Philips is currently trading below the price during the Covid-19 crash.
Opdateret: 23. apr.
It has been a rough year for Philips, and they are now trading below the price it reached during the Covid-19 crash. The reason is that they needed to recall millions of Respironics and sleep apnea due to potential helps risks related to the sound abatement foam component they used. This is hopefully a onetime event and could mean a great buying opportunity. In this analysis I will investigate if Philips is worth a buy.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and also briefly go through why the company has meaning to me. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
It was a copier of mine that asked if I could have a look at Philips. It isn't a company that I had thought about investigating myself, and the company hasn't been on my watchlist. However, as I want to keep my copiers happy, and with the latest price action, I found it intriguing to investigate if the company is worth an investment. For full disclosure, I should mention that I'm in the time of this writing do not own shares in Philips.
Koninklijke Philips (Royal Philips) is a Dutch multinational conglomerate corporation that was founded in Eindhoven in 1891. It is a company that I have known all my life, and if my memory serves me right, I had a Philips TV as a child. However, the Philips of today is very different than Philips from a decade ago. Philips no longer make TV's as they in 2012 sold the license to Japanese Funai in North America and Chinese TP Vision in the rest of the world. Their very successful Philips Hue and other lightning products is made through the company Signify, which is a spin-off Philips made in 2016. Finally, they sold their Domestic Appliances business (coffee machines, vacuum cleaners etc.) to Hillhouse Capital in 2021. Hence, when you invest in Philips, you invest in the following segments: Diagnostics & Treatment (diagnostics imaging, ultrasound, enterprise diagnostics informatics and image guided therapy), Connected Care (monitoring and analytics, sleep and respiratory care, therapeutic care, and connected care informatics and population health management) and Personal Health (oral healthcare, mother and childcare, and personal care). Of the three segments diagnostics and treatment is largest with 51 % of the sales in 2022, while connected care was 25 % of sales in 2022, and personal health was 20 % of sales in 2022 (there is also small "other segment" that had 4 % of sales in 2022). Despite Philips changing their operations, I would still argue that they have a large brand moat, due to their very famous brand.
Their CEO is Roy Jacobs. He joined Philips in 2010 and had held several management positions until he became the CEO in October 2022. He holds two master's degrees, one in Business Administration and one in Marketing. As a leader he describes himself as a realist and believes that it is very important to lead with realism, which is why he is a great believer in knowing where to he wants to go and having a clear plan on how to get there, a plan that people can understand and have confidence in. It is why he wants to change how Phillips is operating. He wants Phillips to remove complexity and become much more focused on strategy and innovation. When talked about where Phillips is now and where they want to go, he said: "We need to be shifting from spreading our resources too thinly over too wide of a portfolio towards a sharper focus on what it takes to create growth and value in our segments and markets". As a realist he said that there is no magic bullet in reaching the goal and that executing will be the key driver to reach the goal. While it is impossible to judge Roy Jacobs after so little time as CEO, I like that he has a clear plan and takes accountability for Phillips moving forward. Nonetheless, management is an unknown for now.
I believe that Philips has a large brand moat but management is unknown. Now, let us investigate the numbers to see if Philips lives up to our requirements for a strong moat. In case you want an explanation about what the numbers are, you can have a look at "MY STRATEGY" on the website.
The first and most important number we will investigate is the return on investment capital, also known as ROIC. We want to see 10 years of history and we want the numbers to be above 10 % in all years. Looking at the numbers of Philips, they are very underwhelming. Philips has only had 2 years in the last 10 years where they managed to deliver a ROIC above 10 %. It seemed like Phillips was back on track in 2021 but then came a horrible 2022 that was affected by the recall of their Respironics devices. Management believes that from 2025 and onwards ROIC will be mid- to high teens. Thus, they think they will get back to the 2021 numbers. Nonetheless, I will need to see it to believe it.
The next numbers are the book value + dividend. In my old format this was known as the equity growth rate. It was the most important of the four growth rates I used to use in my analyses, which is why I will continue to use it moving forward. As you are used to see the numbers in percentage, I have decided to share both the numbers and the percentage growth year over year. The numbers are a bit mixed throughout the years, but Phillips has managed to keep the numbers relatively steady. It is promising to see that the headwinds in 2022 didn't affect the equity too much.
Finally, we investigate the free cash flow. In short, free cash flow is the cash a company generates after it has paid for operating expenses and capital expenditures. Levered free cash flow is the amount of money a company has left remaining after paying all of its financial obligations, I use the margin for it to make more sense. Free cash flow yield is the free cash flow per share a company is expected to earn against its market value per share. The numbers are a big mixed throughout the years with 2021 being the best year when looking at levered free cash flow margin and free cash flow yield. It is not surprising that 2022 was a disastrous year because of the recall of their Respironics devices.
Another important thing to investigate is debt, and we want to see if a business has a reasonable debt that can be paid off within 3 years. We do so by dividing the total long-term debt by earnings. We cannot make the calculations in 2022 as Phillips had negative earnings. However, looking at previous years the calculations show that debt was 1,44 years in 2021, 3,91 years in 2020, and 3,23 years in 2019. Thus, while there are years where debt was above 3 years of earnings, it isn't alarming.
Like with all other companies, there are some risks if you choose to invest in Philips. The first and most obvious risk is the recall of their Respironics devices, which can affect Philips in various ways. The recall means that their restructuring, acquisition-related and other charges came in at 350 million euros above their guidance. Furthermore, a recall like this can have catastrophic consequences for the brand. If their brand is hurt from the recall, it could hurt their moat and their future sales. Luckily, strong brands usually come back from events like these, as we have seen in numerous occasions before. Philips has stated that they expect to have delivered all of their repaired Respironics devices by the first quarter in 2023. Another risk is supply chain shortages. Philips has more than 5.000 suppliers, which has resulted in challenges for Phillips due to the global supply chain challenges. In their 2020 fourth quarter earnings call, management mentioned that although the component supply chain is improving, the situation is still challenging. Management wants to reduce the number of suppliers but has mentioned that it is a multiyear effort. Thus, the supply chain will continue to be a risk for years to come. Macroeconomics. Management mentioned that in 2022 component and wage inflation affected EBITDA margin by 3 %, and management mentioned that they continue to see a significant wage and component inflation in 2023. Furthermore, management expects that uncertainties in the external economic environment will affect sales in their Personal health segment, and management lowered expectations to low single-digit growth.
There are also lots of potential for Philips moving forward. They currently have a large order book. In the 2022 fourth quarter earnings call, management mentioned that their order book is significantly higher than in 2019 and 2020. They mentioned that in absolute terms the order book was 30 % higher by the end in 2022 compared to 2020. The order book was lower by the end of 2022 compared to 2021, which is due to Phillips cancelling orders. However, management believes it is a good thing as the cancelled orders were low margin orders, meaning that despite fewer orders in 2022, they should have higher margins. They expect to resume growth. With their new business strategy in which Phillips will be more focused on key markets, management expects that they will resume growth. Management mentioned that they will prioritize and drive growth across Image-Guided Therapy, Monitoring, Ultrasound and Personal Health, as these are businesses where they can accelerate growth and margins more quickly because of their strong leadership positions. It means that Phillips expects that we will see impacts next year, while they are targeting to reach their full potential in 2025, which is why they guided a high ROIC in 2025. Some macroeconomics factors could benefit Philips. Management has talked about how the hospital system is facing some severe challenges. They are dealing with higher costs because of inflation and staff shortages. It means that hospitals need to increase staff productivity and drive efficiency. To do so, they look at companies like Philips that has products that delivers products that are a pathway to optimization that results in better staff productivity. Furthermore, management also mentioned that hospitals need to catch up with technology because of under investments during Covid. This, we could see a higher number of investments from hospitals moving forward.
All right, we have gone through the numbers, risks, and potential regarding Philips and now it is time for us to calculate a price. To calculate price, we will need numbers that I have explained in the "MY STRATEGY" section of the website. I do not want to go through the whole calculation here. Remember that Phillips had negative earnings in 2022. I chose to use an EPS of 1,5 euros. which is lower than 2021 but the highest since 2017. I chose an Estimated future EPS growth rate of 5, which is in line of their expectations. Estimated future PE 10 (which the double of the growth rate, as the historically PE for Philips has been higher) and we already have the minimum acceptable return rate on 15 %. Doing the calculations by using the formula I described in "MY STRATEGY", we come up with the sticker price (some call it fair value or intrinsic value) of 6,04 euros, and we want to have a margin of safety on 50 % , so we will divide it by 2 meaning that we want to buy Philips at price of 3 euros (or lower obviously), if we use the Margin of Safety price.
Our second way to calculate a buy price is the TEN CAP price, which is also explained at "MY STRATEGY". To do so, we need some numbers from their financial statements, keep in mind that all numbers are in millions. Phillips had higher expenses than income in 2022, so it isn't possible to do the calculations based on 2022 numbers. However, the calculation based on the 2021 looks like this: The Operating Cash Flow last year was 1.629. The Capital Expenditures was 763. I tried to look through their annual report to see, how much of the capital expenditures were used on maintenance. I couldn't find it though, so as a rule of thumb, you expect 70 % of the capital expenditures to be used on maintenance, meaning we will use 534,1 in our further calculations. The Tax Provision was -103. We have 904,3 outstanding shares. Hence, the calculation will be like this: (1.629 - 534,1 - 103) / 904,3 x 10 = 10,97 euros in TEN CAP price.
The last calculation is the PAYBACK TIME. It is also described in "MY STRATEGY". Phillips had a negative free cash flow in 2022, so it isn't possible to do the calculation based on the 2022 numbers. However, the calculation based on the 2021 as followed: With the Free Cash Flow Per Share at 1,53 and a growth rate of 5 %, if you want your purchase back in 8 years, the PAYBACK TIME price is $12,24.
I believe that Philips is an interesting company, as they have just restructured their business. And if management can execute on their new strategy, they could reach higher profitability than previous. Nonetheless, management is unknown, so only time will tell if they manage to do so. You could argue that Philips is currently going through what is called an event with the recall of their Respironics devices. What I mean by that is that it is a one-time event that won't happen again. While Philips expects to deliver all the modified Respironics devices soon, it isn't over yet. They are a defendant in several class-action lawsuits, and they received a subpoena from the U.S. Department of Justice to provide information related to events leading to the recall. So far, we don't know what it will amount to, so it needs to be monitored. I also must admit that I'm underwhelmed with the numbers Philips has delivered over the last 10 years. However, Philips is a new company since their restructuring and strategy, and it will be a company that will be interesting to follow moving forward to see if they can deliver better numbers. Nevertheless, I do not intend to invest in Philips for the time being, as I think there are much better opportunities out there.
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