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Morningstar | Philips 3Q: Solid Operational Improvement but Results Below Market Expectations; Shares Undervalued

With its third-quarter update, narrow-moat Philips delivered on our expectations for revenue growth (owing to the firm’s refreshed product portfolio and strong positions in high-growth healthcare, grooming, and shaving markets) and margin improvement (owing to operational leverage, growth of high-margin catheter products, and strong cost control). Despite revenue growth (4% year on year on a reported and organic basis) and adjusted EBITA margin expansion of 40 basis points, Philips’s third-quarter reporting set was below market expectations, mainly because of negative currency movements and higher-than-expected marketing costs. We are encouraged, however, by the stellar comparable order intake growth of 11% in the quarter, and we maintain our narrow moat rating and our fair value estimate of EUR 42 per share for the Amsterdam-listed shares and $50 for the ADR. We believe Philips remains one of the most attractive investment opportunities under our coverage, and today's sharp share-price correction offers investors a buying opportunity.

While Philips' group results were solid, performance was rather mixed on a divisional level. We are happy with the uptake in the firm’s diagnostic imaging, ultrasound, and image-guided therapy product and services, with 6% comparable sales growth and double-digit order growth for Philips' second-largest division, diagnosis and treatment (close to 40% of group sales) in the third quarter. Despite severe negative currency effects, D&T’s adjusted EBITA margin increased 40 basis points. Philips' largest division, personal health, reported solid sales growth of 4%, driven by mid-single-digit growth in sleep and respiratory care and personal care. This was mainly due to higher advertising and promotion spending, while adverse currency movements reduced divisional margins by 10 basis points.

As the market leader in patient monitoring systems with over 50% market share, Philip’s connected care and health informatics was negatively affected in the quarter by flat to slightly declining demand of mature patient monitoring markets like North America. Due to lower sales and unfavourable mix (more low-margin hardware sales), CC&HI adjusted margins declined 190 basis points. CC&HI performance was below our expectations, but we do recognise that Philips’ smallest division (17% of sales in third-quarter 2018) faced tough comparisons, as comparable sales growth in third-quarter 2017 was an impressive 8%.

In our five-year forecast for Philips, we foresee increasing recurring revenue and EBITA margin expansion by 80 basis points per year on average, owing to increasing maintenance support for medical devices, growing monthly fees from partnerships with hospitals, additional sales of software licences, and increasing use of high-margin catheter products. In this respect, we are happy with Philips' third-quarter performance, as the firm signed another six long-term strategic partnership agreements, including a partnership with a children’s health hospital in Dallas for patient monitoring and two contract wins in Australia for precision diagnosis and therapy.