In April 2023, I upgraded Koninklijke Philips N.V. (NYSE:PHG) from sell to hold. Against my expectations, the stock has jumped 28% since. However, it should be noted that this was driven by a settlement regarding the company’s apnea devices. Most likely, absent the settlement, we would have seen the stock flat to slightly down as Philips stock jumped 35% on $1.1 billion settlement news. In this report, I discuss the most recent report and discuss whether Philips is now better positioned for investment.
Pricing And Productivity More Than Offset By Respironics Settlement
For the first quarter, reported sales growth was negative 1% while comparable sales growth was 2.4%. Comparable order intake was down 4% driven by soft consumer demand and industry-wide anti-corruption measures in China. Income from operations tumbled from a €583 million loss to a €824 million loss. This was driven by a €982 million settlement provision for the Respironics litigation and total Respironics costs of €1.078 billion. It is not the case that operating income would have improved by hundreds of millions of euros if there would have been no charge because in Q1 2023 there already was a €575 million charge against earnings.
Adjusting the operating income in both years for all Respironics costs shows that adjusted operating income would have been a €46 million profit in Q1 2023 and a €254 million profit in Q1 2024. The adjusted margins also06 shows that the underlying business was performing better year-on-year, driven by productivity gains, pricing and royalty income growth outpacing cost inflation.
Diagnosis and Treatment sales were modestly higher €2.026 billion with 3% comparable sales growth but adjusted EBITDA margins were down significantly from 15.4% to 11.5% driven by a normalization in product mix and higher restructuring costs and value adjustments on fixed and intangible assets in the comparable quarter last year.
Connected Care saw compare sales decline by 1% to €1.164 billion. Operating income decreased from a €717 million loss to a €1.065 billion loss, driven by the Respironics litigation and field-action costs. Interesting to note is that even if we add back the €1.078 billion, the Connected Care segment would be operating at a break-even operating margin. Adjusted EBITDA margins expanded strongly from 6.3% to 11.5% driven by productivity and mix, but one can wonder whether this business segment will actually be able to operate at a strong operating margin even when there is no cost growth due to the Respironics fiasco.
In the Personal health segment comparable sales growth was 3% but down €8 million measured by real growth to €790 million with operating income of €116 million pointing at margins of 14.7% compared to 12% a year ago. Productivity and cost absorption led to year-on-year growth to the adjusted earnings.
Philips Guides For Acceleration In Sales Growth And Margin
For 2024, Philips is aiming to achieve comparable sales growth of 3 to 5 percent with adjusted EBITDA margin of 11 to 11.5 which would be an acceleration from Q1 where growth was 2.4% in CSG and EBITA margin was 9.4%. The free cash flow guide has improved from between €0.8 billion and €1 billion to €0.9 billion and €1.1 billion and includes €540 million from insurers for the Respironics claims. Important to note is that while Philips has reached an agreement in the US for personal injury and medical monitor litigation, the DoJ investigation and other proceedings are still ongoing. So, while the litigation settlement is a welcome one and caused the surge in the Philips stock price, it is definitely not the case that the Respironics debacle is a thing from the past.
We also note that Philips has seen margins decline for a decade and a focus on cost optimization is key. The company aims to realize €2 billion in cumulative savings, of which €1.1 billion has been realized by the first quarter of 2024.
Philips Stock Has Significant Upside For 2025
In my previous reports covering Philips, I used a rather simple model to value the stock. I have now used a more elaborate model using balance sheet data, scheduled debt repayments, as well as projections for EBITDA, free cash flow, share repurchases and the current balance sheet to value Philips. For 2024, there is 11% upside to $28.59 with significant more upside in the years ahead. As a result, I am upgrading the stock to buy with the sidenote the Respironics segment might still provide a risk to business as litigation other than the ones are still ongoing.
Conclusion: Philips Is De-Risking But Is Not Fully De-Risked
The $1.1 billion litigation settlement is good news for Philips in the sense that it takes away some uncertainty. However, it should be noted that not all risk has been eliminated. Perhaps with that in mind, the jump in the stock price is surprising. Currently, we cannot make any projections for future charges tied to the Respironics fiasco. If there are any future charges, this will provide downside risk to Philips’ stock price.
The business is showing some appreciable margin expansion driven by productivity gains as well its €2 billion cost reduction program, of which another €900 million has to be realized. While I am aware that there is still downside risk, I am upgrading the stock to a buy as I expect that Philips is inching closer to being fully de-risked on the Respironics debacle, which should clear a lot of overhang and put the company’s margin expansion in the spotlight.
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