The European medical-technology supplier is starting to emerge from a torrid period, marked by the recall of machines for treating sleep apnea
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August 14, 2023
By guest author Stephen Wilmot from the Wall Street Journal.
This column is part of the Seventh Annual Heard on the Street stock-picking contest.
When venerable industrial companies fall on hard times, things can look bleak: They are often over-indebted, overstaffed and overly complex. But the stocks have a way of bouncing back because the high-tech markets they serve aren’t easy to disrupt.
This story, familiar to American investors from GE, has a European parallel at Royal Philips PHG 3.80%increase; green up pointing triangle. The once-sprawling Dutch conglomerate is now a medical-devices company that competes with GE Healthcare and Siemens Healthineers. Trading about 60% below their peak, Philips shares are the cheapest in the sector after a torrid couple of years marked by the mass recall of machines designed to treat sleep apnea. Now the stock looks ripe for recovery.
The problems started in April 2021, when Philips first noted that users of some of its devices might face health risks from inhaling particles of sound-dampening foam. The crisis snowballed as the company initiated a recall and the U.S. Food and Drug Administration and Justice Department got involved. The company has ended up needing to replace some 5.5 million devices, including several hundred thousand ventilators—a huge task for a company that in a normal year makes about 900000 sleep-apnea machines.
The situation is far from resolved, but there are signs of improvement. The company said in last month’s quarterly report that it had manufactured 99 % of the replacement devices and repair kits required and supplied the vast majority of those produced to patients and care providers.
The next step is likely to be a so-called consent decree between Philips and the Justice Department, which will determine the company’s ability to operate its sleep and respiratory-care business in the all-important U.S. market in the future. This unit is semi-dormant, contributing just 7% of revenues last year, down from 16 % in 2020.
Some investors were likely disappointed when the company had no progress on the decree to report in its latest quarterly report. The shares fell about 7 % on the day of the results last month. But that reaction also highlights the opportunity for those prepared to bet early on a benign outcome. A settlement is expected in the coming months.
Among the investors that are happy to shoulder the risk is Exor, the investment vehicle of Italy’s Agnelli automotive dynasty and a kind of European Berkshire Hathaway in its long-term thinking. On Monday it came out in support of Philips’s strategy and said it had taken a 15 % stake, becoming the company’s largest shareholder. Philips stock jumped about 5 % in early Amsterdam trading.
The shares are cheap in two ways: They change hands at a low multiple of profit forecasts relative to peers and those forecasts are depressed due to the recall crisis. Earnings per share this year are expected to be 37 % lower than in 2020, based on FactSet consensus.
The risk for investors is that the legal processes drag on, clouding the company’s outlook. Even when a deal with U.S. regulators emerges, the question of Philips’s exposure to class-action lawsuits will remain. It set aside €575 million, equivalent to $629 million, to cover litigation in its first-quarter report this year, and didn’t update this number last month.
Still, the path forward seems likely to be one of greater legal clarity, which the market should reward. And operationally the business has already found a better place. Comparable sales growth was 9% in the second quarter, buoyed by improving supply-chain snarls. The company also swung from cash outflows to inflows, which is important given its €8.2 billion debt load.
It helps that Philips is no longer a conglomerate but instead a focused company serving a fundamentally attractive industry. While new Chief Executive Roy Jakobs has announced swingeing job cuts of 10000 since he took over last October, out of a previous total of 79000 staff, he hasn’t had to perform transformative corporate surgery in the way Larry Culp has at GE.
Traditional fund managers often avoid betting on legal situations because they can’t be elegantly modelled or timed, but that is also an opportunity for armchair stock pickers to pick up what should be a quality stock on the cheap.