Koninklijke Philips NV Q3 FY2021 Earnings Call

Good morning, and welcome to Philips' Third Quarter 2021 Results Conference Call. I'm here with our CEO, Frans van Houten; and our CFO, Abhijit Bhattacharya. Frans and Abhijit will take you through our strategic and financial highlights for the quarter, and after that, we will take your questions. Our press release, the related information slide deck as well as FAQs on the recall notification of certain sleep and respiratory care products were published at 7 a.m. CET this morning on our Investor Relations website. The full transcript of this call will also be made available today on the website. As mentioned in the press release, adjusted EBITA 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. Over to you, Frans.

Thank you for joining us today. As the COVID-19 pandemic continued in the third quarter, our teams remained focused on three main priorities: meeting customer needs, safeguarding the health and safety of our employees, and ensuring business continuity. We are prioritizing necessary corrective actions for patients impacted by the component quality issue we announced earlier this year. We have mobilized resources across the company to address this because patient well-being remains central to our mission at Philips. Our strategy and portfolio are resonating well with customers. In the third quarter, we saw a 15% growth in comparable order intake in Diagnosis & Treatment and 21% in Connected Care, excluding the partial ventilator order cancellation from last year. This momentum is supported by a favorable hospital capital expenditure environment and the strength of our portfolio, resulting in a record-high order book for Philips, as indicated in our presentation. We also established 19 long-term strategic partnerships globally, reflecting the trust hospital leaders place in our capabilities to enhance health outcomes, reduce care costs, and improve experiences for both patients and staff. Our comparable sales declined by 7.6% this quarter, following a 10% growth in Q3 of 2020. This decline was anticipated and was influenced by a €150 million headwind from the sleep recall, as we prioritize remediation for affected devices. Additionally, we experienced heightened global supply volatility, including shortages of electronic components and longer shipping times, which impacted our ability to convert opportunities into revenue, resulting in another €150 million setback, particularly in September. Year-to-date, our comparable sales grew by 3%, with an adjusted EBITA margin improvement of 90 basis points. When excluding the Sleep & Respiratory Care business, we saw a 10% growth in comparable sales year-to-date and an adjusted EBITA margin improvement nearing 500 basis points. I will provide further details on the numbers shortly. I want to highlight some initiatives responding to today’s hospital leaders’ needs as they plan for the future. We have long provided our customers with benefits in spectral diagnostics, such as reduced follow-up scans and enhanced lesion characterization. The new Spectral CT 7500 introduced earlier this year has received strong customer demand and contributed to double-digit growth in our computed tomography business. The University Medical Center Utrecht in the Netherlands is one of the institutions already utilizing these systems to improve clinical diagnosis outcomes with high-quality images and faster scans for all patients. Building on our leadership in Image-Guided Therapy for cardiology, we are also strengthening our presence in growing areas like neurology and oncology. For example, Piedmont Health in the U.S. has outfitted its neurosurgical operating rooms with specialized Philips Azurion solutions for stroke treatment. We also announced positive results from a clinical study aiming to enhance safety and accuracy in diagnosing small peripheral lung lesions with the Philips Lung suite and Azurion. In the quarter, we launched two key HealthSuite informatics solutions that support customers in achieving the Quadruple Aim of care. The Patient Flow Capacity Suite manages the patient journey, while Acute Care Telehealth builds upon our Tele-ICU solutions. We continue to grow market share in our core businesses through deeper customer partnerships. For instance, we supplied the new Yili Chuanxin Oncology hospital in China with a range of solutions to meet clinical needs for cancer patients, including IntelliSpace Digital Pathology and various advanced imaging systems. As part of a 10-year partnership with Rutherford Health in the U.K., we opened the first Community Diagnostic Center in Taunton, where we provided innovative diagnostic imaging systems, including our helium-free 1.5 Tesla Ambition MR that lowers care costs while ensuring accurate diagnoses. The Capsule business also continued to enhance its Medical Device Information Platform, which integrates with over 1,000 unique types of medical devices, allowing customers to connect more devices and advance their health systems' digital transformation. In Personal Health, we are investing in new product launches and have introduced several oral healthcare innovations, including two electric toothbrushes and a professional teeth whitening product in partnership with LinkedCare in China. Additionally, in Latin America, we are seeing strong demand for our oral care products through our co-branding partnership with Colgate. We have successfully completed the sale of our Domestic Appliances business, concluding our major divestments, which allows us to focus on health technology and accelerate our transformation into a solutions company. We reported an after-tax gain of €2.5 billion related to this divestment in the third quarter. Regarding our actions in sleep, we are committed to delivering solutions to our patients and caregivers as quickly as possible. Our repair and replacement program is progressing well in the U.S. and other countries, with over 750,000 units of repair kits and replacement devices produced, and more than 250,000 units already delivered to customers. Our production volume has significantly increased to 50,000-55,000 units per week, with plans to reach 80,000 units per week in the fourth quarter. We aim to complete the repair and replacement programs within 12 months. We have a capable program management team overseeing these corrective actions. While several civil and personal injury claims related to the recall have been filed, it is too early to comment on their merits or timelines. Our focus remains on patients and the necessary corrective actions. When we announced the recall in June, we acted based on a worst-case clinical impact scenario assessment related to the PE-PUR foam issue, informed by the available data at the time. We are continuing research and testing to better evaluate any potential patient risk and will provide expert assessments to the relevant authorities and healthcare providers as soon as possible, expected in the fourth quarter. As noted, we have published FAQs on the recall to clarify our progress. There are some areas, particularly regarding litigation, where we cannot provide additional details at this time. We will update information transparently as the situation progresses. Looking ahead, we face ongoing uncertainty related to COVID-19, and global supply chain volatility has intensified, leading to longer lead times for revenue conversion from our strong order book in the third quarter, with expectations for continued headwinds in the fourth quarter. As a result, we now anticipate delivering low single-digit comparable sales growth and modest adjusted EBITA margin improvement for the full year 2021. However, based on robust customer demand and a growing order book, we expect to resume growth and margin expansion in 2022 as we navigate these challenges. We are making significant progress on our strategic roadmap on our journey to becoming a leader in health technology. We are executing a clear strategy to transform care across the healthcare continuum, with a stronger portfolio than ever to meet our customers’ needs. I remain confident in our company’s medium-term growth and margin opportunities. I will now turn the call over to Abhijit.

Thank you, Frans, and thank you all for joining us today. Let me provide some color on the third quarter comparable order intake growth of 47%. You will remember in Q3 last year, we had the partial cancellation of the ventilator contract in the U.S., and that provides a favorable comparable base. When taking out this effect, order intake growth is still a strong 17%. Diagnosis & Treatment order intake grew by 15% in the third quarter, driven by double-digit growth in MR, in CT, in Ultrasound, and in Image-Guided Therapy. Order momentum was very strong in North America, Europe, Asia Pacific, and most growth geographies. China delivered mid-single-digit order growth, with short-term momentum affected by additional procedures required for importing health care products. We have a strong position in China, including our R&D centers, our factories, local for-local innovation, and our fully Chinese management team and are further investing in local for local products and capabilities. Order intake grew 270% in Connected Care, and that is 21% when excluding the impact of the partial cancellation of the ventilator order last year. Patient Monitoring orders grew 20%, building on similar growth last year as a result of a fundamental shift in adoption of our patient care management solutions in both high- and low-acuity care settings. Comparable sales declined 7.6% in the quarter on the back of 10% growth in Q3 2020. As Frans mentioned, in addition to the high comparison base and the anticipated headwinds in our sleep business, we also faced stronger-than-anticipated supply chain disruptions at the end of the quarter. I will elaborate further on that a bit later. Coming back to the performance of our businesses, Diagnosis & Treatment comparable sales grew 10% in the quarter, with double-digit growth in Image-Guided Therapy and Enterprise Diagnostic Informatics and high single-digit growth in Diagnostic Imaging and Ultrasound. We expect strong momentum in these businesses to continue in the fourth quarter. The volume of elective procedures tracked above pre-COVID levels during Q3, even though they were below the levels seen in the second quarter due to the impact of the Delta variant in parts of the U.S. and Asia Pacific early in the quarter. We expect hospitals to continue to normalize their operations and work through the backlog of patients in the coming quarters, although COVID remains a risk, of course. The comparable sales for Connected Care businesses declined by 39%, driven by a substantial decline in the Sleep & Respiratory Care on the back of a very strong Q3 last year as well as headwinds related to the recall. Patient Monitoring comparable sales growth also declined on the back of a very strong Q3 last year and an increase in the lead time to convert the order book into sales. Personal Health comparable sales were in line with Q3 2020. As anticipated, sales growth in the quarter was impacted by 2 phasing factors: the shift of Amazon Prime Day from Q3 last year to Q2 this year; and pre-deliveries made in June due to the cutoff period related to the legal and financial disentanglement of Domestic Appliances as of July 1, 2021. As mentioned during the Q2 earnings call, we estimated that these factors had a negative impact of 5 percentage points of growth of Personal Health in the third quarter. Year-to-date growth was 15%, with double-digit growth across businesses. Underlying consumer demand for our strong portfolio in Personal Health remains very solid, but the current supply issues are expected to affect revenue in the fourth quarter as well. Consequently, we expect Personal Health sales in Q4 to be in line with last year compared to mid- to high single-digit growth if we were unconstrained by supplies. Let me now turn to the profitability development in the third quarter. Adjusted EBITA for the group was €512 million, which is 12.3% of sales. In Diagnosis & Treatment, the adjusted EBITA increased by 450 basis points to 14.2% of sales, mainly driven by sales growth and productivity. In Personal Health, adjusted EBITA was 15.9%, up 100 basis points from last year, mainly driven by productivity measures. Connected Care delivered an adjusted EBITA margin of 6.2% of sales, impacted by the sales decline in the high-margin sleep business, which was partially offset by our productivity programs. It’s important to note that Connected Care, excluding Sleep & Respiratory Care, was up 600 basis points between 2019 and 2020, and we expect to hold on to that gain despite the decline in sales this year. Adjusted EBITA for the group was also impacted by higher-than-expected license income in the segment Other, mainly due to phasing of royalty settlements. We continue to focus on driving productivity initiatives that delivered €73 million savings in the quarter, most specifically: €34 million through procurement programs; €16 million supply chain productivity; and €23 million overhead cost reductions. These initiatives help partly mitigate the impact of the increase in components and broader supply chain costs that we are experiencing. Adjusting items were €53 million lower than guidance in the quarter due to lower restructuring and acquisition-related costs and lower cost for the separation of Domestic Appliances. Financial income and expenses included the positive impact from the increase in value of our minority participations. Income tax expense was a gain in the quarter, mainly due to the positive impact of the recognition of some tax assets relating to business transfers. The adjusted diluted EPS from continuing operations was €0.40 in Q3 this year. Year-to-date, adjusted EPS grew by 19%, and free cash inflow was €45 million in the quarter, mainly due to phasing as the inflow for the first half of the year was €140 million higher than last year. Let me provide some additional guidance for certain areas of our business. In the segment Other, we expect an adjusted EBITA loss of around €80 million for the full year 2021. This is €30 million better than our prior guidance due to higher cost savings year-to-date. For Q4, we expect a net loss of around €20 million at the adjusted EBITA level for segment Other. Restructuring charges are expected to be around 60 basis points in 2021, which is lower than our prior guidance of 70 to 80 basis points due to lower costs year-to-date. Acquisition-related costs are expected to be around 30 basis points lower this year compared to our prior guidance of 70 basis points. This is also due to lower costs year-to-date as we have optimized some of our integration processes. In the fourth quarter, we expect restructuring, acquisition-related, and other charges of approximately €105 million. Financial income and expenses are expected to be a net cost of around €70 million in 2021. This is lower than our prior guidance of €115 million, largely due to the increase in value of our minority stakes. We expect the effective tax rate to be between low to mid-single digits in 2021. This is due to the impact of the recognition of tax assets relating to business transfers that I just mentioned earlier. Our midterm guidance of 24% to 26% effective tax rate, excluding incidentals, remains valid. On capital allocation, we are currently executing 2 share buyback programs for capital reduction purposes of €1.5 billion each. The program, which was initiated in the first quarter of 2019, will be completed this year as more than 20 million shares purchased through forwards are expected to be delivered and canceled by December 31. This will result in a reduction of 2% of the outstanding shares. Under the program announced in July 2021, we entered into a number of forward transactions in the course of Q3, covering approximately half of the program and totaling 19.6 million shares with settlement dates in 2022, 2023, and 2024. The remainder of the program will be executed through open market purchases by an intermediary, with a significant part taking place during this quarter. More details on the share buyback programs are available on our Investor Relations website. To conclude, I’d like to take you through how the year has progressed so far and our outlook. As Frans mentioned, our end markets remain very healthy, and competitive momentum of our solutions is very strong as evidenced by the record order book. In the first 9 months of the year, our comparable sales grew 3%, and our adjusted EBITA margins improved 90 basis points. Excluding the Sleep & Respiratory Care business, comparable sales growth was 10%, and adjusted EBITA margin improved by almost 500 basis points year-to-date. We are delivering on our transformation initiatives and our programs. We have been working through the global supply chain headwinds for some time now. But in the earlier part of the year, our ability to mitigate supply chain risk was higher, especially during Q3. As supplier inventory started depleting and global supply chain challenges intensified, lead times to convert our strong order book to revenue increased, impacting our ability to deliver on part of the revenue upsides we had planned in Q3 and Q4 to mitigate the shortfall from sleep. The impact is particularly strong on businesses like Patient Monitoring, Oral Healthcare, and Image-Guided Therapy, which, as you know, are our high-margin businesses and also the businesses which have been showing high growth. For Q4, for example, we are challenged with suppliers that are unable to give full visibility on the component availability and shipping times, and incremental short-term demand remains difficult to fulfill. We remain focused on driving necessary actions to deliver on our strategic performance roadmap. Due to the intensified supply chain volatility that we are working through, we now expect to deliver low single-digit comparable sales growth and a modest adjusted EBITA margin improvement in the full year. I want to reiterate that based on our strong customer demand and growing order book, we expect to resume our growth and margin expansion trajectory in the course of 2022 as we work our way through the recall and that we remain very confident in our medium-term financial trajectory. With that, Frans and I are happy to take your questions. Thank you.

The first question comes from Veronika Dubajova from Goldman Sachs.

Frans, Abhijit and Leandro, I have 2 questions, please. My first one is I appreciate you've not given us 2022 guidance, but I'm just trying to kind of get your impressions and thoughts on the pulls and pushes as you head into next year. On one hand, looking at the order backlog, I think this is the highest I remember seeing it. And I followed your stock for a while, so clearly, there are some real revenue opportunities as we move into next year. At the same time, I think, Frans, you were quoted on Bloomberg this morning talking about wage inflation, and I suspect some of the inflationary cost pressures on the supply chain side also continue to bite into next year. So my first question is really kind of your degree of confidence, both on the revenue and the midterm margin outlook as it translates into 2022. And maybe what are the incremental upside and downside risks that you see at this stage? And my follow-up, I'm going to ask it now, so we don't have to go back and forth. But just a quick word on the failure rate that you're observing at the moment with the DreamStation as you go through the repair and replace process. How far is it off the initial figures you had given us? And then any time line for the VOC studies, if you can give us an update on that.

Sure. Veronika, regarding our guidance for 2022, I will start by mentioning that our order book looks very promising and supports a significant portion of our expected revenue for next year. Our innovation pipeline is robust, arguably the strongest it has been in a long time, which is encouraging as we anticipate continued strong orders, particularly on the consumer side, where we feel well positioned. However, we need to consider year-on-year comparisons, especially since the first half of this year showed strong revenue growth, making the upcoming year-on-year comparisons somewhat challenging. Additionally, our sleep business will only begin generating revenue in the second half of the year after the recall is resolved. Consequently, there are several factors to weigh when forecasting revenue. As we mentioned in our press release, while we face some headwinds, we expect to resume our growth trajectory. We prefer to provide more precise details toward the end of the year, but our goal for the second half is to be on that trajectory. When discussing the first half, we want to hold off on details for now as we conduct further calculations. Looking ahead, we anticipate margin expansion next year despite inflationary pressures, and we are confident in our ability to achieve this. As Abhijit noted, excluding the impact from the sleep devices, we've actually recorded a 500 basis point profit expansion. While it has been a bit challenging to see the overarching trends this year, we believe there is solid underlying margin expansion potential that will be realized next year, even considering inflationary factors. We expect shipping issues to be temporary and do anticipate that labor costs may rise slightly more than this year, representing a factor to consider. We believe the semiconductor shortages will ease by the second quarter, leading us to be strategic in our long-term contracts, which we are already addressing. We have begun increasing prices, especially in the consumer sector, to help manage some of the temporary added costs like shipping. To summarize, we are optimistic about our ability to offset these pressures, and we foresee ongoing productivity improvements that will help us get back on the path we outlined at our Capital Markets Day in 2019. Regarding the sleep apnea devices, we have seen an increase in complaints since the recall was announced, which is to be expected as people become aware of the situation and submit their complaints. Importantly, the nature and severity of these complaints have not changed significantly since the safety notice, which reassures us that there are not new, serious issues emerging. No fatalities have been reported, and the failure rate as a percentage has not increased materially. However, given we have halted shipping since May to prioritize the remediation, it makes more sense to evaluate complaints against the cumulative units shipped over the years. We still maintain very low failure rates, well below significant thresholds. We also aim to develop a comprehensive body of evidence through continued testing as we have expanded our testing beyond the initial narrow set of data considered in April and May. This is in accordance with regulatory requirements. Now, we have additional units being tested and are collaborating with more testing houses and third-party specialists to better assess the compounds involved. Although we initially estimated these evaluations would take about three months, we might experience some delays. However, we anticipate providing updates within the fourth quarter. We plan to share findings transparently following regulatory consultations, recognizing the importance of clear communication regarding litigation risks for investors and analysts. We understand that litigation assessment can be complex, and we believe waiting for these test results will provide better clarity on the potential risks involved. I hope this addresses your concerns, Veronika.

That was very comprehensive, Frans. Can I just confirm, as you think about 2022, I mean, I guess you have the midterm guidance out there, right, which is the 5% to 6% sales growth and the 60 to 80 bps adjusted EBITA margin improvement. Would you expect 2022 to be in that range already?

Well, I’ve tried to say that we need to grow into that range rather than be there on January 1.

The next question comes from Hassan Al-Wakeel from Barclays.

I have 2 questions, please. So firstly, following up on your commentary on 2022 and more specifically on Connected Care, we've seen a more meaningful impact to margins this year in Connected Care, and I wonder how you think about this evolving into next year. Do you think the business can grow the top line or demonstrate margin expansion, albeit from a low base as the recall continues to weigh for a significant chunk of 2022? And then secondly, in D&T, do you expect a sequential acceleration of growth into Q4 based on the current phasing of orders? Or could the supply constraints mean that this is now unlikely? And then also, what about 2022? And are you confident about 5% to 6% growth in D&T?

Yes. Let's start with Connected Care. There, we will have the complexity of comparables and as the sleep business was affected from the second quarter onwards, right? So obviously, as the sleep business resumes, we should see very strong growth in the second half of the year. I'm looking at Abhijit, whether you want to say anything more to that.

Well, I think I mentioned it earlier as well. Overall, if you look at the Connected Care margins, excluding the Sleep & Respiratory Care business, they are holding despite the lower sales on the back of tough comparables last year and the whole supply chain situation. So I think we've made a good step in margin, and we will return to growth, and Q4 margins will be good as well, given that it's a big quarter, so similar to what you said, Frans. And on the D&T Q4, yes, Q3 was, as we said, already double-digit growth. We expect it to be in a similar range, maybe slightly up but again depends a bit on the supply chain volatility. Current outlook is it will be a bit stronger than Q3.

And 2022 for D&T based on the current order book?

Yes. 2022 will also be a strong year. So the 5% to 6% is very doable, given where we are in our order book at this point.

That's helpful. And if I can just ask a follow-up on sleep. Could you talk about the impact that you're seeing on the mask side of the business? I remember this wasn't a significant impact in Q2, and I wonder if that's changed in Q3.

Yes. We have focused our sales force more on masks now and, of course, on the other products that we still have. And whereas you would expect a decline in masks commensurate with the decline in systems, actually, that decline has been much less, suggesting that we were able to sell masks on a stand-alone basis into the installed base, right? And I think that’s great. We didn’t call it out in our report here because it’s not that significant, but still, we are pleased that we have been able to ship more masks than you would normally assume.

The next question comes from Lisa Clive from Bernstein.

I have two questions, both regarding the recall. You received FDA approval for repairing the devices, as well as other international regulatory approvals. Was the timing of these approvals in September what you expected? I'm trying to understand why you're still estimating that two-thirds of the devices will be replaced. Is this mainly the most cost-effective strategy? Additionally, from a business standpoint, could you estimate what percentage of your CPAP machine sales typically consists of replacement devices? I assume that if you're distributing a lot of DS2s, the replacement cycle might be shorter over the next few years. Lastly, regarding the VOC testing, what kind of information will you be sharing? Will it include details like how long the foam may release VOCs as it deteriorates? For example, is it three days, three weeks, or three months? I'm trying to get a clearer understanding of the information we can expect to see next month.

Okay. Lisa, the approvals were by and large in line with expectations, maybe a tad slower in coming – there were a ton of questions that we had to work through, and also the paperwork to document all these processes was enormous and, to a degree, still is. But we are out of the gate now, and I think that’s what matters. And you have seen some of the numbers coming through already, right? So maybe it could have been a few weeks faster, but it is what it is. The repair and replace cycle – or repair and replace proportion is still roughly in line with what we signaled earlier. We felt it was a bit too early to count on a benefit there. It could happen. But for a repair process, you need the return flow of units affected. That return flow takes time to organize. And once we are fully underway with the circular model there, we will be in a better position to tell you the quality of the units that are returned, right, whether they are, in fact, worthwhile to repair. You could argue that, hey, if a patient has a unit in bad shape, you should give back a unit of equal status. But that’s not how it works, right? You need to – as we touch the unit and the repair protocol is classified as a remanufacturing process as opposed to a field repair, that also means that high-quality standards apply to the repair process, right? And therefore, not all units can be reworked, so to speak. That’s taken as an assumption already into the provision, so I’m not flagging you a new risk, right? But that is why we are cautious to already cry victory over a better repair-replace ratio as perhaps you would have hoped for. Moreover, as we don’t want patients to wait and we are able to produce DS2s, DreamStation 2s, we are basically shipping DreamStation 2 units into the field to get underway with this whole cycle, right? And therefore, you should assume that in the early months of the repair-replace program, you will see an overweight of new; whereas later on when that return path is well underway, we will see a more beneficial ratio of repair, right? Hence, we cannot give you more information at this time. Then the test. Priority number one is to characterize the compounds and try to determine the level of toxicity, right? Obviously, that’s very important to the patients and to the doctors and to the regulators. So that is where we are putting a lot of effort in. Furthermore, we’d like to understand how does the degradation process take place over time, how does ozone effectuate that, et cetera, et cetera. I think that is what you can expect. As I mentioned earlier, we will prioritize, of course, communication to regulators and doctors, but we are fully cognizant of the importance for you to be able to assess the health risks and therefore, the litigation scope. And I hope that we are in a much better place to help you assess that in a more reasonable manner later this quarter.

The next question comes from Scott Bardo from Berenberg.

Yes. The first one, please, just on, again, the sleep and respiratory franchise. I think last quarter, you provided an update that there were some 2.2 million active device registrations for DreamStation for your field action. Forgive me if I missed that update this quarter, but I wonder if you can help us understand whether that's trended up or down just to get a sense of continuity. And furthermore linked to this question, please, again on your broader study set that you are conducting currently, can you help us understand the potential ramifications for this update? Could it indeed be enough to change the FDA's current recommendations on DreamStation? Is that the sort of magnitude, the data package we should expect? Some comments there would be appreciated. And second question, please, if I may. So thank you for the comments about sort of returning to your communicated trajectory. Of course, this year, we're not seeing much in the way of growth or margin expansion, I think, for obvious reasons. But what I'd like to understand is, do you envisage any catch-up effects for the margin and growth loss this year? Or are we actually going to be growing Philips from a lower base now?

Yes. Scott, on the sleep registered units, we are currently at 3.3 million registered devices. That does not mean that all registered devices are qualified devices for repair and replace, right? Because we basically, after they are registered, need to determine whether they actually have been used – in use or whether they have just been taken out of the cupboard and put on the registration list but were not in active use. Then the study set, and you asked that in conjunction with, will it be enough for the FDA to change their view? I need to understand a bit better what your question is because if you read the FDA advisory on their website, they actually say, continue to use, contact your physician, consult your physician and then decide what to do. So in fact, the FDA is not on the same page as Philips field safety notice where we said basically stop use, then consult your doctor, and then decide what to do, right? And there is this discrepancy between the FDA advisory and our own advisory, is something that doctors and patients have flagged this something that they would like to see aligned. Let’s say, we were, of course, the ones that put the advisory out in the first place. And then we are not doctors. We cannot do the risk-benefit analysis as doctors and regulators can do, right? And so the FDA came to a slightly different conclusion as to continued use, whereas we said worst-case scenario was a stop-use scenario. So there is that discrepancy out there already for actually quite some months, actually. The new data set that we are getting, we cannot anticipate what is going to be the outcome of that, right? I mean, if – otherwise, I would publish it today. So we will need to get all the expert opinions in as to the nature of the compounds, potential toxicity of the compounds, and therefore, what potentially the health hazard that is if you move away from that kind of initial worst-case scenario. I’m afraid we’ll still have to wait for that study to be published before we can expect also the FDA to do their evaluation of that, right? So it will take a little bit of time. Then on your questions on the trajectory, we flagged that we resume the trajectory. We did not indicate a catch-up benefit. Obviously, I’m ambitious and I would love to do that. But with the inflationary pressures that we talked about earlier, at this time, we signaled that we would like to come back to the 60 to 80 basis points, but we are not signaling any catch-up effect.

The next question comes from Julien Dormois from Exane BNP Paribas.

Frans, Abhijit and Leandro, the first one would relate to the supply chain volatility. I think you have stressed that you experienced €150 million headwind at the sales level in Q3. I was just curious whether you could elaborate on which division is the most impacted by this. So if you could detail that for each and every one of your 3 divisions, that would be very helpful. And the second question relates to a comment you made also about the positive CapEx trends you see from hospitals. I would be very keen to get any sort of visibility on whether you believe this is just a recovery to a pre-COVID situation, or whether there is really something structural happening at the hospital level and whether we should expect a stronger market for equipment going forward, at least for a couple of years.

Okay. Abhijit, do you want to take the first? And I'll take the second.

Yes. Maybe, Frans, you start with the second question, and then I'll give the detail. I have it but not the exact.

Sure, sure, sure. The positive CapEx trend actually came on the back of quite some slowness in the markets in the years before. I think on the capital equipment, on imaging, we know that the installed base is quite aged and old. I have heard many hospital systems wanting to build diagnostic centers in the community outside of the main premises of the hospital, and that could coincide with an investment cycle that will take a few years rather than only a few months. Probably the older equipment units will stay in place in the hospital, but these more efficient and more patient-friendly diagnostic centers that can operate at a lower cost and would potentially also not be affected by a COVID breakout seem to be a trend going forward that we recognize in multiple parts of the world. So that, I think, is good news. Same with ambulatory surgical centers, ASCs, where elective procedures can go in a patient-friendly and safer manner versus the main hospital campus. So we also see quite a few plans there that I would imagine is there for at least the next few years. Also, the backlog of elective procedures points to building more capacity. The CapEx trend in China always a bit higher than the Western world will continue. There, we see a strengthening of local for local rules, which basically say that your product needs to be registered with the NMPA as a locally produced product. So it does not mean that it has to be a local brand. It has to be a company like us who produces it completely local and the NMPA saying it is a local product. Then on monitoring and Connected Care-related areas, I think we all remember 2019 when we were saying what was flat, and you guys challenged us, when is it not going to be flat anymore? Well, COVID was a big accelerator for the insight that monitoring at other care settings is appropriate, discharging patients faster with wearable sensors and then using command centers to oversee cohorts of patients remotely yet leveraging telehealth, all of that has come to an acceleration. And so basically, we see finally this whole vision of Connected Care coming to fruition. If we look at acquisitions like BioTel and Capsule, both of which are bellwethers for this kind of trend, then I can tell you that strong double-digit growth is continuing there across the board. So we think that Connected Care will structurally have a higher growth rate going forward, of course, in 2022, initially still with some puts and takes due to year-on-year comparisons but structurally should be at a higher growth rate. I look to Abhijit, whether you have the data.

Yes. Yes, yes. So Julien, just to be clear, the €150 million we talked about is the, let's say, the higher impact on the supply chain volatility, right? So out of that, about €20 million was Personal Health because some of it was already factored into the plan. The unfactored element was about €20 million, and the rest was roughly evenly split between Connected Care and Diagnosis & Treatment with maybe Connected Care slightly higher than the Diagnosis & Treatment.

Yes, Patient Monitoring and IGT. In fact, all 3 businesses are high-profit businesses that were affected, which is unfortunate.

The next question comes from Patrick Wood from Bank of America.

I have two questions. First, I would like to hear your overall thoughts on the situation in China. There has been a lot of news regarding various macroeconomic factors, including recent GDP data. Given your significant presence in the Chinese market and the insights you have about consumer behavior there, I’m interested in your perspective. Second, regarding the supply chain issues, I recall that the impact was around €150 million mainly in September. Thank you, Abhijit, for clarifying the implications for Personal Health in Q4. Should we interpret that total in the context of other areas beyond Personal Health as potentially leading to a Q4 impact of roughly €300 million? I’m trying to understand if the €150 million was solely from September's situation, or if we can expect a larger impact in Q4. Additionally, is there a chance that supply chains are improving as you navigate some of the blockages?

Yes. Let's not keep that hanging because the Q4 issue is about €200 million estimated.

Correct.

So let's not have anybody think that it is going to get out of hand. €200 million is bad enough, of course, but we have mitigation actions in place to avoid a much bigger number. There is some volatility around it, so you could say €200 million was for us kind of the midpoint of some scenarios. But shipping should get better gradually.

And the €150 million is not all in September. Bulk of it was in September, so you can say 2/3 was in September and 1/3 in July, August. So you saw it accelerating in September.

Consumer demand in China is actually strong, with significant interest in consumer devices. However, we need to compete with strong local brands. Additionally, we have noticed a decrease in inventory levels in the channel, indicating that sales are robust. Nevertheless, we have faced supply constraints due to previously mentioned component issues. Looking ahead to the fourth quarter, Abhijit, is there anything you can share about our expectations for China?

Yes. I mean, like you mentioned, order intake was good, and I think that will continue. Also this sales momentum is slightly slower. But for PH, we continue to have growth. So I think that will – the trend of Q3 will continue into Q4.

The next question comes from Falko Friedrichs from Deutsche Bank.

I have two questions. The first one is about the product recall. Can you provide any feedback from doctors who prescribe your sleep apnea product? Do you think there's still a strong interest in sticking with Philips after the recall, or do you feel it might be challenging to regain some of the market share you may be losing to your major competitor? Some qualitative information would be helpful. My second question is regarding your free cash flow. We noticed that part of the decline was related to the use of provisions, likely for the recall. Can you quantify that for us? How much of the provision was released in the third quarter?

Yes. Falko, we have heard from both doctors as well as from DMEs, the distributors, that they are judging us more on how we handle the situation rather than that it happened in the first place. And we hear that doctors appreciate on how we do the communication and support them with intense information. They also told us that why they like us. For example, the informatics applications around sleep devices and the ability to observe trend lines, they like that very much. They've also said that they don't want to end up with a situation where there's only one big supplier, right? So on the basis of all the feedback, we expect to be able to recoup our market share maybe not immediately but over time. And we are also planning already, in parallel to the remediation, a comeback plan where we will go out, of course, with all energy to fight back and to regain and recoup our share. Then on the free cash flow, Abhijit.

Yes. For Q3, I think we consumed around €60 million out of that, out of the provision. So that, of course, kept the cash flow down a bit in the quarter. But like we said, year-to-date, for the first half, we were well ahead. So we remain in line to get to the target for the year, excluding, of course, the cash impact of what we have to spend on the recall.

The next question comes from James Vane-Tempest from Jefferies.

Firstly, you've lowered the restructuring cost guidance, and I think you said you expect it to be even lower next year. Just wondering if you can provide any more color around this. Is this because restructuring charge has been pushed back, and/or you expect fewer changes are required in the underlying business? And then my second question is, you mentioned sort of growing into the 60 to 80 bps margin expansion next year. And given the first half comparison which you highlighted on the call, is it fair to say you're more likely to see that more in the second half of next year?

Yes. We have not delayed any restructuring efforts because that would affect our productivity programs moving forward. At the beginning of the year, considering the pandemic and a longer-term outlook, we thought we might need to take more significant actions. However, with the increase in demand and a strong order book, we have determined that some restructuring is unnecessary. As a result, it's positive that we can reduce the adjusting items sooner than we initially planned.

Yes. And then on the phasing, when Veronika asked the question in the beginning, I said we have to grow into that trajectory. We will not be immediately on that trajectory on January 1, right? So the second half of the year will be stronger than the first half of the year. And I hope that, that answers your second question, James.

The next question comes from Wim Gille from ABN AMRO-ODDO.

Yes. Wim Gille, ABN AMRO-ODDO. A pretty simple one, I think. The Other segment was quite well this quarter, in particular related to the phasing of royalty settlements. Taking also into account the disentanglement of Domestic Appliances this quarter, it gave us a bit of feeling where we should pitch our adjusted EBITA numbers for Other going forward, so moving more into 2020. Is it fair to assume that we will have structurally better adjusted EBITA results in Other on the back of this?

Yes. Wim, so what I said about the royalty was it's a phasing between Q3 and Q4. So overall, we have kept costs lower this year, and therefore, we reduced our guidance by €30 million lower. Going forward, typically, what I do is in Q1, I gave a very explicit guidance for the year. So I just request you to be a bit more patient, and then we will do all our puts and takes and come back with a view as we start next year.

Okay. Maybe to put it differently then. Can you remind us just what the impact is going to be of the royalty income from Domestic Appliances on an annualized basis?

It’s going to be plus/minus €60 million or so.

We have a follow-up question from Lisa Clive of Bernstein.

One follow-up on the recall. Am I correct that every device that's returned for either replacement or repair will actually have its foam tested? And if yes, would you be able to disclose to us at some point the proportion that show any sign of breakdown once those results are available to you?

Lisa, every unit that comes back will be photographed and inventorized. Tested is a big word because we are not necessarily putting millions of devices through a comprehensive test, but they will be inspected.

The next question comes from Kate Kalashnikova from Citi.

Frans, Abhijit, this is Kate Kalashnikova. For imaging diagnostics, on one hand, hospitals are under pressure due to COVID. On another hand, your costs are increasing due to supply chain challenges, high logistics cost. So how do you think about the net impact of this change? And could you also comment on competitive dynamics when it comes to price?

Yes, hospitals are under pressure, but there's also a lot of government money going into shoring up hospitals and expanding the capacity of health care, right? So we should not take this pressure thing too much, right? I spoke earlier about diagnostic imaging change being built. I spoke about a strong CapEx environment. A lot of the cost of radiology is actually not equipment but labor, and there's a lot of efficiency to be gained in that whole workflow. And this is also why the Philips informatics solution is so appropriate. I mean, our radiology command center, ROCC, and the radiology solutions suite can drive productivity in radiology centers by over 30%, which is fantastic if you think about having more patients that need to be diagnosed, et cetera. So overall, I look with optimism towards the market. There is enough to be done. What you will see is that many hospitals will buy good enough rather than the most super-duper machine. It's all about diagnostic confidence and efficiency rather than on the features. What we observed with the Spectral CT 7500 is that it gives a confident diagnosis in record time, right? This is very important. And reconstruction time is very fast. And given that you get spectral information without having to predetermine whether you want conventional or spectral imaging is a huge benefit, right? The fact that our MRI is helium-free and doesn't need expensive quench pipes in the real estate, right, is great, especially when now new diagnostic imaging centers are going to be built that you can build basically structurally with lower real estate costs, right? And so some of our competitors continue to emphasize the academic centers as the only determining factor, but I can tell you that most C-suites are very focused on productivity instead. So overall, we think that we can hold our own in terms of competitive position. And yes, I think on pricing, health economics play more and more a role. And then it is important about lifetime cost and rather than on the initial price. So I think we can maintain our position there.

And as a follow-up, what proportion of your D&T sales in China is produced in China currently?

Yes, we have made significant progress. I mentioned that the criterion is registered as a local product with the NMPA. This means it's not just about local manufacturing, but also about being accurately labeled as a local product. We are generally in line with our competitors.

Are there any plans to increase it further?

Yes, somewhere around the 40% or so on a formal basis, goes up rapidly as we understood that this was important. So we have been on a path already to localize manufacturing and increase the local labeling. The NMPA takes quite some time to process these requests. So we are a bit dependent on the regulator there. But otherwise, I think we are on a good path forward.

The last question is a follow-up question from Veronika Dubajova from Goldman Sachs.

Just a quick one follow-up actually on the China topic. I know you've mentioned some softness in order momentum in Q3. Just curious if you've seen improvements in that as you move through the third quarter, and if you can give us sort of a first look on how the China order momentum is progressing in the fourth quarter and your best guess for when you might see a return to normalized order growth in this market.

We actually, I think, flagged that we had mid-single-digit order growth in China. We flagged some revenue delays also in China, partly also by the processing of all these IPPA regulations. That's, I think, where we stand. So it was more a revenue recognition that was a bit slowed versus the order momentum as such. Anything else, Abhijit?

No. I think last year, I think the comparables in Q4, we had 17% order intake growth, so that will have some impact. But in general, I think China is slower than it used to be. But as soon as the guidelines get clearer, you will see momentum picking up there.

Is there a timeline for that? Is Q1 2022 a realistic expectation for it?

Very difficult to say, Veronika. It’s a thing that the government is working through. And of course, they see also the impact of things that are stuck in the pipeline, so we’ll have to wait and see.

Thank you, Mr. van Houten and Mr. Bhattacharya. That was the last question. Please continue.

Okay. Well, thank you for all your questions. Let me summarize by expressing my conviction that we are going to be on a path upwards and work through the challenges that you have asked numerous questions about. I do believe that the end goal of high teens profitability by 2025 remains intact. We have a competitive set of innovations. We are going to resume our growth and margin expansion. And we hope that we will have, let's say, the sessions with you to go deeper on those questions as soon as possible. In the meantime, thank you very much for today, and stay tuned.