Bright Outlook for LEDs to Benefit Philips (PHG)

Royal Philips Electronics, a global company based in the Netherlands, is well known for its lighting and electronics businesses. Apart from these two divisions, Philips has also diversified into semiconductors and the highly profitable medical systems area. Its medical systems division includes products such as ultrasound devices, X-ray systems, defibrillators and even healthcare related IT systems.

My interest in Philips stems not only from its very attractive current valuation but also due to a company called Lumileds based in San Jose, California. Lumileds was founded in 1999 as a joint venture between Agilent Technologies (A) and Philips to manufacture high-power Light Emitting Diodes (LEDs). In 2005 Philips acquired Agilent's stake in Lumileds for almost $1 billion. LEDs have traditionally been used as status indicators in devices such as remote controls and toys. Their low power requirements, long life and durability made them ideal for these low-light applications.

However, recent advances have improved the lighting ability of LEDs while retaining many of its advantages over traditional light bulbs. LEDs are now increasingly used in traffic lights (saving cities millions of dollars), automobiles, projectors and even for business lighting. In the near future, LEDs are going to replace bulbs in homes and offices.

Lumileds is a private company and hence determining its 2005 revenue is difficult. Based on a presentation done by Philips in 2005, we know that Lumileds had revenue of $280 million in 2004 and a scorching average annual growth rate of 43% over a three year period from 2001 to 2004. Assuming a conservative growth rate of 35% for 2005 and 2006, Lumileds should contribute $510 million in revenue to Philips in 2006.

Considering that 2005 annual revenue for Philips came in at $36 billion, the Lumileds revenue may only seem like a drop in the bucket. Given the bright (pun intended) outlook for LEDs and the leadership position Lumileds currently enjoys thanks to its patents, Philips may stand to benefit a lot from Lumileds in the future.

The electronics division of Philips has also been very successful with two of its flat panel TVs making it into recent Consumer Reports best buy lists. When I was shopping around for a HDTV last year, I ended up buying a Philips TV and have been very happy with it. Sonicare toothbrushes, Norelco electrical shavers and SENSEO coffee brewing machines are other noteworthy Philips products.

The stock has also seen a strong upward trend over the last three months and this is a positive sign. The valuation is still very attractive with a current P/E of 12 and Price/Sales of 1.08. While revenue growth for 2005 came in at an anemic 3.57%, Philips still managed to generate net income of $3.4 billion. If management were to meet its 2006 forecast for growth of 5 to 6% while improving their profit margins, the stock could see further appreciation. The current dividend yield for Philips is a nominal 1.6%, which is in line with the average dividend yield of the S&P 500.

Competitors:

Philips faces strong competition in its electronics business from Sony (SNE), Samsung and Matsushita (MC), the parent company of Panasonic. The lighting and medical systems divisions face competition from Siemens (SI) and General Electric (GE). Lumileds faces direct competition from Cree Inc (CREE) and a privately held company called Nichia.

The Good:

* Profitable company sporting attractive current valuation with a P/E of 12 and P/S of 1.08.
* Increasing adoption of LEDs for conventional lighting could be very positive for Lumileds.
* Strong growth expected from the medical systems division.
* A strong balance sheet with $14.07 billion in cash and long-term investments when compared to $5.31 billion in debt.
* A renewed focus on research and development. Almost 49% of 2005 revenue came from products developed in the last three years.

The Bad:

* Anemic growth rate of 3.57% in 2005.
* Very strong competition and pricing pressure in its electronics division.

The Numbers

P/S	1.08	Cash	$6.27 Billion
P/E	12	Long Term Debt	$3.93 Billion

PHG 1-yr Chart

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