Koninklijke Philips NV Q2 FY2021 Earnings Call

Welcome to the Royal Philips second quarter and semi-annual 2021 results conference call on Monday, July 26, 2021. During the call hosted by Mr. Frans van Houten, CEO, and Mr. Abhijit Bhattacharya, CFO, all participants will be in a listen-only mode. After the introductions, there will be an opportunity to ask questions. Please note that this call will be recorded and a replay will be available on the Investor Relations website of Royal Philips. I will now hand the conference over to Mr. Leandro Mazzoni, Head of Investor Relations. Please go ahead, sir.

Good morning and welcome to Philips second quarter 2021 results conference call. Joining me today are our CEO, Frans van Houten and our CFO, Abhijit Bhattacharya. Frans and Abhijit will take you through our strategic and financial highlights for the period and after that we will take your questions. Our press release and the related information slide deck were published at 7:00 AM CET this morning. Both are available on our Investor Relations website. A full transcript of this call will also be made available today on the website. As mentioned in the press release, adjusted EBITDA is defined as income from operations excluding amortization of acquired intangible assets, impairment of goodwill and other intangible assets, restructuring charges, acquisition-related costs, and significant one-off items. Comparable growth for sales and orders are adjusted for currency and portfolio changes. As of Q1 2021, the Domestic Appliances business is reported as discontinued operations. Sales and results from this business are no longer included in the results of continuing operations and relevant assets and liabilities are reported under assets and liabilities held for sale. All forward-looking projections exclude the Domestic Appliances business. Over to you, Frans.

Yes. Thanks. Hello everyone and thank you for joining us today. I hope that you and your families are keeping safe and well. Let me upfront mention the upcoming field actions related to the component quality issue in our sleep apnea therapy devices that we announced back in June. I want to talk about that first to highlight the impact that it is having on patients as well as their well-being, which is at the heart of everything we do at Philips. I want you to know that we have mobilized the necessary resources across the company to address this issue effectively and I will come back later in this call with more details. Zooming out, the COVID-19 pandemic is clearly not over and our teams are very focused on delivering against what we call the triple duty of care, meeting customer needs, safeguarding their health and safety of employees, and ensuring business continuity. Despite the impact of COVID, we delivered strong performance momentum in all our businesses except for the Sleep & Respiratory care business. This resulted in 9% comparable sales growth, an adjusted EBITDA margin increase of almost 300 basis points, and a free cash flow of €167 million for the group in the second quarter. We are very encouraged by the close to 30% comparable order intake growth for the Diagnosis & Treatment business, with all major markets contributing, driven by the improvement of hospital CapEx and elective procedures, and the very positive customer response to our innovative products and solutions. Order intake for the Connected Care businesses decreased, following the exceptional growth of last year, as well as the headwinds in the Sleep & Respiratory care business. Personal Health delivered strong 33% revenue growth in the quarter. Now I would like to provide some color on some of our initiatives to respond to the needs of today's hospital leaders across the globe as they plan for the future. Highlighting our strength in smart diagnostic systems, in the second quarter we introduced the Spectral CT 7500. Let me spend a minute on this innovation as it is quite impactful. With the launch of the IQon in 2016, we established the category of detector-based spectral computed tomography. The Spectral CT 7500 is an important expansion to our portfolio and it delivers high-quality spectral images for the broadest patient base of any company, including cardiac, pediatric, and bariatric patients. It's the only system that makes spectral data available on 100% of the scans, allowing clinicians to adapt their protocols for different patients, thus eliminating the need for special workflows or multiple rescans. It is also the only system that provides spectral imaging for interventional procedures. The Spectral CT 7500 was extremely well-received by customers and further expands our comprehensive CT portfolio, which is continuing its double-digit growth trajectory from last year. We also launched IntraSight Mobile, a fully mobile interventional suite system to assist with coronary and peripheral artery disease procedures. IntraSight Mobile offers users in hospitals and office-based labs the integration, flexibility, and affordability for intravascular imaging, physiology measurements, and co-registration for seamless workflows and enhanced patient care. Our image-guided therapy devices portfolio continues to gain significant traction as we announced a series of important achievements in this business in the quarter. For example, the first structural heart repair procedure using our 3D intracardiac echocardiography catheter VeriSight Pro was performed at the Mayo Clinic. We also announced progress on several clinical studies, including the positive two-year clinical study results for the Tack Endovascular System for dissection repair, the first patient enrollment in the DEFINE GPS multicenter study to drive the adoption of iFR for percutaneous coronary interventions based on clinical evidence, and the start of the WE-TRUST multicenter stroke study to shorten treatment times by identifying, planning, and treating ischemic stroke patients in the interventional suite. Importantly, we continue to grow market share in our core businesses through deeper and more comprehensive customer partnerships. During the second quarter, we signed several new long-term strategic partnerships in countries ranging from North America, Europe, Latin America, and the Middle East. This builds on the strength of our portfolio and demonstrates the trust that hospital leaders have in our ability to enhance health outcomes, lower the cost of care, and improve patient and staff experience. In Personal Health, we introduced the Sonicare 9900 Prestige globally, which leverages AI to optimize the user's brushing technique, ensuring full coverage of the mouth and instilling brushing habits that improve oral health. We also expanded our leading male grooming portfolio with the introduction of the Shaver Series 9000 with SkinIQ technology in China, which leverages AI and sensors to offer a personalized shave tailored to each unique skin and hair type and will be launched in North America and Europe in the second half of this year. The integration of the recently acquired BioTelemetry and Capsule businesses is proceeding very well. Reactions from customers to the expanded portfolio of end-to-end patient care management solutions from the hospital all the way to the home have been very positive. We already see strong joint customer wins and funnel, including several major integrated delivery networks adopting these in the United States. We are also in the process of aligning assets, capabilities, and product roadmaps, which is a step towards joint R&D activity and platform development. On a different angle, in line with our plans, on July 1, the Domestic Appliances business became a stand-alone entity, and we are on track to complete the sale of this business to Hillhouse Capital in the third quarter, of course, subject to customary conditions. Also important, today we announced a new share buyback program for capital reduction purposes for an amount of up to €1.5 billion, and Abhijit will cover that in more detail later. Let me now speak about the planned field actions in Sleep & Respiratory care. This is, of course, a major correction and we take it very seriously. As mentioned, we have mobilized the necessary resources across the company to address the issue. This is due to the possible risk of direct degradation of the sound abatement foam embedded in the devices. At the same time, we realize that the field action itself has temporarily also a significant impact on patients. We are fully prepared to start with comprehensive repair and replacement actions for the affected units. We are still in discussions with the relevant regulatory authorities to obtain authorization to start deploying the repair kits and replacement devices that we are producing. For example, we have submitted the relevant applications to the FDA in June. We have already increased the overall production of DreamStation 1 and DreamStation 2 devices as well as repair kits from 30,000 units per week to 55,000 units per week as of the start of the third quarter, and we expect to reach 80,000 units per week in the fourth quarter, which underpins our expectation to address all devices in scope within 12 months of regulatory approval. As a consequence of the prioritization of the repair or replace actions, we are currently not taking new orders for sleep therapy systems, while masks and other consumables, of course, continue to be sold. As a reference, before COVID-19, the annual revenue in our Sleep business was close to €1.1 billion, with approximately 60% from systems and 40% from masks and consumables. In the longer term, we do not expect this issue to have a substantial impact on the fundamentals of our Sleep & Respiratory care business nor on the growth dynamics of this market. We have a market-leading innovative portfolio in these businesses and continue to work closely and transparently with physicians, customers, and patients to ensure that we address this issue as quickly as possible. Following our voluntary field safety notice for which we have assumed a worst-case scenario, we are still conducting research and further tests to get insights so that we are better able to scope possible patient risk. To be clear, we do not have data at this point such as preclinical or clinical study results indicating that exposure to the particulates or emitted chemicals related to the sound abatement foam will lead to disease, while at this point, we cannot exclude it either. The various regulators around the world have made their own interpretation of the field safety notice and the data, also weighing the patient risks and benefits. As a result, we are seeing some variance in what regulators are advising patients in this matter. I would like to point you to the table in the investor presentation. As I know this is on your mind, I can say that some civil complaints and personal injury claims have been filed in courts against Philips. However, it is far too early to draw any conclusion to talk about the merits of the claims or speculate about Philips' exposure. In due course, we will be able to assess the merits of any claim, and we intend to defend our position vigorously, supported by the further test data that we are gathering. Obviously, the timelines that may apply to the handling of claims is not yet clear. I also want to talk about the broader context of quality across Philips. In the last few years, we have made strong progress in our quality culture and approach. Improved design controls, improved post-market surveillance, and improvements in the way that we handle corrective and preventative actions. The affected products were designed and have been in full compliance with appropriate standards at the time of release and commercialization, and the component issue was identified through our own post-market surveillance processes. Overall, the robustness of our processes has increased a lot. That doesn't mean, of course, that we are done. This journey remains a top priority for all of us at Philips. I want to again reiterate that patient well-being is at the heart of everything we do. To round off, looking ahead, while we continue to see uncertainty related to the impact of COVID across the world and the impact of electronic component shortages, our overall financial guidance remains within the earlier guided rates. I am pleased with the progress that we are making on the strategic roadmap as well as the strong performance momentum in all our businesses, except for Sleep & Respiratory care. We are working hard on the field action, and our journey to HealthTech leadership continues. We are executing on a clear strategy to help transform healthcare along the health continuum combining smart systems, devices, informatics, data, and services. And I am convinced, and I want to repeat that, the growth and the margin profile of our company remains very well underpinned. And with that, I will turn the call to Abhijit.

Thank you, Frans, and thank you all for joining us today. Let me provide some color on the second quarter comparable sales growth of 9%, which was even 17% if you exclude the Sleep & Respiratory care business. Let me remind you that our comparable sales growth does not include the double-digit growth of BioTelemetry and Capsule, which we take into the comparable growth only after one year after acquisition. The Diagnosis & Treatment business's comparable sales growth was 16% in the quarter, with double-digit growth across diagnostic imaging, ultrasound, image-guided therapy, and enterprise diagnostic imaging informatics. We are particularly pleased to see the very strong growth in our image-guided therapy business driven by traction in both systems and the devices businesses. The volume of elective procedures continued to track above pre-COVID levels during the second quarter, and we expect this to continue as hospitals normalize their operations and also work through their backlog of patients. The sales for the Connected Care businesses declined 16% in Q2, driven by a substantial decline in the Sleep & Respiratory care business on the back of a very strong Q2 last year, as well as the headwind related to the field action. Patient Monitoring's comparable sales grew mid-single digits as we continue to successfully convert the strong order book in this business and performed well above even the 2019 levels. Personal Health delivered a comparable sales growth of 33%, driven by consumer demand for our new product innovations with good growth momentum across all geographies. All Personal Health businesses grew strong double digits. It is important to note that two phasing factors also had a positive impact on the growth rate of Personal Health in the quarter. The first being the impact of the shift of Amazon Prime Day from Q3 last year back to Q2 in 2021. The second was the impact of the legal and fiscal disentanglement of Domestic Appliances as of July 1. This meant that our IT systems related to Personal Health had to be shut down in the first week of July, leading to some pre-deliveries in June to avoid supply issues during the cutover period. We estimate that these factors had a positive impact of five percentage points on the growth of Personal Health in the quarter. Consumer sales through digital channels represent 45% of the total sales for Personal Health in Q2, and our shift to direct-to-consumer continues to gain momentum. With the strong performance in the second quarter, we closed the first half of the year with a 9% comparable sales growth and an adjusted EBITDA margin increase of 330 basis points compared to last year. Excluding the Sleep & Respiratory care business, comparable sales growth was 14% in the first half of the year. Moving on to orders, I am pleased to share that the Diagnosis & Treatment comparable order intake grew close to 30% in Q2, driven by strong double-digit growth in magnetic resonance, computed tomography, ultrasound, and image-guided therapy. This is due to positive market conditions as well as the strong competitive momentum of our portfolio. As a result, we saw further increase of an already strong order book in these businesses in the quarter. Comparable order intake in Connected Care declined over 50% on the back of around 170% growth in Q2, driven by the spike in COVID-19 generated demand. While we continue to expect demand for ventilators and patient monitors to normalize in the course of 2021, activity levels are expected to remain higher than in 2019 in these businesses. I am pleased that we continue to experience very positive competitive momentum of our monitoring solutions in the ICU and in other care settings. Let me now turn to the profitability development in the second quarter. Adjusted EBITDA for the group increased by 280 basis points to €532 million, which is 12.6% of sales. In Diagnosis & Treatment, the adjusted EBITDA increased by 450 basis points to 13.2% of sales, mainly driven by sales growth and productivity. Connected Care delivered an adjusted EBITDA margin of 11.3% of sales, mainly due to the impact from lower sales in the Sleep & Respiratory care business, partly offset by the results of our productivity programs. In Personal Health, the adjusted EBITDA was 17%, up from 5.6% last year, driven by sales growth while we continue to execute on the planned higher investments in advertising in Personal Health. We continue to focus on driving productivity, executing initiatives that will deliver cumulative net savings of €2 billion by 2025. These initiatives delivered €90 million savings in the second quarter, specifically €44 million through procurement programs, €30 million supply chain productivity, and €16 million overhead cost reduction. Restructuring, acquisition-related, and other charges were €264 million higher than guidance, mainly due to the €250 million provision increase related to the field action that we announced last month. Financial income and expenses were an expense of €7 million and included the positive impact from the increase in value of our minority participations. The adjusted diluted EPS from continuing operations increased to €0.40 in Q2 compared to €0.27 last year. In the first half of the year, adjusted diluted EPS from continuing operations grew almost 70% to €0.69. Free cash was an inflow of €167 million in the quarter. In the first half of the year, free cash was an inflow of €336 million compared to an inflow of €197 million last year. Let me provide some guidance for certain areas of our business. In the segment others, we expect an adjusted EBITDA loss of around €110 million for the full year 2021. This is €10 million better than our prior guidance due to lower costs year-to-date. The EBITDA loss in this segment is expected to be around €290 million this year or €50 million worse than our prior guidance, mainly due to a loss related to the divestment recognized in the second quarter. For Q3, we expect a net loss of around €45 million at the adjusted EBITDA level and around €110 million at the EBITDA level for segment others. In line with our previous guidance, restructuring charges are expected to be 70 to 80 basis points and acquisition-related costs are expected to be around 70 basis points in 2021. We continue to expect one-time EU MDR and consent decree-related costs around €40 million in the year. Financial income and expenses are expected to be a net cost of around €150 million in 2021. This is lower than our previous guidance of €140 million, largely due to the increase in value of our minority participations, and assumes no one-off gains or losses in the rest of the year. We currently expect the effective tax rate to be in the mid-single digits in 2021. This is significantly lower than our previous guidance due to one-off tax benefits relating to business transfers that result in the recognition of some tax assets. Our midterm guidance of a 24% to 26% effective tax rate, excluding incidentals, remains valid. Today, we announced a new share buyback program for capital reduction purposes for an amount of up to €1.5 billion in line with our balanced capital allocation policy. At the current share price, the program represents a total of approximately 37 million shares or 4% of the total shares outstanding. We expect to start the program in the third quarter and to complete it within three years through forward purchase transactions and/or open market purchases. This new program reflects our confidence in the execution of our strategy and financial trajectory. Moreover, under the ongoing €1.5 billion share buyback program for capital reduction purposes, which was initiated in the first quarter of 2019, we repurchased shares in the open market and entered into a number of forward transactions. 2.5 million shares were delivered in June 2021, with an additional 18 million shares expected to be delivered via outstanding forward contracts through the remainder of the year. These 20.5 million shares will be canceled by December 31, resulting in a reduction of 2% of the outstanding shares and an estimated reduction of the total number of issued shares to 897 million compared to 917 million shares at the end of Q2. More details are available on our Investor Relations website. To conclude, let me restate what we stated at the start of the year. Given the comparison base of 2020, we expected overall performance to be stronger in the first half of 2021, and this has been confirmed by our performance in Q1 and Q2. As Frans said, there is no change to our earlier guided range. Our adjusted EBITDA margin outlook is a year-on-year step-up of 60 basis points with low to mid-single-digit comparable sales growth. This will be driven by the momentum of a strong performance across all our businesses, offsetting to a significant degree the decline in Sleep & Respiratory care. Overall, we expect double-digit growth in Diagnosis & Treatment and Personal Health this year, while Connected Care sales are expected to decline in the high teens range. Let me remind you that Connected Care faces a high comparison base from the spike in COVID-19 generated demand that resulted in 22% sales growth for the full year and 32% in the second half of last year. In addition, we have the negative impact on the Sleep & Respiratory care business. We expect performance in the second half of 2021 to be backend loaded given the comparison base of 2020 in Connected Care and the phasing impacts that I mentioned for Personal Health and the estimated timing of installations of our very strong order book. With that, I am happy to take your questions along with Frans.

The first question comes from Veronika Dubajova from Goldman Sachs. Please state your question.

Hi guys. Good morning. And I hope you are doing well. Two questions for me, please. The first one is just an update. Frans, when do you think you will get the emergency use authorization in the U.S. to commence the repairs? And I guess, maybe if you can comment on some of the other major markets and what the timeframe is looking like at this stage for you to commence that work, that would be really helpful? And if you have had any feedback so far from the regulatory agencies on the repair process and their thoughts on that? Apologies, I know it's broad, but it's just a big theme of focus. And my question is on the guidance. Just, Abhijit, wondering if you can narrow it down for us, as low to mid-single digit is a pretty wide range? So just would love to understand where in that range you feel more comfortable? And maybe the tweak to that margin guidance? You are no longer up to the 80 basis points. What has changed for you? Is it transport cost? Is it shortages? Is it raw materials? Or something else that's kind of leading you now towards the lower end of that 60 to 80 basis point range? Thanks guys.

Yes. Hi Veronika. Good morning to you. Let me try to tell you as much as possible on all the ins and outs of the field action. First of all, you know we have engaged with all regulators throughout the world on the field safety notice. It's interesting to observe differences in the risk-benefit interpretation that regulators take. And that's why we have included the page that some regulators were inspectional guide for continued use while waiting for the repair, and others point to the doctor. Then on the repair procedures, let me point out that there are multiple devices within the platform family of DreamStation 1. We have submitted multiple packages to the FDA for regulatory approval, that's so-called 806.4 for the emergency field action. The FDA has engaged on these submissions, and we have already had several rounds of queries on those procedures, asking for more data, and so on. I cannot exactly predict when we will get approval. I can only say that the FDA is on top of it and working very diligently. Experience would show that kind of an eight-week approximate throughput time on an 806 could be expected, right, but that's based on prior experience, not necessarily related to this case. In anticipation, we have already produced repair kits and also placed stocks in bonded warehouses in a few countries in the world so that we can move quickly out of the gate. We are all ready to go, and I expect that imminently we should be able to give updates on that. Does that answer your question on the upgrade process, Veronika? Maybe let you react immediately on that?

No. That's really helpful. Thanks, Frans.

All right. Good. Then, Abhijit, the guidance with how many digits behind the comma?

Yes. Veronika, I would love to do that. We have six months to go. There are, as you have said, a lot of uncertainties, be it COVID, e-component shortage, etc. We have a strong order book and good demand. So I think, and yes, if you take low to mid-single digit, it can be from zero to six. So I understand that range is wide but somewhere in between is a fair indication of where we are likely to end. The margin guidance is not really a change. I have seen different people reacting differently. Look, you know, we have just seen where we are in the process. We are halfway through the year and we think the 60 basis points step-up year-on-year with the issues that we have in Sleep & Respiratory care, I think with what we know today is just a more accurate view of where we will end up.

Yes. Let me just reiterate. The whole company is completely geared up to compensate for the revenue loss in Sleep. There are so many opportunities that we are chasing and pursuing that perhaps that creates a lower than normal kind of ability to precisely nail the forecast. But don't read anything into it. We are all over it and remain very confident in our ability to perform.

Excellent. Thank you both. And Frans, if I can just quickly ask. You said you have had some conversations with the FDA on the EUA. Just curious if you've heard anything from them that would make you less confident on that eight-week timeline for the EUA?

I think all the questions are completely understandable and legitimate. They point to the complexity of this whole area around volatile organic compounds (VOCs). I am sure that we will get other questions during these calls, but the FDA has asked us to provide data that the replacement material is safe and sound. If we boil it all down, then everybody wants to assure that if you go out with a repair and replace action on a couple of million devices, you do so knowing it's a sound solution. I think that, in my own words, describes it. So I think the diligence is there, and the only unfortunate thing is that it takes time. Patients want this dealt with as soon as possible because not using the therapies is also causing a lot of discomfort.

Understood. Thank you guys so much. Super helpful.

Our next question comes from Patrick Wood from Bank of America. Please state your question.

Perfect. Thank you very much. I am also asking two upfront, if that's all right. So I guess tediously on the Sleep side as well. Just curious how the order book developed through the quarter and the revenue line? Obviously, thank you, Abhijit, for commenting around the group numbers with and without Sleep. Sort of playing around with that, I get the sense that towards the end of the month, presumably the sleep hardware business was down like 90% or something. I could be wrong about that. So I am just curious how that business developed through the quarter and whether you think that reflects just purely the repair actions or a little bit the consumer anger on the issue? And then the second one, I am just curious, thank you Frans for your commentary around the group and the product qualities and those sort of things. But do you feel that maybe internally how things are structured within Philips, how information gets fed up to the executive team, is that something you are looking at changing to help mitigate issues or surprises? Or is that an unreasonable expectation as you think you have got it working all right?

Okay. Abhijit, you take the first?

Yes. Overall, the Sleep business developed as we expected. Once we announced the repair actions, we haven't sold any more of the systems. The mask sales continued, and those were actually pretty good. We don't have an issue there. Normally, the sleep systems business sees the bulk of the deal done towards the end of the quarter. So yes, you are right, Patrick, towards the end of the quarter you really see the comparable decrease year-over-year. But not something that we were not expecting to happen. So no surprises there.

Yes. Then Patrick, on your second question. Several years ago, as we moved from a conglomerate organization with a holding model to an operating company focused on health technology, we changed our quality and regulatory organization. At that time, we moved the reporting line of all quality and regulatory people to the functional leader of Q&R. We have a Chief Medical Officer and Chief Quality and Regulatory Officer. The Chief Quality and Regulatory Officer reports directly to me, and all the resources, all 4,000 of them, in the company functionally report to the Head of Quality and Regulatory. That’s my first point. Second point, the learnings out of previous audits, 483s, and inspections pointed to the need to strengthen post-market surveillance. We have made significant progress and also have implemented a companywide information system called TrackWise where all complaints are registered and analyzed. The post-market surveillance process led us to detect the issue at hand. Remember, we have sold over 10 million devices. We track complaints coming in and eventually noticed a pattern instead of isolated incidents. In the beginning, we had one complaint here and another there, but as recently as we detected a pattern. We did additional investigations and that led us to the information we are discussing today. This is something we detected through our own PMS processes. Over the last several years, we have made significant progress. But I want to emphasize that the journey is not over. I feel good about the robustness of our processes. I don’t anticipate a need for change in the way we work. As for information movement within the company, we believe it is reported quickly and transparently.

It does. Thank you for the commentary, guys.

The next question comes from Hassan Al-Wakeel from Barclays. Please state your question.

Hi. Thanks for taking my questions. I have three, please. Firstly, could you talk about current manufacturing capacity within Sleep and where they fit relative to your 3.5 million installed base? What are costs to increase capacity here? Secondly, could you talk a bit about the momentum in North America? How did order intake within D&T fare? And what about MRI, where I believe the number was with plus-45% in Q1? Finally, following up on the guidance, could you talk about your confidence around topline guidance based on where your order books sit today? And then also on margins, given the quantum is of higher margin Sleep sales that you will lose over the course of the year, and do you assume any impact to the mask business as part of this year's guidance? Thank you.

Great questions, as usual, Hassan. Let me first reiterate on manufacturing capacity. We are ramping up capacity for the replacement and repair actions from 30,000 to already 55,000 a week currently, aiming at 80,000 by the beginning of the fourth quarter. When you multiply that by the number of weeks, you reach somewhere between 3.5 million to 4 million units. That's the expected throughput time of this effort. We haven’t specifically mentioned the cost of increasing capacity, but I can assure you that we would be able to go faster if we could obtain scarce materials from suppliers. We have helped our suppliers with mold capacity, etc., to speed up their ramp-up. Our goal is to shorten the 12 months if possible, but it’s too early to speculate on that. Secondly, the feedback we have received from distributors and doctors indicates that the manner in which we deal with this issue is more important than the issue itself; technical component issues can happen, but how we manage them is critical. So far, we have received positive feedback on our handling of it. Regarding your question about North America, I can say that order intake in Precision Diagnosis was very solid, upwards of 40%. Meanwhile, MR saw lower performance because we had significant order intake in Q1. Hence, Q2 was low single digit, but for the first half, we see strong double-digit growth. Our X-ray business also had huge order intake, as did CT and ultrasound. As for our topline guidance, we remain confident in our order book and establish a solid guidance for the future.

If you look at the impact on masks, to the extent that the masks went with the systems, we lose some of those sales. Although we have programs in place in the third and fourth quarters to compensate for that. However, it has an overall negative impact on the mix in Sleep & Respiratory since Sleep is a high-margin business and some of the compensation is coming through oxygen concentrators, which have a lower margin profile. Overall, for Connected Care, that’s a relatively small impact because Patient Monitoring is also growing.

And on that, if we take a wider view, Patient Monitoring is a profitable business that continues to grow strongly throughout the year. We continue to see government stockpile programs. Also, in D&T, the growth in image-guided therapy and devices with a strong margin profile helps continue our margin trajectory.

The next question comes from Michael Jungling from Morgan Stanley. Please state your question.

Thank you and good morning. I have two questions, please. Firstly, on the recall, you highlighted in your slide deck that 2.2 million people have registered out of the 3.5 million machines. Do you know what proportion of those 2.2 million are in the U.S.? How many patients highlighted that they actually have an issue with their DreamStation 1? Are you surprised that it's no higher than the 2.2 million at this stage? Secondly, about the foam of the DreamStation 1. Was that foam FDA approved by the vendor you sourced it from? And are you able to tell us who the manufacturers of that foam are? Thank you.

The 2.2 million registrations are more in the U.S. than the normal proportion of our business. Over 65% of the expected impacted devices are in the U.S., but the proportion of registrations in the U.S. is higher. This is due to the rapid launch of the patient engagement program driven by the strength of the DME network in the U.S., explaining why we expect participation to pick up in other international markets soon. Obviously, most reports are for DS 1 because that is by far the vast majority of devices affected. Unless I misunderstand your question, it’s logical that most of these registrations are DS 1 users. Regarding the foam, I must emphasize that when the product DS 1 was released, it was tested against all standards in place, including VOC standards at that time. The product met all those standards; otherwise, it would never have been released. The foam has been used for over ten years and we never had any issues with it. However, I am unable to disclose if the manufacturer had its own approvals, but we have used this foam in DreamStation 1 and prior generations without any issues.

Okay. Thanks for that. Kind of a follow-up on the question I asked about the 2.2 million patients who have registered. Have you been able to collect data to see what the issue is, why they have filed or registered?

We are still conducting analytics on that database. So I cannot provide more data than that. We first needed to ensure there are no duplicates and now we are mapping it against registrations and product production dates. I prefer to do a thorough job on analytics before answering your question.

Okay. And Frans, you didn't answer the question about who the foam manufacturer is? Could you highlight that, please?

Yes. I realized that I didn't answer that, so I am not going to answer that.

The next question comes from Kate Kalashnikova from Citi. Please state your question.

Hello. This is Kate Kalashnikova from Citi. I have three questions on Sleep, I am afraid. Firstly, Philips supplemental information sheet sent to doctors in July mentioned that the toxicity was noted for the extraction concentration and also that two genetic test assays show positive mutagenic response. What chemical specifically is the document referring to because the chemicals noted in the release such as CG, CGI, and GEG are not proven carcinogens in humans? It would be very helpful if you could clarify this. Secondly, Philips changed the sound abatement foam in DreamStation 2 to silicon. Why have you made this decision if there were no safety risks identified for PE-PUR in DreamStation 1? Finally, what proportion of patients normally start sleep therapies and then discontinue, perhaps even while they source this device? And what proportion of users in the U.S. regularly use ozone cleaners? Thank you.

Wow. Hi Kate. With regards to the VOC characterization, it's a complex matter. The supplemental information we referred to mentioned gases, and we have noted that some misinterpreted the type of gases, leading to a more serious interpretation than perhaps warranted. We have also, at the request of regulators, started a slate of additional tests to further characterize those gases. I can tell you that we have not detected TDI or TDA in those samples tested in the lab, but further research is ongoing. Regarding the foam change in DreamStation 2 to silicon, a new standard released in June 2018 had heightened VOC requirements. The grandfather clause allowed previously approved products not to be retested against the new standards unless safety concerns arose. We did not initiate a design change of the DS 1 at that time because no data suggested safety concerns. Routine practices suggest not retrofitting all old systems without a safety concern. We can’t ascertain the proportion of patients using ozone cleaning exactly, but aggressive marketing occurred even prompting the FDA to issue its warning in early 2020. Many complaints started occurring in the U.S. in 2020, correlating with regions where ozone cleaning was more prominently marketed.

Thanks for that. Just to clarify your answer to the first question. As you saw, the TDA and TDI were not detected in the tests done to date. GEG was detected, but it's not cytotoxic. What chemicals were responsible for the potential report of cytotoxicity, if not TDI, TDA, and given that DEG is not cytotoxic? If you can help us a bit, that would be very helpful.

I am now getting assistance from Steve.

Hi. We need to further identify those compounds. This analysis was done on lab-degraded foam, so the foam was aged artificially to simulate degradation. We did an extraction and analyzed all compounds there. We could detect diethylene glycol. There were a number of unidentified compounds that we are now further investigating. But we did not detect TDI or TDA.

Okay.

So to round it up, Kate, it is too early to conclude that the gases have a severe health impact. We took a worst-case approach back in April and June because that is what is expected from a responsible manufacturer. If you do not know the finite consequences, you initially deal with the overall worst-case scenario. Then as data becomes available, you can always reduce that rating, but that is our process. The supplemental medical information already gave a more balanced view, which was appreciated. Continued testing on a broader sample and aged products will help determine if VOC exposure is a concern. I feel that taking a responsible worst-case approach is essential.

Thank you very much, Frans. Just very briefly, have you got any data showing how ozone is accelerating foam degradation perhaps?

Yes. We have tested that, and we see a 40 times factor of acceleration of degradation when ozone is used. That’s with an average use of ozone cleaning. If people do it every day, it would accelerate even more. But the acceleration factor caused by ozone cleaning is significant, which is why we do not recommend it on medical devices.

The next question comes from Scott Bardo from Berenberg. Please state your question.

Thanks very much, guys. Sorry again to focus on the Sleep & Respiratory business. Frans, you mentioned several volatile organic compounds, and I understand why. I think this may be the bigger consideration compared to particulate matter. The MHRA in the U.K. conducted a biological safety assessment and highlighted that they did not see any volatile organic compounds of concern after 24 hours, suggesting this was a first usage issue rather than something sustainable over prolonged periods. Could you confirm whether you agree with that observation? Second question please, Frans, I wonder if you could provide more details about how you intend to repair and replace? Can you give us a split between repair and replacement? And does that alter between geographies? Could you give us a sense of what you expect the profit impact to be as a result of no sales for CPAP devices, including mitigation factors? Lastly, you seem confident and pleased with the process for remediation within 12 months. Am I right in saying that there’s no reason to deter from your 2022 provision or outlook for, say, 5% to 6% topline growth, and 60 to 80 basis points margin expansion?

Yes. Excellent questions, Scott. The MHRA test in the U.K. is very encouraging. We have taken a worst-case approach to be responsible because our lab tests, which noted VOCs, were based on a limited sample. Consequently, we took action as we could not ignore those findings. We have launched a wider range of tests, working with multiple labs to guarantee consistent results. I find it encouraging that no VOCs were found in the U.K. test, but we need to review the raw data of that assessment. Testing takes time, and I would like to expedite the process as patients are seeking timely resolutions. Regarding the repair and replace split, when we built the provision, the estimates were approximately 60/40 for repair vs. replace. The 806 approval from the FDA relates to the repair procedure and the assurance that after repair, the machine is good to use. The complexity of the repair process leads us to the split, and while there is a preference for repair among DMEs, we need to validate the repair thoroughly. We expect to lose revenue for at least 12 months, and with Sleep accounting for €1.1 billion, with 60% attributed to systems and 40% to masks and consumables, the math is apparent. If we can speed up production, we would aim to reduce that timeline. Looking to 2022, we believe we will maintain our guidance of 5% to 6% growth and 60 to 80 basis points of profit expansion.

Yes, we expect to see a provision of around €511 million for expenses related to the repair and replacement efforts. That portion includes communication costs and managing the database for tracking those cases. But we have not included any provisions for legal cases, as estimating those is too uncertain at this stage.

The next question comes from Ed Ridley-Day from Redburn. Please state your question.

Hi. Good morning and thank you for your detailed answers. One follow-up please on costs, specifically related to supply and freight. We have heard that some of your peers who have reported rising costs, particularly with freight. Abhijit, can you speak to that a little? And while it seems that second quarter wasn't too badly affected, how do you see that panning out over the third and fourth quarter, both in regards to freight and electrical components?

Yes, Ed, the second quarter was affected. However, we offset that with our productivity programs. While freight costs are at a heightened level and will remain in the second half, we are making efforts to mitigate that through our productivity programs, resulting in minimal impact on overall profitability. However, e-component shortages and higher spot buy prices are impacting profitability as well. Our guidance for the year has taken all these factors into account.

Thank you. And just one quick follow-up, you gave us some color on the growth in BioTelemetry. And I don't know if you can provide more color on the growth that you are seeing in that business this year?

The business remains strong. They are performing slightly better than the plans we had during the acquisition, remaining in strong double-digit growth with good profit expansions. So far, we are very pleased with how it's progressing.

This also highlights the early indications that CMS may increase reimbursement on parts of continuous mobile monitoring. While some analysts worried about reimbursement being cut, we see upheaval on MCOT with a small increase, putting some worries to rest. Earlier this year, long-term holter reimbursement was reinstated, which further strengthens our position on the BioTel platform.

The next question comes from Julien Dormois from Exane BNP Paribas. Please state your question.

Hi. Good morning, Frans. Good morning, Abhijit. Thanks for taking my questions. I will actually try to give you a break from the Sleep care business. Could you just help us understand what was at stake in the margin trajectory for D&T in Q2? Because when I compare the margin achievements to 2019, the gain you posted in Q2 was significantly below the gain you posted in Q1. So I am just curious whether there is a phasing issue or anything related to the product or geographic mix.

So tell me once more, Julien: When you say you compared D&T?

Yes. The margin in D&T compared to the last normal year, if I can call it that, which is 2019, the margin gain was about 100 basis points in Q2.

Yes.

While it was 250 basis points in Q1. So it seems you can see it as well. I am just curious whether there is something here? Or it's just phasing in the business?

I think it's primarily phasing. We are on a very good trajectory for D&T. The growth mainly comes from equipment sales, which typically have lower margins compared to service. Therefore, the disproportionate growth in equipment has a slight dampening effect now. However, as we get the service contracts, you will see the overall margin continue to improve.

And Q1 2019 was relatively low, right?

Yes.

Okay. Thanks for that. And maybe just as a follow-up in the broader approach or your discussions with hospitals at this time and maybe on a geographic basis. How do you see things evolving? I mean, you obviously posted a strong order book development in Q2. But how would you qualify the current discussions you have and how willing the hospitals are to spend more on CapEx?

A great question, Julien. Hospitals are in much better shape than half a year ago. Elective procedures are back, and hospital finances are improving. Growth strategies are being implemented. We have seen a strong willingness to invest, which reflects itself in the 29% order growth in our D&T business. Much of that is market-driven. While we do not have market share numbers for Q2 yet, I would expect some market share increase, reflecting overall market strength. Besides capital equipment, we see strong interest in telehealth and informatics, which are tracking quite well. All three market clusters for Philips are performing strongly. We see strength across North America, Europe, and Asia, with China also doing well. Hospitals are now better equipped to manage the COVID pandemic, so we anticipate positive trends for the rest of the year. I would also like to clarify that if you look at Q1, the growth in our sales from 2019 was about €134 million, whereas in Q2 it was €54 million. That explains some of the operating leverage between the two years.

Please limit your questions to one question with one follow-up only. The next question comes from Falko Friedrichs from Deutsche Bank. Please state your question.

Thank you. Good morning. I keep it to one question. It's on the share buyback program. So what led you to the decision to spend this €1.5 billion now for this program rather than use it for bolt-on acquisitions to strengthen your business? Is there simply a lack of good acquisition targets you currently see? Or what's the reason for that?

Yes. Hi. Good morning, Falko. You know that at our Capital Markets Day, which was one-and-a-half years ago, we reiterated our balanced capital allocation policy. What does balanced mean? Organic growth, M&A, dividends, and share buybacks. I have always said that we would allocate capital to M&A, which we did when we closed two acquisitions worth approximately €3 billion in Q1, BioTel and Capsule. We continue to see good M&A opportunities. The share buyback program does not limit our ability for acquisitions. In fact, it allows us to have more room for further bolt-on acquisitions. We are very confident in our ability to generate strong cash flow and profitability. Therefore, the share buyback program is a normal action in this sequence. If you evaluate our track record over the last five to eight years, you would see that we have been doing this fairly consistently.

Okay. Thank you.

The next question comes from Wim Gille from ABN ODDO. Please state your question.

Good morning. I have two questions. First on the provisions that you have taken here, about €511 million to date. Can you give us a bit of feeling how that number is split between repair, replace, and any other costs, including legal and regulatory costs? And as a follow-up there, the ozone issue is clearly a part of the problem. Is there a case to start legal action against the companies that have marketed ozone cleaning and try to recoup some of the costs that you are incurring for this?

The provision we have taken includes an approximate split of two-thirds for repairs and one-third for replacements. However, we have not included provisions for legal cases, as estimating these is too uncertain at this stage. We also have numerous costs related to communications, management of the database, and material and labor costs associated with repairs and replacements. On the ozone manufacturers, we don’t think it’s the time or place to discuss potential legal actions.

Unfortunately, we only have time left for one more question. The last question comes from Sezgi Ozener from HSBC. Please state your question.

Hi. Thanks for taking the time to take my question. My question relates to whether the first batches of repair and replacement kits have shipped, and which material was used. Are you able to estimate a cost based on the replacement and repair costs in these devices? How do these compare to the €500 million, roughly, of provisions that you set aside? My second question is regarding the positive one-offs we saw this quarter, such as a remeasurement of environmental liabilities and favorable results in legal matters. Could you elaborate on both?

Yes. Good morning. Regarding your first question, you might be reading too much into the repair kit batches already shipped. I referred to bonded warehouse facilities, and we will provide consistency in those units under regulatory requirements. We don’t intend to disclose the costs of every batch of repair kits. For your second question, I’ll turn it over to Abhijit.

Yes, two things: We had a legal case for which we had taken a provision in Q3 last year and that case was actually withdrawn against us. So we had to release that provision, which resulted in positive impacts this quarter. Regarding environmental provisions, these are long-term provisions that are accounted for over a 60-year cycle. Changes in interest rates affect volatility, so we benchmarked and now have it for a maximum of 30 years, which led to the release of some provisions.

Thank you very much, Abhijit.

I fully appreciate the concern around all the open issues. I want to assure you that we are on top of it, taking appropriate actions to deal with the patient situation as fast as we can. Meanwhile, business continues, and the resilience in our other areas contributes to maintaining our guidance, and we look with optimism to the future. Thank you all for staying with us.

This concludes the Royal Philips second quarter and semi-annual 2021 results conference call on Monday, July 26, 2021. Thank you for participating. You may now disconnect.