2022 has (so far) been brutal for MedTechs – down c.27% in market value terms vs. c.10% correction for the AV universe stocks. This is a stark underperformance for a sector that for a very long time had been the markets’ darling – average P/E of 28x since 2013 vs. 16x for the broader markets. While the Ukraine-Russia war and interest rate hike fears spooked MedTech investors – as corporate growth had largely harped on easy money-fuelled (inorganic) growth bets, issues at Royal Philips cropped up much before in April 2021, when the firm acknowledged problems with its sleep/respiratory products – which some reports claim were known to management since 2014. This precipitated the biggest operational crisis the firm has faced in a decade. As a result, the stock plummeted >60% and is now trading close to 2016 lows.

EDPL at Philips

Since our last idea kicker – PHILIPS NEXT GROWTH PHASE – in March 2021, almost everything has gone against the firm due to both company-wide concerns/risks and sector-wide headwinds (discussed below). Given that Philips had always been regarded as a governance bellwether amongst European corporates, the board and management’s ineffectiveness / lack of transparency in tackling the on-going issue(s) triggered a calamitous fall in market value terms.

Operational risks to the fore

While Philips did well to mitigate the pandemic impact in 2020 – with organic sales growth of 3%, a flat operating margin (13.2%) and EPS growth of 5.1%, supported by pandemic-induced demand for Monitoring & Analytics, and Sleep & Respiratory Care, 2021 was full of disappointments. Although the bone of contention was the recall of 3.5m sleep apnea devices (in Connected Care division; CC), which the FDA classified as Class 1 recall (the most severe type of recall). Moreover, the recall programme scope was gradually increased to 5.5m units in Q1 22, which resulted in both higher provisions (€250m recognised in April 2021 vs. total €885m by the end of Q1 22) but also increased the timeline of repair/replacement programme from Q4 22 targeted earlier to early 2023.

Besides litigation risks, in other geographies as well – with French investigations also underway, Philips and some of its subsidiaries were subpoenaed (in April 2022) by the US DOJ seeking information with respect to the product recall debacle. While the firm-initiated testing of recalled devices through five certified and independent testing laboratories, which concluded that the devices passed volatile organic compound and respirable particulate emission testing – in a way giving Philips a clean sheet, it failed to soothe investors’ nerves. As of end June 2022, c.200 personal injury lawsuits and c.100 class actions have been consolidated into a multidistrict litigation in Pennsylvania. While lost sales from sleep apnea were just <5% of group sales, our preliminary calculation for the litigation settlement (taking Bayer’s lawsuits as a benchmark) suggests provisions in the range of €4-6bn.

Adding further to its woes, in April 2022, the firm recalled some ventilators (c.99k) as the electrical circuit linked to the power supply could malfunction without alerting healthcare providers. Then, in September 2022, the firm ‘voluntarily’ recalled >17m masks (as per the FDA) as their magnetic headgear clips used to attach the straps to masks (common industry-wide practice) could interfere with certain implanted metallic medical devices and metallic objects, resulting in potential injuries or death. These issues also pertain to CC – which accounts for c.24% of Philips’ gross assets.

In a nutshell, the Dutch firm’s ‘quality’ MedTech profile has been badly bruised and it will take considerable patience to bring it to pre-2021 levels.

Supply-chain woes’ added burden

Fortunately, Diagnosis & Treatment (D&T), i.e. the lynchpin division (c.50% of group sales), had an impressive 2021 (8.1% organic growth), not much-behind its close competitor Siemens Healthineers’ Imaging division (+11%; ex. Varian; September financial year-end). However, in their recent earnings updates, both firms highlighted the impact of supply-chain headwinds and Chinese lockdowns, which took a toll on their comparable divisional results. Besides this, Philips’ Personal Healthcare (PH) division too witnessed a double-digit decline in the Chinese region in Q2. While things began normalising with the gradual reopening of the Chinese markets in June 2022, another round of lockdowns has now simply delayed any underlying normalisation.

Unavoidably, for 2022, Philips reduced its guidance, with comparable sales expected to grow by 1-3% vs. 3-5% growth anticipated earlier, whereas ‘reported’ adjusted EBITA margin is expected to be c.10% vs. 12% in 2021. Furthermore, 2023-25 guidance has been moderated, wherein comparable sales are now expected to post 4-6% growth vs. the previous estimate of 5-6%, but the adjusted EBITA margin is now expected in the range of 14-15%.

Some green-shoots though

Amid all the mess, fortunately, existing and potential clients have so far kept their faith in Philips’ capabilities – which reflects in still promising order-book dynamics (illustrated below). More importantly, so far, no news of any major order cancellation has come to the fore.

Despite all the noise, innovation initiatives continued to flow in, including: 1/ FDA’s clearance for the MR7700 3.0T system – delivering the highest image quality to help improve diagnostic outcomes along with artificial intelligence for better workflow, and SmartSpeed MR acceleration software – adding AI data collection algorithms to existing Compressed SENSE MR engine; 2/ Chinese market clearance for locally-made helium-free operations MR Ingenia Ambition and the partnership with B-Soft to develop a healthcare informatics solution for Chinese hospitals; and 3/ in PH, new product launches/upgrades under oral healthcare earlier this year were promising developments.

Lastly, but most-importantly, the board announced the departure of President and CEO, Frans van Houten, who had been accredited with Philips’ MedTech transition – hence, his exit wasn’t an easy decision. Anyhow, this step was much needed to limit further reputational damage. The incoming CEO, Roy Jakobs, has been associated with Philips for more than a decade across divisions/geographies, with his latest role as Chief Business Leader for CC. Being an insider, he would have an in-depth understanding of the current situation. Only the time table of tough decisions is an unknown.

Being patient is the only option

Even after very conservative performance estimates and taking on board additional litigation-related provisions, the upside on Philips remains substantial (c.33%) – which garners big support (+46-80%) from fundamental metrics, and 7-73% upside from price-to-book and dividend yield metrics.

While it is difficult to conclude if the storm is behind, the smaller but presumably well-targeted remedial measures, and simultaneous sector-wide headwinds – thereby limiting further market share loss risk(s), imply that now may not be a bad time to (further) bet on the Dutch firm’s revival. The new CEO’s decision-making capabilities – including the important dividend decision towards year-end, is what one buys for the very near term. The longer term is one of a great firm that will have learnt from its mistakes.