Philips – Plenty Of Cloud, Minimal Silver Lining

By Stephen D. Simpson, CFA | January 09, 2012 AAA

Dutch conglomerate Koninklijke Philips (NYSE:PHG) has been an underachiever for so long now, it hardly seems fair to call another poor quarter a "disappointment." Nevertheless, the company announced that its fourth quarter results would be meaningfully short of analyst expectations and the stock is weak once again. Although Philips may remain a fixture on the "due for a turnaround" lists, investors would do well to stay skeptical about this company's ability to compete as currently constructed. (For more, see Earning Forecasts: A Primer.)

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Another Warning
Although estimates have come down as much as one-third over the last quarter, Philips still found a way to underperform in the fourth quarter. Management guidance suggests that sales will come in a few percentage points below expectations, while margins fell off even worse. Based on an informal survey of sell side analyst expectations, it looks like Philips' anticipated EBITDA of 500 million euros will be some 10-20% short of estimates.

Philips definitely blamed Europe as a source of weakness and that's not altogether surprising. Western Europe is about one-third of the company's revenue base and there's no strength in any of Philips' core markets. Lighting is weak on lower consumer spending and lower construction activity, while healthcare is coming under significant pricing and margin pressure as nationalized healthcare systems press for relief. Consumer electronics is likewise soft in Europe on those same consumer spending issues.

It doesn't look like this is just a Europe problem, though. The market for capital healthcare equipment in the U.S. really isn't that strong, except for some significant productivity or traffic-generating features (like Intuitive Surgical's (Nasdaq:ISRG) robots). Likewise, other LED players like Cree (Nasdaq:CREE) also aren't seeing especially healthy demand at this time.

Longer Term Reasons For Worry
Missing one quarter is not really a reason for panic, but Philips has far-reaching problems that have lingered for some time now and frankly, seem to be getting worse.

The LED/lighting business is really just not working out for anybody right now. The aforementioned Cree is off its lows, but the stock is just a shadow of its 2009/2010 self when LED was all the rage. Likewise, General Electric (NYSE:GE) and Siemens (NYSE:SI) aren't making much money in lighting either, and both would like to be rid of these businesses. Granted, construction activity has been really weak, but if neither GE or Siemens think they can make significant returns over the long haul in lighting, why will Philips be successful?

Healthcare is another place where Philips looks increasingly vulnerable. The company does have a good position in CT and MRI imaging, but the company looks vulnerable to GE and Toshiba (OTCBB:TOSBF.PK) in North America and Mindray Medical (NYSE:MR) in China. Elsewhere, companies like Hologic (Nasdaq:HOLX) are chipping away at the company's franchise and the entry of Samsung into healthcare "Big Iron" is a major threat.

Then there's the matter of consumer electronics. Philips has maintained at least some of its legacy as a forward-thinking product developer, but like Sony (NYSE:SNE), it seems Philips is in a losing battle with companies like LG and Samsung.

The Bottom Line
Even with the weakness in these shares, I can't really come up with a solid reason to own them today. The enterprise multiple ratio is below six (often a good buy point), but the company's returns on capital, margins and free cash flow production are pretty pathetic right now. What's worse, the company's management doesn't seem to have a lot to offer in terms of how or why things are going to get better anytime soon. While there are some positive qualities to build on, including good emerging market exposure and brand value, what's the plan for building on them?

Assuming a 3% forward growth rate in revenue and some improvement in free cash flow margin (actually doubling the very low 10-year average), fair value seems to lie in the mid-to-high teens. Those are conservative assumptions, but with stagnant management and a lack of initiatives for improving operating performance, it's hard to argue for more. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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