Primary Analysis: Philips Domestic Appliances €850M SSNs Underpinned by Strong Cash Generation, Substantial Equity Cushion, Recognized Brand; Concerns Over Execution Risks From Carve-Out, China Transformation, Reliance on Time Limited Brand Licenses

Relevant Items:
Primary Analysis
Historical Financials on Aggredium
EMEA Covenant Analysis

Reorg has produced a comprehensive financial and legal analysis of Philips Domestic Appliances’ €850 million 2028 senior secured notes issuance HERE. Full historical financials can be found on Aggredium by Reorg HERE. To request a trial, please email sales@reorg.com.

Dutch household appliances group Philips Domestic Appliances’ (Philips) €850 million 2028 senior secured notes are underpinned by strong cash generation, a substantial equity cushion and a solid position with favorable market dynamics.

Proceeds from the issuance, alongside the group’s concurrent €850 million 2028 term loan B and €2.326 billion of equity, will be used to fund the buyout of Philips, which is a carve-out from Royal Philips, by Hillhouse Capital. The enterprise value of the transaction as per Reorg’s calculations is €3.885 billion, net of transaction fees, implying a post-IFRS 16 EV multiple of 12x based on pro forma adjusted EBITDA of €323 million. The OM mentions an EV of €3.7 billion based on which the EV multiple would be 11.5x.

Pro forma net leverage will rise to 5.1x, however the group’s capacity to generate free cash flow hints at its future deleveraging potential. Additionally, Philips has a substantial equity cushion underpinning the issuance, with LTV at 42% net of cash. Peer comparables trade at a similar multiple, with DeLonghi and SEB trading at 12.3x and 11.7x EBITDA, respectively.

Philip’s China strategy and the carve-out from Royal Philips however carry execution risks, which may result in higher unanticipated costs. Management noted that around 10% of revenue related to advertising and promotions costs, which is expected to increase to around 11.5% of 2021 revenue as it plans to increase its portfolio of flagship products. Additionally, total capex is expected at €63 million in 2021, up from €45 million in 2020. That said, the new sponsor, Hillhouse Capital, has demonstrable experience in expanding market share in China, working with brands such as Topsports, Loch Lomond, Burton, Peet’s Coffee, Run on Clouds and the Mayo Clinic.

The company relies on licensing agreements with Royal Philips and JDE Peet’s which expire in 15 years and four years, respectively. Under certain conditions, Royal Philips may terminate the right of use for the Philips company name or the brand licenses under the trademark license agreement before their expiry. These conditions primarily relate to material breaches by Philips, its insolvency, if Philips intentionally or recklessly harms the Royal Philip’s reputation, or if it is acquired by a competitor.

Initial price whispers on the TLB are Euribor+3.5%, OID 99.5 and 0% floor. Price talk for the notes is in the mid-3% area.

Near-term deleveraging is expected to be supported by continued free cash generation. However, there is the potential for near-term pressure on cash generation stemming from unexpected separation costs from Royal Philips as well as higher advertising and promotional expenditure, coupled with potentially higher growth capex to fund its China strategy.

On a pro forma basis, assuming a 3.5% rate on the issuance and the TLB, levered free cash flow would have been €198 million as of LTM March 31, 2021, based on €323 million of PF adjusted EBITDA, €60 million of new financing costs, €3 million of cash tax, and €63 million of net capital expenditure expected in FY’21, excluding any working capital movements.

The transaction comes with a new €250 million 2028 revolving credit facility, which is expected to be undrawn on the closing date. The RCF has a springing senior secured net leverage covenant set at 10x if 40% or more of the facility is drawn. The closing date of the acquisition is expected around Sept. 1.

Philips’ pro forma capital structure is below:

 

 

• Strong market position across diversified product offerings, underpinned by strong brand recognition and favorable demand for domestic appliances: The group has a leading product portfolio in the small domestic appliances market, with its Kitchen Appliances (34% of FY’20 sales) and Garment Care (17%) business lines ranked the first in the market, while Coffee (26%) and Home Care (21%) are ranked second. This is supported by Philips’ strong brand recognition and reputation. In addition, the group is positioned in high growth segments of the small domestic appliances market, which grew about 4.6% per annum between 2017 and 2019, and is expected to grow about 5.4% per annum between 2022 and 2025 (more details under “Industry Overview” section). However, it should also be noted that the group relies on brand licensing from Royal Philips and JDE Peet’s, which is time limited (more detail under “Key Risks” section).

• High leverage, but cash generation capacity shows potential for deleveraging, substantial implied equity cushion: Although pro forma net leverage is relatively high at 5.1x compared to peers, the group’s capacity to generate free cash flow hints at its deleveraging potential. As per Reorg’s calculations, pro forma for the transaction, the group can generate levered free cash flow of about €198 million excluding any working capital movements, based on €323 million of pro forma adjusted EBITDA, €60 million of new financing costs assuming a 3.5% rate on the issuance and the TLB, €3 million of cash tax, and €63 million of net capital expenditure expected in FY’21. Pro forma for the transaction, the LTV would be 42% net of cash, which is relatively low. Based on a €3.885 billion enterprise value, the group’s equity cushion is €2.251 billion. The multiple of 12x of the transaction is also in-line with trading comparables, as DeLonghi and SEB trade at 12.3x and 11.7x, respectively. DeLonghi’s acquisition of Capital Brands valued the U.S. company at around an 8x 2020 forecast adjusted EBITDA. Additionally, on March 22, 2021, DeLonghi acquired the remaining 60% stake in Swiss company Eversys for a total enterprise value of CHF 150 million, or 12.5x EBITDA.

• Asset-light business model supported historical free cash generation by limiting capex, augmented by improving working capital management: The group outsources about 76% of manufacturing, contributing to low capital expenditure and working capital requirement. Capex averaged 2.5% of sales in 2018 and 2019, declining to 1.8% in 2020 due to Covid-19 related uncertainty, with Philips having around €15 million of annual maintenance capex, with the remaining capital expenditure related to investment in software and capitalized R&D for new product introductions. The asset-lite business model and limited capex has supported cash generation in the past, with the group generating positive levered free cash flow of €115 million, €250 million and €316 million from 2018 to 2020 respectively. LTM to March 31, 2021, levered free cash flow reached €396 million boosted by a €50 million working capital release. However, as highlighted in the “Key Risks” section, potential for unexpected separation costs and potentially higher capex and higher advertising and promotion expenditure linked to the group’s growth strategy could partially limit free cash generation in the short to medium term. Management noted that around 10% of revenue related to advertising and promotions costs, which is expected to increase to around 11.5% of 2021 revenue as it plans to increase its portfolio of flagship products. Additionally, total capex is expected at €63 million in 2021, up from €45 million in 2020.

• Sufficient pro forma liquidity: Pro forma for the issuance, Philips has around €350 million of available liquidity, including a new €350 million 2028 senior secured RCF. The liquidity should be sufficient given most of the group’s debt would be due in 2028 and the group has a potential to generate approximately €198 million of free cash flow even when taking into account higher 2021 capex and pro forma interest costs.

• Well-positioned for growth potential in Asia with sponsor’s expertise, especially in China, albeit with fierce local competition: With an already established brand in Asia, the group has the local industry knowhow such as supply chain management and R&D related knowledge, management said on the roadshow call. This will be further supported by sponsor Hillhouse’s local expertise related to market expansion in China, as demonstrated by the rollout of Topsports, Loch Lomond, Burton, Peet’s Coffee, Run on Clouds and the Mayo Clinic. It should be noted however that in the past Philips has reported weak comparable sales growth in China due to local competition, with comparable revenue down 14.8% and 66.8% in 2019 and 2020, respectively, and 6.7% lower year-over-year in the first quarter of 2021. That said, we view the group’s shift towards direct-to-consumer sales in China as favorable, allowing Philips to bring new products to market faster, which should reduce the risk of inventory write-downs as was experienced in 2020. Philips has recently changed its go-to-market strategy in China to reduce inventory levels and allow new products to be brought to market quicker, which has impacted revenue as distributors reduced stock.

 

 

• Execution of carve-out and business repositioning in China carry risks which could put pressure on free cash generation in near-term: The business carve-out from Royal Philips involves execution risk, as the group would need to set up its standalone IT infrastructure which incurs €11 million capital expenditure in FY’21, and mitigate the dis-synergies related to new arrangement of transportation, warehousing and insurance. Although the pro forma adjusted EBITDA of €323 million already captures negative impacts related to the carve-out, there is risk of higher unanticipated costs which can put pressure on EBITDA and cash generation. In addition, the group’s transformation plan in China, which includes updating product portfolio to match preferences of Chinese consumers and adapting go-to-market strategy, may be challenged by intense competition from local players with lower prices. From 2018 to 2020, revenue in China fell from €285 million to €80 million, following the group’s decision to accelerate destocking to clear out distribution channels and refocus online. The China strategy will require further investments in research and development spend, as well as higher advertising and promotion expenditure to boost brand promotion and increase its online presence.

• Reliance on brands licensed through Royal Philips (15-year term) and JDE Peet’s (four-year term): Post-transaction, the ongoing business relies on recognized brands such as “Philips,” “Gaggia,” “Saeco” and “Walita”, which are licensed under the trademark license agreement with Royal Philips. The group can continue to use these brands for 15 years following the transaction (subject to extension) for a fee of 3% of net turnover generated from these brands with a minimum royalty cost of €60 million per year, which equates to an estimated net present value of approximately €700 million over 15 years. According to the OM, Royal Philips may, under certain conditions, terminate the right of use for the Philips company name or terminate the brand licenses under the trademark license agreement before their terms have expired. These conditions primarily relate to material breaches by Philips, its insolvency, if Philips intentionally or recklessly harms the Royal Philip’s reputation or it is acquired by a competitor.In addition, The “Senseo” and “L’Or Barista” brands are licensed from JDE Peet’s, the relationship of which will expire in 2025. Reorg estimates that these two brands contribute to around €109 million, or 5% of 2020 revenue. Failure to renew branding could result in loss of sales and additionally management may start spending more on advertising and promotional costs to support new brand building strategy or in anticipation of not rolling over certain trademark licenses.


• Relatively smaller scale compared to peers, higher leverage: Philips is the smallest company by revenue relative to a peer group consisting of DeLonghi Group, Bosch and SEB Groupe, which operate on a global scale. However, we note that there are further peers focusing in specific geographies with relatively broader portfolios, including Midea and Miele, and category champion such as Breville and Dyson. According to the OM, Philips has a #2 market position across its active geographies and categories, and has a total focus (defined as a subset of the global small domestic appliances) market share of 11.8%. Philips reports pro forma net leverage of 5.1x compared with 1.8x at SEB, with de minimis net leverage at Bosch and DeLonghi. This is however partially mitigated by low LTV at 42% net of cash, as well as its high cash conversion which should support deleveraging over the near-term. However, it should be noted that the group is less exposed to China than some peers, and Chinese expansion could require relatively high capital expenditure which could limit deleveraging in the near term.


• Exposure to concentrated suppliers from outsourcing: The group has in the past and will continue to rely on a relatively limited number of third parties to assemble and manufacture a large portion of finished goods, with its ten largest suppliers representing 57% of the cost of finished goods (including those supplied by a Royal Philips retained factory). In addition, certain of its products are primarily manufactured at a single location. For instance, 99% of its cost of goods for garment care products were outsourced, including that from its manufacturing facility in Batam, Indonesia.

 

There are few comparable bonds with similar ratings to Philips, although the initial price whispers on the notes is in the mid 3% area, in-line with the E+3.5%, 0% floor and OID 99.5 price guidance on the group’s new €850 million term loan B, with the notes sharing collateral and the same maturity as the new term loan. A broader comparable group includes Italian furniture specialist International Design Group and German PVC window and door producer Profine, which trade at 2.78% and 2.99% respectively.

Philips is the smallest company by revenue relative to a peer group consisting of DeLonghi Group, Bosch and SEB Groupe, which operate on a global scale. However we note that there are further peers focusing in specific geographies with relatively broad portfolios, including Midea and Miele, and category champions such as Breville and Dyson. According to the OM, Philips has the second top market position across its active geographies and categories, and has a total focus (defined as a subset of the global small domestic appliances) market share of 11.8%.

Philips’ pro forma EBITDA margins are broadly in-line with peers at 13.5%, which includes adjustments for the payment of licensing fees to Philips as a result of the divestiture. DeLonghi benefits from a higher gross profit margin at 49.8%, compared to 43.4% at Philips, which contributes to higher adjusted EBITDA margins.

Philips would be the the most levered peer, with pro forma net leverage at 5.1x, which compares with 1.8x at SEB, de minimis net leverage at Bosch and DeLonghi. This is however partially mitigated by low LTV at 42% net of cash, as well as its high cash conversion, which should support deleveraging over the near-term.

Relative to peers, Philips has a relatively more asset-light business model, with 76% of its production activities outsourced, which results in minimal capex. On an LTM basis, Philips’ capex as a percentage of revenue was 1.9%, compared with 3.1% at DeLonghi, 6.3% at Bosch and 2.6% at SEB. In turn, Philips’ low asset base supports high cash conversion, as measured on an EBITDA-less-capex basis. Philips reported 80.5% cash conversion based on €323 million of pro forma adjusted EBITDA and €63 million of capex expected in 2021, which we view as a more normalized level. This compares with 24.3% and 78.6% at Bosch and SEB respectively. We note that the comparison with Bosch is muddied due to its investments in associates, which are not captured by our cash EBITDA calculation. Based on LTM March 31 capex, cash conversion was 86%.

The estimated purchase price paid is around 12x LTM pro forma EBITDA, which is approximately in-line with trading comparables - DeLonghi and SEB trade at 12.3x and 11.7x, respectively. Further, DeLonghi Group’s acquisition of Capital Brands valued the U.S. company at around an 8x 2020 forecast adjusted EBITDA. Additionally, on March 22, 2021, DeLonghi acquired the remaining 60% stake in Swiss company Eversys for a total enterprise value of CHF 150 million, or 12.5x EBITDA.