Too cheap?

Philips Electronics’ announcement this morning that it is buying back 1.9 billion EUR of its own stock after the price fell on the announcement that quarterly profits were off 69% may signal confidence but it should not yet be misconstrued as a signal to pick up the shares.

Although operating profits more than doubled this quarter to 367 million EUR and sales were up 10%, the figures do not look quite so bullish when set aside the most recent yearly financials: at the end of 2005 operating profits were off more than 30% and sales had fallen by nearly half that; in addition, catch-up with end-of-year 2004 numbers is still some way off.

Rather, what this signals is just how difficult  it is to make money in the overcrowded and brand-dominated markets – and in particular the semi-conductor market – in which Philips operates. At first glance a P/E of 10 seems to be pretty cheap for the proprietor of the successful LG brand and more broadly speaking for a company in the heavily traded tech sector right now, and one almost understands CFO Sivignon’s announcement that the valuation is “attractive” – until, that is, one looks closer at the earnings.

2004, the big year so far for Philips, was most notably marked not by a substantial increase in product sales or even a sharp spike in gross margin on products sales (both of which grew steadily), but by a dramatic uplift on interest earned from equity holdings. This is a wary form of income for a business where market share and brand dominance is everything.

Philips’ sale of its stake in digital map maker Navteq last year – which trades at twice the valuation of the former – was a necessary move, but it is up to Sivignon once again now to prove to shareholders that he can effectively invest the cash in R&D and marketing to offer a substantial threat to goliaths such as Sony, Siemens and Texas Instruments, all of which trade at a minimum of one and a half times the price and all of which focus heavily on the former two departments. CEO Gerard Kleisterlee’s 3 billion EUR plus acquisitions binge this year may be expanding the size and scope of the company, but unless that expansion is paying off in terms of profit margins derived from product sales – rather than short term bets – it’s a meaningless indicator of the long-term prosperity of the company. 

It’s the age-old rule of quality of earnings. In a sector where depreciation of unsold goods is about as high as it gets, and where brand loyalty is as flighty as the next new new thing (as evidenced by LG’s sharp wake-up call on July 11), Philips’ focus on strengthening product quality and innovation and perception of product quality and innovation needs to defined more clearly before the shares look cheap. Spending some of these billions in development and marketing must follow next.