RYLPF - Philips: Litigation Will Likely Be An Overhang On The Stock Near Term

2023-04-27 13:44:16 ET

Summary

• I believe ongoing litigation is going to cause Philips stock to be rangebound as the effect on the balance sheet is cause for worry.
• It should soon enter its normalization phase, during which I expect growth to slow.
• If we look past the current uncertainties, the upside is pretty decent on a normalized earnings basis in my view.

Thesis

Koninklijke Philips (RYLPF) is a health technology corporation that provides diagnostic imaging, image-guided therapy, patient monitoring, and health informatics solutions. I had an optimistic outlook on KP and the industry as a whole, believing that companies like KP would thrive in the post-crisis environment as a result of the large backlogs and easing supply chain dynamic. This has turned out to be true and over the past three quarters, revenue has shown healthy growth. A word of warning, though: KP will likely soon enter its normalization phase, during which growth slows, so this situation of easy comps won't last forever in my view. With this assumption and the ongoing litigation overhang, I am recommending a neutral rating for KP as I believe the stock is going to get impacted by a negative narrative revolving around the litigation. While the valuation seems cheap today on normalized earnings (FY24/25), I believe the stock is going to be rangebound until regulatory issues are resolved.

Results review

The D&T segment outperformed the other two businesses in terms of revenue and adjusted EBITA, as supply chain issues have been resolved, allowing for delivery on backlog with a corresponding incremental margin flow through. The 11.3% increase in D&T margins was impressive and nearly 500bps above what consensus expected. However, despite the strong double digit order growth in the D&T's segment, declining Connected Care orders led to relatively stagnant overall order growth. Overall, I found D&T's solid outperformance to be quite unexpected, and I attribute the subsequent increase in share price to this factor. But I think investors have readjusted their expectations going forward, so this isn't likely to happen again. Before the print, many investors, including myself, predicted that cost savings would not materialize as quickly and that growth would fall short of the mid-teens. Furthermore, the D&T margin in 1Q23 was at an all-time high, indicating that sequential decline is likely over the next couple of quarters and that 1Q24 will have a very difficult comp. Outside of D&T, Personal Health LFL sales dropped by 6% as falling consumer demand and business decisions to leave Russia took their toll. From a macro perspective, I would still say this division is difficult, but I think things will improve gradually from here on out. As for Connected Care, the focus is on the consent decree, which I think the development from here onwards is hard to underwrite.

Update on respironics

A provision of €575 million was made for economic losses at Respironics, as stated in the quarterly report. This provision is the main contributor to the -€583 million EBIT loss. This is another major cloud hanging over the stock, and I have no idea if this provision is adequate. I can only wait for the release of the consent decree and the results of any additional testing that Respironics may conduct in the second quarter of this year. One thing I am confident in is that management seems to have done a fantastic job of attempting to catch up. The new devices and repair kits needed to fix the registered devices have been manufactured almost entirely. In addition, most of the sleep therapy devices have also been shipped to the rightful destinations.

Litigation overhang

Litigation and its effect on the financial statements is, in my opinion, the most pressing problem. This quarter's €575m provision covers, for example, economic damages to hospitals. However, cash payments aren't expected for at least a year, and if they do come through, they may be offset by insurance payouts (which is the bull case here, and if so, the balance sheet is largely fine). Whatever the case may be, the effect on the balance sheet is cause for concern. If we include these provisions that could end up being cash payments (and thus should be treated like debt), then as of 1Q23, net debt stands at about €9+ billion. The problem is that this amount of net debt will cause the KP leverage ratio to rise to well above 4x, almost 5x. The first effect is that valuation will likely come under additional stress because credit risk has increased. Second, this raises the question of whether or not management must now seek additional funding in order to remain liquid.

Valuation

I've already mentioned the stock's negatives and near-term pressures. Here, I attempt to lay out the bull case using normalized earnings, which indicate a decent amount of upside if we can fast forward to FY24 or FY25. According to current consensus, KP will generate €1.2 billion in net income in FY24, which is the same as in FY21 but still lower than in previous years. Assume €1.2 billion is the new normal, and KP trades at its average forward PE of 17x on that earnings, implying a market cap of €20.5 billion, or €23 per share. This represents a 20% upside. Now, if we assume that things will fully normalize in FY25, when KP generates €1.5 billion, the implied share price at 17x would be near €29/share, representing a 50% upside. Nonetheless, I believe none of this will matter until the litigation is concluded.

Conclusion

The key conclusion here is that KP will soon enter its normalization phase, during which growth is expected to slow, and ongoing litigation may impact the stock negatively. The provision made for economic losses at Respironics is a major concern, and the effect on the balance sheet is cause for worry. Despite the potential for upside in the future based on normalized earnings, the ongoing litigation overhang is likely to keep the stock rangebound until regulatory issues are resolved. Therefore, I recommend a neutral rating for KP until we have more clarity on the litigation front and path to normalized earnings.

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