Description

Signify ("LIGHT"), formerly known as Philips Lighting, is a lighting and component parts manufacturer that was spun out of Royal Philips in 2016.  On sale is a business with a 15% FCF yield and 5.5% dividend yield offered at a 6x EBITDA multiple as the market believes Signify's cash flow is in secular decline.  We believe the future is bright. By continuing execution on cost savings and returning sustainable cash flow to shareholders, we see 45% upside without assuming multiple expansion.

Business description. Signify produces both light bulbs and light fixtures, in traditional (CFL, halogen, fluorescent etc.) and LED technologies, to professional end markets and retail customers around the world.  Signify breaks its business into 4 segments. The first two segments manufacture and sell light bulbs, referred to in the industry as lamps, and related component parts and the last two segments manufacture and sell light fixtures, referred to in the industry as luminaires. The segmentation is a bit confusing so bear with us while we walk through it.

Lamps. Manufactures and sells conventional light bulbs to both professional end markets (such as industrial, commercial, office, outdoor etc.) and retail consumers.  This business also sells conventional components that go into lamp fixtures. Lamps is ~25% of revenue but ~50% of profit with a ~20% EBITA margin.

LED. Manufactures and sells LED light bulbs to both professional end markets and retail consumers.  This business also sells LED components that go into light fixtures to luminaire manufacturers around the world.  LED is ~25% of revenue, ~25% of profit with a ~10% margin. We believe revenue and profit is split about evenly between LED light bulbs and LED components.

Professional. Manufactures and sells both conventional and LED light fixtures to professional end markets. Professional is ~40% of revenue, ~35% of profit with an ~8% margin (this margin is guided to be around 11-14% by 2019, in line with peers).

Home. Manufactures and sells both conventional and LED light fixtures to retail consumers. The majority of this business today is Philips Hue, which you may by familiar with. Home is 10% of revenue and right now the business is loss making but is guided to have a normalized 5-8% margin by 2019.

Furthermore, LIGHT breaks out it's business into its profitable, cash flow Lamps business and its "growth engine" businesses which include LED, Professional and Home.  When we refer to "growth engines" we are referring to these three businesses.

Quick/over simplified primer on lighting: Every LED lighting fixture needs a "driver", an electronic component that controls the power.  The driver is the most important part of the fixture. The more "smart" and connected lighting becomes, the more sophisticated the driver has to be.

This is old fashioned value.  For 6x EBITDA and at a current 15% FCF yield you are buying a company that has generated sustainable cashflow of between €300-400mn over the last 3 years since the IPO.  The pillar of this cash flow is Signify's Lamps business which has high margins and low capex but is in decline. As it has declined, LIGHT has successfully reduced costs and rationalized its manufacturing base to maintain a high margin and cash flow conversion.  Cash flow was lower in 2018 due to expected, higher restructuring costs. The company guides to >5% FCF conversion going forward.

Additionally, management is focused on allocating cash returns to shareholders.  Since the IPO, they have spent 50% of cash flow on share repurchases and 45% on dividends.  The current dividend yield is 5.5%. Returning value to shareholders is a high priority for the company.  

Why it's cheap. The skeptics (most of the sell-side) say that the ~20% margin, high cash flow Lamps business is being replaced by the 3 LED businesses with ~10% margins that are subject to Chinese competition and have low barriers to entry.  Furthermore, pessimists will state that LED has reached full market saturation and with a much longer replacement cycle (LED light bulbs last much longer than traditional light bulbs). Signify's "profit business" is rapidly declining while its "growth engines" are not growing.

There are justifiable reasons for some of the negative sentiment.  However, the stock has declined 33% over the course of 2018 and compared to other lighting fixture peers that trade in the 8-12x EBITDA range, this negative sentiment seems more than priced in at 6x.  And there are legitimate counter arguments to be made as to why the above narrative is wrong.

Sales Growth.

Note: Normalized revenue growth normalizes for a destocking issue the Home segment experienced in H2 2017 and H1 2018 where retailers overestimated demand for the holiday season causing 45% and 53% Home division growth in H2 2017 to reverse to -6.5% and -6% in H1 2018.  Growth rates shown are on a constant currency basis.

The "growth engine" businesses have seen sales growth over the past few years, albeit at a declining pace.  2018 looks particularly light due to the recognition of a few large projects in the Professional division in 2017 which can be lumpy.  We estimate moderate sales growth going forward, but sales growth nonetheless, based on the following logic:

Chinese competition normalizing. LED sales slowed in 2018 as LEDvance (the former Osram lamps business, now Chinese owned and fixture focused) in Europe and an influx of smaller Chinese imports in the US aggressively priced product to gain market share.  However, the number of new Chinese products approved by safety certification institutions in the US (a proxy for Chinese imports into the US) declined by 25% starting in the second half of 2018 compared to an increase of 25% in 2017 and a more than doubling every year from 2013 to 2016.  Additionally, the price of LEDs started to stabilize throughout 2018 after an average of ~30% YoY declines in 2017. Lastly, LIGHT and the other large OEMs recently implemented multiple price increases to counter cost increases associated with tariffs. These price increases more than recoup the increase in costs, and represent the first price increases applied since LED has taken off.

The LED markets to which LIGHT is exposed are still underpenetrated. Broadly speaking, the lighting market is broken down into indoor and outdoor lighting.  Indoor comprises around 75% of the market whereas outdoor is 25%. Although it varies, consultants estimate indoor LED lighting penetration at somewhere near 60%.  Outdoor LEDs are higher powered and therefore about 10x more expensive than indoor fixtures causing the outdoor market to lag the indoor market, resulting in outdoor LED penetration closer to 10-20%.

In its Professional division, LIGHT has more exposure to less penetrated segments including:

• Outdoor lighting, with a large presence in street lighting.
• Specified lighting, which is generally designed into a project and therefore more insulated from Chinese competition vs. "stock and flow" commoditized products.
• Horticulture lighting, where LIGHT is by far the market leader and where LED lighting is only starting to take off with cannabis legalization in Canada and the US as a tailwind.

Connected lighting opportunity. If LED was the first wave of new lighting technology, connected lighting is the second wave which is still in its early innings.  Our industry checks indicate that about 10% of current LED lights are connected. In its current form, connected lighting allows for lighting control based on schedules and environmental changes, more efficient maintenance, data tracking, workspace optimization, and in the future, a plethora of other upcoming technologies (including LiFi, a faster and more secure alternative to Wifi).  A good example of basic connected lighting is the Philips Hue home system. Signify is extremely well placed, with sustainable competitive advantages, as LED lighting becomes more connected. Within Professional, Signify is aggressively pursuing connected outdoor lighting opportunities around the globe. High profile recent wins include illuminating Shanghai's buildings, bridges and rivers (50,000 connected lights) and 15 of London's iconic bridges (22,000 connected lights).  Additionally, the more connected lighting becomes, the more sophisticated the electronic components must be as well. Signify sells LED drivers to the entire industry (aka their luminaire competitors) and is one of only three players that can manufacture highly complex LED electronics suitable for connected lighting. Signify is recognized as best in class with an estimated 50-55% market share in the high output market. LED drivers are half of Signify's LED Lamps business group and will drive LSD growth for it going forward - something often overlooked.

Replacement cycle.  Because light sources are more and more integrated into a connected light fixture rather than comprised of a bulb simply screwed into a fixture, the replacement cycle will be based on design, refurbishment and technology upgrades rather than a light bulb blowing out.  The industry experts we've spoken to confirm that the replacement cycle for LEDs won't be that much longer than conventional lighting because decisions will be driven off of design cycles. The idea that you'll only need to buy a new LED light bulb once every 20 years compared to once every 5-7 years with conventional light bulbs is an over-simplification and outdated thinking.

Steady EBITA.

Pessimism regarding sales has naturally filtered its way to EBITA despite steady performance:

Note: EBITA is adjusted for the revenue in the home destocking issue discussed above.

Cost savings. Sales growth questions aside, a major driver of EBITA strength and margin improvement has been cost savings.  When the Company IPO'ed in 2016, its indirect cost base, which includes SG&A and R&D, was around 32% of revenue.  Management set a 2019 target indirect cost percent of revenue level of 25-29% in line with peers through reductions in 1) Finance, 2) IT, 3) real estate and 4) non-manufacturing headcount.  The company is on track; in 2018 they were just under 30% reducing indirect costs by €225mn or ~10%. This was 30% of 2018 EBITA highlighting its relative importance. We model another €60mn of reductions in 2019 - potentially conservative given the magnitude of 2018 cost savings - to get to the high end of their target range of 29% of revenue.

Lamps: A second major source of EBITA has been the Lamps business.  Conventional lamps manufacturing has been dominated by 3 large players including Signify (previously Philips Lighting), Osram and GE (the Edison light bulb was the original GE product!).  Since 2017, the other 2 manufacturers have exited and/or de-emphasized traditional lighting products, allowing Signify to pick up market share, and decline at a slower rate, in this highly profitable business.  

The steady and predictable decline of the Lamps division, growth of 1.5% to 2% p.a. from LIGHT's remaining, growth engine businesses and €60mn of cost savings this year followed by €20mn in the next 2 years should enable LIGHT to produce significant and steady EBITA and FCF moving forward, contrary to the general consensus. After 2021, the decline in the Lamps division becomes insignificant compared to the contribution of the growth engine businesses and maintaining / growing EBITA becomes far less challenging.

Valuation

A normalized Home business combined with modest growth of 1.5% to 2% in the LED and Professional businesses, an "as usual" decline in the Lamps division of -22%, and cost savings of €60mn, implies 2019 EBITA of €693mn or an 11.3% EBITA margin.  This compares to consensus EBITA estimates of €622 and EBITA margins of ~10%. Our model assumptions imply €350-450mn in annual cash flow and assuming no multiple expansion, results in a target price of €33 in 2020.

Alternatively, the Lamps division alone (in runoff) is worth €6-8 per share implying that the rest of the business is worth 5.5x EBITDA.  As mentioned, other fixture comps are trading between 8-12x.

Note: Financials above are actual and may not tie to charts based on home adjustment.  (1) We take out stock comp for valuation and add it back for cash flow (2) includes the sale of PPE and intangible spending (3) We split the restructuring expense into ongoing (lamps) and one-off.  Ongoing is capitalized and treated as debt in enterprise value whereas one-off is deducted from cash flow.

Risks

• Increase in competition from China.
• Macro economic down turn or cyclical downturn.
• Lamps business declines accelerate.
• LED luminaire business starts to decline.
• Industry dynamics in flux (competitors constantly entering and exiting)
• Whac-a-mole dynamic (complicated industry with many end markets)

Catalyst

• Execution on 2019 guidance
• FCF generation
• Home business normalizing