Investment Thesis

Although the stock has moved significantly in the past few months, we believe Philips (PHIA NA) still represents a compelling risk/reward at current levels.  This is certainly more of a GARP name than deep value. The company has undergone a transformation from an industrial conglomerate to a company focused on consumer health and healthcare technology.  While near-term valuation is fair to robust, a clear runway for margin expansion and growth should result in very attractive valuation metrics within the next few years. We think the company is trading for less than 14x EPS and 9x EBITDA on 2020 numbers.  We think this is too cheap for a company with an incredibly strong portfolio of assets in attractive end-markets that should be able to grow earnings by double-digits for the next 5-10 years.

Company Overview

Philips spent the last few years transforming from an industrial conglomerate to a company focused on healthcare and health-related consumer products.  This transformation was accomplished through acquisitions and by spinning off, via IPO, the company’s lighting division. Philips has been selling down its holding in Signify (formerly called Philips Lighting) but still owns an 18% stake worth ~550mm euros.  They plan on selling the remaining stake and we net out the holding in our Net Debt assumption at a 20% discount to market.

The company is currently undergoing a large (1.2bn Euro) cost restructuring program in which they are cutting the number of global manufacturing locations from 50 to 30, significantly reducing overhead redundancies and focusing on procurement savings.  This program, along with continued growth, should result in large margin expansion over the next few years.

The company essentially operates in three broad segments with various sub-segments underneath those:

1.     Personal Health (~40% of rev)

a.       Sleep and Respiratory Care

This sub-segment mainly sells CPAP machine masks for sleep apnea.  This is a great business that is pretty much controlled by two companies (Philips and Resmed).  The end market for sleep apnea is massively underpenetrated and newcomers to the industry have not made much of a dent due to the focus on quality.  Resmed trades at ~20x EBITDA

b.      Health and Wellness

This sub-segment mainly consists of Sonicare electric toothbrushes.  This business is somewhat of a duopoly with Oral-B (owned by P&G). This is also an underpenetrated market with a recurring revenue element.

c.       Personal Care

Primarily electric shaving products such Philips Norelco shavers. Competitive market but company has continued to innovate and take share.

d.      Domestic Appliances

This includes sales of air purifiers and small home appliances.  This sub-segment is likely non-core and we would not be surprised to see this sold to a larger appliance company.

The Personal Care segment has been growing at mid-to-high single digits for years and this should continue for the foreseeable future due to various underpenetrated end-markets.  EBITDA margins have increased over the past couple years from ~17.5% to ~19% and Philips should be able to add a couple of % points by 2020.

2.     Diagnosis and Treatment (~40% of rev)

This segment is comprised mainly of:

-          Ultrasound equipment

-          CT scanners

-          MRI machines

-          X-ray machines

-          Software and Services that are utilized in the above mentioned applications

In the majority of these markets, the other main competitors are Siemens Healthineers and GE.  There has been enough business to go around and the three competitors have played relatively well in the sandbox as end-markets continue to see relatively strong growth.

This segment also includes the fast growing sub-segment of image guided therapy, which is utilized in minimally invasive surgical procedures.  This past year, Philips purchased Spectranetics for ~$2bn in order to further grow this business. The purchase was made for ~6x revenue (zero adjusted EBIT) and was not very popular with investors.  However, this sub-segment is growing rapidly and should eventually become highly profitable utilizing the distribution of Philips.

Overall, this segment has been significantly under-earning due to large investments in R&D (~10% of segment Rev) and ramping up of faster-growing sub-segments that are just starting to hit scale.  Current EBITDA margins are less than 13% but should grow materially in the next couple of years to 18%+ (comp margins are ~20%).

3.     Connected Care & Health Informatics (~20% of rev)

The majority of this segment is comprised of various medical devices such as:

-          Ventilators

-          Defibrillators

-          Patient monitoring systems

The segment also sells patient monitoring software and services.  This segment should show strong growth over the next few years with EBITDA margins expanding from the current level of ~16% to 18-20%.  

Valuation

While Philips is not exactly a bargain on near-term numbers, we think it is necessary to look out a couple of years due to the fact that there is significant structural margin upside versus peers.  Overall organic revenue growth should continue in the mid-single digit range. However, we see EBITDA margins expanding from ~15.75% in 2017 to over 19% in 2020. This leads to EBITDA CAGR of mid-to-high teens over the next few years.  Also, the company is only levered at 0.7x TTM EBITDA (including the Signify stake) and the balance sheet could be used to accelerate EPS growth.

On our assumptions, Philips is trading at <9x 2020 EBITDA and 14.5x EPS.   We think this is relatively cheap for a high-quality company with significant positions in high-growth markets.   When thinking about the right multiple to use, we look at a blend of comps based on end markets. For Personal Health, we look to Resmed, PG, etc.  For Diagnosis and Treatment/Connected Care and Health, we look to Siemens Healthineers, TMO, MDT, Cerner, Athena, etc. This diverse set of comps trade at 12.5-15x EBITDA on the low end (exceptions are higher for the most part).  If we go with the low end, we get a 52 euro stock and using 15x we get to a 63 euro stock (~40-70% upside over 2 years plus a 2% div yield).

Major Risks

-          Potential for management to overpay for M&A

-          Inability to hit margin targets

-          Increased competition