Philips Pumps Up Profitability

After adjusting our 2017 and 2018 revenue and margin expectations and taking into account the time value of money, we have increased our fair value estimate to $39/EUR 36 from $35/EUR 32. For 2017, we expect modest sales growth (3.2% versus 2.9% previously) and increasing adjusted EBITA margins (11.5% versus 11.1% previously) as a result of operational performance improvements, mainly in the healthcare segment, and benefiting from progress in ramping up production and shipments from the U.S. Cleveland manufacturing facility. We are happy with another strong quarter of margin improvement, and we believe Philips remains one of the most attractive investment opportunities under our coverage.

As in previous quarters, personal health delivered strong top- and bottom-line performance. Comparable sales grew 5%, driven by double-digit growth in fast-growing geographies such as the Middle East and Turkey. Adjusted EBITA was EUR 268 million, or 15.6% of sales, up 150 basis points due to operational leverage from higher sales. In the diagnosis and treatment unit, sales and adjusted EBITA margin (up 190 basis points) improved in the quarter, owing to growth in image-guided therapy, ultrasound, and diagnostic imaging. For the past eight quarters, Philips has delivered on our expectations for margin improvement, such that we believe management’s long-term adjusted EBITA margin target of 11%-13% is realistic and achievable; our 2021 forecast is 12.4%.

In February, the company decreased its shareholding in Philips Lighting to 55.2% from 71.2%, and we believe it will continue selling down its stake in the coming years. In the meantime, however, we expect Philips Lighting’s consolidated financial results to improve further. LED lighting sales grew 19% in the first quarter and now account for 61% of overall lighting sales. Adjusted EBITA improved year on year for the 10th consecutive quarter, with margin expansion of 130 basis points. As LED becomes a larger part of the total portfolio, Philips Lighting is expected to return to growth in the second quarter.

Philips did not provide an update on the Jan. 24 announcement from the U.S. Department of Justice regarding the Food and Drug Administration’s investigation of Philips’ U.S. defibrillator business. The business impact is unclear, as discussions are ongoing, but at this stage, we believe it should be significantly less material than the FDA medical imaging investigation in 2014. At that time, close to EUR 1 billion of revenue was related to the Cleveland facility, and the impact was approximately 300 basis points on the EBITA margin at the group level. Philips’ defibrillator business, part of its connected care and health informatics division, generates only EUR 290 million in sales, or 1.1% of 2016 group sales, of which U.S. defibrillator sales constitute less than 50%. For now, it is business as usual, but given the elevated uncertainly, we slightly reduced this division’s sales growth and margin expectations for 2017 after the announcement.

Transformation Has Been Impressive Philips introduced its first light bulb more than 120 years ago; today, it is the premier lighting manufacturer in Europe. Through numerous acquisitions and divestitures, the company grew into other businesses and has admirable positions in lighting, healthcare products, and consumer lifestyle. The firm sold its consumer electronics businesses to focus the portfolio on healthy living and prevention products, and management is concentrating on improving the company's cost structure. In September 2014, Philips announced what we think is the logical next strategic step of its impressive transformation by combining healthcare and consumer lifestyle into one company and splitting off the lighting solutions business into a separate firm. We believe the breakup has potential for shareholder value creation and better allocation of capital. In February, the firm reduced its stake in Philips Lighting to 54%. We expect it to sell the remaining shares during the next few years.

With the market’s transition to LED lighting products, the competitive landscape is changing. New players are entering the market, and intensified competition is strongly apparent at the LED component business. Philips announced its intention to sell the LED component and automotive lighting divisions, as it doesn’t want to participate in the next capital expenditure cycle, given limited visibility on returns. Instead, it is focusing on the strong and growing demand for professional lighting solutions. Fewer players are active in this market, and we think Philips is well positioned, given its deep application and systems integration expertise.

We see softer demand resulting from hospital consolidation and focus on cost, which hurts Philips’ imaging business. Imaging is effectively a three-player market with General Electric GE and Siemens SIEGY, and long-term emerging-market growth is mitigating our concerns. Philips’ product suites tie well into growing demand for integral value-based healthcare solutions and the aging population with more chronic diseases. Philips has a clear strategy to partner with hospitals to manage the work flow, lower the cost of care, and offer home-care devices and solutions.

Switching Costs Build Narrow Moat We assign a narrow economic moat rating to Philips, mainly due to switching costs and, to a lesser extent, intangible assets and technology leadership. The firm's strong competitive positions in healthcare diagnostics and imaging, traditional lighting, and professional lighting solutions should result in returns on invested capital exceeding the cost of capital over our five-year forecast period. The switching costs result from the firm's healthcare products being well integrated in hospitals and Philips' strong focus on training of doctors at hospitals, which ensures strong relationships. The company's medical equipment has a long economic lifetime, and support services increase customer loyalty. Patents for healthcare and lighting products are Philips' main sources of intangible assets.

The lack of pricing power for domestic appliances, LED components, and consumer luminaires, due to competition, prevents us from assigning the firm a wide moat rating. Although Philips has dominant positions in the personal-care and health and wellness markets, like male grooming and oral healthcare, we believe the entry barriers and switching costs for consumer products are low. Philips has an excellent position in conventional lighting, but this market will be taken over by energy-saving light solutions like LED and OLED. The value chain for LED products is much more fragmented than the conventional lighting value chain, given the former’s strong Asian competition.

Diversification Mitigates Risk We assign a medium fair value uncertainty rating to Philips, as the company's portfolio is well diversified in different products, market segments, and countries. The company operates in cyclical end markets, with much of the demand for its products tied to the overall health of the economy. As a result, cash flow forecasts--a key driver of our discounted cash flow model--are susceptible to economic slowdowns, and a prolonged global recession will hamper the company's performance. Furthermore, Philips' acquisition-driven growth in the healthcare technology and lighting markets carries a high degree of integration and execution risk. U.S. government spending cutbacks on healthcare have an outsize effect on Philips' medical equipment business. We will review our uncertainty rating after the sale of the remaining shares of Philips Lighting is complete.

Philips is in relatively solid financial shape. The company had EUR 4.0 billion in long-term debt and EUR 1.6 billion in short-term debt compared with EUR 1 billion of cash as of Dec. 31, 2016. The firm operates with a relatively straightforward capital structure, composed mostly of U.S.-dollar-dominated unsecured bonds, but it also uses small amounts of bank loans and finance leases. The unused EUR 1.8 billion standby facility matures in February 2018. The debt maturities issues are spread evenly, and the average tenure of long-term debt is 12.4 years. Only EUR 1.3 billion of the outstanding debt is due in the next five years. We believe Philips can comfortably cover this obligation in 2018 with internally generated cash flow. Thus, we do not expect repayment or refinancing to be an issue.