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Philips: Will the company regain trust?

Opdateret: 27. apr.

It has been a challenging few years for Philips, and currently, their stock is 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 devices due to potential health risks related to the sound abatement foam component they used. This is hopefully a one-time event and may present a great buying opportunity. In this analysis, I will investigate whether Philips is worth buying.

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.

For full disclosure, I should start by mentioning that at the time of writing this analysis, I do not own any shares of Philips. If you would like to view the stocks in my portfolio or copy my portfolio, you can do so on eToro. Instructions on how to do so can be found here. I do not own any stocks in any of Philips' direct competitors either. Thus, I have no personal stake in Philips. If you want to purchase shares or fractional shares of Philips, you can do so through eToro. eToro is a highly user-friendly platform that allows you to start your investment journey with as little as $50.

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 when I was a child. However, the Philips of today is very different from the Philips of a decade ago. Philips no longer manufactures TVs as they sold the license to Japanese Funai in North America and Chinese TP Vision in the rest of the world in 2012. Their highly successful Philips Hue and other lighting products are made by the company Signify, which was spun off from Philips in 2016. Finally, they sold their domestic appliances business (coffee machines, vacuum cleaners, etc.) to Hillhouse Capital in 2021. When you invest in Philips, you are investing in the following segments: Diagnostics & Treatment (including diagnostic imaging, ultrasound, enterprise diagnostics informatics, and image-guided therapy), Connected Care (comprising monitoring and analytics, sleep and respiratory care, therapeutic care, and connected care informatics and population health management), and Personal Health (encompassing oral healthcare, mother and childcare, and personal care). Of the three segments, diagnostics and treatment accounted for the largest share, representing 49% of the sales in 2023. In 2023, connected care accounted for 28% of sales, while personal health represented 20% of sales in the same year. Additionally, there was a small "other segment" that contributed 3% to the total sales in 2023. Personal health is the segment with the highest margins, delivering an EBITDA margin of 16,6% in 2023, followed by diagnostics and treatment, which delivered an EBITDA margin of 11,6% and connected care, which delivered an EBITDA margin of 6,9%. Despite Philips changing its operations, I would still argue that they have a strong brand moat, thanks to their highly renowned brand.

The CEO is Roy Jacobs. He joined Philips in 2010 and 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 crucial to lead with realism. He is a strong advocate for understanding the desired destination and creating a clear plan to achieve it. This plan should be easily understandable and inspire confidence in others. It is the reason 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 asked about Phillips' current position and future goals, he stated, "We need to shift our resources from being spread too thin across a wide portfolio to a more focused approach on creating growth and value in our segments and markets." As a realist, he stated that there is no magic bullet to achieve the goal, and that execution will be the key driver to reach it. While it is impossible to judge Roy Jacobs after such a short time as CEO, I appreciate that he has a clear plan and takes responsibility for the future of Phillips. Nonetheless, the quality of management is currently unknown.

I believe that Philips has a brand moat but the management is relatively unknown. Now, let us investigate the numbers to determine if Philips meets our criteria 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 metric we will investigate is the return on invested capital, also known as ROIC. We require a 10-year history where all figures exceed 10% each year. Looking at the numbers from Philips, they are very underwhelming. Philips has only had two years in the last decade where they managed to deliver a return on invested capital (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, which also impacted 2023, and ROIC was negative in both years. Management believes that from 2025 and onwards, the return on invested capital (ROIC) will be in the mid- to high teens. Thus, they believe they will return to the 2021 figures and continue to progress. Nonetheless, I will need to see it to believe it.

The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. The numbers have been somewhat mixed over the years, but Phillips has managed to maintain relatively stable figures. It is promising to see that the headwinds in 2022 did not significantly affect equity, as it remained at its second-highest level in the past ten years. However, equity decreased further in 2023 and is now below the ten-year average, which is slightly concerning.

Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins offer a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. The numbers are a bit mixed as Philips has experienced two years with negative free cash flow, one of which was in 2022, and was influenced by the recall of Respironics devices. However, it is encouraging that Philips managed to deliver its highest free cash flow in the past ten years in 2023. The levered free cash flow margin has been inconsistent over the years and is currently close to the ten-year average in 2023. However, both 2022 and 2023 were impacted by the recall of Respironics devices. Hopefully, Philips will manage to reach previous heights moving forward. Free cash flow yield is at its second-highest level in the past ten years, indicating that Philips is trading at an inexpensive valuation. However, we will revisit this later in the analysis.

Another important aspect to consider is the level of debt. It is crucial to determine whether a business has manageable debt that can be repaid within a period of 3 years. We do this by dividing the total long-term debt by earnings. We cannot make the calculations for 2022 or 2023 as Phillips had negative earnings. However, based on previous years, the calculations indicate that the debt-to-earnings ratio was 1,44 years in 2021, 3,91 years in 2020, and 3,23 years in 2019. Thus, while there have been years when debt exceeded three years of earnings, it is not a cause for alarm.

Investing in Philips, like with all other companies, carries some risks. The first and most obvious risk is the recall of Respironics devices. Since June 2021, Philips has had to recall millions of Respironics and sleep apnea devices due to potential health risks associated with the sound abatement foam component they utilized. This recall has affected Philips' financials, as seen in the numbers presented earlier in this analysis. Philips has reached an agreement with the FDA regarding a consent decree. As part of the agreement, Philips Respironics will refrain from selling new CPAP or BiPAP apnea devices, as well as other respiratory care devices, in the U.S. until they fulfill the necessary requirements outlined in the consent decree. While Philips can sell its devices in other markets, the impact will be significant as the U.S. has historically been its largest market. Furthermore, the Respironics recall has also damaged the Philips brand, which could weaken their competitive advantage and impact their future sales. Macroeconomics. There are several macroeconomic factors that could affect Philips. Wage and component inflation will affect Philips' profit margins, while high inflation and higher interest rates may affect its customers' discretionary spending, impacting its personal health segment, which is its highest margin segment. Finally, high inflation and high interest rates have led to increased financial pressures on hospitals. This indicates that hospitals are reducing their capital investment plans and tightening their operational budgets. Management has mentioned that they continue to see hospitals and healthcare systems exhibiting cautious buying behavior, which has affected Philips' sales. The introduction of obesity drugs. Companies such as Novo Nordisk and Eli Lilly have introduced obesity drugs, and it is unclear how this development will impact Philips' business in the future. For instance, obesity is a major contributor to sleep apnea. In the future, there is the potential for even better drugs and eventually generics to help lower the price point, which would lead to more people using these drugs. Hence, obesity drugs may alter the long-term requirement for sleep apnea devices. Management has mentioned that there will be a medication that will help address some of the causes of sleep apnea. However, they also mentioned that on average, a sleep apnea patient has five comorbidities, and obesity is one of them. Obesity drugs can help, but they will not address the root causes. Nonetheless, there is some uncertainty regarding the impact of obesity drugs.

There is also a lot of potential for Philips moving forward. They currently have a significant backlog of orders. While order intakes were lower in 2023 due to the exceptionally high comparison base in the last two to three years in China and Russia, and lower order-to-delivery lead times. However, the order book is still 15% higher than when the global supply chain crisis started in 2021. Furthermore, Philips experienced sequential improvement in Q4 2023 and remains focused on implementing the necessary actions to reduce lead times. The company aims to leverage its enhanced operating model and AI-driven innovations to improve order intake. Thus, management expects to see positive growth in order intake for the full year 2024. It is important because orders and the order book account for around 40% of Philips' revenue. A smaller portfolio. CEO Roy Jacobs has stated, "We need to shift our resources from being spread too thin across a wide portfolio to a more focused approach on creating growth and value in our segments and markets." Hence, Philips has been pruning parts of its portfolio lately, which allows the company to focus on its high-growth drivers, get their innovations out there, and put scale behind their winning products. It means that Philips now has a less fragmented portfolio, which allows for a more impactful presence and enables them to drive better margins. New opportunities. Philips wants to leverage new technology to gain new opportunities. They are introducing new innovations that focus on empowering clinicians with artificial intelligence for deeper clinical insights, improved workflow, and productivity. For example, they recently launched Philips HealthSuite Imaging, a cloud-based next-generation of Philips Vue PACS that offers AI-enabled workflow orchestration, high-speed remote access for diagnostic reading, and integrated reporting. They have also signed an eight-year, $150 million agreement with NYU Langone Health in the U.S. to provide patient monitoring, AI-enabled diagnostic imaging, digital pathology, and enterprise informatics solutions to its newest hospital. Philips aims to expand access to maternal health through AI-powered ultrasound technology, addressing the shortage of healthcare workers by placing a diagnostic tool that was previously reserved for expert technicians into the hands of midwives.

Now it is time to calculate the share price of Philips. I perform three different calculations that I learned at a Phil Town seminar. The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. Philips has had negative earnings in the past two years, so I chose to use an EPS of 0,73, which is from the year 2021. I have selected a projected future EPS growth rate of 7%. Finbox expects EPS to grow by 12,3% in the next five years, but I'm not as optimistic. Additionally, I have selected a projected future P/E ratio of 14, which is double the growth rate. This decision is based on Philips' historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $4,97. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Philips at a price of $2,49 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 2.136, and capital expenditures were 644. I attempted to analyze their annual report in order to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 451 in our calculations. The tax provision was -73. We have 906,403 outstanding shares. Hence, the calculation will be as follows: (2.136 – 451 - 73) / 906,403 x 10 = $17,78 in Ten Cap price.

The final calculation is referred to as the Payback Time price. It is a calculation based on the free cash flow per share. With Philips' free cash flow per share at $2,31 and a growth rate of 7%, if you want to recoup your investment in 8 years, the Payback Time price is $25,36.

Philips has had a rough couple of years, which has also been difficult for shareholders. However, they recently appointed a new CEO who has introduced some innovative ideas. Under his leadership, Philips achieved its highest free cash flow in ten years, which is encouraging. Philips is still facing risks related to the Respironics recall. Currently, Philips is not permitted to sell its Respironics products in the United States, and it is challenging to predict how the recall will impact future sales. Philips is also facing various short-term risks due to macroeconomic factors. However, macroeconomics will eventually improve. There is a lot of uncertainty regarding the introduction of obesity drugs and how it will affect Philips in the future. Management seems optimistic, but everything is uncertain for now. Philips still has a large backlog of orders, which is higher than in 2021. The company expects to see positive order intake growth in the full year 2024, indicating continued demand for its products. Philips now has a smaller portfolio, which allows the company to focus on its high-growth drivers and allocate resources to their successful products. This strategic shift is expected to result in increased margins. Finally, Philips has numerous opportunities to capitalize on new technology for developing new products, which could act as a growth catalyst in the future. This is particularly significant as many of these opportunities lie in monitoring, a highly profitable business. Philips expects to achieve a higher ROIC from 2025 onwards. However, its current low ROIC, coupled with the uncertainty surrounding the impact of its Respironics business, leads me to refrain from investing in Philips at this time.

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