Description

Disclaimer: for those not inclined to invest in the Chinese markets regardless of valuation, and/or those with much larger sums of money to deploy (average daily traded volume for MTD in July is ~USD 1.5mn), please kindly move on.

Shanghai Baosight is an industrial software solutions provider in China which provides a full suite of products across the automation pyramid. It was founded in 1978 as the automation department within Baosteel (which is now part of China Baowu Steel, the world’s largest steel producer). Baosight trades on the Shanghai Stock Exchange in 2 different classes, namely the ‘traditional’ A shares, and B shares, which are known as Domestically Listed Foreign Investment shares. The domestic A shares trade at approximately 34-35x trailing twelve-month (TTM) earnings, 33-34x free cash flow and 3% yield, whereas the B shares trade at a huge discount of around 12-13x TTM earnings, 12-13x free cash flow and 7% yield. I believe that the investor today can purchase a fractional ownership in a business that has been growing at a high teens rate per annum (topline has grown ~18% compounded while bottom line has grown about 35% compounded for past 6 years), with high returns on capital, strong cash flow generation, and very high % of recurring profits (~99%) at a heavily discounted price. I believe such an opportunity is present primarily due to a lack of attention on the archaic B share class, which has generally received less investor attention compared to H shares.

Brief history / background of Baosight

Shanghai Baosight Software was established in 1978 within Baosteel as their automation department. Baosteel took over Wuhan Iron and Steel to form Baowu Steel, which now owns around 65% of Baosight. Baosight currently offers the full suite of products across the International Standard of Automation (ISA-95) automation pyramid as depicted by the chart below.

Baosight has now developed the following core capabilities:

• Information Solutions (Manufacturing Execution Systems MES, Integrated Process Quality Management Systems IPQMS, Energy Management Systems EMS), Programmable Logic Controller (PLC)
• Smart Storage (Crane Location Tracking Systems CLTS, Unmanned Automatic Crane System UACS)
• Electromechanical Equipment (Industrial Robots, Bell-type Furnaces, Surface Inspection Device, Automation Solutions for whole metallurgical process and cold rolling process)

In particular, one of the main highlights of Baosight was when it managed to develop a large scale PLC product in mid 2021 after years of research, in a business that has traditionally been dominated by EU, US and Japan companies. Baosight’s medium and large sized PLC products are designed and manufactured in China, something which had proved technically hard for Chinese companies in the past.

The private steel company Hongwang Group chose Baosight as its partner and has applied Baosight's products in multiple projects, such as Hunan Hongguang's silicon steel production line, etc. The products have been promoted to Fujian Hong, Guangxi Hongmao and other projects which has shown some degree of confidence in Baosight’s products.

Challenges in the Iron & Steel Market and how Baosight solves these problems

The iron and steel industry faces intense competition and operational challenges that demand advanced solutions for efficient production and supply chain management. Key issues include the shift from a make-to-stock to a make-to-order production model, which has amplified the need for accurate and timely communication between sales and production, and effective tracking and control of production events.

Challenges in the Iron & Steel Industry

1. Inefficient Production Communication:
• Customer requirements are often not communicated to production lines in a timely or accurate manner, leading to delays and mismatches in production.
2. Inadequate Production Tracking:
• Events during production cannot be effectively tracked or controlled, which complicates the management of varied and complex production processes.
3. Complex Production Processes:
• Steel manufacturers face difficulties in managing products that are varied in nature and involve long process flows, multi-process lines, and complex manufacturing steps.
4. Lack of Real-Time Production Status:
• Manufacturers struggle to obtain accurate and current information on production status, which hampers their ability to provide clients with up-to-date shipping and order information.

How Baosight’s MES Addresses These Challenges

Baosight’s Manufacturing Execution System (MES) is designed to tackle these industry-specific issues by providing a comprehensive set of functions:

1. Order Management:
• Function: Receives sales orders from Enterprise Resource Planning (ERP) systems, effectively connecting sales and production teams.
• Benefit: Ensures seamless communication between customer orders and production processes, improving accuracy and reducing lead times.
2. Quality Management:
• Function: Manages quality design, control, and tracking through the Planning, Doing, Acting, and Checking (PDAC) cycle.
• Benefit: Standardizes manufacturing processes to ensure consistent product quality and compliance with industry standards.
3. Product Management:
• Function: Monitors the real-time status of customer contracts throughout their lifecycle—from contract signing to order delivery and contract closure.
• Benefit: Provides transparency and control over each contract’s progress, enhancing customer satisfaction and operational efficiency.
4. Schedule Management:
• Function: Forms detailed sequences of operations based on order status, material availability, and process unit limitations.
• Benefit: Optimizes scheduling and resource allocation to improve production efficiency and meet delivery deadlines.
5. Material Tracking and Results Management:
• Function: Collects and provides real-time access to production process information and status from production units.
• Benefit: Enables accurate tracking of materials and results, enhancing visibility and control over production processes.
6. Warehouse Management:
• Function: Manages raw materials, work-in-progress (WIP) inventory, and finished product inventory.
• Benefit: Organizes inventory to support productive operations and streamline material handling.
7. Shipping Management:
• Function: Coordinates delivery schedules based on product orders to ensure timely delivery.
• Benefit: Enhances logistics efficiency and customer satisfaction by ensuring on-time delivery of products.
8. Tool Management:
• Function: Manages tools that influence the main production line.
• Benefit: Ensures proper maintenance and usage of tools, contributing to smoother and more reliable production operations.

Overall landscape has been mostly dominated by foreign companies, with increasing substitution by domestic Chinese firms

Market Growth and Domestic Penetration

China's PLC market has seen fast growth over the past decade. China's market share for PLCs increased rapidly from less than 10% in 2015 to nearly 30% in 2021. This growth underscores both the technological advancements in Chinese PLCs and the increasing trust and recognition of domestic brands by local firms.

In 2022, the domestic medium- and large-sized PLC market was valued at 8,265 million RMB, reflecting a 3.93% increase year-on-year. The small-sized PLC market was valued at 8,341 million RMB, showing a 5.71% increase year-on-year. Notably, the localization rate of small-sized PLCs in China has reached 36.1%, signifying that domestic PLCs are starting to lead in specific market segments.

Baosight’s Role and Market Position

Baosight stands out as a leading player in the domestic large-scale PLC market, a sector previously dominated by foreign companies. After nearly a decade of development, Baosight has established over 200 core process algorithms and launched its self-developed large-scale PLC in July 2021. This move marked the beginning of the domestic substitution of large-scale PLCs and initiated a rapid growth phase for the company.

Currently, Baosight has expanded its offerings to include core domestic large-scale PLC & SCADA industrial control software, information software, AI large models, robots, and AIDC solutions. The company’s growth is closely linked with the steel industry, especially given its significant partnership with Baowu. Baosight holds approximately 20% of the market share in this sector, with 80% of revenue coming from the steel industry.

Development of domestic Chinese brands and difficulties faced

Recent years have witnessed a substantial increase in industry penetration by Chinese brands in the small PLC market. This success is attributed to their cost-effective solutions, flexible business models, and ability to develop customized models for specific industries. Technological innovation remains the core driver behind the rise of Chinese PLCs. For instance, Unionscience Technology has made significant strides by investing in R&D to produce high-performance PLC products with fully independent intellectual property rights. These products have effectively replaced imported products in industries such as metallurgy and transport.

However, the high-end market for Chinese PLCs faces several challenges. Technical barriers, industry constraints, and product exclusivity pose significant hurdles. For example, many production lines are entirely imported, and foreign brands have established long-term relationships with these companies, making it difficult for Chinese brands to penetrate these markets. Additionally, replacing PLCs involves extensive work, including redesigning processes and dealing with potential time costs and risks of errors.

Expansion of Baosight outside of China

Baosight has also expanded its reach internationally. Notable projects include:

• India: Collaboration with Steel Authority of India Limited (SAIL)

• Projects:
• Manufacturing Execution System (MES): Includes SYMS (Steel Yard Management System) and CYMS (Cold Yard Management System).
• CLTS (Conveyer Line Tracking System): Implemented for the Rourkela hot rolling mill.
• the MES and CLTS solutions provided support enhanced operational efficiency and tracking capabilities at their Rourkela facility.

• Vietnam: Partnership with Formosa Ha Tinh Steel Corporation (FHS)

• Projects:
• Manufacturing Execution System (MES): Facilitates real-time production monitoring and control.
• Advanced Planning System (APS): Enhances planning and scheduling for optimized production.
• Integration of MES and APS has enabled more efficient management of their production processes and improved planning accuracy.

Focus areas and development strategies

Baosight is strategically concentrating on advancing its core competencies in industrial software and artificial intelligence (AI). These focal areas are pivotal for the company’s growth and innovation in the competitive industrial automation sector.

1. Industrial Software Development

A primary objective for Baosight is to enhance and upgrade its industrial software systems, with a particular emphasis on PLCs. This involves the development of independent and controllable industrial software solutions, where Baosight drives iterative improvements and performs comprehensive reconstructions and upgrades of its software products. By focusing on these initiatives, Baosight aims to strengthen its position in the industrial software market and address the evolving needs of its clients.

2. Artificial Intelligence (AI)

In addition to industrial software, Baosight is investing in AI with the goal of developing large-scale models tailored to the metallurgical industry. Initiatives in this area include creating end-to-end solutions that span the entire industrial chain. This encompasses research into the application of humanoid robots within the steel industry, aiming to integrate AI technologies to enhance operational efficiency and innovation.

Investment and Development Highlights

Baosight has significantly increased its R&D for both industrial software and AI. In 2023, the company achieved notable milestones:

• Barobot Application Scenario: The successful construction of demonstration production lines for Barobot applications marked a significant advancement in showcasing the practical capabilities of its technologies.
• Integration with Baoluo Cloud: Baosight promoted the large-scale integration of robots with the Baoluo Cloud platform. This integration involved implementing the BOO (Build-Own-Operate) and RAAS (Robot-as-a-Service) models across multiple steel bases, underscoring the company's commitment to advancing robotic and AI applications in industrial settings.

Increasing margin profile and strong cash flow generation as offerings mature

Baosight has been growing at a pretty fast clip across the past few years. Most notably, margins have been slowly on the rise as software offerings slowly started to mature, and almost all net profits have been recurring. For e.g. in 1Q 2024, the net profits were RMB 590mn, of which RMB 586mn were recurring. A similar picture happened back in 2023 where net profits were RMB 2,554mn and recurring profits were RMB 2,413mn. Cash flow generation has been very strong, with a significant proportion of net profits converted to cash, hence why Baosight currently sits on a strong net cash position of around RMB 5,140mn (cash of RMB 5,496mn and short-term borrowings of RMB 805.4mn and no long term borrowings). Management has shown a general willingness to return excess cash with the dividend payout ratio reaching 94% in 2023.

The high returns on capital and margins are typical of an asset-light business model where fixed assets constitute only about 10% of the total assets. This strategic approach allows the company to maintain flexibility and minimize capital expenditure, enhancing its operational efficiency and financial agility.

Baosight has shown continuous improvement in its gross margins, driven by the maturation of its software offerings. Personnel-related costs remain the primary expense, but the efficient management of these costs has contributed to the overall profitability of the company. Reporting is split into 4 different segments, with software development being the largest segment within the company and outsourcing services being the segment with the highest gross margins. All 3 business divisions have shown increasing margins over time.

Despite appearing high, Baosight's inventory levels are primarily reflective of accounting practices rather than actual excess, where a significant portion (~95%) of the inventory is related to labour fees rather than physical stock.

Employee productivity and incentives

From 2015 to 2023, Baosight experienced a significant increase in headcount by 40%, while salaries grew by 125%. During the same period, topline revenue surged by 220%, and profits attributable to shareholders rose 660%. These figures highlight the company's successful expansion and its ability to translate growth not only into substantial shareholder returns, but also enrich employees together at the same time. As part of their employee incentive programme, Baosight announced on 19 January the granting of 26,231,000 restricted shares to 857 employees at RMB20.43/share.

Expansion Plans and Development

Vertical and Horizontal Expansion

Vertical Expansion:

Baosight initially focused on providing ERP and MES solutions tailored for the steel industry. Over time, the company has successfully diversified its offerings into other sectors such as pharmaceuticals, rail transportation, and chemicals. This expansion has leveraged Baosight’s deep industry knowledge and extensive software capabilities accumulated over decades, enabling the company to apply its expertise across multiple verticals.

Horizontal Expansion:

Baosight has significantly broadened its software portfolio to include a range of innovative products:

• EMS (Energy Management System)
• LMS (Logistics Management System)
• PLS (Production Logistics System)
• PLC and DCS (Distributed Control System) Software
• xIn³ Plat: An industrial internet platform aimed at upstream applications

Baowu's growth through acquisitions should benefit Baosight

Baowu’s acquisition of several steel-making companies and the unification of their information systems has created substantial IT demand for Baosight. Continued mergers and acquisitions in the steel sector are expected to further increase this demand. The Ministry of Industry and Information Technology's (MIIT) 2020 guidelines proposed increasing the concentration ratio (CR10) of China’s steel industry to 60% by 2025, driving significant demand for informationization solutions. This is likely to benefit Baosight as Baowu grows through acquisitions over time.

Key Developments and Breakthroughs

Industrial Software and Automation:

Baosight has evolved from focusing solely on MES and ERP to enhancing its software offerings with new products such as BM2-I, BM2P, and BXeCTD, which reinforce its ERP and MES capabilities. Notable advancements in PLC and robotics include the development of self-designed PLC products for cold rolling processes at Hunan Hongwang Factory in 2022 and significant enhancements to its robot business in 2023. This includes integrating robots with the Baoluo Cloud platform and investing in Shanghai Turin Smart Robot.

xIn³ Plat:

Baosight's industrial internet platform, xIn³ Plat, has progressed into the industrialization phase, with the large-scale promotion of ePlat software that includes unified management and smart office components.

AI Software (xAI):

The xAI software has efficiently constructed and managed AI models, which have been applied to several core industrial intelligence algorithm models, demonstrating Baosight’s commitment to incorporating advanced AI capabilities into its offerings.

Breakthrough in PLC Products

Launch of Large PLC:

Baosight’s launch of a domestically developed large PLC represents a significant technological achievement in industrial control systems, a field traditionally dominated by foreign companies. This new PLC offers high reliability, openness, safety, and scalability, specifically tailored for the steel industry and validated in various production lines.

Baosight has shifted from an IDC driven growth model to focusing on large-scale PLCs, SCADA industrial control software, and robotics. This transition is expected to drive significant profitability growth. The anticipated increase in gross profit margins will be supported by the high margins of large-scale PLCs and software control systems, coupled with the growth of the robot business.

Valuation of Baosight B is at a substantial discount to all competitors and its own A shares

Competitors

Baosight mainly competes against foreign companies like Siemens, Rockwell, Mitsubishi Electric, Schneider Electric, and Honeywell, as well as Unionscience and to some extent Supcon. Most of these companies are however not pureplay industrial automation competitors and hence have been removed from comparison. The comps set below highlighted in green are more direct competitors, while the others are software providers in other industries. The valuations serve as a basis of comparison

Competitors

1. Supcon Technology

• Products: Provides industrial automation solutions, including DCS (Distributed Control Systems) and industrial software.

2. Siemens

• Products: Offers a wide range of industrial automation solutions, including PLCs, SCADA systems, and industrial software.

3. Rockwell Automation

• Products: Specializes in industrial automation and control systems, including PLCs, SCADA, and manufacturing execution systems (MES).

4. Schneider Electric

• • Products: Provides comprehensive automation and control solutions, including PLCs, DCS, and industrial software.

5. Honeywell

• • Products: Offers industrial automation solutions, including PLCs, SCADA systems, and process control software.

6. ABB

• • Products: Known for its industrial automation and control systems, including PLCs, DCS, and robotics.

Valuation discount to A shares does not necessarily need to narrow for investment to work out

Not only does Baosight’s B shares trade at a substantial discount to its own A shares, but also pretty much against the entire group. However, the investor should not necessarily expect the discount to narrow if at all, as Baosight has so far not shown any intention of narrowing the A-B share discount either through a buyback programme or conversion to H shares (which poses a set of challenges on its own). The B shares should serve as a method of purchasing a fractional ownership in a company at a reasonable valuation, which would have otherwise been trading at lofty valuations. Should Baosight continue to grow, if valuations remain at similar levels alongside a generous payout, the long-term investor will participate in the future growth of Baosight.

Risks of Baosight’s business

Challenges and Financial Considerations

Despite Baosight Software's strategic expansions and technological advancements, the company faces several challenges that may impact its growth trajectory. One significant issue is the lackluster downstream demand or slower product expansion, particularly given the dependence on the steel industry which has been affected by the property slowdown in China.

Given the nature of how Baosight used to be part of Baowu, Baosight has a high reliance on related party transactions. In 2023, the sales volume of Baosight's top five customers amounted to RMB 3.9 bn, representing 30.23% of the total annual sales. Within this, the sales volume of related parties was RMB 2.64 bn, accounting for 20.45% of the total annual sales. This concentration of sales among a few key customers, particularly related parties, underscores the need for Baosight to diversify its customer base to mitigate risks associated with revenue concentration

Additionally, Baosight has experienced a fair amount of bad debt from businesses outside of Baowu, including the real estate sector.

In RMB mn

One other concern is that Baosight’s receivables are significantly higher than its profits, exceeding twice the amount. This discrepancy raises questions about the efficiency of the company's credit policies and its ability to convert receivables into cash flow promptly. As a slight mitigating factor, about 2/3s of receivables are due from Baowu and its related companies, and its status as the largest steel producer in China does mitigate the credit risk to a certain extent.

Another concern revolves around the potential cyclicality of Baosight’s business. The steel industry's changing demand plays a crucial role in this context. Despite the steel industry currently experiencing a structural downturn, there is an increased focus on intelligent manufacturing, high-end product structure adjustments, and low-carbon transformation. These factors have led to a scale of investment by steel companies that has far exceeded previous expectations. Consequently, the demand for intelligent manufacturing and domestic production technologies is rising rapidly. Although market concerns suggest that a decline in steel industry investment could negatively impact Baosight, the transformation and upgrading of numerous production lines and the construction of new product lines are expected to stimulate the company's business development in intelligent manufacturing.

During a recent meeting, the focus was on Baosight Software's position in the open-screen communication and navigation software series and the importance of domestic alternative technologies. It was emphasized that the company is at a critical moment in transforming its business and profit models, with the automation business viewed as the core driving force for future growth. By optimizing its business structure and promoting localization, Baosight expects its gross profit margin to continue increasing, particularly in the information technology and IDC business areas.

Catalyst

Special dividend from its cash pile

Conversion of B to H shares could narrow discount

Just valuation and consistent payout in itself could see returns grow over time