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Re-initiating coverage

  • 20 Feb 17

Recommendation and upside We are re-initiating coverage on Royal Philips (market cap. of €26bn and a float of c.98%) with an ‘Add’ recommendation and a target price of €32.0 (c.15% upside). Our upside is driven by the transformation of Philips into a pure play HealthTech player (we estimate deconsolidation of Philips Lighting with ownership stake falling below 50% in H2 FY17), margin upgrade potential (primarily in the Diagnostics & Treatment segment) and focused cost optimisation initiatives. Royal Philips holds dominant positions in most of its €145bn addressable health continuum (c.60% of sales is derived from businesses in which Philips has a leading position) and is a market leader in sleep & respiratory care, power toothbrushes, cardiac ultrasound and patient monitoring. The HealthTech industry offers robust growth opportunities (c.6.5% organic growth until 2019) and we expect Royal Philips to strengthen its market position further (estimated to clock mid single-digit revenue growth until 2019) on the back of an innovative product portfolio and higher growth opportunities in the emerging markets (c.42% of revenue; e.g. China, LatAm region). Moreover, the shift towards a diversified integrated solutions provider will lead to faster growth in the high margin service business. The IPO of Philips Lighting in May 2016 (Royal Philips offloaded a c.29% stake through the IPO) triggered a fresh rally in the Royal Philips stock (it was range bound since the separation of lighting and healthcare was announced in September 2014). The scrip touched a life-time high level in January 2017 (c.21% return from the IPO date); however, the momentum has somewhat fizzled out since (down c.7% from the all-time high). We believe that any announcement on further stake sales in Philips Lighting will lead to deconsolidation of the Philips Lighting business (estimated in H2 17) and could trigger the next rally in the stock price (healthcare industry offers low beta, high growth and resilient margin vs a lower revenue growth and subdued margins in the existing conglomerate). Business and Trends Over the past decade, Royal Philips has transformed from a diversified conglomerate (low single-digit revenue growth and mid single-digit profitability) into a focused HealthTech organisation (mid single-digit revenue growth with resilient double-digit profitability). This business is organised into three operating segments – Personal Health (c.29% of sales; target market worth €47bn), Diagnostics and Treatment (c.27% of sales; target market worth €52bn) and Connected Care & Health Informatics (c.13% of sales; target market worth €46bn). The Personal Health business has been the primary growth contributor over the past couple of years with average lfl growth of c.6% per year during 2014-16. Going forward, we expect this positive growth trajectory to continue (revenue growth of mid to high single-digit) on the back of huge untapped opportunities (e.g. 15% penetration of power toothbrushes globally, 80% of the 100m patients suffering from sleep apnea are untreated), innovative product pipeline (dream station portfolio for sleep care) and geographical expansion with proven propositions (e.g. launch of air purifiers and a one blade shaver in other countries). The growth momentum is expected to pick up in the Diagnosis & Treatment segment (mid single-digit revenue growth until 2019 vs c.1.5% per year during 2014-16), driven by the market share restoration in the imaging business (FDA issues at Cleveland facility are now resolved) and the diversification of the ultrasound portfolio into underpenetrated adjacent activities (€2bn general imaging and €1bn gynaecology market). The Connected Care & Health Informatics segment is expected to grow in mid to high single-digits (vs lfl growth of 4.5% in FY16), led by an extension of the patient monitoring franchise across larger care settings (entry into general ward and home care with wearable and contactless connected devices) and the expansion of the informatics business into specialised disciplines such as oncology and neurology (beyond radiology and cardiology). The strategic shift towards a digitally-integrated healthcare solutions provider (from a hardware provider) has enabled Royal Philips to grab multi-year cooperation agreements with many hospitals. The move has significantly boosted the company’s recurring revenue generation capability (service revenue growth of 11% per year expected until FY19) and is likely to benefit Philips in the long. Need to know Alongside revenue growth, margin expansion has also been a key driver for FCF generation for Royal Philips. A favourable product mix in the Personal Health segment (+280bp during 2014-16), margin accretive Volcano acquisition in the Diagnostics & Treatment segment (+75bp during 2014-16) and focused cost optimisation initiatives (cumulative savings of c.€2.3.bn during 2014-16) have advanced the company’s operating margin (+150bp during 2014-16). In the coming years, we expect further upside in the margin (60-80bp per year until 2019), driven by faster growth in the high margin service business and a three-year €1.2bn cost-cutting programme. Moreover, peer benchmarking further supports the profitability upside (Siemens and GE achieve 1.5x margins compared to Philips’ Diagnostics & Treatment segment). In December 2016, Philips entered into an agreement to sell a c.80% stake in Lumileds to Apollo Global Management for c.$1.5bn (c.40% below the offer from GO Scale Capital in March 2015). The company plans to use these proceeds (along with the proceeds from further stake sales in Philips Lighting) for debt deleveraging, pension de-risking and M&A. The company hasn’t announced a new share buy-back programme (post the recent completion of the €3.5bn share buy-back programme which was started in 2011) and intends to maintain the dividend payout stability after the disposal of Philips lighting. Upcoming triggers We expect the next major trigger for the company to be the deconsolidation of the Philips Lighting business (estimated in H2 17). Moreover, the recovery in the mature US and Western European market, acceleration in the company’s cost-cutting initiatives (historically, Philips has delivered cost savings ahead of plan) and the bridging of the margin gap with peers (particularly in the Diagnostics & Treatment segment) could also result in an earnings surprise/upside stock price movement.