Philips is currently trading below the price during the Covid-19 crash.
Opdateret: 25. jun. 2022
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 child care, and personal care). Of the three segments diagnostics and treatment is largest with 42 % of the sales, while connected care and personal health is 28 % each (there is also small "other segment" of 2 %). 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 Frans van Houten. He joined Philips in 1986 and had held several management positions until he became the CEO in 2011. He studied economics at Erasmus University Rotterdam and started his career in Philips in marketing and sales. He is highly recognized and in 2017 he was named among the Top 20 Global Business Leaders by Fortune magazine. Besides being the CEO of Philips, he is also a member of the European Round Table of Industrialists, while he also a member of the Board of Directors of Novartis. Once he became the CEO, he made the decision to get focus on medical technology and get out of their other divisions, a mission that he finally achieved when he sold the domestic appliances last year. His focus on medical technology resulted in Philips being ranked as the most innovative medical technology company in the world in 2020. He has explained that when selling off the domestic appliances division, Philips should result in a higher growth, larger market share and a rise in profitability. As a manager, he has stated that he believes in transparency and communication, as you need it to get people along with you. Personally, I like that he has the courage to solely focus on medical technology and sell their traditional business. Combined with his vast experience, I feel comfortable in Frans van Houten being the right person to drive Philips forward.
I believe that Philips has a large brand moat. I'm confident in the management. 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 %. The only positive thing is that Philips has delivered their highest ROIC in 2021. As written previously, Philips sold their domestic appliances business in 2021 but I don't know if that is the explanation of the higher ROIC. Time will tell and it will be interesting to see what they deliver in 2022. Looking at the numbers now, I'm not impressed.
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. Once again, 2021 is an outlier compared to the other years, and it will be interesting to see if that is a trend that will continue moving forward. So far, I'm a bit underwhelmed by the numbers.
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. Philips has managed to deliver a positive free cash flow in all years except for one. These numbers are a bit more encouraging than what we have seen in the other numbers. Hopefully, Philips can grow their free cash flow moving forward. It is something I will be monitoring.
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. Having done the calculations on Philips, they show that Philips can pay off their debt in 1,44 years. It is below the required 3 years, which means that from a debt perspective, I would have no issues investing in Philips.
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 end of 2022 or in the first quarter in 2023. Other risks are supply chain shortages. Philips, like many other companies, is dependent on their supply chain to make their products. The lockdowns we have seen in China lately has put further pressure on Philips supply chains. Until the supply chain normalizes it is a potential risk for Philips. Freight prices is also a risk. Higher freight prices will hurt margins, and right now it doesn't seem like freight prices are going to be lowered any time soon. The final risk I want to mention here is the pandemic. While we might see more countries opening, there are still countries that are affected by the pandemic. Last year, many of Philips customers pushed equipment installations at hospitals due to the pandemic, if this continues in the new year, Philips will not be able to deliver their products.
There are also lots of potential for Philips moving forward. They currently have an all-time high order book. Philips continues to grow their order book and reported a new all-time high order book in the first quarter in 2022, as order intakes grew by 5 % quarter over quarter. Instead of me explaining why this is important for Philips, I will let management explain themselves in a quote from the conference call in the first quarter in 2022: "we are operating with high margin but also high fixed cost businesses. And therefore, volume is a key driver towards profitability. They expect to resume growth. Because of strong customer demand, growing order book and actions they have taken, they expect to resume their growth and margin expansion in 2022. In the conference call in the first quarter in 2022, management stated that "we expect a strong recovery in the second half of the year". Looking longer term, management expects 5-6 % sales growth from 2025 and onwards compared to 4-6 % now. Furthermore, management expects EBITDA margin to improve by 60-80 bps in 2025. Some macroeconomics factors could benefit Philips. Management has talked about how staff costs at hospitals are going through the roof due to wages. Hence, 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. Their business restructuring is done. They may now fully focus on medical technology, and while their Connected Care division will hurt in 2022, they still expect to deliver 3-5 % growth in 2022. Furthermore, they will be able to fight inflation with their Personal Health division, as we are expected to see price increases in April, as we have seen in January.
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. 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. 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". 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 made some calculations on the free cash flow per share in 2020 as well, and the PAYBACK TIME price would be 23,96 euros).
I believe that Philips is an interesting company, as they have just restructured their business. The management seems very competent, and most of their risks seem to be short-term that shouldn't last for years. 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 a but underwhelmed with the numbers Philips has delivered over the last 10 years. However, Philips is a new company since their restructuring, 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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