Disclosure for people who do not get my sense of humor: We are short Hollysys.
If you get to the end of the post and do not understand why read the note on the blog as to humor - or just read this.
Hollysys is a Chinese rail technology company listed in the USA (NASDAQ:HOLI).
The stock is having a rough trading day today. As I write the stock is down about 20 percent. My first reaction was the Chinese rail crash but Hollysys has denied its signalling is involved.
That is a relief because Hollysys is an amazing company. And because it did not cause the railway accident it should be able to sweep the board of its inferior competition.
How to approach Hollysys
I approach Hollysys like I approach many amazing Chinese companies - businesses with amazing technology, amazing growth and amazing margins.
Some of the amazing claims made have turned out to be false - but some are yet to be falsified and some of those might actually be true. After all 1.3 billion people should be able to some amazing things.
Hollysys however is possibly the most amazing company I have seen yet.
As this blog is a fan of Fox News I wish to be fair-and-balanced. I report. You can decide.
What Hollysys does?
Hollysys makes control systems. It started in the railways industry and specializes in very fast trains. Here is a description from their website:
HollySys Automation Technologies is a leading provider of automation and control technologies and applications in China that enables its diversified industry and utility customers to improve operating safety, reliability, and efficiency. Founded in 1993, HollySys has approximately 2,400 employees with 9 sales centers and 13 service centers in 21 cities in China and serves over 1700 customers in the industrial, railway, subway & nuclear industries. Its proprietary technologies are applied in product lines including Distributed Control System (DCS) and Programmable Logic Controller (PLC), high-speed railway Train Control Center (TCC) and Automatic Train Protection (ATP), subway supervisory and control platform (SCADA), and nuclear conventional island automation and control products. HollySys is the largest SCADA systems supplier to China's subway automation market, and is the only certified domestic automation control systems provider to the nuclear industry in China. HollySys is also one of only five automation control systems and products providers approved by China's Ministry of Railways in the 200km to 250km high-speed rail segment, and is one of only two automation control systems and products providers approved in the 300km to 350km high-speed rail segment.
Their website then goes through various businesses that they run and describes their achievements. The achievements are on par with global players in the control-automation business such as Siemens. For instance on nuclear power this is what they say:
Since 1995, HollySys starts providing solutions for the nuclear power plant automation in China and since then, we have been continuously providing digital I&C system for the nuclear power plant. Through hardship of innovation and development, HollySys has now self-developed products and solution for the nuclear power plant control system. With more than 10 years of experience and over 40 successful NPP projects, HollySys has both the ability to become very competitive product suppliers and service providers.
- In 1997, HollySys developed China’s first computer control system for the nuclear power plant. The system was exported to Pakistan Chashma 300MW NPP and has been successfully operating ever since.
- In 1998, Qingshan Phase II NPP adopted HollySys DCS system. It is equip with centralized supervision and safety control of the nuclear power plant with system of conventional island design.
- In 2004, HollySys was the first to enter the field of nuclear safety testing and successfully implemented the project of digital safety testing devices.
- In 2005, HollySys became the localized sub-contractor of Ling’Ao Nuclear Power Plant phase II, and undertaking the project implementation for digital I&C system.
- In 2007, HollySys has successfully developed its first generation totally digital I&C system, the HOLLiAS NMS system.By far, HollySys has 44 signed and completed contracts within our nuclear power business unit covering almost all of the China’s Nuclear Power Plant either in construction or in operation. These have put us in the top league in competition among other competitors in China. This vast achievement wins recognition from our customers, at the same time, have proven the reliability and safety of our solution, and the professionalism in our engineering services that we provided.
They make similarly large claims about their business in other sectors such as control systems for subway automation or factory automation.
One long investor I know visited the plants and was shown a very impressive company. There headquarters photographed on the website - is very impressive.
But as regular readers of this blog know I am a balance sheet kind of guy. When I see such amazing businesses built out of nothing I want to know what assets are employed and how much cumulative R&D there has been. After all HollySys looks like a serious threat to Siemens on its claimed businesses.
Here is the balance sheet from the last annual filing (on form 20F). Numbers are in US dollars and the balance dates are June 30:
Cash and cash equivalents
Contract commitment deposit in banks
Accounts receivable, net of allowance for doubtful accounts of $6,276,670 and $8,408,318
Cost and estimated earnings in excess of billings, net of allowance for doubtful accounts of $744,113 and $1,102,016 (note 5)
Other receivables, net of allowance for doubtful accounts of $178,532 and $214,789
Advance to suppliers
Amount due from related parties (note 18)
Inventories, net of provision of $1,114,140 and $2,393,546 (note 4)
Income tax recoverable
Deferred tax assets (note 16)
Deposit for acquisition of equity interest from minority interest
Total current assets
Property, plant and equipment, net (note 6)
Long term investments (note 7)
Long term deferred expenses
Deferred tax assets (note 16)
LIABILITIES AND STOCKHOLDERS’ EQUITY
Short-term bank loans (note 9)
Current portion of long-term bank loans (note 12)
Current portion of long-term bonds payable (note 11)
Construction cost payable
Accrued payroll and related expense
Income tax payable
Warranty liabilities (note 8)
Other tax payables
Amounts due to related parties (note 18)
Deferred tax liabilities (note 16)
Total current liabilities
Long-term b ank loans (note 12)
Long-term bonds payable (note 11)
Well lets piece this apart. The company claims $65.3 million in property plant and equipment (PP&E) and it directs us to Note 6. Note 6 breaks the PP&E down further:
A summary of property, plant and equipment at cost is as follows:
Land use right
Vehicles and other equipment
Construction in progress
Less: Accumulated depreciation and amortization
Construction in progress consists of capital expenditures and capitalized interest charges relating to the construction of facilities and assembly lines projects. Interest of nil, $206,595 and $1,102,772 during the period of construction for the years ended June 30, 2008, 2009 and 2010 respectively have been capitalized.
During the year ended June 30, 2009, the Company commenced the construction of a new facility with building area of about 150,000 square meters. As of June 30, 2010, the construction in progress of the new facility was $39 million. The Company completed this new facility and related construction project in August 2010, and the whole construction cost amounted to approximately $44 million including the cost of land use right of $5 million which had been acquired during the year ended June 30, 2008.
The depreciation and amortization for the years ended June 30, 2008, 2009 and 2010 were $1,817,657, $2,241,344 and $ 2,683,042 respectively.
We learn that the 65.3 million in net PP&E is $76.6 million gross PP&E - the difference being accumulated depreciation. Of that 76.6 million most is buildings and land use rights. There 13.6 million in buildings, 7.3 in land use rights and another 39.3 million under construction.
Only $3.1 million of machinery is in use. That is kind of funny because this company is a manufacturer of some pretty high end kit. Indeed it is pretty hard to imagine how you manufacture the control systems (sensors etc and the computers to go with it) with only $3.1 million in kit - but the company seems to do so. Those machines should also include all the computers on which staff make the software to run all this fancy kit. The company has $3000 of kit - so there is less than a laptop per staff member in machines - and surely all of this manufacturing requires some machines.
Whatever: this is a miracle of machine efficiency - as amazing as any other Chinese company I have written on.
The rest of the balance sheet is perverse. The company had revenue in 2009 and 2010 of $157.5 million and $174.1 million respectively. Costs estimated in excess of billings are over $60 million. In other words they have done a third of year's work and not been paid. Net income last year was $27 million. Over the past three years net income is about $20 million. The company has many years income in work which it has done but has not yet got around to billion.
That is perverse. You work and work and work and it is not cash - it is just unbilled receivables. They better be sure they can bill somebody and that they will collect it in cash.
If you look at the last quarterly the costs estimated in excess of billings have ballooned to $86 million. They continue working. They do not collect in cash.
Another 10 million - or half the profits for the last three years - is advanced to suppliers. That number is rising too.
There is 23 million of inventories too. I guess that makes sense - they are a manufacturer - but there are next to no machines to work on these inventories with...
Admittedly their liabilities are also larger than would appear normal - there is for instance 33 million in deferred revenue. That is also large relative to profit. I guess working capital management is just different in China...
Revenue in the last nine months is skyrocketing. Its up over 60 percent. Property plant and equipment however is almost unchanged. This company is one of the most advanced manufacturers in the world - and as far as I can see it does this almost without machines.
Reasons to be long this company
About six months ago I was talking to a (former) long in this company and he told me that I should be wary shorting it. It was very close to the Railway department and the Railway Minister. (My friend just assumed I would be short - but truly I am looking for companies to go long...)
Hollysys he said had lots of Guanxi - and that Guanxi might help them make money. He thought it even possible that they had obtained machinery and know how from the Railway Department without having to pay for it.
He really did think that there was a relationship with the Railways Minister that would play well for the company. And not being that familiar with the innards of the Chinese Politburo I was not one to quibble.
The stock however got weaker when the Railway Minister was arrested for corruption.
This company has done about 25 million cumulative R&D in the past three years. This is a lot by Chinese standards but it is tiny by the standards of Siemens. Given the enormous advances that this company has (claimed to have) made in fast train and nuclear power control systems I am getting worried about nuclear reactors controlled on the cheap. Still I report: you decide.
This company is a June balance date. The auditor is BDO Hong Kong. This is an auditor stung a little by scandal lately but then so has every auditor in China.
This one is amazing. Utterly amazing. It might trip up on audit (which is not far away). But this might actually be the real deal - the company with world-class technology on a modest cumulative R&D budget. The company with world class manufacturing where the manufacturing requires next to no machines. The company that does work greater than its accumulated profit and neither expenses nor bills that work. The company that breaks all the rules and still succeeds.
The company that proves that this time it is different in China.
And imagine - because they did not cause the railway accident they are going to be getting a lot more work.