Earnings Transcript for HOLI - Q3 Fiscal Year 2020

Operator: Ladies and gentlemen, thank you for standing by and welcome to the Hollysys Automation Technologies' Earnings Conference Call for the Third Quarter and the First Nine Month ended March 31, 2020. At this time all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. [Operator Instructions] Please be advised that this conference is being recorded today, May 15, 2020, Beijing Time.I would now like to hand the conference over to Mr. Arden Xia, the Investor Relations Director of Hollysys Automation Technologies. Thank you. Please go ahead, Mr. Xia.

Arden Xia: Hello, everyone, and thank you for joining us. Today, our speakers will be Mr. Baiqing Shao, CEO of Hollysys Automation Technologies; Mr. Steven Wang, CFO of Hollysys; and myself, the IR Director of Hollysys. On today's call, Mr. Shao will provide a general overview of our business, including some highlights for the third quarter of fiscal year 2020. Mr. Steven Wang will discuss our performance from financial perspective and we will answer questions afterwards.Before getting started, I would like to remind everyone that this conference call may contain forward-looking statements within the meaning of Private Security and Litigation Reform Act of 1995. Forward-looking statements are statements that are not historical facts, including statements relating to the expected growth of Hollysys future products and future introductions, the mix of products in future periods and future operating results. Such forward-looking statements based upon the current beliefs and expectations of Hollysys' management are subject to risks and uncertainties, which could cause actual results to differ from the forward-looking statements.The following factors, among others, could cause results to differ from those set forth in these statements

Baiqing Shao: Thank you, Arden, and greetings to everyone. I would like to discuss some key events during this quarter. COVID-19 has laid a negative impact on our business. Contract bidding and project execution were delayed for Industrial Automation and rail business and only started to recover starting in March. In response to such impact, we have actively prepared internal work in advance, including staff training, marketing preparation, solution improvement, internal testing, et cetera while also maintained communication with clients to the greatest extent, and made procurement in advance to counter the uncertainty of overseas supply chain. With the reopening of economy in China, we expect our business to recover to its normal course. Going forward, the Company will be imposing more stringent criteria on cash collection and payment, contract quality and expense.IA business finished the third quarter with revenue and contract at $34.2 million and $63.2 million, representing 43.0% and 24.7% year-to-year decrease, respectively. For the first nine months of the fiscal year, IA revenue and contract achieved 0.5% and 4.1% year-to-year growth, respectively. In coal fire sector, we continued our effort in strengthening our market position in high-end market and won the bidding for Xinjiang Wucaiwan 2 units of 660MW power units this quarter.In chemical and petro-chemical sector, we continued our effort in key bidding tracking. Several major contracts that we signed this quarter include a 5 million tons per year oil treatment DCS upgrade project for Sinopec and a comprehensive surveillance project covering six LNG storage centers of Henan Natural Gas Storage & Logistics Company, where we provided a wide range of solutions including SCADA, DCS, SIS, and GDS et cetera to assist with our market penetration strategy, we kept improving our solution and product through internal R&D and cooperation with external parties, with particular focus in the vertical of coal-chemical and oil and gas. We also continued to build the reputation of the Company in the industry in various manners, including industry conference, successful key project demonstration, cooperation with experts, key clients strategic relation management, et cetera.In smart factory business, internal structural optimization was made as we established the digital factory business unit. The new BU will be responsible for the marketing, solution and software development and execution of smart factory project.We expect such change to lead to more focused internal resource deployment for serving client of various industries. As a comparison, the business used to be carried out separately by different industry teams, with our advantageous power industry being the primary focus.Under the 3+1+N strategy, we continued the effort to integrate the sales platform of the Company for greater internal synergy, to develop and strengthen our industrial cloud capacity covering cloud platform and cloud-based software, and to expand our solution for full lifecycle coverage.With the effort, we have made meaningful progress in pharmaceutical business in terms of solution expansion, thanks to the inclusion of the design capacity and greater coordination between members of the Company. In this quarter, key contracts of pharmaceutical business include an engineering design contract with Shandong Fulkon, a renowned domestic pharmaceutical producer, and three tens of millions RMB level control system contracts.Rail business finished the third quarter with revenue and contract at $28.7 million and $5.0 million, recording 38.7% and 86% year-to-year decrease, respectively. For the first nine months of the fiscal year, revenue and contract recorded 5.3% and 53.5% year-to-year decrease, respectively.In high-speed rail sector, major contracts include an ATP contract for cargo high-speed train, a TCC contract for Zhengzhou section of the Taiyuan-Jiaozuo High-speed Railway and several aftersales contracts covering part components, maintenance and upgrade.In subway sector, no significant contracts were signed this quarter. On quality management, following the successful delivery of Phase 1 of Hohhot subway line 1 cloud-based SCADA project last quarter, subway business continued to strengthen quality management, with particular focus on supply chain management and engineering standardization. On aftersales service, several contracts covering system upgrade and part components were signed.To actively address the aftersales opportunities in the market, rail business has been implementing the service transformation strategy, to strengthen local service network, to expand service solution and to develop the technology and service-centered service for better differentiation.In HSR sector, other than the current aftersales service provided to on-board products, we have been exploring and developing service solution for on-ground products. In subway sector, with current client base and numerous line under operation, we are gradually reviewing existing projects for maintenance and upgrade opportunities.As part of the 3+1+N strategy, rail business is actively executing the digital empowerment for the current product line. New solutions on smart maintenance and smart workshop for clients from HSR and subway have been identified and are currently under development and testing.With urbanization as an ongoing process, we will keep leveraging our strong R&D capacity and prepare for the application of our solution in more verticals of transportation in the future.Going forward, our rail business will continue to adhere to the diversity strategy for stable and healthy growth. M&E business finished the quarter with revenue and contract at $17.9 million and $19.9 million, recording 2.6% year-to-year decrease and 18.6% year-to-year increase respectively. For the first nine months of the fiscal year, revenue and contract recorded 37.0% and 3.7% year-to-year decrease respectively.Given the macro economy in Southeast Asia and the Middle East, as well as the outbreak of COVID-19 and its potential impact, risk control remains to be the key focus of our M&E business. In our direct sales and overseas EPC project, progress is constantly made in terms of establishment of new cooperation with new key EPC players as well as ongoing cooperation with existing partners.In addition to our previous effort on overseas headquarter upgrade and appointment of overseas officer, we have set up a three year long global management capacity action plan. The plan aims to gradually incorporate our current overseas business into the management system of the domestic business, and to ultimately build our global management capacity.With that, I'd like to turn the call over to Steven Wang, who will read the financial results analysis. Steven?

Steven Wang: Thank you, Mr. Shao. I'd like to share some highlights for the third quarter ended March 31, 2020, comparing to the third quarter of the prior fiscal year with total revenues for the three months ended March 31, 2020 decreased from $125.2 million to $80.8 million, representing a decrease of 35.5%. Broken down by the revenue types, integrated contracts revenue decreased by 33.2% to $67.7 million, products sales revenue decreased by 72.8% to $3.6 million, and services revenue decreased by 11.1% to $9.5 million.The company's total revenues can also be presented in segments as follows

Arden Xia: At this time, we'd like to open it up for the Q&A session. Please note that for the Chinese-speaking participants, we can also do the Q&A in Mandarin and we'll provide translation. Operator, please.

Operator: Ladies and gentlemen, we’ll now begin the question-and-answer session. [Operator Instructions] Our first question comes from the line of Joseph Qi [ph] from JPMorgan. Please ask your question.

Unidentified Analyst: [Foreign Language]

Arden Xia: Okay. The first question based on the gross margin and for the Q3, the gross margin compared to decrease a lot. Could you please do separate down the proposition with business, IA rail or M&E, I mean influenced a lot based on the whole business of the gross margin. And for the – and also give us some hint about the Q4 gross margin trends and also the second harp of calendar year of this year trend for the gross margin.The second question focused on the infrastructure of rail sector, and because we could the policy driven for Fujian infrastructure based on the rail, but it seems like a lack and not to reflect that for the current market. What about the expectation from your side? And what about the ATP bidding about this year? And we also could see last year you were – you won 40 sets of the ATP contract. So right now has this, or delivered – finished deliveries?

Baiqing Shao: [Foreign Language]First of all, this is just a one-time input and that the current Q3 gross margin compared in the history lower, but have several reasons on way handed revenue recognized more lower margin project by this quarter. This is just coincidence. And on the other hand, because the COVID-19, there was no business treatment on the rail side to implement the work that jump up the project delivery rate. In other words, that means leads to the costs are writing up. So that’s why the Q3, the margin compare decreased a lot, but we recommend that to see based on the year labors out, because currently, it will be flat rate and in future, the trend would be just abnormal between satisfied to full teams. This is the normal range of the margin.

Unidentified Analyst: [Foreign Language]

Arden Xia: [Foreign Language]The question about could you please give us some separation of the IA and rail, which was decreased more to contribute the gross margin down and that the answer is that those of IA and rail have been influenced by the gross margin. So, just like the CFO said before, it’s really because of the two reasons and this is better to focus on the yellows out, not to fluctuate by coddling.

Unidentified Analyst: [Foreign Language]

Arden Xia: [Foreign Language]Okay. And also Mr. Shao and its document, the surveys come back, the project – sorry, the surveys project implementing relatively lower, because during the coronavirus COVID-19, we can’t hardly do to implementing provide services. So, this part has a relatively high gross margin. So that is to say to recognize revenue for this quarter, the high gross margin proportion lower than the normal. So also, this is the reason.

Unidentified Analyst: [Foreign Language]

Arden Xia: [Foreign Language]Okay. For the rail sector, because the COVID-19 and right now, we also need the tougher situation that right now for example, like the China Railway Corporation. They are not stopped, opening to the people. So, that to say our salespeople work or marketing people can hardly communicate with them. And also the first half of kind of year, you could see there has no too much bleeding complement and we think it most probably would start from second half of this calendar year and for the long-term, to see the rail sector, because the central government to also emphasize on the high speed rail and the intercity infrastructure, it’s ranking at the seven large infrastructure investment area and we believe the supportive policy would be launching in the next and the company will follow the national planning to catch up the challenge for the new construction support to the rail sector. And about the labor rate for the ADP, because of the coronavirus, it also influenced the implementing work. So we just delivered a part of it, not as few half the ATP comp backlog have it. It’ll wait for the customer demand to recover.

Unidentified Analyst: [Foreign Language]

Operator: [Operator Instructions] Your next question comes from the line of Alex Chang from Citi. Please ask your question.

Alex Chang: [Foreign Language]

Baiqing Shao: [Foreign Language]

Alex Chang: [Foreign Language]Okay. The question itself is, the coronavirus influence right now, the company already recovered the production from March. And what about the recovery rate for the March and could you give us some, some hint about the April and May what kind is level for the recovering values in production and the business.

Baiqing Shao: [Foreign Language]We've faced the COVID-19 very seriously, so after that we just have a very few employee in the company just for maintain the production, the basic production and the emergency project. And in March around 70% to 80% of recovered production by the company and also recovered working by our company. But we also meet the requirements by the isolate and several control by the central government – by the government, local government. And the April and May we recovered to around 90% of the working recovered.However, I want to emphasize, recovered work not means recovered for the business activities, because our client has not started yet. Like the sales, like the marketing and/or engineering, implementing work on the rail side cannot start, because are end-user costumer non-stop work. So we use the remote communication and also hard to do the technology or implementing growth on the rail side.So we knew that the [indiscernible] to do the bidding for communicating with a customer and along with the facing gradually to open to the other cities and also along with the other offices spread across the whole country to open. And we believe that the recovered working of our company have no problems, that’s a steal, like what I said; that the recovery the business activities still need time? So basically to see a trend, we think that in this automation we’ll be better because you can see the performance for third quarter, even based on the [indiscernible] fast low and the CoV-19 influence, industrial performance is good. So we think either gradually to recover faster than the others.

Baiqing Shao: [Foreign Language] And – but right now, the good thing is that the massive China business activity is recovering very faster, faster, and our customer also on the road to recover the business. However, the international environment compares weak and domestic China. For example, like our MAE businesses focused on the Southeast Asia, especially i.e., for example, in Southeast Asia like Malaysia, like Indonesia, like India or Singapore, right now a lot of companies not working. So that also influence, I mean too much than the rest of the China business.

Alex Chang: [Foreign Language] The question is about the chemical and petro-chemical industry. Currently could you see some new beading or infrastructure driven for this area of business?

Baiqing Shao: [Foreign Language] The chemical and petro-chemical industry by the IA is very important and take a large proportion off the IA’s revenue. So we focused on this area. We put a lot of resources to develop the project. You could see within our [indiscernible] operation we also introduced some improvement projects that we can this part. The COVID-19 influenza the whole things, however, because the chemical and petro-chemical and the customer are a large state owned enterprises. So they are recovering better than the other company. So we through that internet beading communication and the finish a lot of project, so generally speaking, it has influence, but it will performance good in the coming quarters.

Alex Chang: [Foreign Language] Okay. The Q3, we could see the R&D expenses rise up very quickly. And could you please introduce that what it contains and also what it will contribute from those R&D to the business?

Baiqing Shao: [Foreign Language]The R&D expenses rising off of the steel leaving the help range, and we focused on the industrial internet and big data those kinds of new driven by the central government investments, the central government call it like the new infrastructure, and also based on the upgrading for the production of our industry. And we always focused on these area and these technology or product already regulate to turns to benefit to the customer and we get the good contract and also we already transferred the technology product to the contract. And this is including, for example, like the big solutions with the IA and also industrial international related to technology and products, and also like the optimized the smart module to develop the focus on the production and also for examples, such as the equipment to analog.And the prediction meant assistant like the optimization operation, decision making system and also the human last checking at the security stabilize system that was within IA. And also rail factor we combined the R&D focus on the combination integration of the industrial internet to the traditional separate SCADA and combined with the automatic train operation technology and to provide the efficiency, reliable reduce the maintenance of customer cost. And also fill this under industrial internet, sorry, industrial information security and we are developing the platform for this area.And the army expenses also including the taxing fee and the certificate for these technology and product secure. So these activities we believe is going to graduate to get a contract. And then meanwhile, we also have the rail project within these areas, no matter IA smarter manufacturing plant or the subway factor the rail side to new lines that we are implementing the work and the combined R&D into the implemented work. So generally speaking, we believe the upcoming years we will graduate to get more revenue and net income from this area. And right now we already see the good result and channel.

Alex Chang: Thank you.

Arden Xia: Thank you everyone for joining us on the call today. If you haven't got a chance to raise your question, we will please to answer them through follow-up contacts. We're forward looking to speaking with you again in the near future. Thank you.

Operator: This does conclude our conference for today. Thank you for participating. You may all disconnect.