I have to be honest right off the bat - I didn't think Philips (NYSE:PHG) had what it would take to really get the business turnaround they needed. Yet, here we are with this European conglomerate reporting steady mid-single digit organic growth and improving margins. While I definitely missed the potential for Philips' self-improvement in 2012 (and the stock performance that has doubled the S&P 500), I still have some long-term fundamental questions about where Philips stands against the competition and whether sell-side analysts (and investors) are expecting too much from this company.
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Progress Continues ... but From a Low Base
With third quarter earnings back in October, Philips delivered another solid mid-single digit organic growth performance. Revenue rose about 5%, with healthcare up 7%, lighting up 4% and consumer products up 3%. These are solid numbers in a difficult operating environment, though the cynic in me points to the fact that the comps were easier given Philips' dismal prior performance. Profits also continue to improve. Reported gross margin eased off about 30 basis points, but the company's "clean" EBITA was up 22% from last year, with a major improvement in consumer (up almost 100%) and more sluggish performance in healthcare (up 26%) offsetting a double-digit decline in lighting (down about 57%). Healthcare and consumer continue to drive the profit story, though, as both EBITAs make up nearly 22% of the company's sales.
Healthcare - Orders Are up, but What About Tomorrow?
With Philips' U.S. healthcare business up a bit, the company is doing alright relative to other vendors of big ticket items like imaging systems. Europe was surprisingly strong, though, with orders showing double-digit growth (the first positive performance in almost three years) on flat sales, and China continues to be a source of growth.
I have my concerns about Philips' long-term competitiveness, though. Philips is well behind Hologic (Nasdaq:HOLX) and General Electric (NYSE:GE) in tomo for mammography and there wasn't much from the company at the recent Radiological Society of North America meeting. What's more, with both Mindray (NYSE:MR) and Samsung (OTC:SSNLF) looking to up their game in imaging for emerging markets, I'm not sure about the sustainability of Philips' healthcare improvements.
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Lighting Still Looks Like a Tough Business
Lighting has been a rough business for all of the major players, so much so that Siemens (NYSE:SI) is still eager to dispose of its Osram lighting business (with a spin-off now expected in the first half of 2013). There have certainly been some signs of progress for Philips, with LED-based sales up 51% in the third quarter (about one-quarter of sales). Sustainability remains a key question, though, and even these improved results are not all that impressive as a percentage of revenue or relative to the capital invested.
A Good Job so Far, but How Much Is in the Tank?
Philips CEO Frans van Houten deserves quite a lot of credit for leading Philips' turnaround to this point, and three straight good quarters (despite a worsening operating environment pretty much around the globe) is a noteworthy accomplishment.
As I've said, though, I have my concerns about the durability/sustainability of this turnaround. I think Philips may actually emerge as a leader in lighting, if for no other reason than GE and Siemens have seemed to deprioritize these businesses after years of disappointment. On the healthcare side, though, I question whether the company can keep up with rivals like GE, Siemens and Hologic, and whether reimbursement will continue to support growth in imaging and respiratory care. Likewise, I question whether Philips can win the long-term battle in consumer appliances against its Korean and Chinese rivals.
The Bottom Line
My biggest concern with Philips as a stock, though, is the level of expectations already in the stock price. Today's price already seems to assume that Philips is going to lift its free cash flow margin into the mid-to-high single digits.
While that's not really ambitious at all relative to comparables like GE or Siemens, it's something this company hasn't done in over a decade. So while it's true that there's plenty of potential in Philips if the company can become a consistent double-digit ROIC generator and deliver free cash flow conversion margins in the low teens, that would seem to be a pretty ambitious call. Nevertheless, Philips is not all that expensive today on a trailing EV/EBTIDA basis, and that solid 3% dividend yield gives investors a reason to hang on and see if Philips really is capable of delivering top-tier performance.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.