|• FORM 20-F • EXHIBIT 8.1 • EXHIBIT 12.1 • EXHIBIT 12.2 • EXHIBIT 13.1 • EXHIBIT 13.2 • EXHIBIT 15.4 • EXHIBIT 15.5 • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE • XBRL TAXONOMY EXTENSION LABEL LINKBASE • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE|
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the fiscal year ended June 30, 2012
For the transition period from ___________ to ___________.
Date of event requiring this shell company report _________________________
Commission file number: 001-33602
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.
(Exact name of Registrant as specified in its charter)
(Translation of Registrant’s name into English)
British Virgin Islands
(Jurisdiction of incorporation or organization)
No. 2 Disheng Middle Road,
Beijing Economic-Technological Development Area,
Beijing, P. R. China 100176
(Address of principal executive offices)
Jennifer Zhang, Tel: (86 10) 5898 1386, Email: email@example.com
Address: No. 2 Disheng Middle Road, Beijing Economic-Technological Development Area, Beijing, P.R. China 100176
(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)
Securities registered or to be registered pursuant to Section 12(b) of the Act.
Securities registered or to be registered pursuant to Section 12(g) of the Act.
(Title of Class)
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act.
Indicate the number of outstanding shares of each of the issuer’s classes of capital or ordinary shares as of the close of the period covered by the annual report (June 30, 2012): 55,998,917 ordinary shares.
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. ¨Yes x No
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. ¨Yes x No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. xYes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:
If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow.
¨ Item 17 ¨ Item 18
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).¨Yes x No
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.
ANNUAL REPORT ON FORM 20-F
FOR THE FISCAL YEAR ENDED JUNE 30, 2012
TABLE OF CONTENTS
USE OF CERTAIN DEFINED TERMS
Except as otherwise indicated by the context, references in this annual report to:
This annual report contains forward-looking statements and information relating to us that are based on the current beliefs, expectations, assumptions, estimates and projections of our management regarding our company and industry. When used in this annual report, the words “may”, “will”, “anticipate”, “believe”, “estimate”, “expect”, “intend”, “plan” and similar expressions, as they relate to us or our management, are intended to identify forward-looking statements. These statements reflect management's current view of us concerning future events and are subject to certain risks, uncertainties and assumptions, including among many others: our potential inability to achieve similar growth in future periods as we did historically, a decrease in the availability of our raw materials, the emergence of additional competing technologies, changes in domestic and foreign laws, regulations and taxes, changes in economic conditions, uncertainties related to China’s legal system and economic, political and social events in China, the volatility of the securities markets, and other risks and uncertainties which are generally set forth under the heading, “Key information — Risk Factors” and elsewhere in this annual report. Should any of these risks or uncertainties materialize, or should the underlying assumptions about our business and the commercial markets in which we operate prove incorrect, actual results may vary materially from those described as anticipated, estimated or expected in this annual report.
All forward-looking statements included herein attributable to us or other parties or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. Except to the extent required by applicable laws and regulations, we undertake no obligations to update these forward-looking statements to reflect events or circumstances after the date of this annual report or to reflect the occurrence of unanticipated events.
A. Selected Consolidated Financial Data
The following table presents selected financial data regarding our business. It should be read in conjunction with our consolidated financial statements and related notes contained elsewhere in this annual report and the information under Item 5, “Operating and Financial Review and Prospects.” The selected consolidated statement of comprehensive income data for the fiscal years ended June 30, 2010, 2011 and 2012 and the consolidated balance sheet data as of June 30, 2011 and 2012 have been derived from the audited consolidated financial statements of Hollysys that are included in this annual report beginning on page F-1. The selected statement of comprehensive income data for the fiscal years ended June 30, 2008 and 2009, and balance sheet data as of June 30, 2008, 2009 and 2010 have been derived from our audited financial statements that are not included in this annual report.
The audited consolidated financial statements for the years ended June 30, 2010, 2011 and 2012 are prepared and presented in accordance with generally accepted accounting principles in the United States, or US GAAP. The selected financial data information is only a summary and should be read in conjunction with the historical consolidated financial statements and related notes of Hollysys contained elsewhere herein. The financial statements contained elsewhere fully represent our financial condition and operations; however, they are not indicative of our future performance.
Financial information in this report is reported in United States dollars, the reporting currency of the Company.
In evaluating our results, the non-GAAP measures of “Non-GAAP General and Administrative Expenses (hereafter “G&A Expenses”)”, “Non-GAAP Income (loss) from Operations”, and “Non-GAAP Net income (loss) and Earnings (loss) per share” serve as additional indicators of our operating performance and not as a replacement for other measures in accordance with US GAAP. We believe these non-GAAP measures are useful to investors, as they exclude amortization of discount and interest on notes payable related to the bridge loan and share based compensation costs. The amortization of discount and interest on notes payable related to bridge loan is non-recurring and non-operation-related in nature. The share based compensation is calculated based on, among others, the number of shares/options granted and the stock price as of the grant date. It will not result in any operating cash inflows or outflows. We believe that using non-GAAP measures help our shareholders to have a better understanding of our operating results and growth prospects. In addition, given the business nature of Hollysys, it has been a common practice for investors and analysts to use such non-GAAP measures to evaluate the Company.
The following table provides a reconciliation of U.S. GAAP measures to the non-GAAP measures for the periods indicated:
Exchange Rate Information
A majority of our business is conducted in China. We also operate in Singapore through HAP and Concord, and several other jurisdictions in Asia and the Middle East. We use US dollars as our reporting currency in our financial statements and in this annual report. For entities whose functional currencies are not US dollars, balance sheet items are translated into US dollars at the rates of exchange as of the balance sheet date; equity accounts are translated at historical exchange rates and revenues, expenses, gains and losses are translated using the average rate for the year as published by the Federal Reserve Bank of New York and the Federal Reserve Board. Translation adjustments are reported as cumulative translation adjustments and are shown as a separate component of other comprehensive income in the consolidated statement of comprehensive income and changes in equity. Transactions and amounts in other parts of this annual report in foreign currencies recorded at the rates of exchange prevailing when the transactions occurred. With respect to amounts not recorded in our consolidated financial statements included elsewhere in this annual report, all transactions from Renminbi into US dollars and from US dollars to Renminbi in this annual report on Form 20-F were made at a rate of RMB6.3249 to $1.00, and all transactions from Singapore dollars into US dollars and from US dollars to Singapore dollars in this annual report on Form 20-F were made at a rate of SGD 1.2737 to $1.00, as set forth by the Federal Reserve Bank of New York. We make no representation that any Renminbi, Singapore dollar, US dollar or other currency amounts could have been, or could be, converted into the other stated currencies at any particular rate, the rates stated below, or at all. The Chinese government imposes control over its foreign-currency reserves in part through direct regulation of the conversion of Renminbi into foreign exchange and through restrictions on foreign trade. On August 31, 2012, the closing buying rate was RMB 6.3542 to $1.00, and SGD 1.2491 to $1.00, as set forth by the Federal Reserve Board.
The following table sets forth information concerning exchange rates between the Renminbi, Singapore dollars and the US dollar for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates that we used in this annual report on Form 20-F or will use in the preparation of our periodic reports or any other information to be provided to you.
B. Capitalization and Indebtedness
C. Reasons for the Offer and Use of Proceeds
D. Risk Factors
An investment in our capital stock involves a high degree of risk. You should carefully consider the risks described below, together with all of the other information included in this annual report, before making an investment decision. If any of the following risks actually occurs, our business, prospects, financial condition or results of operations could suffer. In that case, the trading price of our capital stock could decline, and you may lose all or part of your investment.
RISKS RELATED TO OUR BUSINESS
We will need to commit greater resources to new product and service development in order to stay competitive, and we may fail to offset the increased cost of such development with a sufficient increase in net sales or margins.
The success of our business depends in great measure on our ability to keep pace with, or even lead, changes that occur in our industry and expand our product and service offerings. Traditionally, the automation and control systems business was relatively stable and slow moving. Successive generations of products offered only marginal improvements in terms of functionality and reliability. However, the emergence of computers, computer networks and electronic components as key elements of the systems that we design and build has accelerated the pace of change in our industry. Where there was formerly as much as a decade or more between successive generations of automation systems, the time between generations is now as little as two to three years. Technological advances and the introduction of new products, new designs and new manufacturing techniques by our competitors could adversely affect our business unless we are able to respond with similar advances. To remain competitive, we must continue to incur significant costs in product development, equipment and facilities and to make capital investments. These costs may increase, resulting in greater fixed costs and operating expenses than we have incurred to date. As a result, we could be required to expend substantial funds for and commit significant resources to the following:
Our future operating results will depend to a significant extent on our ability to continue providing new product and service solutions that compare favorably on the basis of time to market, cost and performance, with competing third-party suppliers and technologies. Our failure to increase net sales sufficiently to offset the increased costs needed to achieve those advances would adversely affect our operating results.
We may experience trade barriers in expanding to our targeted emerging markets and may be subject to tariffs and taxes that will result in significant additional costs for our business and products.
We may experience barriers to conducting business and trade in our planned expansion to emerging markets. These barriers may be in the form of delayed customs clearances, customs duties or tariffs. In addition, we may be subject to repatriation taxes levied upon the exchange of income from local currency into foreign currency, substantial taxes of profits, revenues, assets and payroll, as well as value-added tax. The markets into which we may expand may impose onerous and unpredictable duties, tariffs and taxes on our business and products. These barriers or expenses could have an adverse effect on our operations and financial results.
To the extent we acquire businesses and technologies from others, we will need to integrate these into our business, which if not successful will adversely impact our business and increase our financial expenses.
As we develop our business, one important aspect of expansion will be the use of acquisitions, which may include acquiring an operating business or specific assets. One such example was the acquisition of Concord. As with any acquisition, we will have to integrate the business with our operations so as to achieve the value of our investment. Accommodating different business cultures, operating systems and product lines, as well as understanding and implementing different regulatory issues, often takes time and can result in unexpected expenses. Acquisitions are not always successful, resulting in unintended expenses and write-downs.
As we expand our business outside of China, we will encounter the increasing need for international certifications and compliance with the regulation of different governments, which if not obtained and complied with may adversely impact our business.
We are expanding our business outside of China, including seeking business opportunities in Hong Kong SAR, Singapore, Malaysia and the Middle East. For our marketing both within China and in other jurisdictions, we seek international certifications such as the European Safety Standard Certification Level 4. As we operate in jurisdictions other than China, we will have to comply with local law, some of which relate to various safety and quality requirements for the kinds of products we provide. The failure to have any necessary or beneficial certifications and the failure to comply with local law will have an adverse impact on our marketing and business, and may result in additional costs and expenses.
We do not have long-term purchase commitments from our customers, so our customers are free to choose products from our competitors, which increases our marketing expenses to continually find new clients and win new contracts.
We are engaged in the design, production and installation of automation and process control systems. As a result, our revenues result from numerous individual contracts that are nonrecurring in nature. Furthermore, customers may change or delay or terminate orders for products and services without notice for any number of reasons unrelated to us, including lack of market acceptance for the products to be produced by the process our system was designed to control. As a result, in order to maintain and expand our business, we must expend increasing amounts on marketing to identify clients and win contracts so as to be able to replenish the orders in our pipeline on a continuous basis. Increased marketing expenses and the inability to continue with current contracts or win new sources of revenue will result in a decline in revenues and profitability.
The success of our business depends, in part, on securing a steady stream of new customers.
Other than our contracts to supply products, systems and services to our rail, power plant and building retrofit customers, our average integrated solutions contract is worth approximately $150,000. While some of those contracts are for upgrades and additions to existing control systems, most of them are for new installations. In order for our business to continue to succeed and grow, we need to secure contracts with new customers on a regular basis. We may not be successful in securing new contracts, which would impact our revenues and profitability.
Although we do not have a concentration of business with any customer at this time, recently our business has become more dependent on a few significant customers.
We have developed significant customer relationships with the several local subway providers and the Ministry of Railways and local railway bureaus in respect of the high speed train system in China. We currently also have significant contracts with the MTR Corporation Ltd. of Hong Kong. We expect that these relationships will continue to grow, and we will win more contracts with them over time. We also are expanding into the business of control systems for conventional and nuclear plants and building retrofitting which may develop into a significant customer base in the future. To the extent that these customer groups or specific customers with a group represent an increasing proportion of our business, we will become more dependent on them for our revenues and business growth. In that case, our cash flow also will become more dependent on those customers’ payment practices and overall public funding policies, including the lengthening of collection times under contracts that have been performed. Therefore, the loss of one or more of these customers or market groups as customers would have a material adverse impact on our revenues and our business operations and development.
We have a substantial backlog of contracts.
To date, our backlog has been a reflection of our ability to sell our products and services and increase our business. This represents an amount of unrealized revenue to be earned from contracts secured by the Company. Backlog, however, can also reflect upon our ability to perform our contracts on a timely basis. Therefore, when evaluating our backlog, analysis should be made of whether or not it is a reflection of an expanding business, successful marketing and increasing acceptance of our products and services in the marketplace or problems in our contract performance and acceptance.
A lack of adequate engineering resources could cause our business to have diminished profitability and lose potential business prospects.
Among the competitive advantages and key business advantages that we enjoy are the plentiful supply of engineering talent in China and the comparatively lower cost of our engineering staff compared to those of our Western and Japan-based competitors. Recently, however, our costs for these persons has been subject to increased wage pressures due to the economic growth of China and certain inflationary pressures and additional employment related taxation. If the available supply of engineers were to be absorbed by competing demands, or otherwise not as plentiful as we have experienced to date, then the costs of hiring, training and retaining capable engineers would likely increase. This could result in a reduction in our profitability and adversely affect our business prospects, or could even cause a change in our business strategy.
Our products may contain design or manufacturing defects, which could result in reduced demand for our products or services, customer claims and uninsured liabilities.
Our products are very complex, integrated systems, often with elements designed specifically for the particular situation of a customer, which may have undetected design or manufacturing issues or defects until put into actual use. Also, we manufacture spare parts for maintenance and replacement purposes after completion of integrated solution contracts. While there have been no significant issues or defects identified so far, any issues or defects in the design, manufacture and spare parts we provide may result in returns, claims, delayed shipments to customers or reduced or cancelled customer orders and other forms of damages asserted against the company. If these issues or defects occur, we will incur additional costs, and if they occur in large quantity or frequency, we may sustain a permanent increase in costs, a loss of business reputation and legal liability. Moreover, we are increasingly active in the conventional and nuclear power generation and railway control systems sectors. Each of these sectors poses a substantially higher risk of liability in the event of a system failure, than was present in the industrial process controls markets in which we traditionally compete.
We generally do not have large amounts of insurance now, and in the future may not be able to obtain adequate insurance coverage, to protect us against the risks associated with our business. The typical practice of the industries with which we are involved is for the customers to obtain insurance to protect their own operational risks. As a practice, we do not carry insurance coverage to protect against the risks related to product failure. It is possible that customers could assert claims against us for any damages caused by a failure in one of our systems, and as a result, the failure of any of our designs, manufacture and installation of our products could result in a liability that would seriously impair our financial condition or even force us out of business.
Our failure to adequately protect our intellectual property rights may undermine our competitive position, and litigation to protect our intellectual property rights may be costly.
Our business is based on a number of proprietary products and systems, some of which are patented, others of which we protect as trade secrets. We strive to strengthen and differentiate our product portfolio by developing new and innovative products and product improvements. As a result, we believe that the protection of our intellectual property will become increasingly important to our business as the functionality of automation systems increases to meet customer demand and as we try to open new markets for our products.
Currently, we hold 80 PRC utility patents that relate to various product configurations and product components and 95 software copyrights and have 45 pending PRC patent applications. We will continue to rely on a combination of patents, trade secrets, trademarks and copyrights to provide protection in this regard, but this protection may be inadequate.
Our pending or future patent applications may not be approved or, if allowed, they may not be of sufficient strength or scope. As a result, third parties may use the technologies and proprietary processes that we have developed and compete with us, which could negatively affect any competitive advantage we enjoy, dilute our brand and harm our operating results.
In addition, policing the unauthorized use of our proprietary technology can be difficult and expensive. Litigation may be necessary to enforce our intellectual property rights. Protection of intellectual property and proprietary rights in China may not be as effective as in other countries. Given the fact that the majority of our intellectual property rights are in China and under Chinese law, the relative unpredictability of China’s legal system and potential difficulties of enforcing a court judgment in China may result in an outcome that is unfavorable to us when we assert intellectual property ownership in a particular situation. Furthermore, any litigation may be costly and may divert management attention away from our business operations. An adverse determination in any lawsuit involving our intellectual property is likely to jeopardize our business prospects and reputation and result in additional expense for penalties, licensing and redesign. We have no insurance coverage against litigation costs so we would be forced to bear all litigation costs if we cannot recover them from other parties. All of the foregoing factors could harm our business and financial condition.
We may develop new products that do not gain market acceptance, which would result in the failure to recover the significant costs for design and manufacturing services for new product solutions, thus adversely affecting operating results.
We operate in an industry characterized by increasingly frequent and rapid technological advances, product introductions and new design and manufacturing improvements. As a result, we must expend funds and commit resources to research and development activities, possibly requiring additional engineering and other technical personnel; purchasing new design, production, and test equipment; and enhancing our design and manufacturing processes and techniques. We may invest in equipment employing new production techniques for existing products and new equipment in support of new technologies that fail to generate adequate returns on the investment due to insufficient productivity, functionality or market acceptance of the products for which the equipment may be used. We could, therefore, incur significant costs for design and manufacturing services for new product solutions that do not generate a sufficient return on that investment, which would adversely affect our future operating results. Our future operating results will depend significantly on our ability to provide timely design and manufacturing services for new products that compete favorably with design and manufacturing capabilities of third party suppliers.
RISKS RELATING TO THE INDUSTRY IN WHICH WE OPERATE
The plans for growth rely on the industrial and manufacturing automation sectors and the high-speed rail, subway and nuclear power automation sectors; in some industry verticals within the industrial automation sector, we may experience slower growth or decrease in growth from time to time, which may present fewer business opportunities; the contracts for high-speed rail, subway and nuclear power are substantially larger which may result in a greater dependence on a particular customer or business sector, and could cause significant fluctuations in our revenues.
The principal focus of our business until recently has been to provide Distributed Control Systems, Programmable Logic Controller and related industrial automation and control software and hardware devices to industrial and manufacturing companies. Even though there are enormous opportunities in the industrial automation arena, some industry verticals may experience slower growth or decreased growth that will provide us with fewer opportunities and contract awards from the industry and manufacturing sectors. Both high-speed rail and nuclear power sectors have one or few customers and are closely related to the national development policies, and the contract size for these two sectors is usually much larger, and as a result, there could be severe fluctuation of these sectors’ growth, which may affect our business and revenues. The competition of SCADA (Surveillance Control and Data Acquisition) in the subway sector is substantial; therefore we may not be able to sustain our position in the market and achieve new contract wins, resulting in a decrease of our revenue within this sector.
To the extent that we devote more of our marketing and business capacities to the larger customer, our revenues and business development will be more dependent on our being able to service their needs. To the extent that the nuclear industry and high speed railway in China may experience slower growth, we would expect that there would be a slowing of our expansion into these business areas.
Although China is committed to expanding its energy production with nuclear power and building a high speed railway network, both these industries have experienced various setbacks due to higher than expected accidents for various reasons. To the extent that the government slows their development and expansion within these two industries on which we are becoming more reliant, we may experience a slowing of our business growth due the inability to win contracts or our ability to win contracts for smaller amounts than previously experienced and anticipated. If we are unable to generate the revenues that we seek and we are unable to replace the revenues in our traditional markets or other new markets, then we will likely experience slower growth or possibly even a reduction in revenues.
To the extent that our business is more dependent on large contracts and contracts from a few customers, our revenues, cash flow and profits will be influenced by this type of contracting and the timely payment for our products and services.
As we develop our business with the entities responsible for building municipal subway systems and railroads, power plants and larger system contract customers, we will be entering into contracts for larger sized projects than in the past, which will be for significantly greater contract value. These contracts will require us to commit greater operating resources to a more limited number of customers and contract fulfillment. Therefore, our revenues, cash flow and profit will become increasingly dependent on our ability to perform these contracts and collect the payments due on a timely basis. As many of the entities that are ultimately responsible for the funding of these types of projects are governmental authorities or ministries, our contract requirements and collections will become subject to these entities being able to adequately budget and have the revenues to timely pay for our products and services. We expect a long collection period in some of our business. To some extent, we may become subject to delays and reductions in scope of project due to changes in the policies, objectives and budgeting of any of the public entities which control the projects on which we are contracting. We will also become increasingly subject to government contract requirements in the performance of contracts that are ultimately the responsibility of public bodies.
At this time, contracting with the entities that provide the subway and rail systems and power plants for which we provide control systems is similar to contracting with the customers we have sold to in the past. Therefore, our contracts are written on a similar basis as before, and we expect that we will be operating under these contracts and accounting for their revenues in a similar manner as before.
Many of our competitors have substantially greater resources than we do, allowing them to be able to reduce their prices, which would force us to reduce our prices.
We operate in a very competitive environment with many major international and domestic companies, such as Honeywell, General Electric, ABB, Siemens, Emerson and Hitachi. Many of our competitors are much better established and more experienced than we are, have substantially greater financial resources, operate in many international markets and are much more diversified than we are. As a result, they are in a strong position to compete effectively with us by, for example, reducing their prices, which could force us to reduce our prices. These large competitors are also in a better position than we are to weather any extended weaknesses in the market for automation and control systems. Other emerging companies or companies in related industries may also increase their participation in our market, which would add to the competitive pressures that we face.
A decrease in the rate of growth in Chinese industry and the Chinese economy in general may lead to a decrease in our revenues because industrial companies in China are the principal current source of revenues for us.
Industrial companies operating in China are the principal current source of revenues for us. Our business benefited in the past from the rapid expansion of China’s industrial activity, which has created additional demand from existing companies and led to the formation of numerous additional companies that have need for our products and services. We have also benefited from the infrastructure projects of the different governmental authorities of China, such as power production and transportation systems. China’s industrial and infrastructure expansion has been fueled in large measure by international demand for the low-cost goods that China is able to produce due to labor advantages and other comparative advantages, such as governmental subsidies to offset research and development expenses and taxes and reduced land use/facilities costs for targeted industries. The Chinese economy may not be able to sustain this rate of growth in the future and any reduction in the rate of China’s industrial growth or a shrinking of China’s industrial base could adversely affect our revenues. We may also be impacted as major infrastructure projects are completed. The resulting increase in competition for customers might also cause erosion of profit margins that we have been able to achieve historically.
Our efforts to operate in the international automation market may not prove successful, and we may expend capital resources without achieving value and needlessly divert management’s time and attention from our principal market.
We are penetrating international markets, emphasizing Southeast Asia and the Middle East. Our expansion is likely to use substantial resources, including substantial amounts of capital and equity and deploy meaningful amounts of management time and attention. Our products and our overall approach to the automation and controls system business may not be accepted in other markets to the extent needed to make that effort profitable. In addition, the additional demands on our management from these activities may detract from our efforts in the domestic Chinese market and market of surrounding countries, causing the operating results in our principal markets to be adversely affected.
We depend heavily on key personnel, and loss of key employees and senior management could harm our business.
Our future business and results of operations depend in significant part upon the continued contributions of our key technical and senior management personnel, including Dr. Changli Wang, our Chairman and Chief Executive Officer. We also will depend in significant part upon its ability to attract and retain additional qualified senior executives and management, technical, marketing and sales and support personnel for our operations. If we lose a key employee, if a key employee fails to perform in his or her current position or if we are not able to attract and retain skilled employees as needed, our business could suffer. Turnover in our senior management could significantly deplete institutional knowledge held by our existing senior management team and impair our operations.
In addition, if any of these key personnel joins a competitor or forms a competing company, we may lose some of our customers. We have entered into confidentiality and non-competition agreements with key personnel. However, if any disputes arise between these key personnel and us, it is not clear, in light of uncertainties associated with the PRC legal system, what the court decisions will be and the extent to which these court decisions could be enforced in China, where all of these key personnel reside and hold some of their assets.
Our control systems are used in infrastructure projects such as subway systems, surface railways and nuclear plants; to the extent that our systems do not perform as designed, we could be found responsible for the damage resulting from that failure.
We face potential responsibility for the failure of our control systems in performing the various functions for which they are designed and the damages resulting from any such problem. To the extent that we contract to provide control systems in larger scale projects, the level of damages for which we may be held responsible is likely to increase. To the extent that any of our installed control systems do not perform as designed for their intended purposes, and we are held responsible for the consequences of those performance failures and resulting damages, there may be an adverse impact on our business, business reputation, revenues and profits. To date, we do believe our control systems have performed as designed, and there are no claims asserted against us based on any significant, non-performance event. Notwithstanding our record, no assurance can be given that no claims will be sought in the future based on the design and performance of our control systems.
We may be exposed to potential risks relating to our internal controls over financial reporting and our ability to have those controls positively attested to by our independent auditors.
As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring public companies to include a report of management on the Company’s internal controls over financial reporting in their annual reports and the independent registered public accounting firm auditing a company’s financial statements to attest to and report on the operating effectiveness of such company’s internal controls. Although our independent auditor has provided a positive attestation as of June 30, 2012, we can provide no assurance that we will comply with all of the requirements imposed thereby and we will receive a positive attestation from our independent auditors in the future. In the event we identify material weaknesses in our internal controls that we cannot remediate in a timely manner or we are unable to receive a positive attestation from our independent auditors with respect to our internal controls, investors and others may lose confidence in the reliability of our financial statements.
Our auditor, like other independent registered public accounting firms operating in China, is not permitted to be subject to inspection by the Public Company Accounting Oversight Board, and as such, investors may be deprived of the benefits of such inspection.
The independent registered public accounting firm that issues the audit reports included in our annual report filed with the SEC, as an auditor of companies that are traded publicly in the United States and a firm registered with the Public Company Accounting Oversight Board (United States), or the PCAOB, is required by the laws of the United States to undergo regular inspections by the PCAOB to assess its compliance with the laws of the United States and professional standards. Because our auditor is located in China, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the PRC authorities like other independent registered public accounting firms operating in China, our auditor is currently not inspected by the PCAOB.
Inspections of firms that the PCAOB has conducted have identified deficiencies in those firms’ audit procedures and quality control procedures, which may be addressed as part of the inspection process to improve future audit quality. The inability of the PCAOB to conduct inspections of independent registered public accounting firms operating in China makes it more difficult to evaluate the effectiveness of our auditor’s audit procedures or quality control procedures. As a result, investors may be deprived of the benefits of the PCAOB inspections.
RISKS RELATED TO DOING BUSINESS IN CHINA
The majority of our operating assets are located in China and the majority of our revenue will be derived from our operations in China so our business, results of operations and prospects are subject to the economic, political and legal policies, developments and conditions in China.
Because the majority of our business is conducted in China, despite the significant operations in Singapore and other South Asian and Middle Eastern jurisdictions, the PRC’s economic, political and social conditions, as well as government policies, will have a tremendous influence on our business currently and in the nearer future. The PRC economy differs from the economies of most developed countries in many respects. China’s GDP has grown consistently since 1978 (National Bureau of Statistics of China). However, we cannot assure you that such growth will be sustained in the future. If, in the future, China’s economy experiences a downturn or grows at a slower rate than expected, there may be less demand for spending in certain industries. A decrease in demand for spending in certain industries could impair our ability to remain profitable. The PRC’s economic growth has been uneven, both geographically and among various sectors of the economy. The PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may have a negative effect on us. For example, our financial condition and results of operations may be hindered by PRC government control over capital investments or changes in tax regulations.
The PRC economy has been transitioning from a planned economy to a more market-oriented economy. Although in recent years the PRC government has implemented measures emphasizing the use of market forces for economic reform, the reduction of state ownership of productive assets and the establishment of sound corporate governance in business enterprises, a substantial portion of productive assets in China is still owned by the PRC government. In addition, the PRC government continues to play a significant role in regulating industry development by imposing industrial policies. It also exercises significant control over PRC economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies.
If the China Securities Regulatory Commission, or CSRC, or another PRC regulatory agency, determines that CSRC approval of our initial merger was required or if other regulatory obligations are imposed upon us, we may incur sanctions, penalties or additional costs which would damage our business.
On August 8, 2006, six PRC regulatory agencies, including the CSRC, promulgated the Regulations on Mergers and Acquisitions of Domestic Companies by Foreign Investors, or the M&A Regulations, which became effective on September 8, 2006. Under these regulations, the prior approval of the CSRC is required for the overseas listing of offshore special purpose vehicles that are directly or indirectly controlled by PRC companies or individuals and used for the purpose of listing PRC onshore interests on an overseas stock exchange.
On September 20, 2007, we completed a merger transaction with Chardan North China Acquisition Corporation, or Chardan, which resulted in our current ownership and corporate structure. We believe that CSRC approval was not required for our merger transaction or for the listing and trading of our securities on a trading market because we are not an offshore special purpose vehicle that is directly or indirectly controlled by PRC companies or individuals. Although the M&A Regulations provide specific requirements and procedures, there are still many ambiguities in the meaning of many provisions. Further regulations are anticipated in the future, but until there has been clarification either by pronouncements, regulation or practice, there is some uncertainty in the scope of the regulations and the regulators have wide latitude in the enforcement of the regulations and approval of transactions. If the CSRC or another PRC regulatory agency subsequently determines that the CSRC’s approval was required, we may face sanctions by the CSRC or another PRC regulatory agency. If this happens, these regulatory agencies may impose fines and penalties on our operations in China, limit our operating privileges in China, restrict or prohibit payment or remittance of dividends paid by Hollysys, or take other actions that could damage our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our securities.
We anticipate that the PRC will experience inflation in the near term, which may have an adverse effect on our cost of operations and profitability.
The PRC economy is experiencing general inflationary pressures due to a number of factors which overall will effect Hollysys. If we are unable to increase the value of our contracts commensurate with increases in our operating expenses, we will experience a reduction in our profit margins. If we raise our contract prices, we may not win the kind and amount of contracts that will permit us to operate profitably and grow our business.
If the PRC imposes restrictions designed to reduce inflation, future economic growth in the PRC could be severely curtailed which could hurt our business and profitability.
While the economy of the PRC has experienced rapid growth, this growth has been uneven among various sectors of the economy and in different geographical areas of the country. Rapid economic growth often can lead to growth in the supply of money and rising inflation. In order to control inflation in the past, the PRC has imposed controls on bank credits, limits on loans for fixed assets and restrictions on state bank lending. Imposition of similar restrictions may lead to a slowing of economic growth, a decrease in demand for our products and generally damage our business and profitability.
Fluctuations in exchange rates could harm our business and the value of our securities.
The value of our securities will be indirectly affected by the foreign exchange rate between US dollars and RMB and between those currencies and other currencies in which our sales may be denominated. Because substantially most of our earnings and cash assets are denominated in RMB and our financial results are reported in US dollars, fluctuations in the exchange rate between the US dollar and the RMB will affect our balance sheet and our earnings per share as stated in US dollars. In addition, appreciation or depreciation in the value of the RMB relative to the US dollar would affect our financial results reported in US dollar terms without giving effect to any underlying change in our business or results of operations. Fluctuations in the exchange rate will also affect the relative value of any dividend we issue that will be exchanged into US dollars as well as earnings from, and the value of, any US dollar-denominated investments we make in the future. Since July 2005, the RMB has no longer been pegged to the US dollar. Although the People’s Bank of China regularly intervenes in the foreign exchange market to prevent significant short-term fluctuations in the exchange rate, the RMB may appreciate or depreciate significantly in value against the US dollar in the medium to long term. Moreover, it is possible that in the future PRC authorities may lift restrictions on fluctuations in the RMB exchange rate and lessen intervention in the foreign exchange market.
Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions. While we may enter into hedging transactions in the future, the availability and effectiveness of these transactions may be limited, and we may not be able to successfully hedge our exposure at all. In addition, our foreign currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert RMB into foreign currencies.
Exchange controls that exist in the PRC may limit our ability to utilize our cash flow effectively.
We are subject to the PRC’s rules and regulations on currency conversion. In the PRC, the State Administration for Foreign Exchange, or SAFE, regulates the conversion of the RMB into foreign currencies. Currently, foreign investment enterprises, or FIEs, are required to apply to the SAFE for “Foreign Exchange Registration Certificates for FIEs.” We believe Beijing Helitong is an FIE. With such registration certificates, which need to be renewed annually, FIEs are allowed to open foreign currency accounts including a “basic account” and “capital account.” Currency conversion within the scope of the “basic account,” such as remittance of foreign currencies for payment of dividends, can be effected without requiring the approval of the SAFE. However, conversion of currency in the “capital account,” including capital items such as direct investment, loans and securities, still require approval of the SAFE. We cannot assure you that the PRC regulatory authorities will not impose further restrictions on the convertibility of the RMB. Any future restrictions on currency exchanges may limit our ability to use our cash flow for the distribution of dividends to our shareholders or to fund operations it may have outside of the PRC.
A failure by our shareholders or beneficial owners who are PRC citizens or residents in China to comply with certain PRC foreign exchange regulations could restrict our ability to distribute profits, restrict our overseas and cross-border investment activities or subject us to liability under PRC laws.
SAFE Circular No. 75 effective from November 2005 and a series of implementation rules and guidance issued by SAFE, including the most recent circular relating to operating procedures that came into effect as of July 1, 2011, require approvals from, and registrations with, PRC government authorities in connection with direct or indirect offshore investment activities by PRC residents and PRC corporate entities. The SAFE regulations require retroactive approval and registration of direct or indirect investments previously made by PRC residents in offshore companies.
As it is uncertain how the SAFE regulations described above will be interpreted or implemented, we cannot predict how these regulations will affect our business operations or future strategy. In the event that a PRC shareholder with a direct or indirect stake in an offshore parent company fails to obtain the required SAFE approval and make the required registration, the PRC subsidiaries of such offshore parent company may be prohibited from making distributions of profit to the offshore parent and from paying the offshore parent proceeds from any reduction in capital, share transfer or liquidation in respect of the PRC subsidiaries. Further, failure to comply with the various SAFE approval and registration requirements described above, as currently drafted, could result in liability under PRC law for foreign exchange evasion.
Because Chinese law governs many of our material agreements, we may not be able to enforce our rights within the PRC or elsewhere, which could result in a significant loss of business, business opportunities or capital.
Chinese law governs many of our material agreements, some of which may be with Chinese governmental agencies. We cannot assure you that we will be able to enforce any of our material agreements or that remedies will be available outside of the PRC. The system of laws and the enforcement of existing laws and contracts in the PRC may not be as certain in implementation and interpretation as in the United States. The Chinese judiciary is relatively inexperienced in enforcing corporate and commercial law, leading to a higher than usual degree of uncertainty as to the outcome of any litigation. The inability to enforce or obtain a remedy under any of our future agreements could result in a significant loss of business, business opportunities or capital.
The ability of our Chinese operating subsidiary to pay certain foreign currency obligations, including dividends, is subject to restrictions.
Our ability to pay dividends may be restricted due to the foreign exchange control policies and availability of cash balances. Since most of our operations are conducted in China and a majority of our revenues are generated in China, a significant portion of our revenue earned and currency received are denominated in RMB. The Chinese government imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currency out of China. RMB is currently not a freely convertible currency. Shortages in the availability of foreign currency may restrict our ability to remit sufficient foreign currency to pay dividends, if any, on our ordinary shares or otherwise satisfy foreign currency denominated obligations. Under existing Chinese foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from the transaction, can be made in foreign currencies without prior approval from the State Administration of Foreign Exchange by complying with certain procedural requirements. However, approval from appropriate governmental authorities is required where RMB is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of bank loans denominated in foreign currencies. The Chinese government may also at its discretion restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay certain of our expenses as they come due. In addition, current regulations in China permit Chinese subsidiaries to pay dividends to us only out of their accumulated distributable profits, if any, determined in accordance with Chinese accounting standards and regulations. In addition, Chinese subsidiaries are required to set aside at least 10% of its after-tax profits each year to the statutory reserved fund until such fund has reached 50% of their respective registered capital. Such reserve account may not be distributed as cash dividends.
If any dividend is declared in the future and paid in a foreign currency, you may be taxed on a larger amount in US dollars than the US dollar amount that you will actually ultimately receive.
If you are a U.S. holder, you will be taxed on the US dollar value of your dividends at the time you receive them, even if you actually receive a smaller amount of US dollars when the payment is in fact converted into US dollars. Specifically, if a dividend is declared and paid in a foreign currency, the amount of the dividend distribution that you must include in your income as a U.S. holder will be the US dollar value of the payments made in the foreign currency, determined at the conversion rate of the foreign currency to the US dollar on the date the dividend distribution is includible in your income, regardless of whether the payment is in fact converted into US dollars. Thus, if the value of the foreign currency decreases before you actually convert the currency into US dollars, you will be taxed on a larger amount in US dollars than the US dollar amount that you will actually ultimately receive.
PRC laws and other conditions may limit our ability to make dividend payments to our shareholders.
We are a holding company in the British Virgin Islands, or the BVI. We generally rely on our PRC subsidiaries to provide us with cash flow and to meet our other obligations. Additionally, to the extent that the board determines that the company should pay dividends, it will likely have to rely on our PRC subsidiaries to provide the cash to be able to make the payments. Relevant PRC laws and regulations permit payment of dividends by a PRC subsidiary only from accumulated distributable profits, if any, determined in accordance with PRC accounting standards and regulations, and only after setting aside at least 10% of its current year profits (up to an aggregate amount equal to half of its registered capital). The PRC tax authorities may initiate changes in determining income of our PRC subsidiaries that would further limit their ability to pay dividends and make other distributions to us. It is therefore possible that our PRC subsidiaries will not have any distributable profit to pay us, even if they are profitable under U.S. GAAP.
The ability, as well as the decision, to declare dividends will also be influenced by the withholding taxes imposed on payments by companies in one jurisdiction to a company in another jurisdiction. For example, there is a 10% withholding tax imposed on a PRC company paying dividends to a company located in the BVI. This will reduce the value of any potential dividend to the ultimate shareholders, and therefore the board may determine that it would be a more prudent use of funds to reinvest funds that could be available for dividends into the business or acquire other businesses and assets.
Our business could be severely harmed if the Chinese government changes its policies, laws, regulations, tax structure or its current interpretations of its laws, rules and regulations relating to our operations in China.
Our principal manufacturing facility is located in China and the majority of our assets are located in China. We generate our most of our sales revenue from customers located in China. Therefore, our results of operations, financial state of affairs and future growth are, to a significant degree, subject to China’s economic, political and legal development and related uncertainties. Our operations and results could be materially affected by a number of factors, including, but not limited to
Over the past several years, the Chinese government has pursued economic reform policies including the encouragement of private economic activities and greater economic decentralization. If the Chinese government does not continue to pursue its present policies that encourage foreign investment and operations in China, or if these policies are either not successful or are significantly altered, then our business could be harmed. Following the Chinese government’s policy of privatizing many state-owned enterprises, the Chinese government has attempted to augment its revenues through increased tax collection. It also exercises significant control over China’s economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Continued efforts to increase tax revenues could result in increased taxation expenses being incurred by us. Economic development may be limited as well by the imposition of austerity measures intended to reduce inflation, the inadequate development of infrastructure and the potential unavailability of adequate power and water supplies, transportation and communications. In addition, the Chinese government continues to play a significant role in regulating industry by imposing industrial policies.
The Chinese laws and regulations which govern our current business operations are sometimes vague and uncertain and may be changed in a way that hurts our business.
China’s legal system is a civil law system based on written statutes, in which system decided legal cases have less value as precedents, unlike the common law system prevalent in the United States or the BVI. There are substantial uncertainties regarding the interpretation and application of Chinese laws and regulations, including but not limited to the laws and regulations governing our business, or the enforcement and performance of our arrangements with customers in the event of the imposition of statutory liens, death, bankruptcy and criminal proceedings. The Chinese government has been developing a comprehensive system of commercial laws, and considerable progress has been made in introducing laws and regulations dealing with economic matters such as foreign investment, corporate organization and governance, commerce, taxation and trade. However, because these laws and regulations are relatively new, and because of the limited volume of published cases and judicial interpretation and their lack of force as precedents, interpretation and enforcement of these laws and regulations involve significant uncertainties. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. We are considered an FIE under Chinese laws, and as a result, we must comply with Chinese laws and regulations. We cannot predict what effect the interpretation of existing or new Chinese laws or regulations may have on our business. If the relevant authorities find us to be in violation of Chinese laws or regulations, they would have broad discretion in dealing with such a violation, including, without limitation: levying fines; revoking our business and other licenses; requiring that we restructure our ownership or operations; and requiring that we discontinue any portion or all of our business.
A slowdown or other adverse developments in the Chinese economy may materially and adversely affect our customers’ demand for our services and our business.
The majority of our operations are conducted in China and much of our revenues are generated from sales to businesses operating in China. Although the Chinese economy has grown significantly in recent years, such growth may not continue. Currently, some sectors of the economy are experiencing a slowdown in business activity. We do not know how sensitive we might be to a slowdown in general economic growth or other adverse changes in Chinese economy which may affect demand for our products and services. A slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in China may materially reduce the demand for our products and services and, in turn, reduce our results of operations.
The implementation of PRC employment law is likely to result in increased labor costs in China, which may effect our business and profitability.
The Labor Contract Law, which became effective on January 1, 2008, imposes on employers requirements to enter into fixed-term employment contracts, and effects the recruitment of temporary employees and dismissal of employees. In addition, under the Regulations on Paid Annual Leave for Employees, which also became effective on January 1, 2008, employees who have worked continuously for more than one year are entitled to paid vacation time ranging from 5 to 15 days, depending on the length of the employee’s service. Employees who waive such vacation entitlements at the request of the employer will be compensated for three times their normal daily salaries for each vacation day so waived. On July 1, 2011, China promulgated the Social Insurance Law to unify pervious scattered laws relating to social insurance matters. The law clarifies that the social insurance system in China includes pension insurance, medical insurance, unemployment insurance, work-related injury insurance and maternity insurance, all of which are mandatory benefits for employees of companies operating in China. Employers are required to make contributions under these insurance schemes, which although local in rates, are overall expected to increase employee expense over time. There is no assurance that disputes, work stoppages or strikes will not arise in the future over these and other matters. Increases in the labor costs or future disputes with our employees could damage our business, financial condition or operating results.
Under the EIT Law, we may be classified as a “resident enterprise” of China. Such classification will likely result in unfavorable tax consequences to us and our non-PRC shareholders.
Under the Enterprise Income Tax Law, or the EIT Law, and implementing rules, both of which became effective on January 1, 2008, an enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” meaning that it can be treated in a manner similar to a Chinese domestic enterprise for enterprise income tax purposes. The implementing rules of the EIT Law define de facto management as “substantial and overall management and control over the production and operations, personnel, accounting, and properties” of the enterprise.
On April 22, 2009, the State Administration of Taxation issued the Notice Concerning Relevant Issues Regarding Cognizance of Chinese Investment Controlled Enterprises Incorporated Offshore as Resident Enterprises pursuant to Criteria of de facto Management Bodies, or the Notice, further interpreting the application of the EIT Law and its implementation for non-Chinese enterprises or group controlled offshore entities. Pursuant to the Notice, an enterprise incorporated in an offshore jurisdiction and controlled by a Chinese enterprise or group will be classified as a “non-domestically incorporated resident enterprise” if (i) its senior management in charge of daily operations reside or perform their duties mainly in China; (ii) its financial or personnel decisions are made or approved by bodies or persons in China; (iii) substantial assets and properties, accounting books, corporate chops, board and shareholder minutes are kept in China; and (iv) at least half of its directors with voting rights or senior management often resident in China. A resident enterprise would be subject to an enterprise income tax rate of 25% on its worldwide income and must pay a withholding tax at a rate of 10% when paying dividends to its non-PRC shareholders. However, it remains unclear as to whether the Notice is applicable to an offshore enterprise incorporated by a Chinese natural person. Nor are detailed measures on imposition of tax from non-domestically incorporated resident enterprises are available. Therefore, it is unclear how tax authorities will determine tax residency based on the facts of each case.
We may be deemed to be a resident enterprise by Chinese tax authorities. If the PRC tax authorities determine that Hollysys is a “resident enterprise” for PRC enterprise income tax purposes, a number of unfavorable PRC tax consequences could follow. First, we may be subject to the enterprise income tax at a rate of 25% on our worldwide taxable income as well as PRC enterprise income tax reporting obligations. In our case, this would mean that income such as interest on financing proceeds and non-China source income would be subject to PRC enterprise income tax at a rate of 25%. Second, although under the EIT Law and its implementing rules, dividends paid to us from our PRC subsidiaries would qualify as “tax-exempt income,” we cannot guarantee that such dividends will not be subject to a 10% withholding tax, as the PRC foreign exchange control authorities, which enforce the withholding tax, have not yet issued guidance with respect to the processing of outbound remittances to entities that are treated as resident enterprises for PRC enterprise income tax purposes. Finally, it is possible that future guidance issued with respect to the new “resident enterprise” classification could result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC shareholders and with respect to gains derived by our non-PRC shareholders from transferring our shares.
RISKS RELATED TO OUR SHARES
The market price of our ordinary shares is volatile, leading to the possibility of its value being depressed at a time when you want to sell your holdings.
The market price of our ordinary shares is volatile, and this volatility may continue. Numerous factors, many of which are beyond our control, may cause the market price of our ordinary shares to fluctuate significantly. These factors include:
Securities class action litigation is often instituted against companies following periods of volatility in their stock price. This type of litigation could result in substantial costs to us and divert our management’s attention and resources.
Moreover, securities markets may from time to time experience significant price and volume fluctuations for reasons unrelated to operating performance of particular companies. For example, from October 2008 until June 2009, securities markets in the United States, China and throughout the world experienced a historically large decline in share price. These market fluctuations may adversely affect the price of our ordinary shares and other interests in our company at a time when you want to sell your interest in us.
We are a “foreign private issuer,” and have disclosure obligations that are different than those of other U.S. domestic reporting companies so you should not expect to receive the same information about us at the same time as a U.S. domestic reporting company may provide.
We are a foreign private issuer and, as a result, we are not subject to certain of the requirements imposed upon U.S. domestic issuers by the SEC. For example, we are not required to issue quarterly reports or proxy statements. Also, we are allowed four months to file our annual report with the SEC. We are not required to disclose certain detailed information regarding executive compensation that is required from U.S. domestic issuers. Further, our directors and executive officers are not required to report equity holdings and transactions in our equity under Section 16 of the Securities Act. As a foreign private issuer, we are also exempt from the requirements of Regulation FD (Fair Disclosure) which, generally, are meant to ensure that select groups of investors are not privy to specific information about an issuer before other investors. We are, however, still subject to the anti-fraud and anti-manipulation rules of the SEC, such as Rule 10b-5. Since many of the disclosure obligations required of us as a foreign private issuer are different than those required by other U.S. domestic reporting companies, our shareholders should not expect to receive information about us in the same amount and at the same time as information is received from, or provided by, other U.S. domestic reporting companies. We are liable for violations of the rules and regulations of the SEC which do apply to us as a foreign private issuer. Violations of these rules could affect our business, results of operations and financial condition.
The payment of cash dividends depends on the decision of the Board of Directors and the cash and legal requirements of our company.
The Board of Directors decides if and when the company will pay cash dividends. The decision to pay dividends will depend on many factors from time to time, including the cash needs of the company and its subsidiaries, the legal requirements of Chinese companies to maintain stated capital amounts, and the tax policies of the various jurisdictions in which we operate. There can be no assurance that there will be regular cash dividends.
You may have difficulty enforcing judgments obtained against us.
We are a BVI company and substantially all of our assets are located outside of the United States. The majority of our assets and our current business operations are conducted in the PRC. In addition, our directors and officers are nationals and residents of countries other than the United States. The assets of these persons are located mostly outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon these persons. It also may be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors. In addition, there is uncertainty as to whether the courts of the British Virgin Islands or the PRC would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state. It is uncertain whether such British Virgin Islands or PRC courts would be competent to hear original actions brought in the BVI or the PRC against us or such persons based upon the securities laws of the United States or any state thereof.
Because we are incorporated under the laws of the BVI, it may be more difficult for our shareholders to protect their rights than it would be for a shareholder of a corporation incorporated in another jurisdiction.
Our corporate affairs are governed by our Memorandum and Articles of Association and by the BVI Business Companies Act, 2004 of the BVI. Principles of law relating to such matters as the validity of corporate procedures, the fiduciary duties of management and the rights of our shareholders differ from those that would apply if we were incorporated in the United States or another jurisdiction. The rights of shareholders under BVI law are not as clearly established as are the rights of shareholders in many other jurisdictions. Under the laws of most jurisdictions in the United States, majority and controlling shareholders generally have certain fiduciary responsibilities to the minority shareholders. Shareholder action must be taken in good faith, and actions by controlling shareholders which are obviously unreasonable may be declared null and void. BVI law protecting the interests of minority shareholders may not be as protective in all circumstances as the law protecting minority shareholders in US jurisdictions. In addition, the circumstances in which a shareholder of a BVI company may sue the company derivatively, and the procedures and defenses that may be available to the company, may result in the rights of shareholders of a BVI company being more limited than those of shareholders of a company organized in the US. Furthermore, our directors have the power to take certain actions without shareholder approval which would require shareholder approval under the laws of most US jurisdictions. The directors of a BVI corporation, subject in certain cases to court approval but without shareholder approval, may implement a reorganization, merger or consolidation, the sale of any assets, property, part of the business, or securities of the corporation. The ability of our board of directors to create new classes or series of shares and the rights attached by amending our Memorandum of Association and Articles of Association without shareholder approval could have the effect of delaying, deterring or preventing a change in our control without any further action by the shareholders, including a tender offer to purchase our ordinary shares at a premium over then current market prices. Thus, our shareholders may have more difficulty protecting their interests in the face of actions by our board of directors or our controlling shareholders than they would have as shareholders of a corporation incorporated in another jurisdiction.
We may be classified as a passive foreign investment company, which could result in adverse United States federal income tax consequences to U.S. shareholders.
We believe that we are not considered a “passive foreign investment company,” or PFIC, for United States federal income tax purposes for our tax year ended June 30, 2012. However, each year we must make a separate determination as to whether we are a PFIC. We cannot assure you that we will not be a PFIC for our tax year ending June 30, 2013 or any following tax year. If a non-U.S. corporation either (i) has at least 75% of its gross income is passive income for a tax year or (ii) has at least 50% of the value of its assets (based on an average of the quarterly values of the assets during a tax year) attributable to assets that produce or are held for the production of passive income, then the non-U.S. corporation will be deemed a PFIC. The market value of our assets may be determined to a large extent by the market price of our ordinary shares. If we are treated as a PFIC for any tax year during which U.S. shareholders hold ordinary shares, certain adverse United States federal income tax consequences could apply to such U.S. holders.
Our Shareholder Rights Plan and charter documents may hinder or prevent change of control transactions.
Our shareholder rights plan and provisions contained in our Memorandum and Articles of Association may discourage transactions involving an actual or potential change in our ownership. In addition, our Memorandum and Articles of Association authorizes our board of directors to issue up to 90,000,000 shares of preferred stock without any further action by the stockholders. Please see Item 10, Additional Information for more information regarding our shareholder rights plan. Such restrictions and issuances could make it more difficult, delay, discourage, prevent or make it more costly to acquire or effect a change-in-control, which in turn could prevent our stockholders from recognizing a gain in the event that a favorable offer is extended and could materially and negatively affect the market price of our ordinary shares, even if you or our other stockholders believe that such actions are in the best interests of us and our stockholders.
A. History and Development of the Company
We were established under the laws of the BVI on February 6, 2006, as HLS Systems International, Ltd., in order to merge with Chardan, a Delaware special purpose acquisition company, originally established on March 10, 2005, with the primary purpose of effecting a business combination with an unidentified operating business that has its primary operating facilities located in China, in any city or province north of Yangtze River. On September 20, 2007, we acquired all of the issued and outstanding ordinary shares of GTH, a BVI company. Simultaneously with the acquisition, Chardan merged with and into us, all of the common stock of Chardan was converted into our ordinary shares, on a one-to-one basis, and we assumed the then outstanding Chardan warrants. As a result of the foregoing transactions, we acquired a controlling interest in Beijing Hollysys and Hangzhou Hollysys, and an indirect interest in their majority and minority owned subsidiaries, and the consolidated financial statements of Beijing Hollysys and Hangzhou Hollysys became our historical financial statements for accounting and reporting purposes. On July 17, 2009, we changed our name to Hollysys Automation Technologies Ltd. to more accurately reflect our core value of leveraging proprietary technologies to provide state-of-the-art automation and control solutions for our clients.
GTH and Subsidiaries
GTH was established under the laws of the BVI on September 21, 2005, as a holding company for our indirect PRC subsidiaries, Beijing Hollysys and Hangzhou Hollysys.
Beijing Hollysys was established in September 1996 as a domestic Chinese company based in Beijing, China. From inception, Beijing Hollysys has been engaged in designing, developing and manufacturing automation control systems for customers throughout China. Beijing Hollysys offers integrated automation solutions for many industries, including electric power generation, transmission and distribution, manufacturing (including metallurgy, construction materials, petrochemical and pharmaceutical industries), and railroad transportation. Beijing Hollysys’ integrated automation systems and solutions have enabled customers to improve the safety, reliability and efficiency of their manufacturing processes and significantly enhance the customers’ overall profitability. Hangzhou Hollysys was established as an equity joint venture under Chinese laws in September 2003. The operations of Hangzhou Hollysys focus on industrial automation and integrated solutions.
During the period from December 2007 to March 2008, we established a series of wholly owned subsidiaries, including (i) Beijing Hollysys Group, a Chinese domestic enterprise which acquired the original shareholders’ 74.11% equity interest in Beijing Hollysys; (ii) Helitong, a wholly foreign owned enterprise in China which acquired the original shareholders’ 100% equity interest in Beijing Hollysys Group; (iii) World Hope, a Hong Kong company which acquired the original shareholders’ 100% equity interest in Helitong; and (iv) Clear Mind, a BVI company which acquired the original shareholders’ 100% equity interest in World Hope. Through this series of ownership arrangement, we obtained the 74.11% legal ownership of Beijing Hollysys instead of through consignment agreements. However, there can be no assurance that the PRC authorities will not, in the future, challenge the appropriateness of the procedures of the transferring of the ownership of the PRC subsidiaries as the Company did not directly go through the procedures required by the M&A Regulations.
On July 1, 2009, we completed the acquisition of 1.78% equity interest in Beijing Hollysys from the noncontrolling interest holder for a consideration of RMB 18 million (approximately $2,638,793), and held 75.89% equity interest of Beijing Hollysys upon the completion of the acquisition.
On December 23, 2009, we entered into a share sale and purchase agreement, or the Share Purchase Agreement, with Unionway Resources Limited, a business company incorporated in the BVI, or the Seller, pursuant to which, among other things, the Company acquired 24.11% equity interests of Beijing Hollysys. As the consideration for the acquisition of the equity interest, we agreed to:
1) issue 4,413,948 ordinary shares, or the Shares, to the Seller, and
2) pay cash RMB 67,634,366.25 (approximately$9,917,063) to the Seller.
The Shares were issued to the Seller and its designee on March 16, 2010. As a result of the acquisition of the equity interest, we indirectly own 100% of Beijing Hollysys.
On September 1, 2009, Beijing Hollysys entered into an agreement with two equity owners of WoDeWeiYe to acquire 51% equity interest in of WoDeWeiYe for a cash consideration of RMB 2 million (approximately $294,477). Upon the acquisition, WoDeWeiYe became a subsidiary of the Company, and the operating result of WoDeWeiYe was included in the Hollysys’s consolidated financial statements effective from September 1, 2009. We acquired WoDeWeiYe to engage in the intelligent electric meter business and to further build up our foothold in subway automation sector.
On June 4, 2010, Beijing Hollysys Group invested RMB 10 million (approximately $1,464,536) to establish a wholly owned subsidiary, Beijing Hollysys Electronics, which engages in the business of automation equipment manufacturing and assembly.
On June 4, 2010, Beijing Hollysys Group invested RMB 5.10 million (approximately $746,913) to establish a subsidiary, Hollycon, which engages in the medical automation equipment manufacturing business.
On March 9, 2011, Beijing Hollysys invested RMB 10 million (approximately $1,520,751) to establish a subsidiary, Xi’an Hollysys, which engages in the research and development business.
On April 15, 2011, Beijing Hollysys Group invested RMB 10 million (approximately $1,528,585) to establish a subsidiary, Hollysys Investments, which engages in the investment management and consulting business.
HAP and Subsidiaries
On November 19, 2007, we entered into a sales and purchase agreement with Fulbond Systems Pte. Ltd., or Fulbond Systems, a Singapore based company partially owned by Mr. Kiam Fee Yau, an ex-director of the company, to acquire a 100% interest of Fulbond Systems for a price of SGD$1,066,234 (approximately $744,596). Pursuant to the sales and purchase agreement, the closing day of this acquisition was November 30, 2007 and after the ownership transfer, we changed the name of Fulbond Systems to “Hollysys (Asia Pacific) Pte. Limited,” or HAP. The purchase price was paid in cash on December 11, 2007. As a result of the transaction, HAP becomes our wholly owned subsidiary and the its operating results are included in our consolidated financial statements, effective from December 1, 2007. We acquired HAP to serve as our Asia Pacific headquarters to market our automation products within the region as well as in other overseas countries.
On May 18, 2011, we entered into a stock purchase agreement with the stockholders of Concord, a Singapore headquartered electrification related service provider to rail and industrials in South-East Asia and the Middle East, to acquire a 100% interest of Concord, including Concord Corporation Pte. Ltd., and its subsidiaries Concord Electrical Pte. Ltd., Concord Electrical Sdn. Bhd. incorporated in Malasia, and Concord Corporation Pte. Ltd. Dubai Branch. The consideration is a combination of cash and stock, with a total value of approximately $42.9 million, consisted of:
Through the acquisition, the Company seeks to expand the existing distribution and marketing channels to cross sell the Company’s existing product lines in rail and industrial segments to fast growing South-East Asia and the Middle East markets. The effective date of the acquisition of Concord was July 1, 2011, at which time it became a wholly owned subsidiary of the Company, and its operation results are included in our consolidated financial statements effective from July 1, 2011.
On May 9, 2012, HAP invested HKD 10,000 (approximately $1,288) to establish a subsidiary, CSHK, which engages in developing the automation business in Hong Kong.
B. Business Overview
We are a leading provider of automation and control technologies and applications in China and increasingly in Southeast Asia and the Middle East that enable our diversified industry and utility customers to improve operating safety, reliability, and efficiency. Founded in 1993, we have approximately 3,500 employees with nationwide presence in over 50 cities in China and subsidiaries and offices in Singapore and the Middle East. We serve over 4,000 customers in the industrial, building retrofit, railway, subway and nuclear power industries in China, and Southeast Asia. Our proprietary technologies are applied through our industrial automation solution suite, including the DCS (Distributed Control System), PLC (Programmable Logic Controller), RMIS (Real-time Management Information System), HAMS (HolliAS Asset Management System), OTS (Operator Training System), HolliAS BATCH (Batch Application Package), HolliAS APC Suite (Advanced Process Control Package), SIS (Safety Instrumentation System), high-speed railway signaling system of TCC (Train Control Center), ATP (Automatic Train Protection), Subway Supervisory and Control platform, SCADA (Surveillance Control and Data Acquisition), nuclear conventional island automation and control system and other products.
We historically focused our efforts on the area of DCS, which are networks of controllers, sensors, actuators and other devices that can be programmed to control outputs based on input conditions and/or algorithms, which are mainly used to control continuous manufacturing processes. Our DCS have been widely used in the industries involving continuous flow of material handling, such as power generation, petro-chemical, chemical, cement manufacturing, paper mills, and waste water recycling. We have also entered the PLC market, which is mainly used in discreet control applied to a wide array of industries. PLCs are usually integrated together into machines providing control at the machinery level. With more of our proprietary products introduced into the market and the behavioral change of customers’ purchasing practice, we gradually have changed our market and sales positioning from being a single DCS/PLC product provider, to being a total solution provider encompassing third-party hardware-centric products such as instrumentation and actuators, our proprietary DCS/PLC products, and valued-added software packages such as AMS (Asset Management System), MES (Manufacturing Execution System), APC (Advanced Process Control), OTS Simulation (Operator Training System),and others.. The safety system SIS (Safety Instrumentation System), certified under European safety standards and newly introduced to the market in July 2012 will further round out our proprietary product suite in the industrial automation segment.
We also branched out from the industrial automation domain into the subway and surface rail businesses, leveraging on our core competency and strong research and development capabilities, and have already established a leading position in the high-speed rail signaling market and subway SCADA (Surveillance Control and Data Acquisition) market. We also command a position in China’s nuclear automation and control market as the only proven local automation and control product provider to the conventional island of nuclear stations. Through our joint venture with China Guangdong Nuclear Power Holdings Co., Ltd., China Techenergy Co., Ltd., we have access to all the nuclear reactors being contracted to our joint venture partner, which is currently holding roughly 60% of China’s nuclear market share. Through Concord, we are able to provide end-to-end complete electrification related services in rail, power, semi-conductor, pharmaceutical, petrochemical and other industrial sectors by working with multinational corporations and Hollysys. We believe that our present leadership position in the high-growth segments is attributable to our vision, execution, and strong research and development capabilities.
We have a reputation in the industry for our comprehensive capabilities in the PRC domestic industrial automation market and have concentrated our focus on the development of this market. We sell our products and services to, or carry out engineering projects for, national or multi-provincial companies with subsidiaries located across 30 provinces in China. To date, we have served more than 4,000 industrial enterprise customers and have undertaken over 10,000 projects. We believe that the quality of our systems is unsurpassed by local Chinese competitors and is comparable to high-end foreign suppliers of DCS and the history of our projects supports that view. For example, after three years of review and analysis, BASF, a large multi-national company, has designated us as a potential qualified DCS vendor for the company, a distinction shared with large multinationals such as ABB and Emerson.
Internationally, we have a strong presence through Concord in Southeast Asia and increasing in the Middle East and through Hollysys marketing efforts in Hong Kong SAR. During the past year we have achieved a number of significant contract wins, including (i) contracts with MTR Corporation of Hong Kong SAR to provide a complete suite of high-speed rail signaling systems to Guangzhou-Shenzen-Hong Kong Express Rail Hong Kong Section, and (ii) a contract with Sendan International Co., Ltd. to provide electrical, instrumentation and control installation works for Rabigh Power Plant II in Rabigh, Saudi Arabia, which is powered by natural gas and oil. Our international stature will be enhanced by our obtaining international certifications such as the European Safety Standard Certification Level 4, which relates to our proprietary subway signaling systems.
Our revenue increased from approximately $157.5 million in fiscal year 2009, to approximately $321.7 million in fiscal year 2012, representing a compounded annual growth rate (CAGR) of approximately 26.9% for the past three years. During the same period, our non-GAAP net income attributable to Hollysys increased by CAGR of 30.7%. These significant increases reflect our success in exploring new business areas and our increasing market penetration. We continually seek to broaden our market reach by introducing new products and improving our profit margin through new business areas such as railway control systems and nuclear power plant control, while exploring international market to fulfill our mission of sustainable and high growth.
Our goal is to become one of the world's leading automation and control technology and product providers. To meet this goal we plan to enhance the core competencies that have made us a leading domestic automation and control technology and application provider in China, the only Chinese company qualified to design and manufacture non-safety control systems of nuclear power stations, and a leader in the industrial automation and in the high-speed rail and subway sectors. The principal elements of our core business strategies are as follows:
The signaling system set includes the onboard ATP (automatic train protection) system with SIL 4 certification for high-speed rail and subway that are used to protect the train from travelling at excessive speeds, the ground based TCC (train control center) with SIL 4 certification for ground safety control of trains, the CBI (computer based interlocking)system with SIL 4 certification for both high speed rail and subways, the ATS (automatic train supervision) system with SIL 2 certification for metro ATC systems, and other auxiliary interfacing products. Based on our own technologies, we are able to customize our system platforms to meet every level of requirements from conventional rail signaling systems to the most state-of-the-art, high-speed rail applications, not only for the Chinese market but also for the international market.
We currently have a proprietary ATP (Automatic Train Protection), TCC (Train Control Center), LEU (Line-Side Electronic Unit), BTM (Balise Transmission Module), TSRS (Temporary Speed Restriction Server), HVC (Hollysys Vital Computer), and Interlocking system according to international standards and have passed the Safety Integrity Level 4 (SIL4) certification for the high-speed rail sector. In the subway sector, the ATS (Automatic Train Supervision) and CBI (Computer Based Interlocking) have passed SIL2 and SIL4 certification respectively. Other products, including the ATO (Automatic Train Operation), ATP (Automatic Train Protection) and ZC (Zone Controller), we expect to pass SIL4 certification by the end of calendar year 2012.
Products and Services
As a leading provider of automation and control technology and applications in China, we provide our customers with our standard and customized products and corresponding services based on each client’s specific requirements. We are committed to providing reliable, advanced and cost-effective solutions to help customers optimize their processes to achieve higher quality, greater reliability and better productivity and profitability.
Industrial Automation: Our principal offering is a comprehensive suite of automation systems for a wide spectrum of industrial market clientele, ranging from petrochemical, thermal power industries, to cement production and paper making industries. Our comprehensive suite of automation solution consists of third-party hardware-centric products such as instrumentation and actuators, our proprietary software-centric DCS/PLC, and valued-added software packages such as RMIS (Real-time Management Information System), HAMS (HolliAS Asset Management System), OTS (Operator Training System), HolliAS BATCH (Batch Application Package), HolliAS APC Suite (Advanced Process Control Package), and SIS (Safety Instrumentation System). The Safety Instrumentation System which was certified under European safety standards and was introduced to the market in July 2012, further round out our proprietary product suite in the industrial automation segment. The two mainstream products for this market segment are our DCS products and our PLC. DCS are a network of controllers, sensors, actuators and other devices that can be programmed to control outputs based on input conditions through logic calculations. In an automated production line, sensors or so-called “instrumentations” are distributed across the production facility to monitor sub-systems like the robots, CNC machines, and logistic tools. These sensors are like human eyes, which monitor the process, and detect any abnormal situations. The information collected from those sensors is then transmitted to the DCS for centralized data processing through communication networks. The central computer (brain) processes information and generates commands, based on sophisticated algorithmic and pre-set parameters. These commands are then sent to actuators (muscles/bones) through communication devices to execute the orders and maintain production flow. PLCs are small computer devices installed on machines or equipment, for example, on a factory assembly line, for manufacturing automation.
High-speed Rail: Over the years, Hollysys has successfully scaled its automation application from industrial manufacturing to rail and subway industry, with proprietary product lines including, TCC (Train Control Center) and ATP (Automation Train Protection). An ATP essentially acts as the train over-speed protection mechanism, which collects real-time information like speed limit ahead, train operation status, line data, instructions from train control center, then combines that information with the train parameters to produce train protection curves. In case of any human errors, like driver’s negligence at the red light, it applies emergency brakes automatically. TCCs are an on-ground control center at railway stations or equipment stations which monitors route condition, track status, train schedules, distance between trains, and the working status of other essential function devices, and then through logic calculation, generates control instructions and commands. The command information from the TCC is then transmitted to the ATP located on the locomotives/trains, through track circuits and electronic beacons located at various points along the railway line, or wireless.
Nuclear Automation and Control: As the only proven domestic automation control systems provider to the nuclear power industry in China, we provide our HOLLiAS NMS product to China’s nuclear power industry. In a nuclear station, the nuclear island operates to transform nuclear energy to heat energy, and pass on the steam generated by the steam generator to the conventional island, where steam drives the turbine to generate the electricity, and pass on to the transformer for loading onto the grid. Our HOLLiAS NMS proprietary control systems are now used for non-safety operation control. The know-how was accumulated from our industrial DCS applications in high-end, conventional energy power plants, with much more sophisticated software and hardware specifications, and more stringent production and quality assurance process. Our nuclear joint venture China Techenergy Co., Ltd. has already successfully completed developing its proprietary safety nuclear power automation and control system, which is expected to be commercialized in 2012 or 2013, when the total automation and control for nuclear power stations will be fully localized for China.
Subway Automation: We have provided our SCADA system to China’s subway market for many years, including the Beijing Subway, Guangzhou Metro, Shenzhen Metro, Dalian Metro and etc. SCADA is an open software platform to enable integrated and unified monitoring of all necessary sub-systems of the subway, including the Power Supervisory Control and Data Acquisition System, Building Automatic System, Fire Alarm System, Platform Screen Door System, Access Control System, Closed Circuit Television, Passenger Information System, Passenger Train Information System, and Alarm System. Given the exponential growth in China’s subway market and the continued growth expected for the decades to come, Hollysys is developing its proprietary Subway Signaling System, based on its strong research and development capability and technical know-how of signaling application accumulated from high-speed rail. The current subway signaling market is predominantly occupied by multi-national corporations, such as Siemens.
We establish a project group for each potential customer, which has a team of systems engineers and managers to provide total integrated solutions to our customers to meet their specific requirements. Each project group is staffed with a dedicated team of sales engineers, technical engineers and project management professionals. The sales engineers and technical engineers work together to offer the best customized solutions as a result of their understanding of the customer’s detailed requirements through on-site studies. The technical engineers are responsible for hardware assembly, software configuration, testing and installation, commissioning and trial operation, and start-up and training; while the project management professionals oversee budgetary matters, coordinate the work force, ensure adequacy of resources and monitor progress and quality to ensure the timely completion of each project. Our integrated solutions projects involve one or more of the following activities:
Our integrated solutions based on our proprietary technology and products create value for and improve the competitive strengths of our customers by:
We customize our floor plans based on careful on-site studies, build design-specific network systems using our advanced DCS technology and proprietary software, and offer manufacturing execution system services to ensure that real-time management control is available to our customers in a streamlined and easy-to-use manner.
We believe that our product design and applications that are integrated in the solutions are unmatched among our domestic competitors. We also believe that the sophistication and quality of our products rival those of the multi-national automation and control product suppliers, while our ability to understand and meet the needs of our Chinese customers gives it a leading edge over foreign competitors. The value of this combination is reflected in our strong revenue and profit growth over the years.
Market for Automation and Controls Solutions
According to the ARC Advisory Group, or ARC, an industry research group, the DCS market in Asia, as measured by revenue, exceeded $4,592.6 million in 2009 and will grow at a compounded annual growth rate of approximately 7.7% through 2014.ARC further projects that the DCS market, as measured by revenue, will exceed $6,654.2 million by 2014 in Asia.
We agree with ARC’s assessment that, “China, in contrast to most other countries, provides robust growth prospects for the DCS suppliers. With new investments continuing to take place in its core process industry sector, the market has excellent growth potential in both the near and long-term. Almost a quarter of a billion people with their growing disposable income are generating an exploding demand for a wide range of products. Domestic and global manufacturers, lured by this opportunity, have created new, world-class production facilities in almost all vertical industries. They are going beyond the near term opportunity for obtaining low cost labor. They are pursuing the best available control system technology and attaining a sustainable competitive advantage.”
Currently, the vast majority of the global automation market is still controlled by a handful of multi-national companies, most of them with western roots. Our competition includes some very recognizable names: Honeywell (US); Siemens (Germany); Emerson (US); ABB (Sweden); Rockwell (US); Westinghouse (US); and Hitachi (Japan). The western roots of automation are not surprising, as that is also where industrialization began and progressed the farthest during the 19th and 20th centuries. However, a new focus of the automation market is China and increasingly Southeast Asia, where the tremendous growth in industrialization is by now a very familiar story. Manufacturing jobs in the US and other western economies over the past two decades have steadily decreased, while the industrial base in China, Southeast Asia and the Middle East has expanded. In particular, China’s shift from a developing country to one of the world’s leading manufacturers of industrial equipment and consumer goods has created a substantial and growing demand for the automation systems that help to make those manufacturing processes more efficient, reliable and safe.
We believe China’s industrial automation growth rate will continue to be significant. We see China enjoying a healthy growth rate given its relative current lower penetration rate and the rising cost of labor. To date, we have implemented over 10,000 projects, with over 4,000 customers. This client base includes large state-owned enterprises, multi-national companies, and other domestic companies. Our main competitors in this field are global players such as ABB, Siemens, and Emerson, as well as Supcon from China. We believe that the Hollysys brand recognition and market reputation and our strong research and development capabilities will enable us to enter and penetrate high-margin market segments currently dominated by foreign companies, and will ensure our revenue from this industrial market to grow at a rate continuously exceeding the industry average.
High-Speed Rail and Subway Market
Another end-market for Hollysys is the high-speed rail market in China, where we command a leading position in providing high-speed rail signaling systems to ensure the safety of passenger train movement. High-speed rail is a relatively new development in China. The Ministry of Railways of China developed a national high-speed rail signaling technological standard, the China Train Control System, or the CTCS. Under the CTCS, the standard governing the 200-250km/hour speed category is called C2, while C3 governs the 300-350km/hour category. These standards are different from the international standards propounded by European organizations or Japan. There are more than 9,000km of high-speed rail tracks in operation in China, with more than 16,000km high-speed rail tracks in construction, according to the Ministry of Railways. The majority of operational high-speed lines are in 200-250km/hour, with only a few operational lines in 300-350km/hour, which include Beijing-Shanghai line, Wuhan-Guangzhou line, Zhengzhou-Xian line, Shanghai-Nanjing line, Shanghai-Hangzhou line and Guangzhou-Shenzhen line, of which the signaling system of Zhengzhou-Xian line and Guangzhou-Shenzhen line were supplied by Hollysys.
According to the official announcement from the Ministry of Railways, China is planning to have 20,000 kilometers of high-speed railways in operation by the end of 2015, with an estimated capital budget of approximately 2.8 trillion RMB. According to China’s Ministry of Railways, the China’s high-speed rail network will consist of artery lines and inter-city lines. The artery lines are “the Four Horizontals and the Four Verticals” referring to their positions on the map of China. The Four Vertical lines include the Beijing-Guangzhou line, Beijing–Shanghai line, Harbin-Dalian-Shenyang-Beijing line, and Shanghai-Hangzhou-Shenzhen line. The Four Horizontal lines include the Lanzhou-Xian-Zhengzhou-Lianyungang line, Shanghai-Wuhan-Chongqing-Chengdu line, Hangzhou-Changsha-Kunming line, and Taiyuan-Shijiazhuang-Qingdao line. The inter-city high-speed lines are mainly planned for economically well-developed regions with high densities of population, such as Zhu Jiang River Delta (Guangzhou-Shenzhen region), Yangtze River Delta (Shanghai-Hangzhou region), and Beijing-Tianjin-Tangshan region. As one of the three high-speed rail signaling products providers admitted by the Ministry of Railways in the C2 category, and one of the only two high-speed rail signaling products providers to the C3 segment, we believe that Hollysys is well positioned to benefit from this unprecedented, world leading high-speed railway build-out.
We also provide our proprietary software platform and solutions of SCADA to the subway market. China’s subway market is expected to receive significant government investment due to urbanization and environmental concerns. According to China’s Ministry of Housing and Urban-Rural Development, the China subway market will grow from 776 kilometers in 2008 to 4,189 kilometers in 2015, with government estimated investment amounting to $129 billion in the period. Leveraging on our know-how from high-speed surface rail signaling technology and our well-recognized brand name, we are developing our proprietary signaling products for the subway market, and hoping to replace foreign platforms currently dominating the China’s subway signaling market and to export our proprietary signaling products to overseas countries. We believe it will present a better value positioning to our subway customers by bundling our proprietary subway SCADA system with our proprietary signaling system, when we will see our market share and margin expansion.
We are well-positioned to benefit from China’s nuclear power development. At present, China’s nuclear power sector is relatively underdeveloped, with the vast majority of power generated by coal-fired power plants. There are currently 15 nuclear reactors in operation, providing approximately 12.6 GW of power, in comparison to the total electricity-generating capacity in China of approximately 700 GW. This represents approximately 1.8% of the total electricity generated by nuclear energy, lagging far behind the world average of 15% power generated from the nuclear energy, with France being the highest with 70% of its power generated from nuclear.
Driven by clean energy initiatives and China’s commitment of reducing its carbon emission by 45% per GDP unit by 2020, China’s installed nuclear power generating capacity is expected to reach 70GW-80 GW by 2020. Approximately, it is believed that one nuclear reactor generates 1GW electricity. During the year 2005, we formed a joint venture, China Techenergy Co., Ltd., with China’s leading nuclear station operator, China Guangdong Nuclear Power Holdings Co., Ltd., to provide its proprietary non-safety automation and control products to the nuclear stations constructed by China Guangdong Nuclear Power Holdings Corporation. We believe this strategic alliance position us to be the dominant nuclear automation system provider in China. China Guangdong Nuclear Power Holdings Co., Ltd. currently has approximately 60% of China’s nuclear market share.
The main channel through which we get our automation system business is the procurement bidding process. Customers seeking bids propose their requirements and specifications in legal bidding documents and those companies that are interested in obtaining these contracts make a bid in written form. If we win the bid, we finalize an integrated contract. We derive over 90% of our total consolidated revenues from the integrated contracts that we win through the bid process. In addition, we have a revenue stream through the sale of spare parts and component products to customers for maintenance and replacement purposes after the completion of the integrated solution contract, which tends to provide a recurring revenue stream, even though this revenue is not in the form of multiple-year contracts.
The purpose of an integrated contract is to furnish an automation system that provides the customer with a total solution for the automation or process control requirement being addressed. The automation system and total solution that we offer consists of hardware, software and services, all of which are customized to meet the particular needs and technical specifications of our customers. None of the hardware, software and service has independent functionality, and therefore cannot be sold separately to customers.
The major terms of an integrated solution contract include solution planning and design, system installation, customer acceptance, payment milestones and warranty. The process of fulfilling an integrated contract consists of the following four stages:
Because of the nature of customized integrated contracts, a customer does not have the right to return the products that we deliver, so long as such products conform and perform to the customer’s specification. Prior to delivering our products to a customer’s site, we perform an internal test to ensure that the automation system works as intended. After installing the products on a customer’s site, any problems are solved during trial runs. Once the testing requirements have been satisfied, a customer will sign and date a customer acceptance document, which begins the warranty period. Due to the nature of this process, many companies in the automation systems business generally do not carry product liability insurance.
The size of an integrated contract is determined by a customer’s needs in terms of the amount of equipment needed and the complexity of integrated solution. The size of an integrated contract drives the revenues generated by the contract. Because certain contracts will require working periods longer than one year, the best way to measure the contract revenue realized is to use the percentage-of-completion method. Ultimately, our revenue stream will be driven by the average price of an integrated contract and how many integrated contracts have started in each reporting period.
Our backlog of contracts presents the amount of unrealized revenue to be earned from the contracts that we have won. Accordingly, any increase or decrease in new contracts won by us, or any change of scheduled delivery dates will have a future impact on our future revenue streams. In the event of a delay of the delivery schedule, then the time of inspection, installation, trial run and customer acceptance will be delayed accordingly, all of which will affect our revenue recognition. If the delay of delivering the specified automation systems was a result of our inability to deliver the system on a timely basis, then we will be held responsible for this delay, in accordance with the terms specified in the respective integrated contracts.
We compete with various domestic and international corporations offering automation and control systems. We believe that our proprietary technology and products provide us with a strong competitive advantage over our domestic Chinese competitors. However, a number of multinational companies, some of whom have substantially greater financial and other resources than we currently have, have been offering first rate automation systems in competition with us. We believe that our primary competitors in the industrial automation market for our products are multi-national corporations, such as ABB, Honeywell, Emerson and Siemens, and the local company Supcon, a private company affiliated with Zhejiang University.
In the PRC high-speed rail business, as China’s Ministry of Railways employs an administrative admission system and China establishes its national rail technology standard, the China Train Control Standard (CTCS), we believe that competition from multi-national companies will decrease or be eliminated. Currently, Hollysys is one of only three entities granted admission to supply signaling products to China’s 200-250km/h segment of the high-speed rail market. The other two are the China Rail Signal & Communication Corp. (CRSC) and the China Academy of Railway Science. Hollysys is one of the only two permitted signaling product providers to China’s 300-350km/h segment of the high-speed rail market. The other provider is CRSC. In the subway business and the SCADA market, we mainly compete with Nanjing Automation Research Institute (NARI). In nuclear automation segment, we mainly compete with multi-national corporations such as Siemens, Areva, and Invensys.
In the Southeast Asian and Middle Eastern markets, our principal competitors for industrial automation are the multinational corporations such as ABB, Siemens, Emerson and Honeywell. The major competitors in the international rail and subway signaling markets are Bombardier and Alston.
When compared to our competitors, apart from satisfying certain China based criteria, we believe that our key competitive edge is the provision of better value for money to our customers with the following distinctive attributes:
Manufacturing and Raw Materials
We design and manufacture the hardware of our products in house, and in rare cases we outsource the production depending on special circumstances and delivery requirements. The core part of the hardware of our products is the printed circuit board. We manufacture the printed circuit boards in our SMT (Surface Mounting Technology) lines and plug-in mounting lines, and assemble them into various types of modules and then form the modules into the final products. The raw materials which we procure mainly include bare printed circuit boards from vendors based on our requirements and design considerations, and electronic components, chips, cabinets and cables among other factors. Our products are subjected to rigorous testing in our facilities prior to shipment.
Several subsidiaries of the Company, including Beijing Hollysys, Hangzhou Hollysys, Hollysys A&D, Hollysys Electronics and etc, have passed several or all of the GB/T 19001/ISO 9001 international quality management system certification, GB/T 24001/ISO 14001 environmental management system certification, and GB/T 28001 occupational health and safety management system certification.
The GB/T 19001/ISO 9001 international quality management system certificate is valid for production, technical service of industrial automatic control system equipment. the other two certificates are valid for production, technical service and related management activities of industrial automatic control system equipment.
Like many other Chinese companies operating in China, our businesses tends to be slower in the quarter that includes the month of March and tends to be to be stronger in the quarter that includes December due to the Chinese New Year factor and the budgeting practice that is on a calendar basis adopted by government agencies and most of Chinese private enterprises.
We operate our business in China under a legal regime that consists, at the national level, of the State Council, which is the highest authority of the executive branch of the PRC central government, and several ministries and agencies under its leadership, including: the Ministry of Agriculture and its local authorities; the Ministry of Commerce and its local authorities; SAFE and its local authorities; the State Administration of Industry and Commence and its local authorities; and the State Administration of Taxation, and the Local Taxation Bureau. The following sets forth a summary of significant regulations or requirements that affect our business activities in China and our shareholders’ right to receive dividends and other distributions from us.
The foregoing summary does not purport to be complete and is qualified by reference to the relevant provisions of applicable law in the jurisdictions in which we operate. We believe that we are currently in compliance with all applicable laws and regulations relating to our business.
Marketing, Sales and Customer Support
Our marketing and sales activities are focused on the development of and addressing the growing demand for automation and control products, systems and services in the Chinese domestic market and the Southeast Asian and Middle Eastern markets. Our basic strategy is to build cooperative relationships with our customers, educating them about technological developments and reflecting their needs in our products and services.
Our sales teams consist of a complementary group of sales personnel and hardware and software engineers from a variety of disciplines to tailor products to specific customer needs. Employing a pool of skilled personnel in the early stage of a project accelerates the design and the subsequent production of a particular customized solution, typically exceeding that of our competitors. Our sales teams possess significant hands-on, industry-specific experience which permit them to do on-site process analyses, which in turn, makes the design and implementation of upgrades simpler. The result is an automation system that is more effective, efficient and reliable, which in turn leads to a truly satisfied customer.
Our sales force is organized into three principal groups, (i) regional sales, to provide business consulting, promote pre-sale activity and serve as customer contacts, (ii) customer service, to manage relations with contracted customers and improve customer satisfaction by coordinating responses to the client’s information requests, sale of supplemental parts or components and make customer visits, and (iii) market planning, to facilitate strategic cooperation with certain specialized manufacturers, to expand the specific fields for our products.
We identify and target market segments and select target sales opportunities within our markets and conduct sales opportunity studies to ensure that adequate sales resources are available. Sales quotas are assigned to all sales personnel according to annual sales plans. We classify market segments and target opportunities on national and regional levels. Segmentation of our markets helps us to determine our primary sales targets and to prepare monthly and quarterly sales forecasts. The sales team approves target projects, develops detailed sales promotion strategies and prepares reports on order forecasts, technical evaluation, sales budgeting expense, schedules and competition analysis. After the report has been approved, a marketing group is appointed, consisting of sales personnel and engineers. We employ marketing personnel to conduct market research, to analyze user requirements and to organize marketing communications.
Our marketing team engages in a variety of marketing activities, including:
We actively participate in technology-related conferences and demonstrate our products at trade shows or at exhibitions targeted at our existing and potential customers. We also evaluate a range of joint-marketing strategies and programs with our business partners in order to take advantage of their strategic relationships and resources. We also support our customers by offering field services such as maintenance and training services, which help customers to cut their costs and improve their operating efficiency.
As of June 30, 2012, we employed 816 direct sales personnel through our Chinese subsidiaries in China and through Concord in Singapore and the Middle East. The sales staffs were assigned to three business areas: industrial automation, rail transportation and overseas sales. Sales activities for industrial automation are widely distributed across China in over 50 cities; the rail transportation sales activities are mainly centralized at our Beijing headquarters; and for overseas regions, sales activities are mainly developed and guided from our offices in Singapore and the Middle East.
C. Organizational Structure
The following diagram illustrates our corporate structure as of the date of this annual report. We are a holding company with no operations of our own. We conduct our operations in China mainly through our Chinese operating companies, Beijing Hollysys, Hangzhou Hollysys and Hollysys A&D, and do our operations in southeast Asia and the Middle East mainly through Concord.
Our corporate headquarters are located at No. 2 Disheng Middle Road, Beijing Economic-Technological Development Area, Beijing, 100176, China. Our telephone number is (+86) 10 58981386. We maintain a website at http://www.Hollysys.com that contains information about our company, but that information is not a part of this annual report.
D. Property, Plant and Equipment
Since 2010, our principal executive offices have been located at No. 2 Disheng Middle Road, Beijing Economic-Technological Development Area, Beijing, 100176, China. At this location in Beijing, we have ample room for substantial expansion, as our needs require. We own the prepaid land leases to the properties at the following principal locations, each of which contains principal administrative offices, sales and marketing offices, research and development facilities, and manufacturing facilities:
The manufacturing facilities at the above locations are used for the system integration production, including hardware testing instruments, auxiliary material processing, packaging and shipping, and for self-made product integration production, including inspection and testing.
There are no unresolved staff comments.
You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes included elsewhere in this annual report on Form 20-F. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including the risk factors and the discussion of our business set forth in other parts of this annual report on Form 20-F.
Through our operating subsidiaries, we are one of the leading automation systems providers in China, developing a number of core technologies and completing numerous projects utilizing a wide array of automation products. With our philosophy of sincere concern for customers and our technical innovation capabilities, we specialize in the research, development, production, sale and distribution of industrial automation for digital railway signals and information systems, e-government, motor drive transmissions and safety controls for nuclear power reactors.
The main channel through which we obtain our automation system business is the procurement bidding process. Customers seeking bids propose their requirements and specifications in legally binding bid documentation, to which the companies interested in obtaining the contract respond with an appropriate bid.
We derive our revenue mainly from the integrated contracts we have won through the bid process, which accounts for approximately 95% of our total consolidated revenue. An additional source of revenue, although small in percentage terms, is the sale of spare parts and component products to customers for maintenance and replacement purposes after the completion of the integrated solution contract. Spare part and component sales are not part of the integrated solutions contracts.
The purpose of an integrated solutions contract is to furnish an automation system that provides the customer with a total solution for the automation or process control requirement being addressed. The automation system and total solution we offer, consisting of hardware, software and services, is customized to meet the customer’s particular needs and technical specifications. None of the hardware, software and services has independent functionality, and therefore, cannot be sold separately to customers. The following table sets forth the information regarding the contracts we won during the last three fiscal years and backlog at the dates indicated:
As indicated above, both the amount of new contracts won and the amount of backlog have been increasing steadily during the past three years. Generally, the backlog represents increasing sales and increasing size of contracts which take more time to perform. The significant growth clearly validates our dedicated industry expert total solution and sales network expansion strategies. Our established brand recognition, strong track record of customization, quality and service, efficient R&D and implementation together with customer-orientated flexibility give us a significant competitive advantage over domestic and international competitors. We made substantial progress in our strategy of international market expansion through our successfully acquired company – Concord. Concord has been actively working on a few international bids and projects in the rail and industrial automation sectors. The acquisition of Concord provided a synergy with the rest of the company, successfully combining our proprietary technology and Concord’s international resources.
As a growing company, we have achieved significant progress in the past three years. Our total consolidated revenues for the fiscal year ended June 30, 2012 was approximately $321.7 million, compared to approximately $262.8 million for the prior fiscal year, representing an increase of 22.4%, followed by a growth of 50.9% from approximately $174.1 million in fiscal 2010.
In order to subdivide the specialization of our industrial automation business and spur a rapid expansion of our business, Hangzhou Hollysys invested RMB 50 million (approximately $7,912,895) to establish a subsidiary, Hangzhou Hollysys System Engineering Co., Ltd (“Hangzhou Engineering” thereafter) on June 8, 2012. The financial results of Hangzhou Engineering will be included in the Company’s consolidated financial statements, effective from the registration date, July 24, 2012.
On August 27, 2010, our Board of Directors adopted a Rights Plan, or the 2010 Rights Plan. In connection with the 2010 Rights Plan, the Board of Directors declared a dividend distribution of one “Right” for each outstanding ordinary share to shareholders of record at the close of business on August 27, 2010, effective as of September 27, 2010. Each Right entitles the shareholder to buy one share of our Class A Preferred Stock at a price of $160.
The Rights will become exercisable if a person or group announces an acquisition of 20% or more of our outstanding ordinary shares, or announces commencement of a tender offer for 20% or more of the ordinary shares. In that event, the Rights permit shareholders, other than the acquiring person, to purchase our ordinary shares having a market value of twice the exercise price of the Rights, in lieu of the Class A Preferred Stock. In addition, in the event of certain business combinations, the Rights permit the purchase of the ordinary shares of an acquiring person at a 50% discount. Rights held by the acquiring person become null and void in each case. Unless terminated earlier by our Board of Directors, the 2010 Rights Plan will expire on September 27, 2020.
Key Factors Affecting Our Growth, Operating Results and Financial Condition
Our future growth, operating results and financial condition will be affected by a number of factors including:
Critical Accounting Policies
The Company accounts for its business combinations using the purchase method of accounting in accordance with Accounting Standards Codification (“ASC”) Topic 805, Business Combinations. The purchase method accounting requires that the consideration transferred to be allocated to the assets, including separately identifiable assets and liabilities the Company acquired based on their estimated fair values. The consideration transferred of an acquisition is measured as the aggregate of the fair values at the date of exchange of the assets given, liabilities incurred, and equity instruments issued as well as the contingent considerations and all contractual contingencies as of the acquisition date. Identifiable assets, liabilities and contingent liabilities acquired or assumed are measured separately at their fair value as of the acquisition date, irrespective of the extent of any noncontrolling interests. The excess of (i) the total cost of the acquisition, fair value of the noncontrolling interests and acquisition date fair value of any previously held equity interest in the acquiree over (ii) the fair value of the identifiable net assets of the acquiree, is recorded as goodwill. If the cost of acquisition is less than the fair value of the net assets of the subsidiary acquired, the difference is recognized directly in the statements of comprehensive income.
The determination and allocation of fair values to the identifiable assets acquired, liabilities assumed and noncontrolling interests is based on various assumptions and valuation methodologies requiring considerable management judgment. The most significant variables in these valuations are discount rates, terminal values, the number of years on which to base the cash flow projections, as well as the assumptions and estimates used to determine the cash inflows and outflows. The Company determines discount rates to be used based on the risk inherent in the related activity’s current business model and industry comparisons. Terminal values are based on the expected life of assets, forecasted life cycle and forecasted cash flows over that period.
Acquisition-related costs are recognized as general and administrative expenses in the statements of comprehensive income as incurred.
Integrated solutions contracts
Revenues generated from designing, building, and delivering customized integrated industrial automation systems are recognized over the contractual terms based on the percentage of completion method. The contracts for designing, building, and delivering customized integrated industrial automation systems are legally enforceable binding agreements between the Company and customers. The duration of contracts depends on the contract size and ranges from 6 months to 5 years excluding the warranty period. The majority of the contract duration is longer than one year.
In accordance with ASC Subtopic 605-35, Revenue Recognition - Construction-Type and Production-Type Contracts recognition is based on an estimate of the income earned to date, less income recognized in earlier periods. Revisions in the estimated total costs of integrated contracts are made in the period in which the circumstances requiring the revision become known. Provisions, if any, are made currently for anticipated loss on the uncompleted contracts.
The Company reviews and updates the estimated total costs of integrated solution contracts at least semi-annually. The Company accounts for revisions to contract revenue and estimated total costs of integrated solution contracts, including the impact due to approved change orders, in the period in which the facts that cause the revision become known as changes in estimates. Unapproved change orders are considered claims. Claims are recognized only when it has been awarded by customers. Excluding the impact of change orders, if the estimated total costs of integrated solution contracts, which are revised during the year ended June, 30, 2012, had been used as a basis of recognition of contract revenue since the contract commencement, net income for the year ended June 30, 2012 would have decreased by $13,109,779. Revisions to estimated total costs for the year ended June 30, 2012 were made in the ordinary course of business.
The Company combines a group of contracts as one project if they are closely related and are, in substance, parts of a single project with an overall profit margin. Whereas, the Company segments a contract into several projects, when they are of different business substance, for example, with different business negotiation, solutions, implementation plans, margins, etc.
Revenue in excess of billings on the contracts is recorded as costs and estimated earnings in excess of billings. Billings in excess of revenues recognized on the contracts are recorded as deferred revenue until the above revenue recognition criteria are met.
The Company generally recognizes 100% of the contractual revenue upon receipt of customer acceptance as the Company estimates that no further major costs will be incurred under a contract, a signed customer acceptance document has been obtained, and the warranty period commences. Revenues are presented net of taxes collected on behalf of the government.
Revenue generated from sales of products is recognized when the following four revenue recognition criteria are met (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the selling price is fixed or determinable, and (iv) collectability is reasonably assured.
Inventories are composed of raw materials work in progress, purchased and manufactured finished goods and low value consumables. Inventories are accounted for on the “first-in, first-out basis”, and stated at the lower of cost or market.
The Company assesses the lower of cost or market for non-saleable, excess or obsolete inventories based on its periodic review of inventory quantities on hand and the latest forecasts of product demand and production requirements from its customers. The Company writes down inventories for non-saleable, excess or obsolete raw materials, work-in-process and finished goods by charging such write-downs to cost of integrated contracts and/or costs of products sold.
Warranties represent a major term under an integrated contract, which will last, in general, for one to three years or otherwise specified in the terms of the contract. The Company accrues warranty liabilities under an integrated contract as a percentage of revenue recognized, which is derived from its historical experience, in order to recognize the warranty cost for an integrated contract throughout contract period. In addition, the Company estimates whether or not the accrued warranty liabilities are adequate by considering specific conditions that may arise and the number of contracts under warranty period at each reporting date. The Company adjusts the accrued warranty liabilities in line with the results of its assessment.
Accounts receivable and costs and estimated earnings in excess of billings
Performance of the integrated contracts often will extend over long periods and the Company’s right to receive payments depends on its performance in accordance with the contractual agreements. Billings are rendered based on agreed milestones included in the contracts with customers. There are different milestones amount the contracts the Company has won. In general, there are four milestones: 1) project commencement, 2) system manufacturing and delivery, 3) installation, trial-run and customer acceptance, and 4) expiration of the warranty period. The amounts to be billed when each of the specified milestones is reached are specified in the contracts. All contracts have the first milestone, but not all contracts have a prepayment. Each interval of two continuous billings under an integrated contract varies depending on the duration of the contract (under certain contracts, the interval of two continuous billings is longer than one year) and the last billing to be issued for an integrated solution contract is at the end of a warranty period. Prepayments received are recorded as deferred revenue. The deferred revenue will be recognized as revenue under the percentage of completion method along with the progress of a contract. If no prepayment is received by the Company, revenue will be recognized through cost and estimated earnings in excess of billings.
The Company does not require collateral from its customers. Based on the prevailing collection practices in China, it is a reasonable expectation for the enterprises in the automation industry to take over one year to collect the accounts receivable in full.
The Company does not charge interest for late payments by its customers. The Company periodically reviews the status of contracts and decides how much of an allowance for doubtful accounts should be made based on factors surrounding the credit risk of customers and its historical experience. The Company sets up a doubtful account for an individual customer based on the customer’s credit worthiness.
Impairment of long-lived assets other than goodwill
The Company evaluates its long-lived assets or asset group including acquired intangibles with finite lives for impairment whenever events or changes in circumstances (such as a significant adverse change to market conditions that will impact the future use of the assets) indicate that the carrying amount of a group of long-lived assets may not be fully recoverable. When these events occur, the Company evaluates the impairment by comparing the carrying amount of the assets to future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. If the sum of the expected undiscounted cash flows is less than the carrying amount of the assets, the Company recognizes an impairment loss based on the excess of the carrying amount of the asset group over its fair value, generally based upon discounted cash flows or quoted market prices.
The impairment loss on long-lived assets for each of the years ended June 30, 2010, 2011 and 2012 were $715,246, $23,711 and nil respectively, included in the general and administrative expenses, which represented impairment loss on property, plant and equipment.
The Company follows the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rate is recognized in tax expense in the period that includes the enactment date of the change in tax rate.
The Company adopted ASC 740, Income Taxes, which clarifies the accounting and disclosure for uncertainty in income taxes. Interests and penalties arising from underpayment of income taxes shall be computed in accordance with the related tax laws. The amount of interest expense is computed by applying the applicable statutory rate of interest to the difference between the tax position recognized and the amount previously taken or expected to be taken in a tax return. Interests and penalties recognized in accordance with ASC 740 are classified in the financial statements as a component of income tax expense. In accordance with the provisions of ASC 740, the Company recognizes in its financial statements the impact of a tax position if a tax return position or future tax position is “more likely than not” to prevail based on the facts and technical merits of the position. Tax positions that meet the “more likely than not” recognition threshold are measured at the largest amount of tax benefit that has a greater than fifty percent likelihood of being realized upon settlement. The Company’s estimated liability for unrecognized tax positions which is included in the accrued liabilities is periodically assessed for adequacy and may be affected by changing interpretations of laws, rulings by tax authorities, changes and/or developments with respect to tax audits, and expiration of the statute of limitations. The outcome for a particular audit cannot be determined with certainty prior to the conclusion of the audit and, in some cases, appeal or litigation process. The actual benefits ultimately realized may differ from the Company’s estimates. As each audit is concluded, adjustments, if any, are recorded in the Company’s financial statements. Additionally, in future periods, changes in facts, circumstances, and new information may require the Company to adjust the recognition and measurement estimates with regard to individual tax positions. Changes in recognition and measurement estimates are recognized in the period in which the changes occur.
The Company accounts for share-based compensation in accordance with ASC 718, Compensation-Stock Compensation. The Company recognizes compensation cost for an award with only service conditions that has a graded vesting schedule on a straight-line basis over the requisite service period for the entire award. The compensation cost for each vesting tranche in an award subject to performance vesting is recognized ratably from the service inception date to the vesting date for each tranche. To the extent the required vesting conditions are not met resulting in the forfeiture of the share-based awards, previously recognized compensation expense relating to those awards are reversed. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent period if actual forfeitures differ from initial estimates.
Recent Accounting Pronouncements
In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2011-04, Fair Value Measurement (“Topic 820”), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”) which amends the fair value measurement guidance and includes some enhanced disclosure requirements. The most significant change in disclosures is an expansion of the information required for Level 3 measurements based on unobservable inputs. The standard is effective for fiscal years beginning after December 15, 2011. Early adoption is not permitted. The Company does not expect the adoption of ASU 2011-04 will have a material impact on its consolidated financial statements.
In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in shareholders’ equity and requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement or in two separate but consecutive statements. This pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. In December 2011, the FASB issued ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 (“ASU 2011-12”). ASU 2011-12 defers the requirement in ASU 2011-05 that entities present reclassification adjustments for each component of accumulated other comprehensive income in both net income and other comprehensive income on the face of the financial statements. ASU 2011-12 requires entities to continue to present amounts reclassified out of accumulated other comprehensive income on the face of the financial statements or disclose those amounts in the notes to the financial statements. The effective date of ASU 2011-12 is consistent with ASU 2011-05, which is effective for fiscal years and interim periods beginning after December 15, 2011 for public entities. Retrospective application is required and early adoption is permitted. The Company has opted to early adopt ASU 2011-05. The provision of ASU 2011-12 did not have a material impact on the presentation of the Company’s financial statements.
The following are some financial highlights for the fiscal year ended June 30, 2012:
However, during the year ended June 30, 2012, due to the state macro-control on the real estate market in the PRC, the Company decided not to dispose of the previous headquarters in Beijing Xisanqi, and reclassified them from assets held for sale to prepaid land lease and property, plant and equipment as of June 30, 2012, respectively. Upon reclassification, each asset was recorded at the carrying amount before it was classified as held for sale, adjusted for any amortization or depreciation that would have been recognized had the asset been continuously classified as held and used, which was lower than its fair value. The effect on the results of operations related to amortization and depreciation charges for the year ended June 30, 2012 amounted to $281,270.
Comparison of Fiscal Years Ended June 30, 2012 and 2011
Revenues: For the fiscal year ended June 30, 2012, total revenues amounted to approximately $321.7 million, an increase of approximately $58.9 million, compared to approximately $262.8 million for the prior fiscal year, representing a significant increase of 22.4%.
Integrated contract revenue accounted for approximately $305.0 million of total revenues, an increase of approximately $56.4 million, or 22.7%, compared to approximately $248.6 million for the prior fiscal year. The increase in integrated revenues was mainly attributable to an increase of approximately $50.1 million in industrial automation projects, an increase of $24.2 million in overseas sales, which was generated by Concord, and a decrease of $16.4 million in rail transportation.
Approximately $16.7 million of total revenues related to product revenue, an increase of approximately $2.4 million, or 17.3%, compared to approximately $14.3 million in product revenue for the prior year. Product revenue depends on overall demand for the Company’s spare parts for customers’ maintenance and replacement purposes.
Revenue Backlog: An important measure of the stability and growth of the Company’s business is the size of its backlog, which represents the total amount of unrecognized revenue associated with existing contracts. Our backlog as of June 30, 2012, amounted to approximately $389.8 million, representing an increase of approximately $93.4 million, or 31.5%, compared to approximately $296.4 million as of June 30, 2011.
Of the total backlog as of June 30, 2012, the unrecognized revenue associated with new contracts signed in the fiscal 2012 period was approximately $242.4 million and the amount brought forward from prior periods was approximately $147.5 million. The total backlog as of June 30, 2011 comprised of approximately $146.9 million from new contracts signed in fiscal year 2011, and approximately $149.5 million from contracts carried forward from prior year.
Cost of revenues: Cost of revenues can be divided into cost of integrated contracts and cost of products sold, in line with the categories of revenues. For the fiscal year ended June 30, 2012, the total cost of revenues amounted to approximately $195.4 million, an increase of approximately $23.6 million, or 13.8%, compared to approximately $171.7 million for the prior fiscal year. The increase was due to an approximate $23.8 million increase in the cost of integrated contracts, and an approximate $0.2 million year-over-year decrease in the cost of products sold.
The cost of integrated contract revenue consists primarily of three components: cost of equipment and materials, labor costs and other manufacturing expenses incurred from designing, building and delivering customized automation solutions to customers. The total cost of integrated contracts was approximately $189.2 million for the fiscal year ended June 30, 2012, compared to approximately $165.4 million for the prior fiscal year, representing an increase of approximately $23.8 million, or 14.4%. The increase was primarily due to an increase of approximately $17.0 million in labor cost because of the higher labor cost of Concord, and an increase of approximately $6.3 million in manufacturing expenses. Of the total cost of integrated contract revenue, labor cost accounted for 13.6% for the fiscal 2012 period, compared to 5.3% for the prior fiscal year; cost of equipment and materials accounted for 71.5%, compared to 81.5% for the prior fiscal year; and other manufacturing expenses accounted for 14.9%, compared to 13.2% for the prior fiscal year. Of the total integrated contract revenue, labor cost accounted for 8.5% for the 2012 period, compared to 3.5% for the prior fiscal year; cost of equipment and materials accounted for 44.4%, compared to 53.8% for the prior fiscal year; and other manufacturing expenses accounted for 9.2%, compared to 8.7% for the prior fiscal year. The cost components of integrated contracts were determined and varied according to requirements of different customers.
Sales of products represent sales of spare parts (either company manufactured or purchased from outside vendors) to customers for maintenance and replacement purposes. The products purchased from outside vendors have different functions and capabilities from our self-made products. We decide whether or not to purchase from outside vendors or make the necessary products ourselves, based on the needs and preferences of different customers and efficiency considerations. Therefore, as a percentage of the cost of products sold, the self-made products and outsourced products have varied significantly from time to time. As our self-made products generally contribute higher margins than products purchased from outside vendors, sales of a greater portion of self-made products generally result in lower costs of products sold. The cost of products sold for the fiscal year ended June 30, 2012 was approximately $6.2 million, a decrease of approximately $0.2 million, compared to approximately $6.4 million for the prior fiscal year.
Gross margin: For the fiscal year ended June 30, 2012, as a percentage of total revenues, the overall gross margin was 39.3%, compared 34.7% for the prior fiscal year. The gross margin for integrated contracts was 38.0% for the year ended June 30, 2012, compared to 33.5% for the prior year. The increase in gross margin for integrated contracts was due mainly to our different sales mix during the fiscal 2012 period. The gross margin for products sold was 62.9% for the fiscal year ended June 30, 2012, compared to 55.4% for the prior fiscal year.
Selling expenses: Selling expenses mainly consist of compensation, traveling and administrative expenses related to marketing and sales and promotion activities of the Company’s marketing departments. Selling expenses were approximately $27.6 million for the fiscal year ended June 30, 2012, an increase of 35.2%, or approximately $7.2 million, compared to approximately $20.4 million for the prior fiscal year, mainly due to the Company’s expanded sales network and increased sales activities. As a percentage of total revenues, selling expenses accounted for 8.6% and 7.8% for the fiscal year ended June 30, 2012 and 2011, respectively. The Company has established guidelines to monitor and evaluate sales performance for its products to customers in different industries and regions to control selling expenses.
General and administrative expenses: General and administrative expenses mainly include compensation, traveling and other administrative expenses of non-sales-related departments, such as the planning and finance department, information systems department and human resources department. General and administrative expenses amounted to approximately $26.0 million for the fiscal year ended June 30, 2012, representing an increase of approximately $9.3 million, or 56.1%, compared to approximately $16.7 million for the prior fiscal year, mainly due to an increase of $4.9 million contributed by the newly acquired subsidiaries; and an increase of $1.6 million in allowance for doubtful accounts. As a percentage of total revenues, G&A expenses were 8.2% and 6.1% for the fiscal years ended June 30, 2012 and 2011, respectively.
Research and development expenses: Research and development expenses comprise mostly employee compensation, materials consumed and experiment expenses for specific new product research and development, and any expenses incurred for basic research on advanced technologies. For the fiscal year ended June 30, 2012, research and development expenses were approximately $25.6 million, compared to approximately $20.1 million for the prior fiscal year. The approximate $5.5 million, or 26.9%, increase was mainly due to increased research and development activities during the 2012 period. As a percentage of total revenues, research and development expenses were 7.9% and 7.7% for the fiscal years ended June 30, 2012 and 2011, respectively.
VAT refunds and government subsidies: The state tax bureaus in Beijing and Hangzhou provide financial subsidies out of the value added tax they collect in order to encourage the research and development efforts of certain enterprises. Beijing Hollysys and Hangzhou Hollysys both received such refunds. All VAT refunds, that have no further conditions to be met, are recognized in the statements of comprehensive income when cash or approval from the tax bureaus is received. For the fiscal year ended June 30, 2012, VAT refunds were approximately $15.0 million, compared to approximately $9.0 million for the prior fiscal year, increasing by approximately $6.0 million, or 67.0%, mainly due to the PRC government approving a VAT refund of $5.3 million in fiscal 2012 related to sales generated during January to June 2011. As a percentage of total revenues, VAT refunds were 4.7% and 3.4% for the fiscal years ended June 30, 2012 and 2011, respectively.
The local governments in Beijing and Hangzhou also provide financial subsidies to encourage development of certain enterprises. Beijing Hollysys and Hangzhou Hollysys both received such subsidies. For the government subsidies that have no further conditions to be met, the amounts are recognized in statements of comprehensive income when received; for the amounts with certain operating conditions, the government subsidies are recorded as liabilities when received and will be released to income when the conditions are met. Gross subsidy income received from the government amounted to approximately $3.3 million and $1.8 million for the fiscal year ended June 30, 2012 and 2011, respectively, an increase of approximately $1.5 million, or 80.6%.
Income from operations: Income from operations increased by approximately $20.7 million, from approximately $44.7 million for the fiscal year ended June 30, 2011 to approximately $65.4 million for the fiscal year ended June 30, 2012. The increase in income from operations was primarily due to the increase in revenue and gross margins.
Gains on disposal of shares of equity investees: The gains on disposal of shares of equity investees amounted to $2.0 million for fiscal year 2012, which was mainly contributed by the Company disposing of a 10% equity interest in China Techenergy Co., Ltd. for consideration of RMB 27.8 million (approximately $4.4 million), and recognizing a disposal gain of $2.0 million during this year. After this transaction, the Company continues to hold a 40% equity interest in China Techenergy.
Interest expenses, net: For the year ended June 30, 2012, net interest expenses decreased by approximately $0.3 million, or 14.7%, from approximately $1.6 million for the prior year, to approximately $1.3 million for the current period. As a percentage of total revenue, net interest expense accounted for 0.4% and 0.6% for the fiscal years ended June 30, 2012 and 2011, respectively.
Income tax expenses: For the year ended June 30, 2012, the Company’s income tax expense was approximately $10.4 million for financial reporting purposes, an increase of approximately $4.0 million, as compared to $6.4 million for the prior year. The large income tax expense for this year was mainly due to an income tax expense of $4.4 million related to certain expenses incurred during the year that were determined not to be deductible for tax purposes. As a percentage of income before income taxes, the effective tax rate was 15.5% and 13.5% for the years ended June 30, 2012 and 2011, respectively.
Net income attributable to noncontrolling interests: The noncontrolling interests of the Company include noncontrolling shareholders’ interests in each subsidiary. For fiscal 2012 and 2011, the noncontrolling interests are the ownership interests of 49% in WoDeWeiYe and Hollycon, respectively. The net income attributable to noncontrolling interest for the fiscal year ended June 30, 2012 was $0.4 million, an increase of $0.4 million, from a net loss of $4.9 thousand for the prior year, primarily due to the increased net income of WoDeWeiYe and Hollycon for fiscal 2012.
Net income and earnings per share attributable to Hollysys: For the fiscal year ended June 30, 2012, net income attributable to Hollysys amounted to approximately $56.2million, representing an increase of approximately $14.7 million, as compared to approximately $41.5 million for the prior year. The basic and diluted earnings per share were $1.01 and $1.01 for the year ended June 30, 2012, as compared to $0.76 and $0.75 for the prior year, representing an increase of $0.25 and $0.26, respectively. Such increase was primarily due to an increase of approximately $35.1 million in gross profit.
Comparison of Fiscal Years Ended June 30, 2011 and 2010
Operating Revenues: For the fiscal year ended June 30, 2011, total revenues amounted to approximately $262.8 million, an increase of approximately $88.7 million, compared to approximately $174.1million for the prior fiscal year, representing a significant increase of 51.0%.
Integrated contract revenue accounted for approximately $248.6 million of total revenues, an increase of approximately $84.5 million, or 51.5%, compared to approximately $164.1 million for the prior fiscal year. The increase in revenues was mainly attributable to an increase of approximately $32.8 million in industrial automation projects and $55.5 million of revenues generated from rail transportation business.
Approximately $14.3 million of total revenues related to product revenue, an increase of approximately $4.3 million, or 43.1%, compared to approximately $10.0 million in product revenue for the prior year. Product revenue depends on overall demand for the Company’s spare parts for customers’ maintenance and replacement purposes during the 2011 fiscal year.
Revenue Backlog: An important measure of the stability and growth of the Company’s business is the size of its backlog, which represents the total amount of unrecognized revenue associated with existing contracts..Our backlog as of June 30, 2011, amounted to approximately $296.4 million, representing an increase of approximately $43.5 million, or 17.2%, compared to approximately $252.9 million as of June 30, 2010.
Of the total backlog as of June 30, 2011, the unrecognized revenue associated with new contracts signed in the fiscal 2011 period was approximately $146.9 million and the amount brought forward from prior periods was approximately $149.5 million. The total backlog as of June 30, 2010 comprised of approximately $145.9 million from new contracts signed in fiscal year 2010, and approximately $107.0 million from contracts carried forward from prior year.
Cost of Revenues: Cost of revenues can be divided into cost of integrated contracts and cost of products sold, in line with the categories of revenues. For the fiscal year ended June 30, 2011, the total cost of revenues amounted to approximately $171.7 million, an increase of approximately $57.8 million, or 50.7%, compared to approximately $113.9 million for the prior fiscal year. The increase was due to an approximate $55.1 million increase in the cost of integrated contracts, and an approximately $2.7 million year-over-year increase in the cost of products sold.
The cost of integrated contract revenue consists primarily of three components: cost of equipment and materials, labor costs and other manufacturing expenses incurred from designing, building and delivering customized automation solutions to customers. The total cost of integrated contracts was approximately $165.4 million for the fiscal year ended June 30, 2011, compared to approximately $110.3 million for the prior fiscal year, representing an increase of approximately $55.1 million, or 50.0%. The increase was primarily due to an increase of approximately $51.0 million in the cost of equipment and materials, and approximately $3.1 million in labor cost. Of the total cost of integrated contract revenue, labor cost accounted for 5.3% for the fiscal 2011 period, compared to 5.1% for the prior fiscal year; cost of equipment and materials accounted for 81.5%, compared to 76.0% for the prior fiscal year; and other manufacturing expenses accounted for 13.2%, compared to 18.9% for the prior fiscal year. Of the total integrated contract revenue, labor cost accounted for 3.5% for the 2011 period, compared to 3.8% for the prior fiscal year; cost of equipment and materials accounted for 53.8%, compared to 56.1% for the prior fiscal year; and other manufacturing expenses accounted for 8.7%, compared to 14.0% for the prior fiscal year. The cost components of integrated contracts were determined and varied according to requirements of different customers.
Sales of products represent sales of spare parts (either self-made or purchased from outside vendors) to customers for maintenance and replacement purposes. The products purchased from outside vendors have different functions and capabilities from our self-made products. We decide whether or not to purchase from outside vendors or make the necessary products ourselves, based on the needs and preferences of different customers and efficiency considerations. Therefore, as a percentage of the cost of products sold, the self-made products and outsourced products have varied significantly from time to time. As our self-made products generally contribute higher margins than products purchased from outside vendors, sales of a greater portion of self-made products generally result in lower costs of products sold. The cost of products sold for fiscal year ended June 30, 2011 was approximately $6.4 million, an increase of approximately $2.7 million, compared to approximately $3.7 million for the prior fiscal year.
Gross Margin: For the fiscal year ended June 30, 2011, as a percentage of total revenues, the overall gross margin was 34.7%, compared to 34.6% for the prior fiscal year. The gross margin for integrated contracts was 33.5% for the year ended June 30, 2011, compared to 32.8% for the prior year. The increase in gross margin for integrated contracts was due mainly to our different sales mix during the fiscal 2011 period. The gross margin for products sold was 55.4% for the fiscal year ended June 30, 2011, compared to 63.2% for the prior fiscal year.
Selling Expenses: Selling expenses mainly consist of compensation, traveling and administrative expenses related to marketing and sales and promotion activities of the Company’s marketing departments. Selling expenses were approximately $20.5 million for the fiscal year ended June 30, 2011, an increase of 68.3%, or approximately $8.3 million, compared to approximately $12.2 million for the prior fiscal year, mainly due to the Company’s expanded sales network and increased selling staffs. As a percentage of total revenues, selling expenses accounted for 7.8% and 7.0% for the fiscal year ended June 30, 2011 and 2010, respectively. The Company has established guidelines to monitor and evaluate sales performance for its products to customers in different industries and regions to control selling expenses.
General and administrative expenses: General and administrative expenses mainly include compensation, traveling and other administrative expenses of non-sales-related departments, such as the planning and finance department, information systems department and human resources department. General and administrative expenses amounted to approximately $16.7 million for the fiscal year ended June 30, 2011, representing an increase of approximately $2.8 million, or 19.8%, compared to approximately $13.9 million for the prior fiscal year, mainly due to increased labor cost. As a percentage of total revenues, G&A expenses were 6.1% and 7.7% for the fiscal year 2011 and 2010, respectively.
Research and Development Expenses: Research and development expenses comprise mostly employee compensation, materials consumed and experiment expenses for specific new product research and development, and any expenses incurred for basic research on advanced technologies. For the fiscal year ended June 30, 2011, research and development expenses were approximately $20.1 million, compared to approximately $13.1 million for the prior fiscal year. The approximate $7.1 million, or 54.0%, increase was mainly due to increased research and development activities during the 2011 period. As a percentage of total revenues, research and development expenses were 7.7% and 7.5% for the fiscal years ended June 30, 2011 and 2010, respectively.
VAT Refunds and Government Subsidies: The state tax bureaus in Beijing and Hangzhou provide financial subsidies out of the value added tax they collect in order to encourage the research and development efforts of certain enterprises. Beijing Hollysys and Hangzhou Hollysys both received such refunds. All VAT refunds are with no further conditions to be met, and are recognized in income statement when cash or approval from tax bureaus is received. For the fiscal year ended June 30, 2011, VAT refunds were approximately $9.0 million, compared to approximately $9.0 million for the prior fiscal year, increased by approximately $0.02 million, or 0.2%. As a percentage of total revenues, VAT refunds were 3.4% and 5.2% for the fiscal years ended June 30, 2011 and 2010, respectively.
The local governments in Beijing and Hangzhou also provide financial subsidies to encourage development of certain enterprises. Beijing Hollysys and Hangzhou Hollysys both received such subsidies. For the government subsidies that with no further conditions to be met, the amounts are recognized in income statement when received; for the amounts with certain operating conditions, the government subsidies are recorded as liabilities when received and will be released to income statement when the conditions are met Gross subsidy income received from the government amounted to approximately $1.8 million and approximately $2.6 million for the fiscal year ended June 30, 2011 and 2010, respectively, a decrease of approximately $0.8 million, or 28.9%.
Income from Operations: Income from operations increased by approximately $12.1 million, from approximately $32.6 million for the fiscal year ended June 30, 2010, to approximately $ 44.7 million for the fiscal year ended June 30, 2011. The increase in income from operations was primarily due to the increased revenue.
Gains on disposal of shares of equity investees: The gains on disposal of shares of equity investees amounted to $1.4 million for fiscal year 2011, which was mainly contributed by the gain on disposal of a 29% interest in Hollysys Information Technology Co. Ltd. which Hollysys will continue to own 20% after the transaction.
Gain in earnings for the issuance of shares by an equity investee: The gain in earnings for the issuance of shares by an equity investee was $0.8 million for the year ended June 30, 2011, which was from the issuance of shares by IPE Biotechnology Co., Ltd (hereafter “IPE”). In April 2011, a third party company injected $4.5 million to IPE, of which $0.9 million was recognized as the paid in capital, and the remaining $3.6 million was recognized as capital premium. As a result of this capital increment, Hollysys’ equity interest in IPE was diluted from 28.04% to 23.39%, and recognized a gain of $0.8 million from this dilution.
Interest Expenses, Net: For the year ended June 30, 2011, net interest expenses increased by approximately $0.5 million, or 47.4%, from approximately $1.1 million for the prior year, to approximately $1.6 million for the current period. As a percentage of total revenue, net interest expense accounted for 0.6% and 0.6% for the fiscal years ended June 30, 2011 and 2010, respectively.
Income Tax Expenses: For the year ended June 30, 2011, the Company’s income tax expense was approximately $6.4 million for financial reporting purposes, a decrease of approximately $1.3 million, as compared to $7.7 million for the prior year. In fiscal 2011, Hangzhou Hollysys declared a cash dividend of $26.9 million, of which $10.8 million was to be paid to Gifted Time Holdings Limited, a BVI company. According to the tax treaty between China and the BVI, the Company recognized a 10% withholding tax of $1.1 million. Excluding the withholding tax related to the dividends declaration for fiscal 2011, and a one-time tax expense of $4.5 million related to Hollysys’ group re-organization recorded in the prior year, as discussed below. The effective tax rate was 11.2% and 9.1% for the year ended June 30, 2011 and 2010, respectively.
Net income attributable to noncontrolling interests: The noncontrolling interests of the Company includes other parties’ interests in each subsidiary. For fiscal 2011 and 2010, the noncontrolling interests is ownership interests of 49% in WodeWeiYe and Hollycon, respectively. The net loss attributable to noncontrolling interests for the fiscal year ended June 30, 2011 was $5 thousand, a decrease of $1.9 million, from a net income of $1.9 million for the prior year, primarily due to the decrease in noncontrolling interests after the acquisition of the remaining 24.11% interest of Beijing Hollysys by the Company during fiscal 2010.
Net income and Earnings per share attributable to Hollysys: For the fiscal year ended June 30, 2011, net income attributable to Hollysys amounted to approximately $41.5 million, representing an increase of approximately $15.8 million, as compared to approximately $25.7 million for the prior year. The basic and diluted earnings per share were $0.76 and $0.75 for the year ended June 30, 2011, as compared to $0.50 and $0.50 for the prior year, representing an increase of $0.26 and $0.25, respectively. Such increase was primarily due to an increase of approximately $31.0 million in gross profit.
B. Liquidity and Capital Resources
We believe our working capital is sufficient to meet our present requirements. We may, however, require additional cash due to changing business conditions or other future developments, including any investments or acquisitions we may decide to pursue. In the long-term, we intend to rely primarily on cash flow from operations and additional borrowings from banks to meet our anticipated cash needs. If our anticipated cash flow and borrowing capacity is insufficient to meet our requirements, we may also seek to sell additional equity, debt or equity-linked securities. We cannot assure you that any financing will be available in the amounts we need or on terms acceptable to us, if at all.
In line with the industry practice, we typically have a long receivable collection cycle. As a result, our cash provided by our operations in any given year may not be sufficient to fully meet our operating cash requirements in that year. We will use available financing means, including bank loans, to provide sufficient cash inflows to balance timing differences in our cash flows.
We estimate our liquidity needs for investing and financing activities for 2013 will be approximately $30 million, which will be primarily related to the repayment of bank borrowings and the capital expenditures, mainly consist of cash payments for phase II of Yizhuang facility construction. Our future working capital requirements will depend on many factors, including, among others, the rate of our revenue growth, the timing and extent of expansion of our sales and marketing activities, the timing of introductions of new products and/or enhancements to existing products, and the timing and extent of expansion of our manufacturing capacity.
Our long-term liquidity needs will relate primarily to working capital to pay our suppliers, and third-party manufacturers, as well as any increases in manufacturing capacity or acquisitions of third party businesses that we may seek in the future. We expect to meet these requirements primarily through our current cash holdings, revolving short-term bank borrowings, as well as our cash flow from operations. For fiscal year 2013, we expect a $20 million capital expenditure program, mainly related to the cash payments for phase II of Yizhuang facility construction. We currently do not have any plan to incur significant capital expenditures for the foreseeable future beyond 2013.
Cash Flow and Working Capital
As of June 30, 2011 and 2012, we had approximately $90.7 million and $96.3 million, respectively, in cash and cash equivalents. As of June 30, 2012, we had total assets of $552.8 million, of which cash and cash equivalents amounted to $96.3 million, time deposits with original maturities over three months amounted to $21.6 million, accounts receivable amounted to $136.6 million and inventories amounted to $26.7 million. While working capital was approximately $248.8 million, equity amounted to $338.1 million and our current ratio was approximately 2.3.
See Item 8, Financial Information, A. Consolidated Statements and Other Financial Information, Dividend Policy, for information on the ability of certain of our subsidiaries in China to make dividends to their respective parent companies.
The following table shows our cash flows with respect to operating activities, investing activities and financing activities for the fiscal years ended June 30, 2010, 2011 and 2012:
For the fiscal year ended June 30, 2012, net cash provided by operating activities was approximately $57.2 million, compared to net cash used by operating activities of approximately $1.8 million for prior fiscal year 2011.
The net cash inflow of operating activities in fiscal year 2012 was primarily due to net income of approximately $56.6 million, and changes in working capital attributable to an increase in deferred revenue of approximately $14.4 million, an increase in accounts payable of approximately $8.8 million, all of which were partially offset by an increase in accounts receivable of approximately $16.9 million, and an increase in cost and estimated earnings in excess of billings of approximately $24.7 million.
For the fiscal year ended June 30, 2011, net cash used in operating activities was approximately $1.8 million, compared to a net cash inflow of approximately $30.2 million for prior fiscal year 2010. The net cash outflow of operating activities in fiscal year 2011 was primarily due to changes in working capital attributable to an increase in cost and estimated earnings in excess of billings of approximately $42.6 million, an increase in accounts receivable of approximately $30.2 million, and an increase of inventories of approximately $3.5 million, all of which were partially offset by the net income of approximately $41.5 million, an increase in deferred revenue of approximately $8.0 million, an increase in accruals and other payables of approximately $2.1 million, an increase of accounts payable of approximately $18.5 million.
For the fiscal year ended June 30, 2010, net cash provided by operating activities was approximately $30.2 million, compared to approximately $40.1 million for prior fiscal year 2009. The net cash inflow from operating activities in fiscal year 2010 was primarily due to the net income of approximately $27.6 million, and changes in working capital attributable to an increase in deferred revenue of approximately $12.5 million, an increase in accruals and other payables of approximately $6.0 million, an increase of accounts payable of approximately $5.0 million, and an increase of $5.0 million in income tax payable, all of which were partially offset by an increase in cost and estimated earnings in excess of billings of approximately $10.2 million, an increase in accounts receivable of approximately $10.1 million, and an increase of inventories of approximately $6.0 million.
For the fiscal years ended June 30, 2012 and 2011, net cash used in investing activities was approximately $27.9 million and approximately $29.1 million, respectively.
The net cash used in investing activities for the fiscal year 2012 consisted mainly of a cash outflow of approximately $21.6 million transferred from current accounts to time deposits in banks with original maturities between six months and one year, a cash outflow of approximately $5.3 million paid for acquisition of Concord, net of cash acquired, a cash outflow of approximately $5.0 million for capital expenditures, and a cash inflow of approximately $4.4 million related to disposal of shares of equity investees.
The net cash used in investing activities for the fiscal year 2011 consisted mainly of a cash outflow of approximately $16.9 million for prepayment for acquisition of Concord Group, a cash outflow of approximately $16.1 million for capital expenditure.
The net cash used in investing activities for the fiscal year 2010 consisted mainly of a cash outflow of approximately $20.9 million for the construction of our new facility.
For fiscal year ended June 30, 2012, net cash used in financing activities was approximately $25.3 million, as compared to approximately $2.8 million for the prior year.
The net cash outflow for fiscal year 2012 is composed of a repayment of short-term bank loans of approximately $12.3 million, a repayment of amount due to the former shareholders of subsidiaries of approximately $8.2 million, a repayment of long-term bank loans of approximately $6.0 million, the proceeds from the exercise of options of approximately $0.7 million, and proceeds of short-term loans of approximately $0.6 million.
The net cash outflow for fiscal year 2011 is composed of a repayment of bonds payable of approximately $12.1 million, a repayment of short-term bank loans of approximately $5.9 million, a repayment of long-term bank loans of approximately $1.51 million, the proceeds of short-term loans of approximately $15.7 million, and proceeds from the exercise of options of approximately $1.1 million.
For fiscal year ended June 30, 2010, net cash used in financing activities was approximately $19.2 million, as compared to approximately $35.9 million cash provided by financing activities for the prior year. The net cash outflow for fiscal year 2010 is composed of a cash outflow of $10.4 million in the acquisition of equity interest from noncontrolling interest, a repayment of short-term bank loans of approximately $4.4 million, a repayment of long-term bank loans of approximately $5.1 million, and a capital injection from noncontrolling interest of $0.7 million.
On March 31, 2009, the Company entered into a seven-year bank loan for RMB 250 million from Industrial and Commercial Bank of China, which is due on March 30, 2016, with an annual interest rate of 6.44%. The borrowing was secured by a pledge of the new headquarters facility in Beijing, comprised of prepaid land leases and buildings with an aggregate carrying value of $37.8 million and $41.1 million as of June 30, 2011 and 2012, respectively. Principal amount of $7.1 million was due and repaid before June 30, 2012, and the scheduled principal payments for the outstanding balance on June 30, 2012 are as follows:
C. Research and Development, Patents and Licenses, Etc.
Research and Development Efforts
As a high-technology company, our business and long-term development rely highly on our research and development capabilities. Our research and development process is based on Capability Maturity Model Integration Level 2&3 and can be classified into the following seven phases:
We use standard project development life cycle models, including the waterfall model, increment model, iterative model and prototype. As a technology leader we continually develop and patent new automation technologies. We also continually review and evaluate technological changes affecting the automation and integrated system industries and invest substantially in application-based research and development. We currently employ over 750 staff in the research and development department or engaged in research and development work.
Our core technologies achieved from our research and development efforts include:
We are committed to incorporating the latest advances in electronics and information system technology into its products and, whenever possible, developing state-of-the-art proprietary products based on its extensive internal expertise and research efforts. We currently spend approximately 7-8% of our annual revenues on research and development. Because part of our research and development efforts are paid for by government subsidies that aim to encourage research and development efforts of certain enterprises, the amount of our research and development spending shown on our financial statements (the total amount of spending less the amount of these subsidies) is only a portion of our total spending on research and development. Our recent major research and development focuses include:
Our research and development efforts have led to the invention of several proprietary systems in the fields of DCS and transportation automation systems. In July 2012, we completed the development of and released our 5th generation DCS (Distributed Control System), which represents higher reliability, stability, better safety protection and user-friendliness with advanced system architecture, hardware, software designs and industry expert solutions. In the same month we completed the development and certified our SIS (Safety Instrumented System) –HiaGuard with SIL3 (Safety Integrity Level 3) in compliance with international standards. HiaGuard is the first domestically developed SIS technology and breaks the monopoly held by foreign systems in China in this product. Hollysys’ HiaGuard can be applied for ESD (Emergency Shutdown System), PSD (Process Shutdown System), and FGS (Fire and Gas Systems) used in various industries. Our core technologies provide a platform that is designed to enable the rapid and efficient development of our technologies for specific applications that are quickly, efficiently and affordably tailored to particular industries and to the needs of our customers. Our software development tools enable us to custom program our systems rapidly, allowing us to apply digital technologies that take advantage of the tremendous advances in electronics and information technology to improve quality and reliability while reducing cost. The market for our products includes, not only the large number of factories that are continually under construction in China’s rapidly expanding industrial base, but also extends to the replacement and upgrading of outdated legacy systems to bring a higher degree of control and efficiency to the automation of processes, delivering increasing benefits to customers as they meet increased competition. In the future we expect that the market for our products will extend to South Asia and the Middle East.
For the fiscal years 2012, 2011, and 2010, aggregate annual research and development expenses were approximately $25.6 million, $20.1 million, and $13.1 million respectively.
Intellectual Property Rights
We rely on a combination of copyright, patent, trademark and other intellectual property laws, nondisclosure agreements and other protective measures to protect our proprietary rights. We also utilize unpatented proprietary know-how and trade secrets and employ various methods to protect our trade secrets and know-how. As of June 30, 2012, we held 95 software copyrights, 80 authorized patents, 45 patent applications and 21 registered trademarks. Our earliest software copyrights will expire in 2048. Our invention patents have terms of 20 years (with the first and the next issued patent expiring in fiscal year 2013 and 2025), and our utility patents and design patents have terms of 10 years (with both of the first and the next issued utility patent expiring in fiscal year 2015 and the first and the next issued design patent due to expire in fiscal year 2016 and 2017 respectively.)
Although we employ a variety of intellectual property in the development and manufacturing of products, we believe that only a few of our intellectual property rights are critical to our current operations. However, when taken as a whole, we believe that our intellectual property rights are significant and that the loss of all or a substantial portion of such rights could have a material adverse effect on our results of operations. Also, from time to time, we may desire or be required to renew or to obtain licenses from others in order to further develop and manufacture commercially viable products effectively.
We market our DCS products mainly under the brand name of “HOLLiAS”. Our brand name is well-established and is recognized as associated with high quality and reliable products by industry participants and customers. We have obtained trademark protection for our brand name “HOLLiAS” in the PRC as well as in other countries in the world. In addition, we have also registered or applied for a series of trademarks including brand names for us and our products. The trademarks are issued for 10-year periods (and may be renewed prior to expiration).
D. Trend Information
Other than as disclosed in the foregoing disclosures and elsewhere in this annual report, we are not aware of any trends, uncertainties, demands, commitments or events for the fiscal year 2012 that are reasonably likely to have a material adverse effect on our net revenues, income, profitability, liquidity or capital resources, or that caused the disclosed financial information to be not necessarily indicative of future operating results or financial conditions.
E. Off-Balance Sheet Arrangements
We do not believe that there are any off-balance sheet arrangements that have or are reasonably likely to have a material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
F. Tabular Disclosure of Contractual Obligations
The following table sets forth our contractual obligations, including long-term and short-term loans and operating leases and capital and operational commitments as of June 30, 2012.
It represents the future minimum payments under non-cancelable operating leases.
As of June 30, 2012, the Company had approximately $140.2 million in purchase obligations for the coming fiscal year, for purchases of equipment, mainly for fulfillment of in-process or newly entered contracts resulting from the expansion of our operations.
As of June 30, 2012, the Company had approximately $13.0 million in capital obligations for the coming fiscal year, mainly for the phase II of the construction of the Company’s headquarters in Beijing, PRC.
We have provided performance bonds to our customers, to insure our performance of the contractual obligations. When a performance bond is issued, a proportion of the total guarantee amount may be required to be deposited in the bank, and is not available until the bond is expired. As of June 30, 2012, we had approximately $5.5 million restricted cash deposited in banks for performance guarantees.
Other than the contractual obligations and commercial commitments set forth above, we did not have any other long-term debt obligations, operating lease obligations, capital commitments, purchase obligations or other long-term liabilities as of June 30, 2012.
G. Safe Harbor
All information included in Item 5.E of this Item is deemed to be a “forward looking statement” as that term is defined in the statutory safe harbors, except for historical facts. The safe harbor provided in Section 27A of the Securities Act and Section 21E of the Exchange Act shall apply to all forward-looking information provided in Item 5.E and F of this Item.
A. Directors and Senior Management
The following table sets forth certain information regarding our directors and senior management as of the date of this annual report.
Dr. Changli Wang, has been our director and Chief Executive Officer since September 2007 and has been our Chairman since May 2010. Since 1999, Dr. Wang has also been the Chief Executive Officer and Vice Chairman of our subsidiary, Beijing Hollysys. Prior to founding Beijing Hollysys in 1993, Dr. Wang worked for the No. 6 Institute of Electronic Industry Department, the predecessor of Beijing Hollysys. Dr. Wang also has been the Vice Chairman of the Chinese Automation Association since 2003. Dr. Wang received his Bachelor’s degree in Automation from Tianjin University in 1984 and his PhD in Automation from Lancaster University in 1988.
Ms. Herriet Qu, has been our Chief Financial Officer since February 2012. Prior to being appointed to the position of Chief Financial Officer, Ms. Qu worked as the Financial Controller of the Company from October 2007 to January 2012. Prior to Ms. Qu joining the Company, she worked as Chief Financial Officer of Beijing Chum Investment Corporation Ltd. from January 2002 to September 2007. Ms. Qu holds an MBA degree from Oklahoma City University and a Bachelor’s degree from Tianjin University of Finance & Economics.
Mr. Jianfeng He, has been our Chief Operating Officer since February 2012. Mr. He has been with Hollysys and its subsidiaries for more than fourteen years, most recently as the Chief Executive Officer of Beijing Hollysys Group Corporation, a subsidiary of Hollysys. Mr. He has a PhD from South China University of Technology.
Mr. Baiqing Shao, has been our Senior Vice President, Business Development since February2012. Prior to being appointed as Senior VP, Business Development, he was in charge of merger and acquisitions and new business exploration. Mr. Shao was Vice President of Beijing Hollysys Group Corporation prior to his current position. Mr. Shao has been with Company for more than eighteen years as one of the founding group of engineers. He holds a Masters of Computer Science from the 6th Research Institute of China Electronics Corporation and an MBA from Peking University.
Mr. Colin Sung, has been our director and the Chair of our Audit Committee since February 2008. Mr. Sung has been adviser of NeWorld Education Group, Inc. since August 2012 and was Chief Financial Officer of NeWorld Education Group since August 2011. Prior to joining NeWorld, he was the CFO of Lighting the Box from March 2011. Mr. Sung served as the deputy Chief Executive Officer and the Chief Financial Officer of Linktone Ltd., a NASDAQ-listed wireless interactive entertainment service provider in China, from 2009 to 2011. From 2008 to 2009, he served as the Chief Financial Officer and President of China Cablecom Holdings, Ltd. From 2005 to 2008, he was the Chief Financial Officer of Linktone Ltd., where he also served as the acting Chief Executive Officer in 2006 and as its director of board from 2007 to 2008. From 2004 to 2005, Mr. Sung was the Corporate Controller of UTI, United States, Inc., a subsidiary of International Freight Forwarder (NASDAQ: UTIW), and from 2001 to 2004, was a Vice President of finance and Corporate Controller of USF Worldwide, Inc., a subsidiary of US Freightways. From 1997 to 2001, Mr. Sung was Vice President and Corporate Controller for US Operation of Panalpina Welttransport Holding, (PWTN.SW). Mr. Sung received his bachelor’s degree in accounting from William Paterson University in 1992 and his MBA degree from American InterContinental University in 2004. Mr. Sung is a Certified Public Accountant and Certified Global Management Accountant.
Ms. Jerry Zhang, has been our director since September 2007. Ms. Zhang is currently the Head of Financial Institutions, Standard Chartered Bank (China) Limited. She leads a group of professional bankers, who are responsible for providing banking solutions to banks and non-bank financial institutions (including government, NGOs, etc.) present and doing business in China. She joined Standard Chartered Bank in 1994. For years she hold the role of the Head of Investors & Intermediaries, responsible for relationship management of broker dealers, insurance companies, fund managers, development organizations, finance/trust companies and professional firms throughout China. Prior to re-joining the Bank in April 2009, she was a Chief Representative of Fidelity International Asset Management Co. Beijing Representative Office. Ms. Zhang received her Bachelor’s degree in electronic and mechanical engineering and obtained an MBA from Lancaster University in the United Kingdom in 2000.
Dr. Jianyun Chai, has been our director since June 2, 2008. Dr. Chai is currently a professor and the head of the Institute of Power Electronic and Electrical Machine System at Tsinghua University in China. Before he joined Tsinghua University as an Associate Professor in 1999, Dr. Chai spent eight years working in the motor and information industries in Japan. Dr. Chai is also a member of various societies and organizations, including the China Renewable Energy Society, the Chinese Society for Electrical Engineering, and the Chinese Wind Energy Association. Dr. Chai received a Bachelor’s degree and a PhD in Electrical Engineering from Tsinghua University in 1984 and 1989, respectively.
Mr. Qingtai Chen, has been our director since June 2, 2008. Mr. Chen has worked for the Dong Feng Motor Group for over 22 years and served as its General Manager prior to joining the Company. While employed by the Dong Feng Motor Group, Mr. Chen also served in various positions, including as a member of the First Session of the Monetary Policy Committee of the People’s Bank of China, as a deputy director of the State Council Economic and Trade Office, as a deputy director of the State Economic and Trade Commission, and as a deputy director of the Development Research Center of the State Council. Mr. Chen also served from 2000 to 2006 as an independent director of Sinopec Corp. Mr. Chen received his Bachelors of Science degree in power and dynamics engineering from Tsinghua University and has been recognized as a National Excellent Entrepreneur and National Economic Reform Talent in China. Mr. Chen currently serves as a standing member of National Committee of the Chinese People’s Political Consultative Conference and as the Dean of the School of Public Policy and Management at Tsinghua University. He also serves as an independent director for the Bank of Communications, which is listed on both Shanghai Stock Exchange and Hong Kong Stock Exchange, and as an independent director of Mindray Medical International Limited, which is listed on New York Stock Exchange.
10b5-1 Trading Plans
Our Insider Trading Policy allows directors, officers and other employees covered under the policy to establish, under limited circumstances contemplated by Rule 10b5-1 under the Securities Exchange Act of 1934, written programs that permit automatic trading of our stock or trading of our stock by an independent person (such as an investment bank) who is not aware of material inside information at the time of the trade. From time to time, certain of our directors, executive officers and employees have adopted Rule 10b5-1 trading plans. Currently, three of our officers and directors have entered into purchase plans under Rule 10b5-1.
The aggregate cash compensation paid to our executive officers as a group was $810,806 for the fiscal year ended June 30, 2012. In the fiscal year ended June 30, 2012, we granted stock options for a total of 1,476,000 ordinary shares under the long-term incentive plan of the company to 9 individuals, including options for 801,000 ordinary shares to the senior executives listed in the table above under Part A of this section. The awards have vesting periods of up to four years depending on the person’s position and all of the grants have specific performance milestones. Additionally, the awards have a provision that if in certain instances the milestones are exceeded by specified targets, then additional ordinary shares will vest for the related period. The exercise periods for the options are five years from the date of grant, February 20, 2012.
We pay each of our independent directors who are not employees a monthly fee as compensation for the services to be provided by them as independent directors. We pay $4,000 a month to Colin Sung, $3,000 to Jerry Zhang and $2,000 to each of other independent directors. We also reimburse our independent directors for out-of-pocket expenses incurred in attending meetings. As additional consideration, we granted to each of the independent directors an option to purchase a certain amount of shares of the Company’s ordinary shares, which vest in equal installments on a quarterly basis over a three-year period beginning on the grant date. Specifically, we granted a stock option to Colin Sung for the purchase of 45,000 shares of our ordinary shares, Jerry Zhang for the purchase of 36,000 shares of our ordinary shares and each of Dr. Jianyun Chai and Mr. Qingtai Chen for the purchase of 30,000 shares of our ordinary shares. Additionally, we grant to each of the independent director restricted shares, which vest in equal installments on a quarterly basis over a three-year period beginning on the grant date. Specifically, we granted 22,500 restricted shares to Colin Sung, and 15,000 to each of Jerry Zhang, Jianyun Chai and Qingtai Chen.
For the fiscal year ended June 30, 2012, the aggregate cash compensation paid to our directors as a group was approximately $132,000.
2006 Stock Plan
On September 7, 2007, our stockholders approved the 2006 Stock Plan, or the Plan. The Plan was assumed by us as of the closing of the merger of Chardan with and into us. The Plan provided for 3,000,000 ordinary shares for issuance in accordance with the Plan’s terms .As of the date of this report, there are 2,460,000 shares available under the Plan, of which 1,696,500 have been allocated to outstanding awards that have not vested or been exercised. A description of the Plan is set forth in the Proxy Statement/Prospectus of our Registration Statement on Form S-4 (No. 333-132826), under the heading “2006 Equity Plan”, and is incorporated herein by reference. The tables below set forth the outstanding options and the restricted shares granted to our current and former directors and executive officers pursuant to the Plan:
The above options vest quarterly over a period of 3 years from their respective grant date.
The following table sets forth options issued on February 20, 2012 to the named directors and officers in the table of Directors and Senior Management in Item 6, Section A above.
1 160,000 options vest on the 24, 36 and 48 month anniversaries of the date of grant if the CAGR of the Non-GAAP diluted EPS exceed stated thresholds on those dates, an additional 40,000 vest on the basis of the June 30, 2011 to June 30, 2014 Non-GAAP diluted EPS exceeds certain thresholds and an additional 40,000 vest if the foregoing thresholds are exceeded.
2 132,000 options vest on the 24, 36 and 48 month anniversaries of the date of grant if the CAGR of the Non-GAAP diluted EPS exceed stated thresholds on those dates, an additional 33,000 vest on the basis of the June 30, 2011 to June 30, 2014 Non-GAAP diluted EPS exceeds certain thresholds and an additional 33,000 vest if the foregoing thresholds are exceeded.
3 132,000 options vest on the 24, 36 and 48 month anniversaries of the date of grant if the CAGR of the Non-GAAP diluted EPS exceed stated thresholds on those dates, an additional 33,000 vest on the basis of the June 30, 2011 to June 30, 2014 Non-GAAP diluted EPS exceeds certain thresholds and an additional 33,000 vest if the foregoing thresholds are exceeded.
4 110,000 options vest on the 24, 36 and 48 month anniversaries of the date of grant if the CAGR of the Non-GAAP diluted EPS exceed stated thresholds on those dates, an additional 27,500 vest on the basis of the June 30, 2011 to June 30, 2014 Non-GAAP diluted EPS exceeds certain thresholds and an additional 27,500 vest if the foregoing thresholds are exceeded.
These options were part of an aggregate of 1,476,000 ordinary shares underlying options issued to senior management issued on February 20, 2012, all with similar vesting provisions.
The above options vest annually over a period of four years from their grant date, subject to different performance conditions and are exercisable once vested for up to five years from the date of grant.
The restricted shares set forth in the table above vest quarterly over a period of 3 years from their respective grant date.
We entered into a three-year employment agreement with our Chief Executive Officer, Dr. Changli Wang on June 6, 2010. Dr. Wang is entitled to insurance benefits, five weeks’ vacation, a car and reimbursement of business expenses and, if necessary, relocation expenses. The agreement is terminable by us for death, disability and cause. Dr. Wang may terminate the employment agreement for good reason, which includes our breach; the executive’s not being a member of the board of directors, and change of control. The agreements contain provisions for the protection of confidential information and a three-year-after employment non-competition period within China.
We entered into a three-year employment agreement with our Chief Financial Officer, Ms. Herriet Qu on February 1, 2012. Ms. Qu is entitled to insurance benefits, four weeks’ vacation, and reimbursement of business expenses and, if necessary, relocation expenses. The agreement is terminable by us for death, disability and cause. Ms. Qu may terminate the employment agreement for any good reason at any time. The agreements contain provisions for the protection of confidential information and a three-year-after employment non-competition period within China.
We entered into a three-year employment agreement with our Chief Operating Officer, Mr. Jianfeng He on February 1, 2012. Mr. He is entitled to insurance benefits, four weeks’ vacation, a car and reimbursement of business expenses and, if necessary, relocation expenses. The agreement is terminable by us for death, disability and cause. Mr. He may terminate the employment agreement for any good reason at any time. The agreements contain provisions for the protection of confidential information and a three-year-after employment non-competition period within China.
We entered into a three-year employment agreement with our Senior VP, business development, Mr. Baiqing Shao on February 1, 2012. Mr. Shao is entitled to insurance benefits, four weeks’ vacation, and reimbursement of business expenses and, if necessary, relocation expenses. The agreement is terminable by us for death, disability and cause. Mr. Shao may terminate the employment agreement for any good reason at any time. The agreements contain provisions for the protection of confidential information and a three-year-after employment non-competition period within China.
C. Board Practices
Terms of Directors and Executive Officers
Our board consists of five directors. Our directors are not subject to a term of office limitation, and hold office until the next annual meeting of members or until such director’s earlier resignation, removal from office, death or incapacity. Any vacancy on our board resulting from death, resignation, removal or other cause, and any newly created directorship resulting from any increase in the authorized number of directors between meetings of members, may be filled either by the affirmative vote of a majority of all the directors then in office (even if less than a quorum) or by a resolution of members.
Our executive officers are appointed by our board. The executive officers shall hold office until their successors are duly elected and qualified, but any officer elected or appointed by the directors may be removed at any time, with or without cause, by resolution of directors. Any vacancy occurring in any office may be filled by resolution of directors.
Independence of Directors
We have elected to follow the rules of NASDAQ to determine whether a director is independent. Our board will also consult with counsel to ensure that our board’s determinations are consistent with those rules and all relevant securities and other laws and regulations regarding the independence of directors. Rule 5605(a)(2) of Listing Rules of The Nasdaq Stock Market, Inc., or the Nasdaq Listing Rules, defines an “independent director” generally as a person, other than an officer of the Company, who does not have a relationship with the Company that would interfere with the director’s exercise of independent judgment. Consistent with these considerations, our board has affirmatively determined that, Messrs. Colin Sung, Jerry Zhang, Jianyun Chai and Qingtai Chen are our independent directors.
Our board has established an audit committee, a compensation committee and a corporate governance and nominating committee. Each committee is comprised solely of independent directors within the meaning of Rule 5605(a)(2) of the Nasdaq Listing Rules, and meet the criteria for independence set forth in Rule 10A-3(b)(1) of the Exchange Act.
Our audit committee consists of Messrs. Colin Sung, Qingtai Chen and Jerry Zhang, who are also the members of the board, with Mr. Sung serving as the Chair. Our board has determined that all of our audit committee members are independent directors within the meaning of applicable NASDAQ listing rules, and meet the criteria for independence set forth in Rule 10A-3(b)(1) of the Exchange Act.
Our board has determined that each of Messrs. Sung, Chen and Zhang has an understanding of generally accepted accounting principles and financial statements, the ability to assess the general application of such principles in connection with our financial statements, including estimates, accruals and reserves, experience in analyzing or evaluating financial statements of similar breadth and complexity as our financial statements, an understanding of internal controls and procedures for financial reporting, and an understanding of audit committee functions.
Our board believes that Mr. Sung qualifies as an “audit committee financial expert” within the meaning of all applicable rules. Our board believes that Mr. Sung has financial expertise from his degrees in business, his activities as a chief executive officer and chief financial officer of various companies, and his consulting activities in the areas of accounting, corporate finance, capital formation and corporate financial analysis.
We adopted an audit committee charter under which the committee is responsible for reviewing the scope, planning and staffing of the audit and preparation of the financial statements. This includes consultation with management, the auditors and other consultants and professionals involved in the preparation of the financial statements and reports. The committee is responsible for performing oversight of the relationship with our independent auditors. The committee also has a general compliance oversight role in assuring that our directors, officers and management comply with our code of ethics, reviewing and approving of related party transactions, dealing with complaints regarding accounting, internal controls and auditing matters, and complying with accounting and legal requirements applicable to us.
Pursuant to the terms of its charter, the audit committee’s responsibilities include, among other things:
Our compensation committee consists of Messrs. Jerry Zhang, Jianyun Chai and Colin Sung, with Jerry Zhang serving as its Chair. Our board has determined that all of our compensation committee members are independent directors within the meaning of applicable NASDAQ listing rules, and meet the criteria for independence set forth in Rule 10A-3(b)(1) of the Exchange Act.
Our compensation committee assists the board in reviewing and approving the compensation structure of our executive officers, including all forms of compensation to be provided to our executive officers. Our chief executive officer may not be present at any committee meeting during which his compensation is deliberated. The Compensation Committee is responsible for, among other things:
Corporate Governance and Nominating Committee
Our corporate governance and nominating committee consists of Messrs. Jerry Zhang, Jianyun Chai and Colin Sun, each of whom is “independent” as that term is defined under the NASDAQ listing standards. The corporate governance and nominating committee assists the board of directors in identifying individuals qualified to become our directors and in determining the composition of the board and its committees. The corporate governance and nominating committee is responsible for, among other things:
We had 3,527, 3,106 and 2,185 employees as of June 30, 2012, 2011, and 2010, respectively. As of June 30, 2012, there were 3,291 employees located in China and 236 employees outside China. The following table sets forth our employees as of June 30, 2012 based on their functional area within the Company:
We believe that our relationship with our employees is good. The remuneration payable to employees includes basic salaries and bonuses. We have not experienced any significant problems or disruption to our operations due to labor disputes, nor have we experienced any difficulties in recruitment and retention of experienced staff. As required by applicable Chinese laws, we have entered into employment contracts with all of our officers, managers and employees.
Our employees in China participate in a state pension scheme organized by Chinese municipal and provincial governments. We also contribute to social insurance for our employees each month, which includes pension, medical insurance, unemployment insurance, occupational injuries insurance and housing providence fund in accordance with PRC regulations.
E. Share Ownership
The following table sets forth information, as of September 30, 2012, with respect to the beneficial ownership of our ordinary shares (i) by each of our officers and directors; (ii) by each person who is known by us to beneficially own more than 5% of our ordinary shares; The table does not include any preferred shares or ordinary shares that may be issued under the Rights Plan of the company. The address of each of the persons set forth below is in care of Hollysys Automation Technologies Ltd., No. 2 Disheng Middle Road, Beijing Economic-Technological Development Area, Beijing, P. R. China 100176.
* Less than 1%.
None of our major shareholders have different voting rights from other shareholders. We are not aware of any arrangement that may, at a subsequent date, result in a change of control of our company.
A. Major Shareholders
Please refer to Item 6.E “Directors, Senior Management and Employees — Share Ownership.”
B. Related Party Transactions
Related Party Relationships
Due from related parties
The Company’s management believes that the collection of amounts due from related parties is reasonably assured and accordingly, no provision had been made for these balances.
Due to related parties
Transactions with related parties
Purchases of goods and services from:
Purchase of building from:
Operating lease expenses paid to:
Sales of goods and integrated solutions to:
Operating lease income from:
Amounts due from and due to the related parties relating to the above transactions are unsecured, non-interest bearing and repayable on demand.
Except as set forth in our discussion above, none of our directors, director nominees or executive officers has been involved in any transactions with us or any of our directors, executive officers, affiliates or associates which are required to be disclosed herein.
C. Interests of Experts and Counsel
A. Consolidated Statements and Other Financial Information
We have appended consolidated financial statements filed as part of this Annual Report. See Item 18 “Financial Statements.”
We are currently not a party to any material legal or administrative proceedings, and we are not aware of threatened material legal or administrative proceedings against us. We may from time to time become a party to various legal or administrative proceedings arising in the ordinary course of our business.
We anticipate that we will retain all of our future earnings, if any, for use in the expansion and operation of our business and do not anticipate paying cash dividends in the foreseeable future. Any future determination relating to our dividend policy will be made at the discretion of our board of directors, based on our financial condition, results of operations, earnings, contractual restrictions, capital requirements, business prospects and other factors our board of directors may deem relevant.
Notwithstanding the understanding that earnings will be accumulated, our ability to pay dividends depends substantially on the receipt of dividends to us by our PRC and overseas subsidiaries. Each of our PRC subsidiaries may pay dividends only out of its accumulated distributable profits, if any, determined in accordance with its articles of association and the accounting standards and regulations in China. Pursuant to applicable PRC laws and regulations, 10% of after-tax profits of each of our consolidated PRC entities are required to be set aside in a statutory surplus reserve fund annually until the reserve balance reaches 50% of such PRC entity’s registered capital. Allocations from these statutory surplus reserves may only be used for specific purposes and are not distributable to us in the form of loans, advances, or cash dividends.
Under the New EIT Law and its implementation rules issued by the PRC State Council, both of which became effective on January 1, 2008, dividends from our PRC subsidiaries to us may be subject to a withholding tax at the rate of 10% if the dividend is derived from profits generated after January 1, 2008. If we are deemed to be a PRC resident enterprise, the withholding tax may be exempted, but in such a case we will be subject to a 25% tax on our global income, and our non-PRC investors may be subject to PRC income tax withholding. For a more detailed discussion of the New EIT Law, see Item 10 - Additional Information, Subpart E, Taxation in China of this Form 20-F.
B. Significant Changes
A. Offer and Listing Details
The common stock, warrants and units of Chardan, our predecessor, were quoted on the Over-the-Counter Bulletin Board maintained by the National Association of Securities Dealers, under the symbols of CNCA, CNCAW and CNCAU, respectively. Chardan units commenced public trading on August 3, 2005 and common stock and warrants commenced public trading on August 31, 2005. On September 20, 2007, we merged with and into Chardan simultaneously with our acquisition of Gifted Time. From September 20, 2007 to July 31, 2008, our ordinary shares were quoted on the OTCBB under the symbol “HLSYF.OB.” On August 1, 2008, our ordinary shares were approved to be listed on the NASDAQ Global Select Market, under the symbol “HOLI”.
The following table provides the high and low trading prices for our ordinary shares and the historical prices for our common stock/ordinary shares, warrants and units prior to the merger, for the periods indicated below.
(1) On September 20, 2007, we changed our fiscal year end from December 31 to June 30, in connection with the acquisition of Gifted Time and our re-domestication to the BVI.
(2) Since August 1, 2008, our ordinary shares have been traded on the NASDAQ Global Select Market. The above table sets forth the range of high and low closing prices per share of our ordinary shares as reported by www.quotemedia.com for the periods indicated.
(3) All periods end June 30 of the stated year, unless otherwise noted.
B. Plan of Distribution
See our disclosures under “Item 9. A. Offer and Listing.”
D. Selling Shareholders
F. Expenses of Issue
A. Share Capital
B. Memorandum and Articles of Association
The following represents a summary of certain key provisions of the Company’s amended and restated memorandum and articles of association. The summary does not purport to be a summary of all of the provisions of our memorandum and articles of association and of all relevant provisions of BVI law governing the management and regulation of BVI companies.
The Company was incorporated in the BVI on February 6, 2006 under the BVI Business Companies Act, 2004, or the 2004 Act. The Company filed a Certificate of Change of Name to change its name from HLS Systems International, Inc. to Hollysys Automation Technologies Ltd. on July 17, 2009. The Company’s memorandum of association authorizes the issuance of up to 100,000,000 ordinary shares of $0.001 par value, and (ii) 90,000,000 preferred shares of $0.001 par value.
Objects and Purposes
The Company’s memorandum of association grants the Company full power and capacity to carry on or undertake any business or activity and do any act or enter into any transaction not prohibited by the 2004 Act or any other BVI legislation.
A director must, immediately after becoming aware of the fact that he is interested in a transaction entered into or to be entered into by us, disclose such interest to the board of directors, unless (i) the transaction or proposed transaction is between the director and (ii) the transaction or proposed transaction is or is to be entered into in the ordinary course of our business and on usual terms and conditions. The director who is interested in a transaction entered into or to be entered into by the Company may (i) vote on a matter relating to the transaction; (ii) attend a meeting of directors at which a matter relating to the transaction arises and be included in the quorum; and (iii) sign a document on behalf of the company, or do any other thing in his capacity as a director, that relates to the transaction.
The directors may fix their compensation for services rendered to us.
By a resolution of directors, the directors may exercise all our powers to borrow money, mortgage or charge our undertakings and property, issue debentures, denture stock and other securities whenever money is borrowed or as security for any debt, liability or obligation occurred by us or of any third party.
Each director holds office until his successor takes office or until his earlier death, resignation or removal by the members or a resolution passed by the majority of the remaining directors.
A director shall not require a share qualification.
Directors may only be removed for cause by the shareholders.
To the fullest extent permitted by the 2004 Act, none of our directors shall be personally liable to the Company or its shareholders for or with respect to any acts or omissions in the performance of his or her duties as a director of the Company.
Rights and Obligations of Shareholders
Subject to the 2004 Act, the directors may, by resolution of directors, declare dividends and distributions by the Company to members and authorize payment on the dividends or distributions so long as that immediately after the distribution, the value of the Company’s assets exceeds its liabilities and the Company is able to pay its debts as they fall due. Any distribution payable in respect of a share which has remained unclaimed for three years from the date when it became due for payment shall, if the board of the directors so resolves, be forfeited and cease to remain owing by the Company. The directors may, before authorizing any distribution, set aside out of the profits of the Company such sum as they think proper as a reserve fund, and may invest the sum so set apart as a reserve fund upon such securities as they may select.
The holder of each ordinary share has the right to an equal share in any distribution paid by the Company.
Each ordinary share confers on the shareholder the right to one vote at a meeting of the members or on any resolution of members on all matters before the shareholders of the Company.
Rights in the event of winding up
The holder of each ordinary share is entitled to an equal share in the distribution of the surplus assets of the Company on a winding up.
The Company may purchase, redeem or otherwise acquire and hold its own shares with the consent of members whose shares are to be purchased, redeemed or otherwise acquired unless the Company is permitted by the 2004 Act or any provision of the amended and restated memorandum of association or the amended and restated articles of association to purchase, redeem or otherwise acquire the shares without their consent.
The Company may purchase, deem or otherwise acquire its shares at a price lower than the fair value if permitted by, and then only in accordance with, the terms of the amended and restated memorandum of association or the amended and restated articles of association or a written agreement for the subscription for the shares to be purchased, redeemed or otherwise acquired.
Changes in the rights of shareholders
The directors are authorized to issue new classes or series of shares and the rights attached thereto. However, the rights attached to any class or series of shares (unless otherwise provided by the terms of issue of the shares of that class or series), whether or not the Company is being wound-up, must be varied with the consent in writing of all the holders of the issued shares of that class or series or with the sanction of a resolution passed by a majority of the votes cast at a separate meeting of the holders of the shares of the class or series.
An annual meeting of members must be held each year at such date and time as may be determined by the directors and if requested to do so by members holding at least 30% of the voting rights in respect of the matter for which the meeting is being held. No less than ten days and not more than sixty days notice of meetings is required to be given to members.
A meeting of members is properly constituted if at the commencement of the meeting there are two members present in person or by proxy or (in the case of a member being a corporation) by its duly authorized representative representing not less than one third of the votes of the shares or class or series of shares entitled to vote on resolutions of members to be considered at the meeting.
A member shall be deemed to be present at the meeting if he participates by telephone or other electronic means and all members participating in the meeting are able to hear each other.
An ordinary resolution of members may be approved at a duly constituted meeting of members by the affirmative vote of a simple majority of the votes of those members entitled to vote and voting on the resolution.
A special resolution of members may be approved at a duly constituted meeting of members by a vote of not less than two-thirds of votes of those members entitled to vote.
A meeting of members convened to consider a special resolution (other than an annual general meeting) may be called on short notice if members holding not less than 90% of the total number of shares entitled to attend the meeting and vote on all matters to be considered at the meeting waive the required notice for the meeting. Attendance at the meeting is deemed to constitute waiver.
The inadvertent failure of the directors to give notice of a meeting to a member, or the fact that a member has not received notice, does not invalidate the meeting.
A member may be represented at a meeting of members by a proxy who may speak and vote on behalf of the member. A written instrument giving the proxy such authority must be produced at the place appointed for the meeting before the time for holding the meeting at which such person proposes to vote.
Limitations on Ownership of Securities
There are no limitations on the right of non-residents or foreign persons to own the Company’s securities imposed by BVI law or by the Company’s amended and restated memorandum of association and articles of association.
Change in Control of Company
While directors of the Company may be appointed by the members or directors for such terms as may be determined at the time of such appointment, and may be removed by resolution of directors with or without cause, directors may not be removed by the members except for cause.
A special resolution of members is required for the Company to issue shares of the Company or securities convertible into shares of the Company resulting in a change of control of the Company. Additionally, the board of directors has the power to issue preferred shares with such rights attaching to them as they decide and that this power could be used in a manner that would delay, defer of prevent a change of control of our company.
There are no provisions governing the ownership threshold above which shareholder ownership must be disclosed.
Changes in Capital
Subject to the provisions of the 2004 Act, we may, by a resolution of directors or members, amend the Company’s memorandum and articles of association to increase or decrease the number of shares authorized to be issued. The directors of the Company may, by resolution, authorize a distribution (including a capital distribution) by the Company at a time, of an amount, and to any members they think fit if they are satisfied, on reasonable grounds, that the Company will, immediately after the distribution, satisfy the solvency test. The solvency test is satisfied if the value of the Company’s assets exceeds its liabilities, and the Company is able to pay its debts as they fall due.
Differences in Corporate Law
The company law of the BVI differs from laws applicable to U.S. corporations and their shareholders. Set forth below is a summary of the significant differences between the provisions of the companies law applicable to us and the laws applicable to companies incorporated in the United States and their shareholders.
Protection for minority shareholders
Under the laws of most U.S. jurisdictions, majority and controlling shareholders of a company generally have certain “fiduciary” responsibilities to the minority shareholders. Corporate actions taken by majority and controlling shareholders that are unreasonable and materially detrimental to the interests of minority shareholders may be declared null and void. Minority shareholders may have less protection for their rights under BVI law than they would have under U.S. law.
Powers of directors
Unlike most U.S. jurisdictions, the directors of a BVI company, subject in certain cases to court’s approvals but without shareholders’ approval, may implement the sale, transfer, exchange or disposition of any asset, property, part of the business, or securities of the company, with the exception that shareholder approval is required for the disposition of over 50% in the value of the total assets of the company.
Conflict of interests
Similar to the laws of most U.S. jurisdictions, when a director becomes aware of the fact that he has an interest in a transaction which the company is to enter into, he must disclose it to our board. However, with sufficient disclosure of interest in relation to that transaction, the director who is interested in a transaction entered into or to be entered into by the Company may (i) vote on a matter relating to the transaction; (ii) attend a meeting of directors at which a matter relating to the transaction arises and be included in the quorum; and (iii) sign a document on behalf of the company, or do any other thing in his capacity as a director, that relates to the transaction.
Written consent and cumulative voting
Similar to the laws of most U.S. jurisdictions, under the BVI law, shareholders are permitted to approve matters by way of written resolution in place of a formal meeting. BVI law does not make a specific reference to cumulative voting, and our current Memorandum and Articles of Association have no provision authorizing cumulative voting.
There is no requirement for a majority of the directors of the company to be independent as a matter of BVI law.
Our ordinary shares are not redeemable at a shareholder’s option. We may redeem our shares only with the consent of the shareholders whose shares are to be redeemed, except that the consent from the shareholders is not needed under the circumstances of compulsory redemption, which occurs at the request of the shareholders holding 90% of the votes of the outstanding ordinary shares entitled to vote, of the remaining issued shares.
On August 27, 2010, our Board of Directors adopted the 2010 Rights Plan. In connection with the 2010 Rights Plan, the Board of Directors declared a dividend distribution of one “Right” for each outstanding ordinary share to shareholders of record at the close of business on August 27, 2010, effective as of September 27, 2010. Each Right entitles the shareholder to buy one share of our Class A Preferred Stock at a price of $160. Unless terminated earlier by our Board of Directors, the 2010 Rights Plan will expire on September 27, 2020.
Initially, the Rights will be attached to all certificates representing ordinary shares then outstanding, and no separate Rights certificates or stock statements will be distributed or provided. The Rights will separate from the ordinary shares and become exercisable if a person or group announces an acquisition of 20% or more of our outstanding ordinary shares, or announces commencement of a tender offer for 20% or more of the ordinary shares. In that event, the Rights permit shareholders, other than the acquiring person, to purchase our ordinary shares having a market value of twice the exercise price of the Rights, in lieu of the Class A Preferred Stock. In addition, in the event of certain business combinations, the Rights permit the purchase of the ordinary shares of an acquiring person at a 50% discount. Rights held by the acquiring person become null and void in each case.
The 2010 Rights Plan is designed to ensure that all of our shareholders receive fair and equal treatment in the event of any proposed takeover of us and to guard against partial tender offers, open market accumulations and other abusive or coercive tactics to gain control of us without paying all shareholders a control premium. The Rights will cause substantial dilution to a person or group that acquires 20% or more of our stock on terms not approved by the our Board of Directors, but the Rights should not interfere with any merger or other business combination approved by the Board of Directors at any time prior to the first date that a person or group has become an acquiring person.
Shareholder’s access to corporate records
A shareholder is entitled, on giving written notice to the Company, to inspect the Company’s (i) Memorandum and Articles of Association; (ii) register of members; (iii) register of directors; and (iv) minutes of meetings and resolutions of members and of those classes of members of which the shareholder is a member.
The directors may, if they are satisfied that it would be contrary to the company’s interests to allow a member to inspect any document listed above (or any part thereof), refuse the member to inspect the document or limit the inspection of the document. Our board may also authorize a member to review the company account if requested.
Under our Memorandum and Articles of Association, we must indemnify our directors or any person who is or was, at the request of the Company, serving as a director of, or in any other capacity is or was acting for, another body corporate or a partnership, joint venture, trust or other enterprise against expenses (including legal fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such persons in connection with legal, administrative or investigative proceedings to which they are a party or are threatened to be made a party by reason of their acting as our directors or agents. To be entitled to indemnification, these persons must have acted honestly and in good faith and in what he believes to be the best interest of the Company, and they must have had no reasonable cause to believe their conduct was unlawful.
Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers or persons controlling us under the foregoing provisions, we have been advised that in the opinion of the SEC, such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.
Mergers and similar arrangements
Under the laws of the BVI, two or more companies may merge or consolidate in accordance with Section 170 of the 2004 Act. A merger means the merging of two or more constituent companies into one of the constituent companies, and a consolidation means the uniting of two or more constituent companies into a new company. In order to merge or consolidate, the directors of each constituent company must approve a written plan of merger or consolidation which must be authorized by a resolution of shareholders.
While a director may vote on the plan even if he has a financial interest in the plan of merger of consolidation, in order for the resolution to be valid, the interest must have been disclosed to our board forthwith upon him becoming aware of such interest. The transaction will not be avoidable if the shareholders approve or ratify it.
Shareholders not otherwise entitled to vote on the merger or consolidation may still acquire the right to vote if the plan of merger or consolidation contains any provision which, if proposed as an amendment to the memorandum or articles of association, would entitle them to vote as a class or series on the proposed amendment. In any event, all shareholders must be given a copy of the plan of merger or consolidation irrespective of whether they are entitled to vote at the meeting or consent to the written resolution to approve the plan of merger or consolidation.
The shareholders of the constituent companies are not required to receive shares of the surviving or consolidated company, but may receive debt obligations or other securities of the surviving or consolidated company, or other assets, or a combination thereof. Furthermore, some or all of the shares of a class or series may be converted into a kind of asset while the other shares of the same class or series may receive a different kind of asset. As such, not all the shares of a class or series must receive the same kind of consideration.
After the plan of merger or consolidation has been approved by the directors and authorized by a resolution of the shareholders, articles of merger or consolidation are executed by each company and filed with the Registrar of Corporate Affairs in the BVI.
A shareholder may dissent from a mandatory redemption of his shares, an arrangement (if permitted by the court), a merger (unless the shareholder was a shareholder of the surviving company prior to the merger and continues to hold the same or similar shares after the merger) and a consolidation. A shareholder properly exercising his dissent rights is entitled to payment of the fair value of their shares.
A shareholder dissenting from a merger or consolidation must object in writing to the merger or consolidation before the vote by the shareholders on the merger or consolidation, unless notice of the meeting was not given to the shareholder. If the merger or consolidation is approved by the shareholders, the company must within 20 days give notice of this fact to each shareholder who gave written objection, and to each shareholder who did not receive notice of the meeting. Such shareholders then have 20 days to give to the company their written election in the form specified by the BVI Business Companies Act to dissent from the merger or consolidation, provided that in the case of a merger, the 20 days starts when the plan of merger is delivered to the shareholder.
Upon giving notice of his election to dissent, a shareholder ceases to have any rights of a shareholder except the right to be paid the fair value of his shares. As such, the merger or consolidation may proceed in the ordinary course notwithstanding the dissent.
Within seven days of the later of the delivery of the notice of election to dissent and the effective date of the merger or consolidation, the company must make a written offer to each dissenting shareholder to purchase his shares at a specified price that the company determines to be their fair value. The company and the shareholders then have 30 days to agree upon the price. If the company and a shareholder fail to agree on the price within the 30 days, then the company and the shareholder shall each designate an appraiser and these two appraisers shall designate a third appraiser. These three appraisers shall fix the fair value of the shares as of the close of business on the day before the shareholders approved the transaction without taking into account any change in value as a result of the transaction.
Similar to the laws of most U.S. jurisdictions, BVI law permits derivative actions against its directors. However, the circumstances under which such actions may be brought, and the procedures and defenses available may result in the rights of shareholders of a BVI company being more limited than those of shareholders of a company incorporated and/or existing in the United States.
The court of the BVI may, on the application of a shareholder of a company, grant leave to that shareholder to bring proceedings in the name and on behalf of that company, or intervene in proceedings to which the company is a party for the purpose of continuing, defending or discontinuing the proceedings on behalf of the company. In determining whether to grant leave, the High Court of the BVI must take into account (i) whether the shareholder is acting in good faith; (ii) whether the derivative action is in the interests of the company taking account of the views of the company’s directors on commercial matters; (iii) whether the proceedings are likely to succeed; (iv) the costs of the proceedings in relation to the relief likely to be obtained; and (v) whether an alternative remedy to the derivative claim is available.
Leave to bring or intervene in proceedings may be granted only if the High Court of the BVI is satisfied that (i) the company does not intend to bring, diligently continue or defend, or discontinue the proceedings, as the case may be; or (ii) it is in the interests of the company that the conduct of the proceedings should not be left to the directors or to the determination of the shareholders as a whole.
In determining whether to grant leave to a shareholder in these circumstances, the BVI Court must take the following matters into account:
(a) whether the member is acting in good faith;
(b) whether the derivative action is in the interests of the company taking account of the views of the company’s directors on commercial matters;
(c) whether the proceedings are likely to succeed;
(d) the costs of the proceedings in relation to the relief likely to be obtained; and
(e) whether an alternative remedy to the derivative claim is available.
C. Material Contracts
Except for the following, we have not entered into any material contracts other than in the ordinary course of business and other than those described in Item 4, “Information on the Company,” Item 7, “Major Shareholders and Related Party Transactions,” or Item 5. Operating And Financial Review And Prospects – Contractual Obligations,” or elsewhere in this annual report.
On December 23, 2009, we entered into the Share Purchase Agreement with Unionway Resources Limited, a business company incorporated in the BVI, or the Seller, pursuant to which, among other things, we acquired 100% equity interest in Maypower Limited, a business company incorporated in the BVI and owned 24.11% of Beijing Hollysys, from the Seller. As the consideration for the acquisition of the equity interest, we agreed to:
1) issue 4,413,948 ordinary shares, or the Shares, to the Seller, and
2) pay cash US$9,917,062.5, or RMB 67,634,366.25 to the Seller.
The Shares were issued to the Seller and its designee on March 16, 2010. As a result of the acquisition of the equity interest, we indirectly own 100% of Beijing Hollysys.
On May 18, 2011, the Company entered into a stock purchase agreement (the “SPA”) to acquire 100% ownership of Concord which is engaged in the provision of electrical works and infrastructure engineering services in South East Asia and the Middle East. The total consideration of the acquisition consisted of cash consideration of SGD$41.5 million (approximately $33,789,285), and 1,006,788 ordinary shares of the Company.
Through the acquisition, the Company seeks to expand the existing distribution and marketing channels to cross sell the Company’s existing product lines in rail and industrial segments to fast growing South-East Asia and the Middle East markets. The effective date of the acquisition of Concord was July 1, 2011, at which time it became a wholly owned subsidiary of the Company, and its operation results are included in our consolidated financial statements effective from July 1, 2011.
In addition, the Company is obligated to issue an aggregate of 1,510,181 ordinary shares of the Company (“Incentive Shares”) to the management of the Concord, if the Concord’s net income equals or exceeds $10 million and $11.5 million for the fiscal years ending June 30, 2012 and 2013, respectively (“Targeted Net Income Threshold”), in accordance with the SPA. The Company shall issue 50% of Incentive Shares to the management of the Concord on an all or none basis per year when the Targeted Net Income Threshold is achieved. The Incentive Shares are granted with service conditions, that if the grantees terminate the employment agreements within two years after the acquisition, the Incentive Shares will be forfeited.
D. Exchange Controls
BVI Exchange Controls
There are no material exchange controls restrictions on payment of dividends, interest or other payments to the holders of our ordinary or preferred shares or on the conduct of our operations in the BVI, where we were incorporated. There are no material BVI laws that impose any material exchange controls on us or that affect the payment of dividends, interest or other payments to nonresident holders of our ordinary or preferred shares. BVI law and our Amended and Restated Memorandum and Articles of Association do not impose any material limitations on the right of non-residents or foreign owners to hold or vote our ordinary or preferred shares.
Exchange Controls in China
Under the Foreign Currency Administration Rules promulgated in 1996 and revised in 1997, and various regulations issued by State Administration of Foreign Exchange, or SAFE, and other relevant PRC government authorities, RMB is convertible into other currencies without prior approval from SAFE only to the extent of current account items, such as trade related receipts and payments, interest and dividends and after complying with certain procedural requirements. The conversion of RMB into other currencies and remittance of the converted foreign currency outside PRC for the purpose of capital account items, such as direct equity investments, loans and repatriation of investment, requires the prior approval from SAFE or its local office. Payments for transactions that take place within China must be made in RMB. Unless otherwise approved, PRC companies must repatriate foreign currency payments received from abroad. Foreign-invested enterprises may retain foreign exchange in accounts with designated foreign exchange banks subject to a cap set by SAFE or its local office. Unless otherwise approved, domestic enterprises must convert all of their foreign currency proceeds into RMB.
On October 21, 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Reverse Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, which became effective as of November 1, 2005. According to the notice, a special purpose company, or SPV, refers to an offshore company established or indirectly controlled by PRC residents for the special purpose of carrying out financing of their assets or equity interest in PRC domestic enterprises. Prior to establishing or assuming control of an SPV, each PRC resident, whether a natural or legal person, must complete the overseas investment foreign exchange registration procedures with the relevant local SAFE branch. The notice applies retroactively. As a result, PRC residents who have established or acquired control of these SPVs that previously made onshore investments in China were required to complete the relevant overseas investment foreign exchange registration procedures by March 31, 2006. These PRC residents must also amend the registration with the relevant SAFE branch in the following circumstances: (i) the PRC residents have completed the injection of equity investment or assets of a domestic company into the SPV; (ii) the overseas funding of the SPV has been completed; (iii) there is a material change in the capital of the SPV. Under the rules, failure to comply with the foreign exchange registration procedures may result in restrictions being imposed on the foreign exchange activities of the violator, including restrictions on the payment of dividends and other distributions to its offshore parent company, and may also subject the violators to penalties under the PRC foreign exchange administration regulations.
The following is a general summary of certain material BVI, China and U.S. federal income tax considerations. The discussion is not intended to be, nor should it be construed as, legal or tax advice to any particular prospective shareholder. The discussion is based on laws and relevant interpretations thereof in effect as of the date hereof, all of which are subject to change or different interpretations, possibly with retroactive effect.
The BVI does not impose a withholding tax on dividends paid by us to holders of our ordinary shares, nor does the BVI levy any capital gains or income taxes on us. Further, a holder of our ordinary shares who is not a resident of the BVI is exempt from the BVI income tax on dividends paid with respect to the ordinary shares. Holders of ordinary shares are not subject to the BVI income tax on gains realized on the sale or disposition of the ordinary shares.
Our ordinary shares are not subject to transfer taxes, stamp duties or similar charges in the BVI. However, as a business company, we are required to pay the BVI government an annual license fee based on the number of shares we are authorized to issue.
There is no income tax treaty or convention currently in effect between the United States and the BVI.
Taxation in China
In 2007, the PRC government promulgated the Enterprise Income Tax Law, or EIT Law, and the relevant implementation rules, which became effective on January 1, 2008. Under the EIT Law and its implementation rules, all domestic and foreign investment companies will be subject to a uniform enterprise income tax at the rate of 25% and dividends from PRC subsidiaries to their non-PRC shareholders will be subject to a withholding tax at a rate of 20%, which is further reduced to 10% by the implementation rules, if the non-PRC shareholder is considered to be a non-PRC tax resident enterprise without any establishment or place within China or if the dividends payable has no connection with the non-PRC shareholder’s establishment or place within China, unless any such non-PRC shareholder’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement. In addition, pursuant to the EIT Law, enterprises established under the laws of non-PRC jurisdictions, but whose “de facto management body” is located in the PRC, should be treated as resident enterprises for PRC tax purposes. However, it is currently uncertain whether we may be deemed a resident enterprise, or how to interpret whether any income or gain is derived from sources within China. See “Risk Factors - Under the EIT Law, we may be classified as a “resident enterprise” of China. Such classification will likely result in unfavorable tax consequences to us and our non-PRC shareholders.” If we, as a BVI company with substantially all of our management located in China, were treated as a resident enterprise for PRC tax purposes, we will be subject to PRC tax on our worldwide income at the 25% uniform tax rate, which would have an impact on our effective tax rate.
United States Federal Taxation
The following is a discussion of the material U.S. federal tax consequences of the ownership of our ordinary shares by U.S. Holders (as described below). It does not purport to be a comprehensive description of all of the tax considerations that may be relevant to a particular person’s situation. The discussion applies to investors in shares that hold the shares as capital assets for U.S. federal income tax purposes and it does not describe all of the tax consequences that may be relevant to holders subject to special rules, such as:
PROSPECTIVE PURCHASERS ARE URGED TO CONSULT THEIR TAX ADVISORS ABOUT THE APPLICATION OF THE U.S. FEDERAL TAX RULES TO THEIR PARTICULAR CIRCUMSTANCES AS WELL AS THE STATE, LOCAL AND FOREIGN TAX CONSEQUENCES TO THEM OF THE PURCHASE, OWNERSHIP AND DISPOSITION OF ORDINARY SHARES.
This discussion is based on the U.S. Internal Revenue Code of 1986, as amended, or the Code, administrative pronouncements, judicial decisions and final, temporary and proposed Treasury regulations, all as of the date hereof. These laws are subject to change, and can change on a retroactive basis. “U.S. Holder” means a beneficial owner of shares that, for U.S. federal income tax purposes, is: a citizen or resident of the United States; a corporation, or other entity taxable as a corporation, created or organized in or under the laws of the United States or any political subdivision thereof; or an estate or trust the income of which is subject to U.S. federal income taxation, regardless of its source. This discussion assumes that we are not, and will not become, a passive foreign investment company, or a PFIC, for U.S. federal income tax purposes, as described below.
Taxation of Dividends
The gross amount of any distributions paid with respect to shares, other than certain pro rata distributions of shares, generally will be treated as foreign source dividend income for U.S. federal income tax purposes. U.S. Holders will not be entitled to claim a dividends-received deduction with respect to distributions paid by us. Dividends will be included in a U.S. Holder’s income on the date of such U.S. Holder’s receipt of the dividend.
If you are a non-corporate U.S. Holder, subject to applicable limitations, you may be eligible to be taxed at a maximum rate of 15% in respect of dividends received in taxable years beginning before January 1, 2011. Please consult your tax advisors to determine whether you are subject to any special rules that limit your ability to be taxed at this favorable rate.
In the event that we are deemed to be a Chinese “resident enterprise” under PRC tax law, you may be subject to PRC withholding taxes on dividends paid to you with respect to the ordinary shares. In addition, subject to certain conditions and limitations, PRC withholding taxes on dividends not in excess of the rate allowed under the income tax treaty between the United States and the PRC, or the Treaty, if applicable, may be treated as foreign taxes eligible for credit against your U.S. federal income tax liability. The rules governing the foreign tax credit are complex. You are urged to consult your tax advisors regarding the availability of the foreign tax credit in light of your particular circumstances.
Taxation of Capital Gains
Upon sale or other disposition of the ordinary shares, a U.S. Holder will generally recognize capital gain or loss for U.S. federal income tax purposes in an amount equal to the difference between such holder’s tax basis in the shares sold or disposed of and the amount realized on the sale or other disposition. Such gain or loss will be long-term capital gain or loss if the U.S. Holder has held the shares for more than one year and will generally be U.S. source gain or loss for foreign tax credit purposes. However, if we are deemed to be a Chinese “resident enterprise” under PRC tax law, gains on disposal may be subject to PRC tax. In that event, a U.S. Holder may be eligible for the benefits of the Treaty. Under the Treaty, if any PRC tax were to be imposed on any gain from the disposition of the shares, the gain would be treated as PRC source income. We urge you to consult your tax advisors regarding the tax consequences if a foreign tax is imposed on gain on a disposition of our shares, including the availability of the foreign tax credit in light of your particular circumstances.
Passive Foreign Investment Company Rules (PFIC)
We believe that we were not a PFIC for United States federal income tax purposes for our taxable year ended June 30, 2012. However, since PFIC status depends upon the composition of a company’s income and assets and the market value of its assets (including goodwill) from time to time, there can be no assurance that we will not be a PFIC for any taxable year.
In general, if we were a PFIC for any taxable year during which a U.S. Holder held shares, gain recognized by such U.S. Holder on a sale or other disposition (including certain pledges) of the shares would be allocated ratably over the U.S. Holder’s holding period for the shares. The amounts allocated to the taxable year of the sale or other disposition and to any year before we became a PFIC would be taxed as ordinary income. The amount allocated to each other taxable year would be subject to tax at the highest rate in effect for individuals or corporations, as appropriate, for such taxable year, and an interest charge would be imposed on the amount allocated to such taxable year. Similar rules would apply to any distribution in respect of shares in excess of 125% of the average of the annual distributions on shares received by a U.S. Holder during the preceding three years or such holder’s holding period, whichever is shorter. Certain elections may be available that would result in alternative treatments (such as a mark-to-market treatment) of the shares. U.S. Holders should consult their tax advisers to determine whether such elections are available and, if so, what the consequences of the alternative treatments would be in those holders' particular circumstances.
Information Reporting and Backup Withholding
Payment of dividends and sales proceeds that are made within the United States or through certain U.S.-related financial intermediaries generally are subject to information reporting and to backup withholding unless (i) the U.S. Holder is a corporation or other exempt recipient or (ii) in the case of backup withholding, the U.S. Holder provides a correct taxpayer identification number and certifies that backup withholding does not apply.
The amount of any backup withholding from a payment to a U.S. Holder will be allowed as a credit against the U.S. Holder’s U.S. federal income tax liability and may entitle the U.S. Holder to a refund, provided that the required information is furnished to the Internal Revenue Service.
F. Dividends and Paying Agents
G. Statement by Expert
H. Documents on Display
We have filed this Annual Report on Form 20-F with the SEC under the Exchange Act. Statements made in this Annual Report as to the contents of any document referred to are not necessarily complete. With respect to each such document filed as an exhibit to this Annual Report, reference is made to the exhibit for a more complete description of the matter involved, and each such statement shall be deemed qualified in its entirety by such reference.
We are subject to the informational requirements of the Exchange Act as a foreign private issuer and file reports and other information with the SEC. Reports and other information filed by us with the SEC, including this Annual Report on Form 20-F, may be inspected and copied at the public reference room of the SEC at 100 F. Street, N.E., Washington D.C. 20549. You can also obtain copies of this Annual Report on Form 20-F by mail from the Public Reference Section of the SEC, 100 F. Street, N.E., Washington D.C. 20549, at prescribed rates. Additionally, copies of this material may be obtained from the SEC’s Internet site at http://www.sec.gov. The SEC’s telephone number is 1-800-SEC-0330.
As a foreign private issuer, we are exempt from the rules under the Exchange Act prescribing the furnishing and content of quarterly reports and proxy statements, and officers, directors and principal shareholders are exempt from the reporting and short-swing profit recovery provisions contained in Section 16 of the Exchange Act.
I. Subsidiary Information
For a listing of our subsidiaries, see “Item 4. Information on the Company – C. Organizational Structure”.
ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
We are exposed to interest rate risk primarily with respect to our bank loans. A hypothetical 1.0% increase in the annual interest rates for all of our credit facilities under which we had outstanding borrowings as of June 30, 2012, would decrease income before income taxes by approximately $0.3 million for the fiscal year ended June 30, 2012. Management monitors the banks’ prime rates in conjunction with our cash requirements to determine the appropriate level of debt balances relative to other sources of funds. We have not entered into any hedging transactions in an effort to reduce our exposure to interest rate risk.
Foreign Exchange Risk
While our reporting currency is the U.S. dollar, more than 90% of our consolidated revenues and consolidated costs and expenses are denominated in RMB, and more than 95% of our assets are denominated in RMB, and the remaining are mainly denominated in SGD. As a result, we are exposed to foreign exchange risk as our revenues and results of operations may be affected by fluctuations in the exchange rate between U.S. dollars, RMB and SGD. If the RMB or SGD depreciates against the U.S. dollar, the value of our RMB or SGD revenues, earnings and assets as expressed in our U.S. dollar financial statements will decline. Assets and liabilities are translated at exchange rates at the balance sheet dates and revenue and expenses are translated at the average exchange rates and shareholders’ equity is translated at historical exchange rates. Any resulting translation adjustments are not included in determining net income but are included in determining other comprehensive income, a component of shareholders’ equity. An average appreciation (depreciation) of the RMB or SGD against the US dollar of 5% would increase (decrease) our comprehensive income by $1.5 million or $63 thousand, respectively, based on our outstanding revenues, costs and expenses, assets, and liabilities denominated in RMB or SGD as of June 30, 2012.
Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may enter into hedging transactions in the future, the availability and effectiveness of these transactions may be limited, and it may not be able to successfully hedge our exposure at all. In addition, our foreign currency exchange losses may be magnified by PRC exchange control regulations that restrict its ability to convert RMB into foreign currencies.
Inflation in China has not materially impacted our results of operations. According to the National Bureau of Statistics of China, the annual average percent changes in the consumer price index in China for 2009, 2010 and 2011 were a decrease of 0.7%, an increase of 3.3% and an increase of 5.4%, respectively. The year-over-year percent changes in the consumer price index for January 2010, 2011 and 2012 were increases of 1.5%, 4.9% and 4.5%, respectively. Although we have not been materially affected by inflation in the past, we can provide no assurance that we will not be affected in the future by higher rates of inflation in China. For example, certain operating costs and expenses, such as employee compensation and office operating expenses may increase as a result of higher inflation. Additionally, because a substantial portion of our assets consists of cash and cash equivalents and time deposits with original maturities over three months, high inflation could significantly reduce the value and purchasing power of these assets. We are not able to hedge our exposure to higher inflation in China.
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITIES HOLDERS AND USE OF PROCEEDS
In August 2010 our Board of Directors adopted the 2010 Rights Plan. The 2010 Rights Plan provides for a dividend distribution of one preferred share purchase Right, for each outstanding ordinary share. Each Right entitles the shareholder to buy 1 share of our Class A Preferred Stock at an exercise price of $160. The Rights will become exercisable if a person or group announces an acquisition of 20% or more of our outstanding ordinary shares, or announces commencement of a tender offer for 20% or more of the ordinary shares. In that event, the Rights permit shareholders, other than the acquiring person, to purchase our ordinary shares having a market value of twice the exercise price of the Rights, in lieu of the Class A Preferred Stock. In addition, in the event of certain business combinations, the Rights permit the purchase of the ordinary shares of an acquiring person at a 50% discount. Rights held by the acquiring person become null and void in each case. Unless terminated earlier by our Board of Directors, the 2010 Rights Plan will expire on September 27, 2020.
In connection with the adoption of the 2010 Rights Plan, we amended our Memorandum and Articles of Association to increase our authorized shares of Class A Preferred Stock from 10,000,000 shares to 90,000,000 shares, and to provide that directors may only be removed by shareholders for cause.
ITEM 15. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As required by Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act, our management has carried out an evaluation, with the participation and under the supervision of our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2012.
Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating and implementing possible controls and procedures.
Management conducted its evaluation of disclosure controls and procedures under the supervision of our chief executive officer and our chief financial officer. Based upon, and as of the date of this evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective as of June 30, 2012.
Management’s Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act for our company. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements in accordance with generally accepted accounting principles and includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of a company’s assets, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that a company’s receipts and expenditures are being made only in accordance with authorizations of a company’s management and directors and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of a company’s assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, a system of internal control over financial reporting can provide only reasonable assurance with respect to consolidated financial statement preparation and presentation and may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.
Our management assessed the effectiveness of our internal control over financial reporting as of June 30, 2012. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Our management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Concord, which is included in the Company’s 2012 consolidated financial statements, and constituted $54.5 million and $43.7 million of total and net assets, respectively, as of June 30, 2012, and $24.2 million and $1.9 million of net revenues and net income, respectively. Based on our assessment, management believes that, as of June 30, 2012, our internal control over financial reporting was effective based on those criteria.
Our independent registered public accounting firm has audited our internal control over financial reporting as of June 30, 2012 and has issued an attestation report, which appears on F-3 of this annual report on Form 20-F.
Changes in Internal Control over Financial Reporting
Except for the controls that are being implemented in Concord which was acquired effective as of July 1, 2011, there has been no change in our internal control over financial reporting during the year ended June 30, 2012, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. In respect of Concord, during the fiscal year ended June 30, 2012, management has implemented and is continuing to implement changes in the controls over financial reporting to enable management to assess their effectiveness in the future under the criteria of COSO. Additional controls are being implemented at the parent level so as to be able to monitor and assess the internal controls over financial reporting of Concord.
ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT
Our board of directors has determined that Mr. Colin Sung meets the criteria for an “audit committee financial expert,” as established by the SEC. Mr. Sung will not be deemed an “expert” for any other purpose, including, without limitation, for purposes of Section 11 of the Securities Act, as a result of being designated or identified as an audit committee financial expert. The designation or identification of Mr. Sung as an audit committee financial expert does not impose on him any duties, obligations or liability that are greater than the duties, obligations and liability imposed on him as a member of our Audit Committee and board of directors in the absence of such designation or identification.
ITEM 16B. CODE OF ETHICS
In March 2006, our board of directors adopted a code of conduct, or Code of Conduct, which applies to all of our directors, officers and employees, including our principal executive officer, principal financial officer, and principal accounting officer. Our Code of Conduct addresses, among other things, honesty and ethical conduct, conflicts of interest, compliance with laws, regulations and policies, confidentiality, and reporting of violations of the code. A copy of the Code of Ethics was filed as Annex G to our registration statement on Form S-4 filed with the SEC on March 30, 2006 and is incorporated herein by reference.
ITEM 16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The principal accountants for the fiscal years ended June 30, 2012 and 2011, were Ernst &Young Hua Ming LLP and BDO Limited, respectively. The aggregate fees billed for each of the fiscal years ended June 30, 2012 and 2011 for professional services rendered by the principal accountant for the audit of our annual financial statements or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for the fiscal years ended June 30, 2012 and 2011 were $830,000 $470,000, respectively.
The fees for procedures of our quarterly financial information in the fiscal year ended June 30, 2012 and 2011, were $100,000 and $ 80,000, respectively, paid to BDO Limited.
The aggregate fees billed in each of the fiscal years ended June 30, 2012 and 2011 for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning were $6,917 and nil, respectively.
All Other Fees
The aggregate fees billed in each of the fiscal years ended June 30, 2012 and 2011 for products and services provided by the principal accountant, other than the services reported above under other captions of this Item 16C are nil and nil, respectively.
Audit Committee Pre-Approval Policies and Procedures
Our Audit Committee pre-approves all auditing services and permitted non-audit services to be performed for us by our independent auditor, including the fees and terms thereof (subject to the de minimums exceptions for non-audit services described in Section 10A(i)(l)(B) of the Exchange Act that are approved by our Audit Committee prior to the completion of the audit).
ITEM 16D. EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
We have applied and granted for following our corporate home country rule of the British Virgin Islands with respect to shareholder meeting’s time and interval with NASDAQ. Under our home country rule, we are not required to hold annual shareholder meeting unless there are issues requiring approval of general shareholder meeting.
ITEM 16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
There were no purchases of equity securities by us or by any of our affiliates during the period covered by this Annual Report.
ITEM 16F. CHANGE IN REGISTRANT’S CERTIFYING ACCOUNTANT
On June 27, 2012, the Company engaged the accounting firm Ernst & Young Hua Ming LLP (“E&Y”), to replace BDO Limited (“BDO”). The resignation of BDO and the appointment of E&Y were approved by the Company’s Board of Directors (the “Board”) following approval by the Company’s Audit Committee.
BDO audited the Company’s financial statements for each of the two years ended June 30, 2011 and 2010. BDO’s reports on the Company’s financial statements for each of the two years ended June 30, 2011 and 2010 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.
The audit reports of BDO on the effectiveness of internal control over financial reporting as of June 30, 2011 and 2010 did not contain any adverse opinion or disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit scope, or accounting principles.
In connection with the audits of the Company’s consolidated financial statements for each of the two years in the period ended June 30, 2011, and in the subsequent interim period through June 27, 2012, the date of BDO’s resignation, there were no disagreements with BDO on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of BDO would have caused them to make reference thereto in any reports on the financial statements for such period, nor have there been any reportable events (as defined in Form 20-F Item 16F(a)(1)(v)) that would require disclosure.
We filed a Current Report on Form 6-K with SEC on June 27, 2012, to announce the change of principal accountant, as disclosed above, and provided a copy of the above-mentioned Form 6-K to BDO and requested that BDO furnish a letter addressed to the SEC stating whether it agrees with the above statements, and if not, stating the respects in which it does not agree. A copy of the letter from BDO addressed to the SEC, dated June 27, 2012, was filed as an exhibit to the above-mentioned Form 6-K filed with the SEC on June 27, 2012.
For each of the two years in the period ended June 30, 2011, and the subsequent period prior to the appointment of E&Y as the Company’s independent registered public accountants, neither we nor any person on our behalf consulted with E&Y regarding either (i) the application of accounting principles to a specific completed or contemplated transaction, or the type of audit opinion that might be rendered on our financial statements and no written or oral advice was provided by E&Y was an important factor considered by us in reaching a decision as to any accounting, auditing or financial reporting issue, or (ii) any matter that was the subject of a disagreement (as defined in Form 20-F Item 16F(a)(1)(iv) and the related instructions to such Item) or a reportable event (as described in Form 20-F Item 16F(a)(1)(v)).
ITEM 16G. CORPORATE GOVERNANCE
Our corporate governance practices have generally followed the requirements of NASDAQ listing rules with respect to corporate governance.
We have elected to provide financial statements pursuant to Item 18.
Our Audited Financial Statements for the Years Ended June 30, 2012, 2011 and 2010 are included at the end of this annual report.
* Filed with this annual report on Form 20-F
The registrant hereby certifies that it meets all of the requirements for filing on Form 20-F and that it has duly caused and authorized the undersigned to sign this amended annual report on its behalf.
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Hollysys Automation Technologies Ltd.
We have audited the accompanying consolidated balance sheet of Hollysys Automation Technologies Ltd. (the “Company”) as of June 30, 2012, and the related consolidated statements of comprehensive income, stockholders’ equity, and cash flows for the year ended June 30, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hollysys Automation Technologies Ltd. at June 30, 2012, and the consolidated results of its operations and its cash flows for the year ended June 30, 2012, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Hollysys Automation Technologies Ltd.’s internal control over financial reporting as of June 30, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated October 12, 2012 expressed an unqualified opinion thereon.
/S/ Ernst & Young Hua Ming LLP
Beijing, People’s Republic of China
October 12, 2012
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Hollysys Automation Technologies Ltd.
We have audited Hollysys Automation Technologies Ltd.’s internal control over financial reporting as of June 30, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). Hollysys Automation Technologies Ltd.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As indicated in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Concord Corporation Pte. Ltd. which is included in the 2012 consolidated financial statements of Hollysys Automation Technologies Ltd. and constituted USD54.5 million and USD43.7 million of total and net assets, respectively, as of June 30, 2012, and USD24.2 million and USD1.9 million of net revenues and net income, respectively, for the year then ended. Our audit of internal control over financial reporting of Hollysys Automation Technologies Ltd. also did not include an evaluation of the internal control over financial reporting of Concord Corporation Pte. Ltd..
In our opinion, Hollysys Automation Technologies Ltd. maintained, in all material respects, effective internal control over financial reporting as of June 30, 2012, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Hollysys Automation Technologies Ltd. as of June 30, 2012, and the related consolidated statements of comprehensive income, stockholders’ equity, and cash flows for the year ended June 30, 2012 and our report dated October 12, 2012 expressed an unqualified opinion thereon.
/S/ Ernst & Young Hua Ming LLP
Beijing, People’s Republic of China
October 12, 2012
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Hollysys Automation Technologies Limited
We have audited the accompanying consolidated balance sheet of Hollysys Automation Technologies Ltd. and subsidiaries (the “Company”) as of June 30, 2011, and the related consolidated statements of comprehensive income, stockholders' equity and cash flows for the years ended June 30, 2010 and 2011. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hollysys Automation Technologies Ltd. and subsidiaries as of June 30, 2011, and the consolidated results of their operations and their cash flows for the years ended June 30, 2010 and 2011, in conformity with accounting principles generally accepted in the United States of America.
/S/ BDO Limited
September 21, 2011
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.
See accompanying notes to consolidated financial statements
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In US dollars except for number of shares and per share data)
See accompanying notes to consolidated financial statements
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In US dollars)
See accompanying notes to consolidated financial statements.
HOLLYSYS AUTOMATION TECHNOLOGIES LTD.