Contribution to adjusted Figure 15: We expect GPM for a CAGR of 61% over FY16-18 IA sales rise to 26% by FY18 adjusted IA to expand on TCMD
70 120% 100% 60% 54% 56% 55% 55% 55% 90% 60 100% 100% 50% 80% 45% 44% 42% 43% 40% 50 70% 38% 39% 40% 80% 40% 36%37% 60% 80% 74% 40 87% 94% 60% 50% 96% 30% 30 US$ mn US$ 50%
48% chg% yoy 40% 40%40% 20% 20 30% 20% 10 20% 10% 10% 20% 26% 13% 6% 0 0% 0% 4% 0% 2014A 2015A 2016E 2017E 2018E 2014A 2015A 2016E 2017E 2018E 2014A 2015A 2016E 2017E 2018E
TCMD sales yoy chg% (RHS) TCMD Industrial automation TCMD Industrial automation Blended
Source: Company data, Deutsche Bank estimates. Source: Company data, Deutsche Bank estimates. Source: Company data, Deutsche Bank estimates.
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As a result of stronger growth and higher margins from TCM, we expect Looking at IA on a standalone HOLI’s whole IA segment (adjusted, incl. TCMD) to bottom out both in terms basis is somehow misleading of sales and GP, starting FY17E (Figure 16 and Figure 17). as it fails to capture strong growth in FA field i.e. TCMD Figure 16: HOLI’s IA sales (adjusted) Figure 17: HOLI’s IA GP (adjusted) to to bottom out in FY17E recover from FY17E
120% 120% 100% 96% 100% 100% 80% 80% 53% 50% 48% 50% 60% 40% 60% 40% 40% 18% 40% 20% 6% 11% 20% 8% -13% -3% -3% 1% 0% 16% 0% -20% -4% 1% -20% 0% -40% -22% -5% -10% -6% FY15A FY16E FY17E FY18E FY15A FY16E FY17E FY18E
Industrial automation Industrial automation TCMD TCMD Industrial automation (adjusted) Industrial automation (adjusted)
Source: Company data, Deutsche Bank estimates. Source: Company data, Deutsche Bank estimates.
Replicable success in other verticals Looking ahead, we believe HOLI’s success in TCMD is highly replicable, as we see substantial similar demand from many other niche verticals. Leveraging on its core technology knowhow and accumulated knowledge on downstream industries, we see a great chance for HOLI to launch new products going forward.
Indeed, the company has identified a number of niche verticals and has developed or is developing products. As these products are largely requested by customers, we expect them to quickly penetrate into relevant markets, in a similar way to TCMD. We see upside potential for the IA segment and our current forecasts have not taken new products into account.
Strong balance sheet to facilitate acquisitions While HOLI is a leader in China’s process automation area, it is still relatively new to the factory automation field, which requires more proprietary technologies to be successful. So far, discrete automation only made up 10% of IA revenue, with most belonging to sales of PLC plus some motion controllers. We expect HOLI to focus more on providing total solutions, instead of offering individual products via M&As.
Indeed, HOLI’s strong cash generation capability, along with its no-dividend policy, has allowed the company to accumulate a net cash position of >US$150m as of end-FY15. With limited capex requirements going forward, we expect the company’s net cash position will likely continue to grow, which should support the company’s acquisition needs to grow its FA business.
Specifically, the company is targeting two areas for acquisitions:
Advanced technologies (likely from overseas) as supplements to its existing product offerings in the factory automation
Expanding or gaining access to the sales distribution network
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Figure 18: Op-CF vs. NPAT (FY13A- Figure 19: Op-CF vs. capex and FCF Figure 20: Net cash position (FY13A- FY18E) (FY13A-FY18E) FY18E) 160 1.4x 140 500 120 450 430 140 1.2x 1.2x 1.1x 120 100 400 1.0x 0.9x 1.0x 0.9x 80 326 100 350 0.8x 60 300
80 0.6x x
0.6x 40 234 US$ mn US$ US$ mn US$ 250 60 20 mn US$ 200 0.4x 157 40 0 150 134 0.2x 20 (20) 100 76 0 0.0x (40) 50 2013A 2014A 2015A 2016E 2017E 2018E 2013A 2014A 2015A 2016E 2017E 2018E 0 Op-CF Net Profit Op-CF/NPAT Ratio (RHS) Op-CF Capex FCF 2013A 2014A 2015A 2016E 2017E 2018E
Source: Company data, Deutsche Bank estimates. Source: Company data, Deutsche Bank estimates. Source: Company data, Deutsche Bank estimates.
Overseas expansion – benefiting from China’s One Belt One Road (OBOR) initiatives
Lastly, for the purpose of expanding its overseas businesses, HOLI is in the process of setting up local service centres abroad. Its acquisition of Bond and Concord (Figure 21) has enabled the company to access its rich international bidding experience and sales channels. The company previously successfully bid for MTR contracts in HK and most recently HOLI inked two DCS contracts in India and Indonesia.
In India, HOLI won the bidding to provide DCS and SIS to the Lanco Solar Power Polycrystalline Silicon Project.
In Indonesia, the company won the bidding to provide DCS and DEH for Indonesia Qingshan 2X350MW Coal-fired Power Units Looking ahead, we expect China’s OBOR initiatives to potentially spur power investment in the countries alongside the route. This should present huge opportunities to HOLI, as a proven Chinese DCS leader.
Figure 21: A brief introduction of BOND and Concord Company name Year acquired Headquarter Key business BOND 2013 Malaysia The company provides design and installation (as a General Contractor), monitoring and testing, the overall value solutions and services. The company specialises in all kinds of mechanical and electrical system installation for factories, clean-rooms, data centres, banks, hospitals, airfields, power stations, gas & instrumentation plants, hotels, commercial & residential buildings, as well as infrastructure works. BOND has grown to become Southeast Asia’s premier one-stop M&E solutions provider, one of the largest of its kind. Concord Corp. 2011 Singapore Concord’s key focus is in rail/transportation infrastructure, power, petrochemical and pharmaceutical plants. Concord possesses a strong team of experienced and dedicated project managers, engineers, technicians and skilled workforce with a presence in Singapore, Malaysia and the Middle East. Source: Company data, Deutsche Bank
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Rail transportation
Key points
We expect the rail segment, a key growth driver for HOLI in last two years, to continue to grow steadily, on China’s rising demand for high- speed trains.
Despite new entrants, we see limited near-term impact on HOLI’s market position in the domestic HSR signalling market.
We expect new products and rail-related after-sales services to potentially yield meaningful earnings upside in the near-to-medium term and become a significant growth driver in the long term.
Figure 22: Rail made up 36% of total Figure 23: High-speed rail makes up Figure 24: China’s ATP market share revenue – 2015 85% of rail segment vs. subway’s (2013-15 three-year cumulative) 15%
Miscellaneous 100% (TCMD) M&E 3% Subway 90% (Concord and 15% 30% Bond) 80% 21% 50% 70% 64% Industrial 60% Automation 50% 40% 7% 40% 70% 30% 43% 20% 36% 10% 0% 200-250km/h 300-350km/h Overall ATP (est. Rail High-speed (volume) (volume) value) transportation 36% rail 85% HOLI CARS/ZZCRRC CRSC
Source: Company data, Deutsche Bank Source: Deutsche Bank estimates; HSR – mostly ATP; subway – all Source: Deutsche Bank SCADA at the moment.
A full spectrum of product offering in rail signalling control
HOLI is one of a handful of qualified rail signalling system providers in China, with a strong presence in both ground-based rail signalling systems – Train Control Centres (TCC), and train-borne rail signalling systems – Automatic Train Protection (ATP). The company is also one of a few major SCADA (Supervisory Control and Data Acquisition) system providers for China’s subway market.
Figure 25: Major types of rail transportation in China and the corresponding signalling control system adopted Control system Type of rail transportation in China adopted
High-speed Operating speed ≥ 300km/h CTCS-3 National railway Operating speed of 200km/h - 300km/h CTCS-2 Railway railway Normal-speed railway CTCS-0/CTCS-1 Intercity railway CTCS-2 Metro CBTC Urban Transit Light rail CBTC Source: Company data, Deutsche Bank. Note: CTCS is short for China Train Control System
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In recent years, the company has also successfully expanded its product offerings by developing its indigenous subway signalling system (CBTC) and track circuit.
We expect a 12% CAGR for HOLI’s sales in the rail transportation segment over FY16-18E as:
The high-speed rail segment will continue to offer a steady revenue stream in the coming years
New products are likely to emerge as new growth drivers
The after-sales service market is expected to take off We expect its GPM to expand from 44% in FY16 to 46%/47% in FY17E/FY18E as the rising after-sales service (higher margins of >60%) and removal of the impact of a one-off pricing cut for CTCS-3 products in FY16 would more than offset the rising contribution from SCADA (lower margins of 15-20%).
Figure 26: Revenue and revenue Figure 27: GP margin changes for Figure 28: Rail segment’s GP trend growth for rail segment (FY13-18E) rail segment (FY13-18E) and % of total GP (FY13-18E) 300 140% 52.0% 140 60% 50% 52% 51% 120% 49.6% 250 50.0% 120 45% 50% 100% 42% 48.0% 47.0% 100 200 80% 40% 46.0% 60% 46.0% 80 29% 150 44.0% 30% 40% 127
44.0% 43.1% 60 115 yoy chg% yoy
102 total of % as 100 20% 96 20%
Sales (US$ mn) (US$ Sales 41.6% 42.0% 40 74
0% mn) (US$ profit Gross 50 20 10% -20% 40.0% 36
0 -40% 38.0% 0 0% 2013A2014A2015A2016E2017E2018E 2013A 2014A 2015A 2016E 2017E 2018E 36.0% Sales yoy chg% GP - rail segment As % of total 2013A 2014A 2015A 2016E 2017E 2018E
Source: Company data, Deutsche Bank estimates. Source: Company data, Deutsche Bank estimates. Source: Company data, Deutsche Bank estimates.
High-speed rail – steady growth in coming years
China’s demand for high-speed trains will stay robust On the continued expansion of China’s HSR network and rising density of HSR trains, Phyllis Wang, our China infrastructure analyst, expects annual deliveries of high-speed trains (inclusive of inter-city rail trains) to post a 5% CAGR over 2016-20 against a high base (Figure 29). This should support HOLI’s sales for train-borne HSR signalling products (i.e. ATP).
Moreover, given the record-high number of railway projects that have kicked off in the past two years (Figure 30), we expect demand for ground-based HSR signalling systems (i.e. TCC) to offer an additional source of growth from FY18 and onwards, as TCC demand typically emerges in the late cycle of track construction.
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Figure 29: China’s annual delivery of high-speed trains to Figure 30: Record-high new railway projects started in post a CAGR of 5% over 2016-20 2014-15 should translate into TCC demand from 2017 700 70 66 61 600 60 500 49 50 400
300 40 train sets train
200 30
# of projectsof # 22 100 20 15 0 10
- 200-250km/h 300-350km/h <200km/h 2011 2012 2013 2014 2015
Source: China Railway Corporation, Deutsche Bank estimates. Source: China Railway Corporation, Deutsche Bank
New entrants possible, but near-term impact likely minimal Based on cumulative tenders over 2013-15 (in value terms), we estimate that Figure 31: China’s ATP market split HOLI holds 43% market share in China’s ATP market. The company is one of (cumulative 2013-15) the three qualified ATP providers in the 200-250km/h segment with market share of 70% and one of two qualified ATP providers in the 300-350km/h 100% 90% 30% segment, with a market share of 36% (Figure 31). 80% 50% 70% 64% 60%
Specifically, China’s CTCS-2 market (i.e. 200-250km/h) is duopolised by HOLI 50% 7% 40% and CARS/Zhuzhou CRRC (a consortium formed by China Railway Academy of 70% 30% 43% Science and Zhuzhou CRRC Times Electric) while CTCS-3 (i.e. 300-350km/h) 20% 36% market is currently duopolised by HOLI and China Railway Signalling & 10% 0% Communication (CRSC). 200-250km/h 300-350km/h Overall ATP (est. (volume) (volume) value)
HOLI CARS/ZZCRRC CRSC In the past three years, HOLI’s market share in both CTCS-2 and CTCS-3 largely remained stable, with the following exceptions: Source: China Railway Corporation, Deutsche Bank estimates.
In 2013, HOLI took up 94% market share of CRC’s ATP tender for the 200-250km/h segment, as orders for high-speed trains were placed very close to year-end and CRC required a very short delivery cycle for that particular batch – HOLI was the only one capable of meeting such a requirement.
In 2015, HOLI obtained c.50% market share of CRC’s ATP orders for 300-350km/h because of a one-off price reduction to protect its market position in the segment, as CRSC was trying to grab market share from the company.
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Figure 32: Market share split (in Figure 33: Market share split (in Figure 34: Market share split (in terms of volume) in domestic ATP terms of volume) in domestic ATP terms of estimated value) in market (200-250km/h segment) market (300-350km/h segment) domestic ATP market (overall)
100% 6% 100% 100% 90% 90% 90% 38% 80% 43% 45% 80% 80% 52% 51% 70% 70% 70% 57% 66% 72% 60% 60% 60% 12% 50% 94% 50% 50% 1% 40% 40% 40% 9% 30% 57% 55% 30% 30% 48% 48% 50% 20% 20% 20% 34% 28% 34% 10% 10% 10% 0% 0% 0% 2013 2014 2015 2013 2014 2015 2013 2014 2015
HOLI CARS/ZZCRRC HOLI CRSC HOLI CARS/ZZCRRC CRSC
Source: China Railway Corporation, Deutsche Bank Source: China Railway Corporation, Deutsche Bank Source: China Railway Corporation, Deutsche Bank estimates.
There are two likely changes that might affect the current competitive Figure 35: HOLI generates higher GP landscape of China’s railway signalling market: margin from rail signalling business than CRSC (2013-15) CARS will likely enter the 300-350km/h segment possibly by the end of this year after acquiring core IP from CRC. 60.0% 49.6% 50.0% CRSC will likely enter the 200-250km/h segment through its JV with 43.1% 41.6% 40.0% 35.0% 35.6% Alstom, namely CASCO. 32.6% 30.0% While the market eventually needs to be shared by more players, we see very limited near-term impact on HOLI’s market position. As the rail signalling 20.0% system is a very important safety control product, it often takes years for new 10.0% entrants to build up track record. 0.0% 2013 2014 2015
HOLI - Rail CRSC - Equipment In addition, given HOLI’s superior profitability on stringent cost control (Figure 35), we believe HOLI holds much stronger pricing power than its peers. In this Source: Company data, Deutsche Bank. Note: GPM data for HOLI sense, we think HOLI can well define its market share in the coming years (just is for fiscal years which end on June 30. like they did in 2015’s tender).
New products – new growth drivers
Subway signalling system Currently, HOLI’s exposure to China’s subway market is mainly through supplying SCADA systems, which accounts for 10-15% of total sales in its rail transportation segment.
Due to fierce competition, its subway SCADA only yields a GPM of 15-20%, substantially lower than the 40-50% for its HSR signalling business.
Leveraging on its technology know-how in HSR signalling control systems, the company has successfully developed its indigenous subway signalling control technology (CBTC) and obtained SIL (Safety Integrity Level) certification, which is viewed as the highest safety standard in this field.
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According to Frost & Sullivan, China’s total mileage of urban transit is Figure 36: Urban transit control th expected to double during the 13 Five-Year-Plan period, reaching c.10k km by system market breakdown (2016-20, 2020 (or a CAGR of 19% over 2016-20; Figure 37). This corresponds to a CAGR in RMBbn) of 10% in China’s urban transit investment during the same period, totalling Upgrade c.Rmb2trn (Figure 38). 19.0 11% More importantly, the control system market for China’s urban transit is expected to outpace the overall investment, reaching a CAGR of 17% during Maintenance 2016-20, due to rising maintenance and upgrade demand. The total market 45.3 size for urban transit control systems is expected to reach c.Rmb170bn during 27% New th construction the 13 Five-Year-Plan Period, or c.10% of total investment in urban transit 104.4 (Figure 39). 62%
Currently, the government has imposed a 55-60% localisation ratio requirement for CBTC system procurement in the domestic market in an effort Source: Frost & Sullivan Forecasts, Deutsche Bank to promote domestic players competing against foreign producers (including Siemens, Alstom, Thales, etc.) who have been dominating the market. We expect major domestic players, such as HOLI, to benefit from government supportive policies.
Having said that, China’s control system market for urban transit is fragmented in nature. Leveraging on its relationship with local governments, each domestic player tends to focus on certain regions. HOLI has been actively positioning in this market. By supplying subway SCADA systems in the past decade (Figure 40), HOLI has built up relationships with a number of local governments including Beijing, Guangzhou, Shenzhen, Kunming, Lanzhou, Tianjin, Chengdu, etc.
The established relationship with various local governments along with HOLI’s proven track record in the HSR signalling control market should greatly facilitate the company’s effort to break into the subway signalling market. Moreover, compared to other local players, HOLI’s ability to offer a one-stop solution (i.e., SCADA+CBTC) should also help it to stand out. The company is aiming to get its very first CBTC order in 2017. Subway signalling typically can generate GPM of >40%, much higher than the 15-20% for its SCADA business.
Figure 37: Total mileage of urban Figure 38: Total investment in urban Figure 39: Market size of urban transit in operation in China transit in China transit control systems in China
12.0 600 50.0 43.9 9.6 10.0 500 477 45.0 38.7 8.5 421 40.0 33.3 8.0 7.3 400 374 35.0 340 320 28.5 6.2 301 30.0 274 6.0 5.1 300 24.3 235 25.0 4.1 bn Rmb 207 20.1 181 189 bn Rmb
Thousand km Thousand 20.0 4.0 200 164 15.3 2.7 15.0 2.0 2.3 10.4 1.4 1.6 8.2 8.0 8.4 2.0 1.0 100 10.0 7.3 5.0 0.0 0 0.0
Source: NBSC, China Association of Metros, Frost & Sullivan Source: NBSC, China Association of Metros, Frost & Sullivan Source: NBSC, China Association of Metros, Frost & Sullivan Forecasts, Deutsche Bank Forecasts, Deutsche Bank Forecasts, Deutsche Bank
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Figure 40: Rich project track record in China’s subway SCADA market
Transportation Hub of Tianjin Railway Station; Line 1 of Shenzhen Metro; MCC for Shenzhen Metro (Phase 1 & 2); Line 4 of Guangzhou Metro ; Yizhuang Line of Beijing Metro; Line 13 of Line 4 of Line 3 of Line 10 of Contract 853 of Beijing Urban Guangzhou Line 10 of Guangzhou Beijing Metro Express Rail Railroad Metro Beijing Metro Metro (Phase 2) Link
2003 2004 2006 2007 2008 2009 2010 2011 2012 2013 2015 2016
Phase 1 of Line Line 3 of Line 5 of Line 4 of Line 8 of Beijing Line 14 of 1 of Shenzhen Guangzhou Rail Guangzhou Shenzhen Metro Metro (Phase 2) Beijing Metro Metro Transportation Metro (Phase 2); MCC for Line 2 of Shenzhen Metro
Source: Company data, Deutsche Bank
Track circuit HOLI has successfully developed its indigenous track circuit product in recent years and completed the first round of testing in 2013. The second round of testing is scheduled to conclude by end-June this calendar year. Once done, the company will be qualified for bidding contracts.
According to the company, the total size of China’s track circuit market is roughly about Rmb2bn per annum, which is comparable to the combined market size of TCC and ATP products (estimated c.Rmb3bn per year).
More importantly, China’s track circuit market is currently monopolised by CRSC. CRC is supportive of introducing another supplier to the market. The company guided that they will likely obtain its very first order in 2H of this calendar year, if it passes the second round of testing as expected in June.
Upside potential from after-sale services
Although HOLI’s current after-sale service revenue is mainly derived from its industrial automation segment, we see substantial potential for rail-related after-sale service as a significant portion of the operational stock of HSR trains will be due for heavy maintenance (i.e., Level 3 and above where trains are sent to service stations or rolling stock producers for maintenance and repair) in the coming years. In addition, as key components of the railway signalling system are essentially similar to DCS, regular maintenance including replacement of modules and upgrade of software would also bring in post- sales revenue.
Our China infrastructure research analyst expects CRRC’s after-sales service growth for high-speed trains to post a CAGR of 15% over 2016-20. Along with higher margins (at least 50-60%), we believe rail-related after sales services, if they materialise, could yield meaningful upside to our forecast in the coming years.
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Figure 41: Total installed base of high-speed trains in Figure 42: Total installed base of ATPs (i.e. train-borne China (2011-15) HSR signalling systems) supplied by HOLI in China 2,000 45% 800
1,800 40% 40% 700 1,600 34% 35% 600 1,400
30% 500 yoy yoy chg% 1,200 27% 22% 25% 400 1,000
20% trainsets trainsets 800 300 15% 600 200 10% 400 100 5% 200 0 - 0% 2006 2007 2008 2009 2010 2011 2012 2013 2014
CTCS-2 CTCS-3
Source: China Railway Corporation, Deutsche Bank Source: Company data, Deutsche Bank
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Earnings, valuation and risks
Earnings forecasts – 13% CAGR over FY16-18E on revenue growth, margin expansion and falling expenses
Overall, we expect HOLI’s NPAT (non-GAAP) to post a CAGR of 13% over Figure 43: NPAT vs. growth (FY13A- FY16-18E. We summarise below our key assumptions: FY18E)
Revenue: after stagnant growth in FY16E (+1%), we expect the top 160 147 60% 140 51% 127 50% line to resume growth of 6% in FY17E and 8% in FY18E, driven by 115 120 103 continued robust TCMD sales and bottoming-out of M&E. 40% 100 87 GP margin: after temporarily troughing in FY16E (est. 38%, reflecting 80 30% 58 60 chg% yoy one-off impact from low-pricing ATP orders), we expect GPM to trend 20%
NPAT (US$ mn) (US$ NPAT 19% 40 16% up in FY17E/FY18E (38.5%/40.4%), on rising after-sales service and a 11% 10% 10% favourable shift in product mix in industrial automation. 20 0 0% 0% 2013A 2014A 2015A 2016E 2017E 2018E Operating expense: we expect admin expense to normalise in FY16E Net profit (non-GAAP) yoy chg% after a one-off bad debt provision in FY15A (US$6.9m due to conservative consideration) and see a gradual decrease in the ratio (i.e. Source: Company data, Deutsche Bank estimates. Note: non- GAAP earnings exclude certain expenses such as share-based admin as % of sales) ahead, driven by efficiency gains. compensation expense and amortisation of acquired intangibles. These items typically would be included under US GAAP Taxation: we expect its effective tax rate to gradually normalise to 15% by FY18E, following the renewal of the company’s high-tech status.
NPAT: decent revenue growth, margin expansion, along with falling admin and taxation would drive 13% earnings CAGR over FY16-18E. Our forecasts are 6-17% higher than the Street over FY16-18E.
Figure 44: HOLI – key assumptions % 2013A 2014A 2015A 2016E 2017E 2018E Revenue growth 9% 49% 2% 1% 6% 8% Industrial automation 11% 6% -5% -10% -6% 0% Rail transportation -18% 116% 8% 20% 8% 8% M&E (Concord and Bond) 1736% 201% 1% -25% 10% 10% Miscellaneous -34% -47% 48% 100% 50% 40% GP margin% 35.4% 33.7% 40.3% 38.0% 39.5% 40.4% Industrial automation 37.9% 36.0% 44.0% 38.0% 39.0% 39.5% Rail transportation 43.1% 41.6% 49.6% 44.0% 46.0% 47.0% M&E (Concord and Bond) 16.0% 14.1% 15.1% 15.0% 15.0% 15.0% Miscellaneous 11.2% 54.4% 56.1% 55.0% 55.0% 55.0% Operating expense ratios (as % of sales) Selling expenses 7.7% 5.4% 4.9% 4.8% 4.6% 4.6% Admin expenses (excl. share-based comp) 8.0% 7.0% 9.1% 7.9% 7.9% 7.7% R&D expenses 9.3% 7.0% 6.7% 6.7% 6.7% 6.2% Effective tax rate (%) 13.4% 21.8% 20.8% 16.5% 15.5% 15.0% Non-GAAP Net profit growth (%) 0.4% 50.9% 18.9% 10.9% 10.5% 16.2% Source: Company data, Deutsche Bank estimates.
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Figure 45: Summary of balance sheet Rmb mn 2013A 2014A 2015A 2016E 2017E 2018E Non-current assets 198 197 177 190 198 207 Restricted cash 7 7 4 4 4 4 PP&E 79 82 80 86 94 103 Prepaid land leases 13 12 12 11 11 11 Acquired intangible assets, net 12 7 2 2 3 3 Interests in JCEs & Associates 20 19 17 23 23 23 Goodwill 66 67 60 60 60 60 Deferred tax assets 1 2 3 3 3 3 Other non-current assets 0 0 0 0 0 0 Current assets 546 730 807 863 986 1,119 Cash and cash equivalents 112 162 208 255 346 430 Restricted cash and time deposits 24 37 75 75 75 75 Account receivable 177 259 253 255 269 291 Cost and estimated earnings in excess of billings 144 180 165 170 182 201 Other receivables 12 11 12 13 13 14 Advance to suppliers 9 12 15 16 17 18 Amounts due from related parties 27 24 39 39 42 45 Inventories 34 35 35 36 37 40 Deferred tax assets 3 7 3 3 3 3 Other current assets 6 4 1 1 1 1 Total assets 745 927 984 1,053 1,183 1,326 Current liabilities 268 399 375 357 385 384 Short-term bank loans 8 4 16 0 0 0 Current portion of long-term borrowings 9 9 14 0 20 0 Accounts payable 111 136 105 110 114 121 Construction costs payable 6 5 1 1 1 1 Deferred revenue 67 131 139 145 150 160 Accrued payroll and related expenses 9 11 12 13 13 14 Tax payables 28 40 26 26 26 26 Warranty liabilities 2 4 7 7 7 7 Accrued liabilities 19 24 31 31 31 31 Amounts due to related parties 2 4 2 2 2 2 Deferred tax liabilities 2 2 6 6 6 6 Other current liabilities 5 30 15 15 15 15 Non-current liabilities 61 36 24 23 4 4 Long-term borrowings 19 15 21 20 0 0 Deferred tax liabilities 3 2 0 0 0 0 Warranty liabilities 2 4 3 3 3 3 Other non-current liabilities 36 15 0 0 0 0 Total liabilities 329 435 398 380 388 387 Total shareholders' equity 414 488 579 663 783 922 Share capital 0 0 0 0 0 0 Additional paid-in capital 171 174 193 193 193 193 Statutory reserves 23 23 30 30 30 30 Retained earnings 183 252 318 403 522 662 Accumulated other comprehensive income 37 39 38 38 38 38 Minority interests 2 4 6 9 13 16 Total equity 415 492 585 673 795 939 Total liabilities and equity 829 981 1,164 1,336 1,578 1,861 Source: Deutsche Bank
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Figure 46: Summary of cash flow Rmb/m 2013A 2014A 2015A 2016E 2017E 2018E Net income (loss) 52 70 97 108 119 139 Minority interest 1 2 3 3 3 4 Depreciation and amortization 9 13 13 13 14 15 Provisions 6 11 17 0 0 0 Gains/losses from disposal (0) (0) 1 0 0 0 Impairment loss 0 0 0 0 0 0 Dividend income (1) 0 (0) 0 0 0 Investment income (0) 3 3 (6) 0 0 Others 1 6 9 0 0 0 Total change in working capital (37) (21) (58) 3 (23) (30) Net cash flow from operating activities 31 83 84 121 113 128 Capex (21) (19) (19) (20) (22) (24) Investment payment (20) (19) (33) 0 0 0 Investment income 0 0 0 0 0 0 Disposals 0 1 1 0 0 0 Others 28 12 12 0 0 0 Net cash flow from investing activities (12) (25) (40) (20) (22) (24) Issuance of equity capital 0 0 0 0 0 0 Proceeds from exercise of options 1 0 1 0 0 0 Capital contributions 0 0 0 0 0 0 Proceeds from (repayments of) note payable 0 0 0 0 0 0 Proceeds from short-term loans 7 15 25 0 19 0 Repayments of short-term loans (5) (14) (13) (30) 0 (20) Proceeds from long-term bank loans 1 0 0 0 0 0 Repayment of long-term bank loans (8) (9) (9) (0) (20) (0) Proceeds from issuance of bonds 0 0 20 0 0 0 Dividends paid 0 0 (23) (23) 0 0 Others 0 0 (0) 0 0 0 Net cash flow from financing activities (4) (8) 1 (54) (0) (20) Net increase/(decrease) in cash and cash equivalents 15 50 45 47 91 84 Effect of changes in FX rate 1 0 0 0 0 0 Cash at beginning of year 96 112 162 208 255 346 Cash and cash equivalents at end of year 112 162 208 255 346 430 Source: Company data, Deutsche Bank, estimates
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Valuation – DCF-based target price of US$25.8 with 49% upside potential
We use DCF to value HOLI given its stable cash flow. Our target price of Figure 47: WACC assumptions
US$25.8 is based on a WACC of 11.2% and a terminal growth assumption of Risk-free Rate of Return 3.9% 0% (Figure 47). Our cost of equity assumption incorporates a risk-free rate of Equity Risk Premium 5.6% 3.9%, an equity risk premium of 5.6% and a beta of 1.3x. Company Beta 1.3 Cost of Equity 11.2% Our target price corresponds to a non-GAAP-based P/E of 11.9x/10.2x and a P/B of 1.9x/1.6x for FY17/FY18, largely in line with its mid-cycle levels in the Pre-tax Cost of Debt 5.0% past five years (incl. the distressed valuation period post Wenzhou HSR crash). Tax Rate 15.0% Compared to its long-term (since 2007) mid-cycle multiples, our TP implied After-tax Cost of Debt 4.3% valuation multiples are at a 10% discount, which we think is fair, given relatively slower earnings growth vs. before. Target debt to total capital 0.0% WACC 11.2% Trading at 8x/7x FY17E/FY18E P/E – one standard deviation below the long- Terminal growth ("g") 0% term mid-cycle average, we believe the market has priced in an overly bearish Source: Deutsche Bank estimates outlook. Double-digit earnings growth in the coming years, on the back of rising after-sales and new product launches, would positively surprise the market and drive up the stock, in our view.
Figure 48: Detailed DCF valuation US$m (US GAAP) 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E Cash flow from operations 113 128 131 141 155 161 169 174 177 182 186 - capex (22) (24) (26) (28) (30) (30) (32) (35) (35) (35) (35) + tax shield 0 0 0 0 0 0 0 0 0 0 0 Unlevered FCF 92 104 105 113 125 131 137 139 142 147 151 Terminal value 1,347 DCF 92 93 85 83 82 77 72 66 61 57 52 PV for the forecasted period 728 PV for the terminal value 467 Enterprise Value (US$m) 1,195 - (Net debt + Minority interest) 313 NPV to equity shareholders 1,508 ÷ total # of shares outstanding 58 NPV per share to equity shareholders $25.8 Source: Deutsche Bank estimates. Note: The company’s fiscal year ends on June 30.
Figure 49: HOLI – One-year forward Figure 50: HOLI – One-year forward Figure 51: HOLI – One-year forward P/E (long-term) P/E (past five years) P/E (past three years) 30.0 17.0 19.0 25.0 15.0 14.1x 17.0 13.0 14.9x 20.0 17.5x 11.7x 15.0
15.0 13.1x 11.0 13.0 12.8x
P/E (x) P/E
P/E (x) P/E P/E (x) P/E 9.0 11.0 10.6x 10.0 9.2x 8.7x 5.0 7.0 9.0 7.0 0.0 5.0
1yr fwd P/E (x) Avg P/E 1yr fwd P/E (x) Avg P/E 1yr fwd P/E (x) Avg P/E +1 STDEV -1 STDEV +1 STDEV -1 STDEV +1 STDEV -1 STDEV
Source: Bloomberg Finance LP, Company data, Deutsche Bank Source: Bloomberg Finance LP, Company data, Deutsche Bank Source: Bloomberg Finance LP, Company data, Deutsche Bank
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Figure 52: HOLI – One-year forward Figure 53: HOLI – One-year forward Figure 54: HOLI – One -year forward P/B vs. ROE (long-term) P/B vs. ROE (past five years) P/B vs. ROE (past three years) 4.0 25.0 3.5 20.0 3.0 20.0 2.6x 20.0 3.0 19.0 19.0 3.0 2.8x 2.5 2.5 2.4x 2.2x 15.0 18.0 18.0 2.0 2.0 2.1x 2.0
2.0x (x) P/B 17.0
P/B (x) P/B (x) P/B
10.0 17.0 (%) ROE ROE (%) ROE ROE (%) ROE 1.5 1.8x 1.5x 1.5 1.0 1.5x 16.0 5.0 1.0 16.0 1.0 15.0 0.0 0.0 0.5 15.0
1yr fwd P/B (x) Avg P/B 1yr fwd P/B (x) Avg P/B 1yr fwd P/B (x) Avg P/B +1 STDEV -1 STDEV +1 STDEV -1 STDEV +1 STDEV -1 STDEV 1yr fwd ROE (RHS, %) 1yr fwd ROE (RHS, %) 1yr fwd ROE (RHS, %)
Source: Bloomberg Finance LP, Company data, Deutsche Bank Source: Bloomberg Finance LP, Company data, Deutsche Bank Source: Bloomberg Finance LP, Company data, Deutsche Bank estimates. estimates. estimates.
Risks to our positive view on the stock
We summarise below the key risks to our investment thesis and rating:
Sector wise An unexpected slowdown in China’s economy, leading to lower-than- expected capex for automation upgrades.
An unexpected slowdown in China’s railway investment and demand for high-speed rail trains.
Worse-than-expected market share loss in the rail signalling market as a result of new entrants. Company specific Slower-than-expected development of new products.
Poor execution of M&As.
Page 24 Deutsche Bank AG/Hong Kong
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Manufacturing
Hollysys Automation
Company basics
Company profile, structure and history
Company description Founded in 1993 and headquartered in Beijing, Hollysys Automation (HOLI) specialises in process automation, factory automation, rail automation and mechanical & engineering solutions. Hollysys has established itself as the local leading automation and IT solutions provider in China and Southeast Asia. Hollysys listed its common stock on NASDAQ in 2008. Figure 55 is a summary of the business scope for HOLI’s three major business segments including industrial automation, rail transportation, and mechanical & Mechanical & Electrical solution (M&E).
Figure 55: Summary of HOLI’s three business segments Business segment Offerings Track record Products Market position Competitors Clients Industrial automation Proprietary ABB, technologies in Siemens, 6,000 customers, including More than 20,000 DCS, Batch, MES, 13-15% share in Process control (DCS) solution, design, Emerson, SOEs, Multinationals, and projects completed AMS , SIS, etc. China’s DCS market manufacture and Honeywell, SMEs. installation. Supcon The only proven Engineering design, Qin Shan I/II/III, Da domestic company procurement, Proprietary nuclear Yawan, Ling Ao, Tian to supply control Siemens, China General Nuclear Nuclear automation integration, installation, power plant Wan, Hong Yanhe, systems to nuclear AREVA Power Group (CGNPG) support, and control systems Ning De, Yang Jiang power automation specialised services market in China Sewage treatment, Sales of TCMD Siemens, Coal mining industry, Coal mining safety, covered ~1,500 PLC, SCADA, Leading supplier of Schneider, sewage treatment industry, Discrete control Chinese Medicine public hospitals as of TCMD, etc. TCMD Rockwell, traditional Chinese Dispensing Machine end-FY15 Xinjie, LS, etc. medicine industry, etc. Rail transportation 1 of the only 2 Supplied ATPs to approved providers CRSC, over 700 sets of in 300-350km/h Bombardier, High-speed Rail high-speed trains ATP, TCC, LEU, China Railway Corporation, High-speed rail segment; 1 of the Siemens, Signalling System and completed c.30 track circuit, etc. Hong Kong MTR, etc. only 3 approved Ansaldo, TCC projects providers in 200- Hitach domestically 250km/h segment A leading SCADA Completed over 10 system supplier and Siemens, projects in Beijing, China and international Signalling System and Signalling system one of the key Alstom, Subway Shenzhen, subway construction SCADA and SCADA proprietary subway Thales, NARI, Guangzhou, Hong authorities signalling system etc. Kong, etc. providers Rail/transportation infrastructure, plants, Design, electrification factories, clean-rooms, data Mechanical & and engineering n.a. n.a. n.a. n.a. centres, banks, hospitals, Electrical solution service airfields, hotels, commercials and residential buildings Source: Deutsche Bank
In fiscal year 2015, HOLI derived 40%/44% of its sales/gross profit from industrial automation, 36%/44% from rail transportation, 21%/8% from mechanical and engineering, and 3%/4% from TCMD.
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Manufacturing Hollysys Automation
Figure 56: HOLI – revenue breakdown (FY15) Figure 57: HOLI – gross profit breakdown (FY15)
Miscellaneous Miscellaneous (TCMD) M&E (TCMD) M&E 3% (Concord and 4% (Concord and Bond) Bond) 8% 21%
Industrial Automation Industrial 40% Automation 44%
Rail transportation 44% Rail transportation 36%
Source: Company data, Deutsche Bank Source: Company data, Deutsche Bank
Shareholder structure Dr. Wang Changli, the founder of HOLI, holds 11.88% equity stake in HOLI as of the end of FY15. The current management team as a whole holds less than 5% of HOLI’s stake (Figure 58).
Figure 58: Hollysys Automation – shareholding structure (as of end-FY15)
Wenfu Wang
Changli Wang Schroders Prudential PLC Unionway Wellington Jianfeng He
11.88% 8.11% 7.22% 7.22% 5.15% Less than 1% Baiqing Shao Herriet Qu Colin Sung Jerry Zhang Jianyun Chai
Less than 1% Less than 1% Less than 1% Less than 1% Less than 1%
Hollysys Automation Technology Ltd. 100%
Hollysys International 1% Pte.Limited (Singapore) 99% 100% 100%
100% Bond Corporation Gifted TimerHolding Hollycon (Italy) Pte.Lte Hollysys (Asia Pacific) Pte.Limited Limited 40% (Italy) Pte.Limited (Singapore) (British Virgin Island)
100% 100% 99% 100% 100% Hollysys Automation Concord Corporation Concord Soution (HK) Bond M&E Sdn.Bhd India Pte.Limited Pte.Limited Limited Clear Mind Limited (Malaysia) (India) (Singapore) (Hongkong)
100% 100% World Hope Enterprises 100% 100% 100% 100% Bond M&E.Pte.Ltd. Limited (Singapore) Concord Corporation Concord Electrical Concord M Design and Concord Electrical (HongKong) Pte.Limited Pte.Ltd Engineering Company Sdn.Bhd (Singapore) (Singapore) Limited (Malaysia) 100% 100% Bond M&E (KL) Beijing Helitong Sdn.Bhd Science & Technology (Malaysia) Exploration Co.Ltd 100%
Hollysys Group Co.Ltd. (China) 100% 100% 51% 100% 100% Hollysys (Beijing) Beijing Hollysys Beijing Hollycon Beijing Hollysys Beijing Hollysys Co., Investment Co., Ltd. Electronics Technology Medicine & Technology Automation & Drive Ltd. (China) Co., Ltd. Co., Ltd. Co., Ltd. (China)
Offshore Companies 40% 100% 60% China Techenergy Hangzhou Hollysys Co., Ltd. Xi’an Hollysys Co., Ltd. Automation Co., Ltd. (China) (China) (China) Chinese JV Operating 100% Hangzhou Hollysys System Engineering Co., Ltd. (China) Source: Company data, Deutsche Bank
Page 26 Deutsche Bank AG/Hong Kong
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Manufacturing
Hollysys Automation
Product offering and how the products work
Product offering
Figure 59: HOLI’s key products
Source: Company data, Deutsche Bank
Figure 60: Traditional Chinese Medicine Dispenser Figure 61: Traditional Chinese Medicine Dispenser MD MD6100 6110
Source: Company data, Deutsche Bank Source: Company data, Deutsche Bank
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Manufacturing Hollysys Automation
Management profile
Figure 62: Hollysys Automation—management profiles Name Age Position Experience & Qualifications Dr. Jianfeng He 52 Chairman Holds a PhD Degree from South China University of Technology in automation and control theory and application. Has served as Chairman of Hollysys since November 30, 2013. Prior to that, Dr. He served as the Chief Operating Officer of the Company from 2012 to 2013. From 2010 to 2013, he served as General Manager of Hollysys Group, Chairman of Hangzhou Hollysys and Chairman of Beijing Hollysys. From 2008 to 2010, Dr. He was Vice President and President of Beijing Hollysys. From 2004 to 2008, he served as Deputy General Manager and General Manager of Hangzhou Hollysys. Has also served as Chairman of Hollysys Group since December 2013. Mr. Baiqing Shao 47 Chief Executive Officer and Holds a Master Degree of Computer Science from the 6th Research Institute of Director China Electronics Corporation and an MBA degree from Peking University One of the main founders of the company and has served as Executive Officer since November 30, 2013. He was the former Senior Vice President, Business Development of the Company from February 2012 to November 2013.From 2002 to 2010, he served as the General Manager of Beijing Hollysys Information Technology Co., Ltd. (currently known as “Shenhua Hollysys Information Technology Co., Ltd.”), one of the indirectly equity investees. Has also served as Vice General Manager of Hollysys Group and Chairman of Hollysys A&D since 2010 Ms. Herriet Qu 45 Chief Financial Officer Holds an MBA degree from Oklahoma City University and a Bachelor’s degree from Tianjin University of Finance & Economics. Served as Chief Financial Officer since February 2012. Prior to that, Ms. Qu served as the Financial Controller of the Company from October 2007 to January 2012. Mr. Colin Sung 49 Director Holds a bachelor’s degree in accounting from William Paterson University in 1992 and MBA degree from American InterContinental University in 2004. Mr. Sung is a Certified Public Accountant and Certified Global Management Accountant Served as CFO for eHi Auto Services Limited since April 2013, adviser of NeWorld Education Group, Inc. since August 2012 and CFO of NeWorld Education Group since August 2011. Previously served in Lighting the Box, Linktone Ltd., China Cablecom Holdings, Ltd. UTI, United States, Inc., USF Worldwide, Inc., and Panalpina Welttransport Holding Also serves as a member of the Board of Directors and Chairman of the Audit Committee of Board of Directors of the Company since February 2008 Ms. Jerry Zhang 43 Director Holds a MBA degree from Lancaster University. Previously served as Executive Vice Chairman & CEO of Standard Chartered Bank (China) Limited, Chief Representative of Fidelity International Asset Management Co. Beijing Representative Office. Dr. Jianyun Chai 54 Vice President Ms. Zhang previously served as deputy director of development department and director of industry department Previously worked in motor and information industries in Japan Also a professor and the head of the Institute of Power Electronic and Electrical Machine System at Tsinghua University in China, member of China Renewable Energy Society, the Chinese Wind Energy Association Dr. Changli Wang 53 Ex-Chairman & CEO, Holds a Bachelor's degree in Automation from Tianjin University and a PhD founder degree in Automation from Lancaster University in UK Previously served as an engineer in the 6th Research Institute of China Electronics Corporation Also served as the Vice Chairman of the Chinese Automation Association since 2003 Source: Company reports, Deutsche Bank
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Manufacturing Hollysys Automation
Appendix 1
Important Disclosures
Additional information available upon request
Disclosure checklist Company Ticker Recent price* Disclosure Hollysys Automation Technologies Ltd. HOLI.OQ 17.63 (USD) 8 Jul 16 NA *Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors . Other information is sourced from Deutsche Bank, subject companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.
For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/Disclosure.eqsr?ricCode=HOLI.OQ
Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s) about the subject issuer and the securities of the issuer. In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Sky Hong/Nick Zheng
Historical recommendations and target price: Hollysys Automation Technologies Ltd. (HOLI.OQ) (as of 7/8/2016)
30.00 Previous Recommendations
Strong Buy 25.00 Buy Market Perform Underperform Not Rated 20.00 Suspended Rating
Current Recommendations 15.00 Buy
Hold Security PriceSecurity 10.00 Sell Not Rated Suspended Rating
5.00 *New Recommendation Structure as of September 9,2002
**Analyst is no longer at Deutsche 0.00 Bank
Jul 14 Oct 14 Jan 15 Apr 15 Jul 15 Oct 15 Jan 16 Apr 16 Date
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Manufacturing Hollysys Automation
Equity rating key Equity rating dispersion and banking relationships Buy: Based on a current 12- month view of total 500 share-holder return (TSR = percentage change in 450 53 % share price from current price to projected target price 400 350 plus pro-jected dividend yield ) , we recommend that 300 36 % investors buy the stock. 250 200 Sell: Based on a current 12-month view of total share- 150 16 % 11 % 100 15 % 20 % holder return, we recommend that investors sell the 50 stock 0 Buy Hold Sell Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not Companies Covered Cos. w/ Banking Relationship recommend either a Buy or Sell. Asia-Pacific Universe Newly issued research recommendations and target
prices supersede previously published research. Regulatory Disclosures 1.Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. 2.Short-Term Trade Ideas Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com.
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Additional Information
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Manufacturing Hollysys Automation
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