Has Philips' Healthcare Transformation Reignited Growth?
- Update on Philips from my 2017 article.
- Analysis of Philips three main segments.
- What should you do?
I last wrote about Philips in July of 2017. The Dutch company had recently spun off its lighting division to focus on healthcare products and services. It had impressive increases in operating income in FY2016, with the Image-Guided Therapy division achieving double-digit growth. However, I also articulated my concern that the healthcare company was relying too much on cost-cutting to improve profitability, without expanding revenue to match its new focus on growth. I concluded my article by advising readers to hold off on purchasing shares until the 2017 annual report to see if the Image-Guided Therapy division had continued strong growth, since it seemed poised to be Philips’ growth engine.
Here are the business segments as we go into Philips’ performance in 2017.
(All images from Philips’ 2016 & 2017 Annual Reports, unless specified)
The Health & Wellness division (mother and child care, oral care) experienced a slowdown from double-digit growth in 2016 to high-single-digit growth in 2017. This was the only subdivision within Personal Health that experienced a decline in growth from the previous year, which points at the market saturation of the Sonicare toothbrush line. The company didn’t disclose any figures relating to revenue derived from oral care. They mentioned a gimmicky “breath analyzer” along with an all-in-one connected oral care platform, but without any numbers to compare, it looks like Health & Wellness division is struggling to maintain growth.
Next is Personal Care (male grooming, beauty), which had mid-single-digit growth in 2017–the same as 2016. The highlight is that the new OneBlade razor generated “EUR 10 million within 18 months of its launch,” according to the CEO. I found this deceptive, because OneBlade’s performance was given over the course of 1.5 years, and there was no mention of how the existing Norelco razor line performed. OneBlade was designed as a “hybrid styler” that would appeal to men with facial hair who didn’t find the original Norelco razors useful. However, with the same growth rate in the previous year, it seems that OneBlade has failed to appeal to a broader audience as Philips had hope, leading to improvement in growth.
Moving onto Domestic Appliances (kitchen appliances, coffee, air, garment care, floor care), there was mid-single-digit growth–same as 2016. I personally think this division needs to be spun off, because its share of the Personal Health revenue shrunk from 34% in 2016 to 32% in 2017, and it is a low margin business. The only product reported on in this category was the Airfryer, which has only sold 10 million to date. Philips appliances also aren’t known for their quality, so as time goes by, I hope to see Philips fully embrace their growth-oriented transformation by shedding the Domestic Appliances division, and doubling down on their strongest consumer product categories: oral care and electric razors.
The final division in the Personal Health segment is Sleep & Respiratory Care (sleep, respiratory, respiratory drug delivery). It also had mid-single-digit growth in 2017–same as in 2016. I am optimistic about this division’s potential after Philips partnered with Oranger (the largest Chinese chronic respiratory disease examination company) to supply products for respiratory screenings. The pollution crisis in China has exacerbated breathing issues, which provides ample opportunity to expand the Sleep & Respiratory Care division in growth markets as mature regions experience stagnation in demand for these products.
The Personal Health segment isn’t a catalyst towards reigniting growth for Philips. Thus, despite the slowdown in growth for 2017, I am encouraged by the 1.1% increase in EBITA margin, which shows that Personal Health will be Philips’ “rock” as the company relies on the Diagnostic & Treatment segment for real growth.
Diagnostic & Treatment
The first division in this segment is Diagnostic Imaging (MRIs, X-Ray, etc.). Growth, at low-single-digits, was the same as 2016. There were only two positive developments in 2017 for this division: first is a multi-year deal with the Singapore Institute of Advanced Medicine Holdings to provide the oncology center with imaging systems; second is strong traction of imaging systems with private hospitals in China. The Singapore deal is an average agreement, which means little growth is to be gained from it. However, China seems to provide another avenue for growth. Philips reported double-digit growth of its imaging systems in the country, which means Philips’ efforts to gain market share in China have been working–good news for shareholders.
The next division is Image-Guided Therapy (interventional imaging, catheters). This was the division in my previous article for which I expected to be Philips’ key to reigniting growth. Part of the key was Stellarex (drug-coated catheter) which was estimated to generate EUR 100 million in its first few years after FDA approval, which occurred in late-July 2017. However, it seems that has not been the case. The Image-Guide Therapy division slowed down from double-digit growth in 2016, to mid-single-digit growth in 2017. This is concerning, because Philips expected this division to continue with robust growth, but following FDA approval with four months left in 2017, growth declined.
Ultrasound (diagnosis treatment planning, OB/GYN imaging, proprietary software) is the final division within the Diagnosis & Treatment segment. Growth was actually up from being flat in 2016, to achieving mid-single-digit growth in 2017. Fortunately, Philips tends to excel in ultrasound innovation. Their new OB/GYN ultrasound machines have made it easier for medical staff to discern the gender of babies earlier in gestational periods, which has won Philips plenty of business from hospitals in mature markets.
The Diagnosis & Treatment segment is the biggest disappointment for Philips in 2017. Comparable sales growth has fallen three years straight in a division that was seen as the healthcare firm’s future growth driver. The only silver lining is a 1% improvement in EBITA margin, but without topline growth, cost-cutting can only go so far for Philips.
Connected Care & Health Informatics
The first division is Patient Care & Monitoring Solutions (patient monitoring/analytics), which accounts for 78% of the segment’s revenue. This division had mid-single-digit growth in 2017, just like in 2016. There wasn’t much discussion about this division, but it was mentioned that Emory Healthcare did save $4.6 million over 15 months in its ICU units because Philips’ product reduced hospitalizations of chronically ill patients due to its preventative nature. Traction in the US for this telehealth technology is good, because telehealth services are poised for growth as healthcare consumers seek greater convenience at lower cost.
Next is Healthcare Informatics (healthcare IT, data visualization), which continued with anemic growth of low-single-digits in 2017–similar to 2016. It is a small division at 15% of total revenue for the segment, and its main issue is that it is somewhat of a luxury. Revenue fell 2% in “growth geographies,” grew 1% in “mature geographies,” and increased by mid-single-digits in North America and Western Europe. The new AI technology from this division is a fancy development that only the wealthier hospitals care to adopt, which is why growth is higher in regions with greater wealth.
The last division is Population Health Management (remote patient monitoring), which is geared towards the geriatric and chronic illness populations. This is the smallest division, accounting for only 7% of sales in a segment that is half the size of other segments. Strangely, I didn’t any mention of revenue growth for this division in the 2017 report. However, in 2016, there was a low-single-digit decline. Since this division is geared towards the elderly and chronically ill, this will be a long-term play for Philips. North America, Europe, and Japan will likely be the best markets, but growth will never be explosive–this will turn into a steady cash flow division.
Since Philips had a minor restructuring in 2015, my DCF starts from 2016 and projects to 2020. For my assumptions in revenue growth in Personal Health, Diagnosis & Treatment, and Connected Care & Health Informatics, I used management's guidance for next year. I assumed Personal Health to grow at a modest rate of around 3% since this segment is a steady cash flow, low growth business for Philips. For Diagnosis & Treatment, although it had disappointing growth, I believe the Spectranetics and Volcano acquisitions are still under development, thus I steadily increased growth from 3% next year to 6% by 2020. Finally, for Connected Care & Health Informatics, growth was flat, but the gains in demand from aging populations that Philips claimed in the annual report seem be a long-term play, thus I assumed anemic growth of 1% until 2020.
On the cost side, gross margin was 46%, meaning cost of goods sold was 54%, which I assumed to be constant until 2020 because the figure didn't change significantly in previous years. SGA was set at 28%, and hovered around that percentage in previous years too. R&D was set at 10%–it has been between 9% to 10% in the past.
(Source: My DCF)
For the WACC, I came up with 7.7%, which increased after the introduction of the Tax Cuts and Jobs Act in late-2017 because Philips' US deferred tax assets were written down, causing their effective tax rate to jump from 19.9% in 2016 to 25.3% in 2017. Management predicted the 2018 effective tax rate to be between 26% and 28%, so I went down the middle with 27%.
The valuation came out to be $34.62 per share, which is below the current price of $37.67.
The price of Philips was $35.67 when I last wrote about them on 7/7/17.
The stock hit its 2018 high of $41.92 in late-January, but now it's only grown less than $3, which is a signal that investors do not consider Philips a growth-oriented company. My DCF also pegged the stock at $34.62, or 8% below what it is currently worth.
However, when compared to Siemens (healthcare competitor), Philips is faring relatively better, and only slightly underperforming versus the S&P 500.
Another positive factor is that short interest decreased by 1 million shares since last July, which proves investors are more confident about Philips than before.
At this point, I wouldn't recommend buying Philips since it has failed to reignite growth with its Image-Guided Therapy division, but I also don't think now is the right time to sell either. The stock continues to chug along in a turbulent market, and tends to move in a predictable fashion. Therefore, my recommendation (if you already own PHG stock) is to write a 2 month call @ $40, and buy a 2 month call @ $45. This strategy can provide you a source of income while Philips' stock continues to trade sideways, but also hedges potential losses in the unlikely event the stock takes off.
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