Is Philips (PHIA:NA) starting to become a two-trick pony? And one that learned the wrong tricks?! In spite of positively received quarterly data, my doubts about the strategic choices of this multinational remain.

"The company structure of Philips looks like a plate of spaghetti!

I want the company to look like a plate of asparagus: structured and neat!"

Cor Boonstra – CEO of Philips 1996 - 2001

I have to admit: I’m a sucker for Koninklijke Philips NV (PHIA:NA), aka Philips.

Although I am not an avid fan of the company’s products, due to some bad experiences in my personal past, I always liked their innovational spirit and the engineer’s culture within the company. “Invent first, market later” was their sometimes reckless, but always inspirational strategy.

The Dutch ‘lightbulb factory in the south of the country’, as it has been lovingly called by its workers and other fans of the brand, was the closest that any Dutch company came to the legendary company A.C.M.E. (i.e. A Company Manufacturing Everything) from the Roadrunner and Bugs Bunny cartoons.

Philips litterally MADE everything! They really did!

Household appliances, consumer electronics, mainframe computers, floppy disks and cassette tapes, as well as computer chips and computer chip printing machines, CD’s, medical appliances and everything else. The brand even owned a successful record company and a movie production house, which delivered their share of successful albums and movies.

While the brand was the epicentre of wild ideas, gung ho innovation and numerous new developments in The Netherlands, it has also been an investor’s nightmare in the past.

Philips was an opaque company with an opaque geographical structure, opaque profit centres, an opaque production and marketing structure, opaque cash flows and opaque profits. There were just simply too many products, too many plants, too many departments, too many geographical profit centres and too many management layers and managers, leading to numerous ‘islands in the stream’ doing their own things, irrespective of what the executive management wanted.

But yet, it always seemed to work after all…

That is, until the company fell in the hands of a series of managers with less passion for engineering than for shareholder value, short-term economics and commercial management. 

After a few extremely expensive inventions and developments went awry, because they were ill-thought through, poorly marketed, superfluous or simply too far ahead of their time, the subsequent CEO’s have torn the company slowly, but surely apart.

Factory after factory in The Netherlands and other Western European countries has been shut down, while the production moved to the Eastern European and Asian low wage countries. The head-office left its century-old roots in the city of its founders Eindhoven, in exchange for a new establishment in the more ‘mondain’ Amsterdam, which was close to international airport Schiphol.

And the number of subsidiaries, production lines and business units of Philips that were either merged with other companies through joint ventures, have been turned into independent companies or have been sold to other companies, has been long and growing: ASML, NXP, Polygram, Whirlpool, UPC and LG Philips LCD to name only a few.

After yet another strategic turnaround in the past decade, that should change the company into a leading developer of healthcare equipment, the company existed only of three main divisions: Consumer Lifestyle, Healthcare and Lighting. And since last year, Philips Lighting is also tagged with a “For Sale” sign. 

This was definitely a shock for the avid endorsers of Philips, as Lighting was the oldest branch of the company. On top of that, during the last, very turbulent decades it has often been the last straw for the company to clutch at, when all else failed. The lighting branch has traditionally been a very stable cash cow over the years and Philips did more than its share of inventions, on their way towards effective and extremely energy-efficient lighting solutions. 

However, that will soon be over… And afterwards the company will be stuck with only two strategic divisions: consumer lifestyle and healthcare; as a two-trick pony.

Personally, I’m afraid that these two tricks might even be the wrong tricks for ‘pony’ Philips:

Consumer Lifestyle

Nowadays, Consumer Lifestyle is an extremely difficult market with fierce competition, as well as high fail rates and extremely short lifecycles for new products.

On top of that, there is a host of factories in the Far East  which are able to “refactor” (read: copy) new inventions and bring them to the market in record time and at absolute bottom prices. These same factories start to become more and more cunning at inventing new products and technologies themselves, making life for Philips even harder.

And there is more: these days many consumers in the First World countries start to become numb for new technologies, especially when they seem to improve nothing. They are so much quicker bored with new inventions and new products, than for instance in the build-up years after the Second World War, when Western families literally had nothing and started to discover such inventions for the first time in their lives.

Although the market for smartphones still grows, every family in the Western world, Australia and the wealthy parts of the Middle East, the Far East and Latin America has a few television sets with Dolby Surround, a few hifi installations and other normal household appliances , like an electric shaving tool, a hair dryer, an electronic toothbrush or a coffee machine.

There comes a time, when such families simply have EVERYTHING they want. Then they don’t want to replace their existing appliances with yet another appliance, which offers an atomic clock timer, wifi parent monitoring or a special app with electronic toothbrush instructions. And many families that don’t have such appliances yet either can’t afford to buy one or deliberately don’t want to own such things. 

Of course Africa, Latin America and the Far and Middle East remain prospects as future growth markets, but the odds there seem much better for cheap Chinese companies than for a more expensive "dinosaur", like Philips, in my humble opinion.

Healthcare

In theory, Healthcare is  a very profitable industry, but it is a notoriously difficult one. In this industry, there are a small number of very competitive, powerful and well-capitalized players, like Siemens, General Electric, Hewlett & Packard and others, who fabricate the extremely expensive equipment.

It is a global industry, but with (in comparison) a limited number of very powerful investors per country. These investors can be found at:

• healthcare ministries; 
• national governmental health bodies;
• large health insurance companies; 
• hospitals; 
• academic research centres;
• medical service centres.

The consequence is that the real decision-makers in these markets operate at a relatively high political, strategical and tactical level: national and local (semi-) government, as well as executive officers at the highest levels. In a small, but extremely profitable industry with such a strong and well-capitalized competition, the positive or negatieve decisions of such decisions-makers, with respect to these (extremely) large investments, can make or break a company, like Philips. 

This makes this whole industry extremely vulnerable for corruption, bribery and embezzlement, but also for industrial and economic espionage.

Dima, a dear Russian friend of us, explained in one of my earlier articles how such corruption works in his country Russia:

“Some time ago, the central purchase department needed to purchase new, very expensive X-Ray machines for the hospitals in St-Petersburg.

You must know; when in Russia an official purchase happens, it almost always takes place according to the following scheme: the official price is for instance ₽100 million, but a discount of ₽20 million is negotiated between the persons representing buyer and seller. The buyer officially pays the ₽100 million, while the seller officially accepts the ₽80 million that they negotiated. Hence, the buyer and the seller divide the ₽20 million profit among eachother and each party walks away with ₽10 million in profits for his own piggy bank.

Unfortunately, however, in this case the people of the purchase department purchased the wrong machines, with the wrong specifications and measures. These machines were unusable for the hospitals in question.

So what happens? These machines are now stored somewhere outdoors, where wind, ice and rain can cause havoc upon the sensitive electronics. As a consequence, their value has probably dropped to virtually nought. The hospitals still need their X-ray machines, but somebody is counting his money coming from the first purchase. And now the same scheme will happen all over again. Welcome to Russia.”

To that respect, Philips have already been caught with their hand in the cookie jar a few years ago. There is a considerable chance that such affairs might happen more often in the future, as it is in some countries the only way to sell their extremely expensive and profitable equipment. 

Especially the United States government and the European Commission have become very vigilant with respect to such acts of corruption over the years and they penalize such offenses with bedazzling fines of dozens of millions of dollars and euros. These circumstances make healthcare an extremely difficult market, in which it is very hard to operate according to the rules.

And on top of that, there is the current personalization trend within the consumer healthcare industry. 

Normal, off-the-shelf smartphones and smartwatches are more and more turning into personalized doctors and nurses for their owners, as they offer additional equipment and applications, which are able to monitor the physical functions of their owners /patients. These smartphones and smartwatches are able to warn either them or their real doctors and nurses, when certain actions are required, with respect to their immediate health. These developments come at the expense of the much more expensive, specialized equipment coming from companies like Philips.

All these issues combined, for both Consumer Lifestyle and Healthcare make that I have serious doubts whether the past choices and focal points of Philips have been the right ones. Has the company become a two-trick pony, that only learned the wrong tricks?

The quarterly data of the company, which have been presented last week, gave some food for thought. Here are a few snippets from an article in De Volkskrant:

 Most important division of Philips has serious issues

At an already ill-tempered stock exchange, Philips was the biggest loser by far. The company, which is especially preparing for a future in healthcare, has to deal with serious issues in particularly that division. The stock rate of the company dropped by 4.99%.

During the last quarter the profitability of the Healthcare division dropped to a level close to nought. One year ago, this figure was yet 5.5% of sales, but last quarter it became 0.8%. “I never saw their margin being this low”, according to analyst Jos Versteeg of trade bank Theodoor Gilissen.

Philips Healthcare still has to deal with the consequences of the shutdown of their factory in Cleveland, Ohio in the United States. The quality control had failed for years in a row, causing the production to be shut down one year ago. Although the production has been resumed in the meantime, the company still suffers from delivery issues. Competitors like Siemens and General Electric don’t have such issues.

Further, the costs of take-overs and reorganizations suppressed profits for the company and the American health market shows very little growth, due to the new legislation that came in power and the accompanying consolidation of hospitals that was the effect of it.

Also in China, theoretically a market with good future prospects, there are serious issues these days. The economic growth is declining, but also the intention of the government to invest in expensive hospital equipment is.

Versteeg:”In China all hospitals are in state hands. Shortly, the state has decided that it will purchase less expensive equipment and that more Chinese equipment will be purchased instead”. 

I have to admit that the same article in De Volkskrant stated that Philips’ household appliances, like vacuum cleaners and electric shavers, showed an excellent 10% sales growth during the last quarter, while their margin improved by 0.6% to 10% from 9.4%. So perhaps the market for consumer lifestyle products will remain solid for the next few years after all, in contrary to what I describe in this very article. 

And perhaps the executive management of Philips made the right choices for the future after all, by trying to sell the lighting division and in earlier years by making independent and selling all parts of the company, which in their opinion did not belong to the core activities of the brand.  

But, as I stated, I was a sucker for the versalitity and sometimes reckless innovation drive of the company. There has hardly been any other company in human history, which did such fundamental research as Philips, with its world-famous NatLab (i.e. Physics Laboratory) and which made such groundbreaking inventions during the first century of its existence. 

Consequently, I found it a pity that they seemed to sell everything that they were good at. These thoughts make it very hard for me to defend their current choices to strip down the company to the bare minimum and gamble on only two horses. 

Can I be wrong? I can be wrong!