Description

Investment highlights

Philips is a very high-quality business with strong, dependable and predictable franchises leading to mid-teens profit growth over the foreseeable future. 60% of sales come from markets where Philips holds either #1 or #2 position. It exhibits a very diversified revenue base and the pandemic has all but proven the business resilience.

Philips has a complex and troubled past and is still rather misunderstood because of it. For many years analysts saw it as an “industrial conglomerate”. The most negative analysts today (e.g. Credit Suisse) are in fact industrial analysts while Philips today is really a pure MedTech business. In March 2017 the Stoxx 600 index changed Philips GICS from industrial to MedTech, reflecting the change in business mix but some people have a long memory and still think of Philips as an electronic TV producer.

We believe that sustained mid to high teens EPS growth combined with a rerating due to a) clear long-term path to margin expansion, b) simplified business structure and c) closing the valuation discount to peers, should lead to attractive (20%+) IRR over the foreseeable future.

Business description

Founded over 1 century ago, Philips has a deep-routed tradition of innovation:

·         Introduced Medical X-Ray in 1918

·         Larger manufacturer of light bulbs in 1921

·         Largest manufacturer of radios in 1927

·         Invented the electric shaver in 1931

·         Invented the CT scanner in 1975

·         Launched first ever MRI-Linac machine in partnership with Elekta in 2018

However, a lack of focus led to sub-par margins and below-peers returns on capital.  CEO Van Houten (since 2011) led a dramatic transformation that effectively led to the disposal of every business (electronics, lumileds etc.) which was not pure Healthcare. The IPO of the lighting business in 2016 was the final large step of this process which will culminate in Q3-21 when Philips will dispose of its domestic appliance division. When this will happen, Philips will become a pure-play med-tech business. Our thesis is that when this will happen, the stock will inevitably re-rate and narrow the c. 25-30% discount to peers.

The business today has 3 divisions:

·         Diagnosis and Treatment (primarily large machinery like X-Ray, CT Scanners, MRI machines). Philips is the global leader in Ultrasound, Image-guided therapy systems Image-guide therapy devices and is a top-3 player (alongside Siemens Healthineers and GE) in diagnostic imaging and radiology informatics

·         Connected Care and Health Informatics (patient monitoring hardware and a range of software solutions connecting patients to devices). Philips is the global leader in patient monitoring , sleep care and respiratory care. It recently strengthened its position in the market with the acquisition of BioTelemetry (BEAT), the #1 cardiac ambulatory home monitoring provider

·         Personal Health (it’s a consumer business, primarily Oral Care). This segment focuses on growth areas where Philips has global market leadership and where there is an important element of innovation. Key areas include oral healthcare (e.g. Sonicare), mother and childcare, male grooming (e.g. Philips blade) and hair removal

The business is relatively high growth – while the overall Healthcare market grows at c. 4%, Philips is guiding for l.t. growth above market (5-6%) thanks to better mix, exposure to higher growth emerging markets and share gains from competitors. There are strong market trends supporting Philips growth:

·         Aging population leading to increase in chronic diseases

·         Emerging markets devoting higher % of GDP to healthcare

·         Digitalization of healthcare

·         Procedure innovation away from invasive interventions

·         Adoption of telehealth supporting growth in remove patient monitoring

·         Consolidation of providers favoring largest vendors like Philips

We believe Philips will play a strategic role in the move away from cost-per-patient models towards outcome-oriented models. Philips is becoming the partner of choice for many hospitals because they can combine systems, devices, services and informatics via cost effective solutions that are structured as recurring-revenue business models, more manageable for providers from cash outflow perspective and more predictable and therefore more efficient for Philips. We believe this move will lead to a further re-rating of the stock as it’s adding visibility to its business reducing volatility in hospital orders. For example, in October Philips signed a 7-year agreement with a large hospital in Indonesia to provide services that include imaging and image-guided therapy technologies, integrated informatics and connected monitoring solutions to support clinical care delivery. Philips aims to scale these types of long-term partnerships into adjacent clinical areas. This strategy also increases the barriers to entry to competitors as it becomes very hard for a care provider to switch partner of choice. By 2025, Philips aims to derive up to half of its revenue from “solutions” rather than from “product sales” from c. 37% in 2020.

Financials

Since the disposals of the non-core business, Philips exhibited consistent growth in line with its 4-6% organic targets:

From a margin perspective, Philips guided in the past to c. 100bps of annual margin improvements thanks to cost cutting measures, productivity, operating leverage and better mix. Due to some issues in the Connected Care division, Philips managed to improve EBITA margins only 70bps annually.

Going forward, Philips aims to continue with similar pace of annual margin expansion (60-80bps) until 2025, when it should reach high-teens EBITA margin:

The above growth algorithm should lead to c. 10% EBITA CAGR and mid-teens EPS CAGR growing forward. We believe Philips could reach an earning power of EUR4 per share by 2025 against a share price of EUR44 today:

While Philips stock appreciated considerably in the last decade and re-rated somewhat, it still trades at a discount to its peers notwithstanding the above-described superior financial profile:

Philips trades at c. 20-25% discount to our selected group of peers:

In our exit scenario analysis, we assume the stock will narrow the valuation discount and re-rate to 22x P/E or 15x EBITDA, which is still a discount to peers. On these exit assumptions, we forecast a 20% IRR for a 3-year investment:

Catalyst

None