Ladies and gentlemen, welcome to the Philips Lighting earnings call Q3 2017. For the first part of this call, all participants will be in listen-only mode, and afterward, there will be a question and answer session. Please note that you are limited to one question and one follow-up per round. I would now like to give the floor to Robin Jansen, Head of Investor Relations. Mr. Jansen, please go ahead.
Good morning, everyone, and welcome to the Philips Lighting earnings call for the third quarter 2017. With me are Eric Rondolat, CEO of Philips Lighting, and Stéphane Rougeot, CFO. In a moment, Eric will provide an update about our business and operational performance, after which Stéphane will take you through the third quarter financial performance. Eric will tell you more about the outlook for 2017. After that, we will be happy to answer your questions. Our press release and the related slide deck were published at 7:00 A.M. CET this morning. Both documents are now available for download from our investor relations website. A full transcript of this conference call will be made available as soon as possible on our investor relations website. With that, I would like now to hand over to Eric.
Thank you, Robin. Good morning, everyone, and thank you for joining us today. I propose that we go straight to slide four. In line with our objectives, we achieved a positive comparable sales growth in the quarter. Comparable sales increased by 1.3%. For the first time in our transformation, the growth of LED and connected lighting systems and services more than offset the decline of our conventional businesses. Total LED-based sales increased by 22% and now represent 68% of total sales, compared to 56% in the same period last year. Europe delivered robust growth with a continued solid performance except in the U.K. and Ireland. The Americas and Saudi Arabia continue to be impacted by challenging market conditions. Overall, our operational profitability continued to improve with LED and connected lighting systems and services substantially contributing to this performance.
As a result, the adjusted EBITA margin increased by 50 basis points to 10.5% in the quarter. Net income more than doubled from EUR 51 million last year to EUR 110 million this quarter. Free cash flow was minus EUR 5 million in the quarter compared to EUR 164 million in the same period last year. Working capital increased as an improvement in our growth profile and a buildup in Home ahead of the high season in the fourth quarter led to higher inventories. In addition, inventories increased in several geographies where sales were softer than initially anticipated. Free cash flow also included a contribution of EUR 42 million to the company's pension fund in the U.S., which was partly offset by proceeds related to the sale of real estate of EUR 21 million. I propose that we go to slide five, where you can see an overview of the financial performance by business group.
LED, Professional, and Home significantly contributed to the overall comparable sales growth performance. 10 basis points for LED, 380 basis points for Professional, and 220 basis points for Home. Overall, as already mentioned, the adjusted EBITA margin improved by 50 basis points, and we are pleased to see that once again, all business groups are delivering in line with strategic objectives. This becomes even more evident when we move to slide six. This slide shows the contribution of each business group to the overall profitability improvement. As you can see, increasing profitability, particularly for Professional and to a lesser extent for LED and Home, more than offset the decreasing profit contribution of Lamps as its size continues to shrink. Let me now quickly walk you through our business groups, starting on slide seven.
Comparable sales in Lamps declined by 20.2%, partly reflecting a high base of comparison in the third quarter last year. We estimate that the conventional lighting market continued to decline faster than our Lamps business in the first nine months of the year, which has resulted in continued market share gains. Despite the high decline in top line, Lamps have been able to sustain a high level of profitability at 20%. This is 110 basis points lower than last year due to the sales decline that was partly offset by procurement and productivity savings. Let me now move to LED on the next slide. Comparable sales in LED increased by 14.3%, driven by significant volume growth, which was partly offset by lower selling prices and stronger growth in more affordable products. Growth was primarily driven by LED lamps, while growth in LED electronics slowed down.
All regions contributed to the growth, although countries with high LED penetration rates, again, showed lower growth rates, of course. The adjusted EBITA margin improved by 10 basis points to 10.7% in Q3, driven by operational leverage and procurement savings, offsetting price reductions and mix impact. Let's now move on to Professional on slide nine. In Professional, comparable sales increased by 7%. This solid growth performance does not reflect any contribution from a larger project we are working on in the U.S. that we already talked about in previous occasions. While production of our products and systems for this project is progressing according to plan, the end customer has decided to change the installation schedule, which has delayed revenue recognition. Systems and services were the fastest growth driver in the third quarter.
Performance in Europe and the rest of the world remained strong while market condition in the United States continued to be soft, in particular for small to medium-sized projects. Market condition in Saudi Arabia continued to be challenging and negatively impacted comparable sales growth by 300 basis points in the quarter. The adjusted EBITA margin improved by 380 basis points to 10.1%, driven by operational leverage, mix improvements, and also cost reductions. Restructuring costs amounted to EUR 9 million related to the ongoing rationalization of the manufacturing footprint and indirect cost reductions. Let's now turn to slide 10 and Home. Home showed an acceleration in sales growth and an improvement in profitability in the third quarter. Comparable sales growth of 28.1% was driven by significant growth in Home systems and by solid growth in all regions.
Demand for Philips Hue home lighting system continued to increase significantly because of our continued market penetration and our strong partnership with the makers of recently introduced voice-activated smart home devices. To support the growth of the Philips Hue offering, investments in innovation, marketing, and the supply chain continued and are expected to drive growth in the fourth quarter and beyond. The adjusted EBITA margin increased by 220 basis points to 1.4% in the quarter. This was driven by operational leverage and a continued focus on product cost innovation. All in all, Home remains on track to become profitable on a full-year basis in 2017, excluding the EUR 15 million real estate gain in the second quarter. This is what I wanted to cover regarding the business and our operational performance.
I will now hand over to Stéphane, who will tell us more about the financial performance for the third quarter of 2017.
Thank you, Eric. Let me now turn to page 12 and look at the adjusted EBITA bridge. When we look at the gross margin, we saw the positive impact of volume and mix. We also continue to deliver significant productivity and procurement savings, as you can see, which helped the overall gross margin as a percentage of sales to further improve by 30 basis points compared to the first quarter of 2016. We also continued to work on our indirect costs, which decreased by EUR 12 million, while we made additional investment to support our growth. Finally, we benefited slightly from favorable currency effect on our adjusted EBITA. Turning to our cost base on page 13.
You can see here the year-on-year evolution of our adjusted indirect cost base, which was 31% in the third quarter of 2017, which is 40 basis points lower than the same period last year. As you know, we have designed a detailed multi-year plan to significantly lower our indirect costs, in particular on selling expenses on IT, on real estate, finance, HR. We continue to implement these plans and all the cost reduction initiatives that we have launched. We achieved during this quarter, compared to last year, a EUR 12 million reduction. This reduction, again, is after some additional investment that we are making in order to support our growth, in particular in Home systems. In addition, as mentioned earlier, we benefited from the favorable impact of currency evolution also on our cost base, which reduced the indirect cost by EUR 14 million.
If we look at the reported EBITA, we have a real estate gain of EUR 21 million related to Lens. Furthermore, like I did also last quarter, I'd like to give you an update on our restructuring charges that support our cost reduction actions both above and below our gross margin. In the first nine months of 2017, we recorded EUR 49 million of restructuring charges. For the remainder of the year, like we said at the end of July, we expect restructuring charges to be in the range of EUR 80 million-EUR 90 million. That brings for the full year, the restructuring charges for the year to be in the range of EUR 130 million-EUR 140 million. That's in line with the guidance we gave, which is between 1.5% and 2% of sales.
These restructuring charges expected to be booked in the fourth quarter are mainly related to the further optimization of our manufacturing footprint, especially in Lens, and also the continued reduction of our cost base across our businesses and across our functions. Let me now take a closer look at the working capital evolution in the third quarter. Overall, in absolute value, the working capital at the end of September increased by EUR 28 million compared to a year ago. It represents 11.9% of sales, which is an increase of 70 basis points compared to a year ago. We ended the quarter with higher inventories compared to the end of June. As mentioned by Eric earlier, that reflects the improvement of our growth profile overall as a company, and also the buildup of inventories, especially in Home, ahead of the high season in the fourth quarter.
In addition, our inventories increased in certain geographies where we had anticipated higher sales in the third quarter. Finally, when you look at this trend in working capital and the impact of free cash flow, this is a very different trend, of course, compared to last year when working capital was lowered in the third quarter as the company was still experiencing negative growth. In the fourth quarter, we do expect a substantial reduction in inventories and more generally in working capital, as this is the highest quarter in terms of sales. Let's look now on slide 15 at the net debt evolution. At the end of the quarter, our net debt is EUR 12 million above the end of June.
If you look at the free cash flow, in addition to the profit that we generated in the quarter, and the impact of the increased working capital that I just talked about, you can see some other elements that impacted our cash and therefore our debt position. Net CapEx was EUR 3 million positive because it includes the favorable impact of the real estate transaction for EUR 21 million. The change in provision of EUR 76 million mainly relates to the contribution to the U.S. pension fund that we did for EUR 42 million, i.e., $50 million. In the quarter, we also paid EUR 33 million for both taxes and interest. Then, outside of the free cash flow, you can see here the share repurchase, the buyback for about EUR 15 million to cover the obligations that we have under our LTI performance share plans.
That leaves us with a net debt position at the end of September of EUR 709 million, which includes our cash position of EUR 605 million at the end of September. Let me now turn to Eric for the last part of the presentation.
Sure. Thank you, Stéphane. Let's now move to slide 17. Let's move to the outlook. Achieving comparable sales growth in the quarter is an important step in the improvement of our growth profile. We are also on track to improve the overall adjusted EBITA margin by 50 to 100 basis points, and for Home to be profitable for the full year in 2017. Please note that this is excluding the EUR 15 million real estate gain in Home in the second quarter of this year. In addition, we expect to deliver a strong free cash flow in the fourth quarter based on a substantial reduction in inventories. With that, I would like to open the call for questions, which Stéphane and myself are very happy to answer.
Thank you, ladies and gentlemen. We are now ready to take your questions. If you wish to ask a question, please press 01 on your telephone keypad. That's 01 on your telephone keypad to ask a question. Please stand by while we register the first question. The first question comes from the line of Andreas Willi with JPMorgan. Please go ahead. Your line is open.
Good morning, gentlemen. My main question is on the inventory that you discussed on the call as well. Of the increase, if you could break that down, how much is in that sense good inventory because you see the strong demand in Q4 in Home, and what's the amount of excess inventory in LED where you couldn't sell as many as you had expected? What's the impact on Q4 in terms of selling out these excess bulbs? Should we expect a negative impact on margins in terms of price reductions or discounts, or can they just be sold instead of basically buying new ones during Q4?
Okay, sure. Thanks, Andreas, for the question. Let me try to take it by piece. I will not give exact proportions. I will tell you what is in the inventory buildup. First of all, there is an increase on the Home business as we had targeted not only an increase in Q3, which has materialized, but we also have anticipated a strong increase in Q4 for that business. In general, for the consumer business of Philips Lighting, Q4 is a strong quarter. I would say that this inventory is built up to prepare for future higher sales. This is also the translation that when you have a big change in the growth profile, with a business overall Home that was growing at 28% in Q3, it does consume working capital, and we need to be able to build the inventory to tackle the demand.
Which, if you remember well, we were not doing so well last year, and I think that we missed opportunities. We didn't want that to happen in 2017. Let's move to other businesses, and let's move to LED. When you look at the performance of LED in Q3, the performance in LED Lamps is pretty much in line with expectation, maybe a bit lower, as we were very aggressive also on that business. We had started to build up inventory, as we said previously, at the end of Q2. The demand that we're forecasting in Q3, and now also coming up in Q4. Where we were surprised is with the lower demand that we experience on the LED electronics part of the business.
This is where we had build up inventory, and not only in finished goods, but also in components, because this is a business where we are not totally outsourced. The demand there was lower than what we had anticipated. Let me give you a very specific example. In the U.S., selling to OEM or to luminaire manufacturers, we've seen that the demand was much lower than we had anticipated, and the market that was far softer, especially when we're selling to big OEM. There's still more dynamic selling to smaller size customers. This is what we experienced on that business. There's no real impact on margin that we see on this inventory buildup. Most of it, I would say, is outsourced. To what is not outsourced, it serves so much in finished goods, but also, fairly sizable amounts in components.
I hope that this answers your question, Andreas.
Yeah, that's very clear. The follow-up question, if I look at your Professional business, which had an excellent quarter, Europe probably needs to grow somewhere in the mid-teens, which is maybe five times what the market grows. Could you maybe give some more comments around where you're gaining share? Are these some larger projects? Is this kind of double-digit growth in Europe sustainable? Thank you.
Let me give an overall comment, not only about Europe. What we are very pleased to see is the two-step transformation really happening. The first step is about converting the business to LED. The second step is moving to connected lighting. What we've said previously in the calls is that we had been investing ahead of the curve on the consumer business, but also on the Professional business, in order to build the right weapons that would help us to be also a leading player in the connected lighting space. Mainly, what we've done on the Professional part of the business, we have invested in technology, because when we sell connected lighting systems, all the technology is ours.
We have been investing in new sales force, new capabilities in all the markets where we operate in order to be able to sell directly to end users in a complicated systems. We have also invested in entities, eight around the world that we call system centers, that do not only the quotation, but also the delivery of the project. When we reviewed, in the last week, the performance in the different markets, we realized that these investments are starting to pay off. They come to a level of maturity that is satisfactory, and this is bringing the sales of connected lighting systems and services up. This has been particularly the case in Europe, where we have been strong on products, but also very strong on connected lighting systems and services. We are touching three major end user segments.
Historically, we've always been good in what we would call the outdoor application, this is still the case. Also now with the newly announced Interact Office offer, we see that we are also successful in office and industry, but also in hotel and hospitality. We see that this trend is really coming to completion, and as I was saying, I think we only scratch the surface. The potential in connected lighting is really, really strong moving forward.
Thank you very much.
Thank you. Moving on to the line of David Vos with Barclays. Please go ahead. Your line is open.
Good morning, gents. Thank you for taking my question. I have one, please, on connected lighting solutions. Acuity in its recent report mentioned that it's now installed 90 million sq ft, around 8 million sq m in its connected lighting solution offering. I was wondering if you could give us sort of a similar number as to where Philips is at this moment in time. Then the second question would be just on the U.S. Professional business also. If you could give an update on how the margin improvement in that particular bit of the business is going. It strikes me that perhaps we've made a bit more progress there, too. Confirming that would be helpful. Thank you so much.
Sure. David, we're not always using the same metrics. For us, the metric that we use, which is very meaningful, and I think it is an unequaled number in the lighting industry at this point in time, is to measure the number of light points that we have connected across all the sectors and all the end-user segments, including consumer and Professional. At the end of September 2017, we had connected 26 million light points worldwide in all the different segments. When you know that 26 billion is the existing number of light points today on the planet, it gives you an idea of the potential that we have moving ahead.
Sorry, Eric. The line just broke up a little bit. That's 26 million as of the end of Q3 versus 26 billion of total light points globally?
Yes, absolutely.
Would you be able to give us a sense of how that's moved between Q2 and Q3, that 26 million number?
Yes, I can tell you how it moved between the end of last year, where we were at 22 million, and the end of this quarter, where we are at 26 million. You see that there's been a big increase in the course of 2017.
Okay, perfect. Thank you so much.
On the U.S. Professional business. We are continuing to see, as we have said it repeatedly in the previous quarters, in the construction non-residential market for small to medium-size projects, the market being soft with a renewed competitive intensity. This is a market which is pretty much battered at this point in time, and the signs of weakness are continuing. We don't see that this will rebounding anytime soon. This is a situation that we are facing since a few quarters. At the same time, we are continuing in that environment in achieving the plans that we have in terms of improvement on many different fronts. That is not deterring in any way our resilience to carry the plans that we had ahead. That's the situation of that market specifically in the U.S. Now, there is another side of bigger project, which is dynamic.
There is another side, now maybe less on the Professional side, but on the Home side, which is also moving up quite fast. I just wanted to highlight because we said that whenever we did the introduction, that we also on specifically the U.S. Professional market, starting in Q1, we continued in Q2, talking to you about a major project that we had taken and that we would be invoicing in Q3, Q4, and potentially also Q1 next year. I just want to make sure and highlight that in the performance of Professional that you have in front of you, there is no contribution of that project. We have not been able to recognize the revenue in Q3. This has nothing to do with the project itself or our contribution to it.
On the contrary, we are totally in line with whatever we had to deliver in terms of production. We are absolutely ready and on time. It's just that the end user customer has decided to postpone installation. As a consequence to this, the revenue recognition is also postponed. I just wanted to make that clear because we were pretty much telling you that this would be recognized in Q3. It hasn't been so far.
Yeah. That's very clear. Thank you for that. Where is the client now in terms of the delays? Have they now made up their mind, and do they want it in Q4 or in Q1 next year? Can you shed some light on that? Go.
Yes. We are in daily contact. At this point in time, we don't know exactly because we have a contractor in between us and the end user. We are discussing. We don't know yet. We have also now a period in the U.S., it's going to be winter. Installing in winter is not always easy. We don't know what is in the mind of the customer at this point in time. I cannot really comment. We are invoicing, and we are being paid. We don't recognize the revenue at this point in time.
I see. Thank you so much.
Thank you. Next one in line is Alexandre Virgo from Bank of America Merrill Lynch. Please go ahead. Your line is open.
Thanks very much. Good morning, everybody. First question, I guess. I wondered if you could just break down the margin improvement in Professional for us. Maybe just give us a sense for how much of it is related to the structural cost reduction, particularly, and how much of it from operational leverage. Pricing headwinds presumably is an offset. Any indication on the granularity of that breakdown you could give would be very helpful.
Yes, sure, Alex. Stéphane here. Let me give you a little bit of direction here without, of course, being specific. We don't provide those breakdown by business. One of the large drivers, of course, has been the revenue increase and the operational leverage. Here for sure in Healthcare, we've seen a higher than usual or higher than before volume effect that is very positive. That is driving overall the operational leverage.
That has a positive effect on the P&L. That's one element. The second one is that, as mentioned by Eric, we've seen in Q3, again, a significant level of activity in systems and therefore growth. As you all know, systems carry a higher margin. From that standpoint, the mix effect of selling more systems than products has also contributed to the margin improvement. It's not something new. It was the case already before, but for sure in Q3 it has helped, and that's the strategy that we are pursuing. Number three, cost reduction. Yes, for sure. Across our various geographies for now several quarters, we've taken actions to reduce our cost. Manufacturing cost, you saw, for example, in Q3 last year, a significant restructuring charge we took in the P&L that was for manufacturing sites in Professional.
Over the last four quarters, we have actually closed those sites. Also on indirect cost and across the P&L in Healthcare, we are also bringing down the cost. It's really those three elements that are driving the improvement in the margin.
Okay. That's very clear. Thank you. Then just the follow-up question. If I just take a quick look at the LED growth for the group, you quoted at 22%. LED growth, divisional growth, obviously is only 14%, but because LED as a division is much, much smaller, obviously, relative to the rest of the group, it implies pretty meaningful growth for Professional. Again, given Home is small in relative terms, with respect to growth in LED and Professional, would it be right to assume that your growth in LED, in Professional, and I guess related to the systems comment you just made, must be north of 25%-30% year-over-year. Is that the right sort of number to think about?
We're not indicating those types of numbers. Where you're right is that the growth of Home LED is substantial and probably higher than the growth of Professional LED, which is also above the average.
Okay. That's helpful. Thank you.
Thank you. Moving on to the line of Alok Katre with Societe Generale. Please go ahead. Your line is open.
Hi. Thanks for taking my questions. I just had one follow-up on connected lighting systems, just to give us a sense of how much growth you're getting out of that. Also, parallelly, if you could just remind me of the connected light points at the end of 2016, I didn't catch that number. As well as the follow-up, and then I'll come to my question.
Yes. We had communicated a long time ago, at the time of the IPO, that the connected lighting systems and services was 10% of the overall Professional business. It has grown since then, as that part of the business has grown much higher than the average. We estimate in here, at this point in time, around 18%-20% of the Professional business.
Fair enough. Number of connected light points at the end of 2016?
At the end of 2016, we had connected, and that's not only on the Professional side, the Professional and consumer side, 22 million light points.
22. Okay, great.
At the end of September this year, it's 26 million.
Okay. Fair enough. Thanks. Just on how are you positioned on the input cost side? I'm just thinking about the input cost and the cost savings within the bridge. Obviously, the decline in non-manufacturing costs is quite modest yet. Obviously, one is when should we expect an acceleration over here? It's still on track for 2018. Then how are we positioned on the input cost side, where we're hearing about rises in chip prices coming out of China. It'd be great if you'd clarify on that. Thanks.
Yeah. Let me take the first part on the non-manufacturing cost. Yeah, you saw in the first two quarters of the year, because of the sales decline, as a percentage of sales, we are still above the same quarter of the previous year. Q3 is a much better trend. We are below the third quarter of 2016 in that percentage by 40 basis points. EUR 12 million is, of course, a significant amount. As I mentioned, it includes also the fact that we have increased our spend in a number of areas to support the growth, especially in Home systems. For example, you can see that overall R&D cost in absolute value are higher in Q3 this year than in Q3 last year. We are also investing to support the growth.
We expect more cost reduction per quarter than the EUR 12 million, but it doesn't come always exactly in a linear way every quarter. Overall, yeah, the programs that are in place are tailored and designed to deliver more than that because, as you know, the goal is that we reduce our non-manufacturing cost as a percentage of sales, and we go to a range which is anywhere between 25%-29% over the next two years. There is more to come and part of the restructuring charges that we are taking also address those items. On your other part of the question on components and bill of material, we've still been able to extract quite a large amount of savings in that area across our various business groups.
We've seen, of course, a bit of tension on some of the components side in terms of pricing, nothing that is changing the trend of the bill of material saving that we've had over the last few quarters.
Okay. Fair enough. Thank you. Moving on to the line of Lucie Cartier with Morgan Stanley. Please go ahead. Your line is open.
Hi. Good morning, gentlemen. Thanks for taking my question. The first one is actually on the LED division. It looks like maybe the growth, you've spoken about the price being a bit of a headwind, but when we look at the overall bridge for EBITA, it doesn't seem that the price pressure overall, at least for the group, was significantly higher than the previous quarter. The operating leverage, of course, on the margin in LED seems to have been quite weak. I'm just trying to understand how we should think about the development of the earnings profile in this division going forward as it seems that the margin is a little bit stalling here.
I think you're right in your analysis. The price pressure has not been drastically higher than before. I think we're capable in that business still to hold on the gross margin. If we connect that to the previous question of Alok, I think that now to see a higher operational leverage, it will also come from our capacity to reduce our overall non-manufacturing cost. Because each business, depending on their share of our revenue, is also allocated some costs from the whole Philips Lighting base cost. This is something that we have in mind and that we are working hard on. The cost and the cost of the company as a whole is a subject that we are tackling at this point in time with the highest level of priority to bring it down.
Thank you. The second question I had was regarding the comments you made around the LED electronics business, which had come much softer than you were expecting. I just wanted to understand that in a bigger context of the demand for this type of product, which are typically led by luminaires manufacturers and bigger lighting system. Do you think it was more of a one-off, maybe something seasonal, or should we read a little bit more into it? Because typically if customers are not buying the control of the electronics, it means they probably don't plan to actually manufacture the luminaire. How should we think about that, please?
It's directly linked, effectively. If people don't buy drivers, it means that they probably are not going to sell luminaires. Just to correct one other thing that you have said, it's not only linked to big lighting system offers. It's luminaires in general, including also a luminaire that would go into systems. You're right, the fact that less drivers or less LED modules are being sold by us, it means that our customers are selling less luminaires. It depends on the geographies. We see at this point in time a trend specifically in Northern America that we don't think is going to be only a quarter issue. It may last a bit longer.
Just to follow up on that, you kind of implying here that you expect potentially the North American luminaire business as a market to continue to be a little bit weaker considering the trends we're seeing in electronics for a bit of a longer term?
This is pretty much consistent to what we've said on and on that we were seeing the non-residential small to medium size project market being soft in the U.S. That's a confirmation of it.
Okay. Thank you.
Thank you. Moving on to the line of Peter Olofsen with Kepler Cheuvreux. Please go ahead. Your line is open.
Good morning. I had a question about the Home systems business. Basically the growth that you are showing is what you're selling into the channel. What are you seeing in terms of retail sell out? Are you seeing a similar growth there, or have your retail partners been building up inventory as well ahead of the Q4 demand? I have a follow-up on the LED segment.
Yes, actually the numbers that you see are the selling in number. The sell out has been extremely fluid. At this point in time, given the growth of that business also at our customers, there's very little time to have in-between inventories to be built. This is an extremely dynamic environment, and the sell out is very strong too.
Okay. That's helpful. On the LED segment, how big is the electronics part within that segment?
Electronics is slightly below 50% for that business.
Okay. It's pretty sizable within the total. Yeah. Okay.
Yes, absolutely.
Thank you. Moving on to the line of Daniela Costa with Goldman Sachs. Please go ahead. Your line is open.
Hi. Good morning. I wanted to go back to the free cash flow point. Can you comment whether you think you will be positive in 2017 on free cash? Also, what do you think is a normalized working capital to sales level for this business, let's say under flat growth? Then I have follow-up quick one.
I will take the first part of the question, which is the easiest one, and I will leave the other one to Stéphane. Yes, we will be positive in free cash flow for our full 2017.
Daniela, to your further comment on whether we see any material evolution in our working cap % and should it change compared to what it was before, fundamentally, no. Of course, when you are in a period of time where you go from decline to growth, the whole % on a quarterly basis can become a little bit different. As you understand, when you are accelerating growth, especially in some businesses, and here I'm referring to Home, when you measure inventory as a % of last 12 months sales, it doesn't really show what's coming, so it increases a little bit the %. Fundamentally, our working capital as a % of sales as a company, even when we return to growth, should not be fundamentally different from what it used to be.
We're not going to go backward compared to the improvements and reduction that we have done over the last two years.
Following up on the positive free cash in 2017, shall we look at Q4 from the prior years as an indication or given growth is potentially much better now, it should be substantially lower than that? Pension contributions, can you comment whether those are going to continue?
Let me take at least the pension part. We said we would contribute EUR 150 million over three years. For this year, we're not going to make any additional contribution. We will make further contribution in 2018 and 2019, and as a consequence, we will reduce, of course, our liability by the same amount and also improve some of the P&L and premium cost that we are paying. On the fourth quarter, we are expecting a strong free cash flow and a strong reduction of working capital in the fourth quarter.
Inventories.
Planning inventories, of course.
Thank you.
Thank you. Moving on to the line of Peter O'Reilly with Jefferies. Please go ahead. Your line is open.
Good morning. I've got two questions, please, on trends in LED and Lamps. Firstly, on LED, I'm interested in the mix. You talked earlier this year and also last year about the U.S. market moving more towards some value at really quite a rapid rate in 2016. I get the impression that's now happening in other parts of the world. Maybe you could talk about the overall mix and whether you see this trend continuing for quite some time. Secondly, on Lamps. I think if my memory is correct, in 2016, the market fell more slowly than you anticipated, which is one of the reasons for the margin being so strong. In 2017, looks like the market is starting to fall faster than you anticipate, and you've got strong growth coming through in LED.
Looking slightly further out, is the risk here that the Lamps business actually starts to decline at a faster rate because it's being cannibalized more rapidly by LED? What can you tell us about the way the trend is developing in the Lamps business, please?
Sure. Thank you, Peter. On the first question regarding LED, our LED business group is, as we've said repeatedly, integrating two different businesses, the LED Lamps and the LED electronics. We've talked about the LED electronics, giving a bit of flavor of what we see happening in the world with a market that has softened, and we gave very specific example in the U.S., which is our biggest market for that business. When it comes to LED Lamps, what we see, we see that in the markets where LED have already penetrated above 50%, we see that the growth of LED Lamps is smaller, and this business is growing slower than in other geographies where the penetration is not as much. Let me give you an example.
There are countries in Europe at this point in time where we are already selling for more than two quarters, more LED than we sell conventional Lamps. In which case, we see the growth of the LED Lamps being slower than in other countries, like probably growth countries, where the penetration of LED Lamps in the overall Lamps market is much more reduced. That has to be taken into account when we look at the overall growth pattern of that business. Of course, we continue to innovate, continue to bring new products to the market and new features, but that's a reality that we also have to face. When it comes to Lamps, I would phrase it in the same way as you did. Probably that in 2016, we were expecting faster decline than what actually happened. In 2017, it's true that we believe that the market is
Declining faster. The estimates that we have is between 23%-25%. With the decline, which is around 18%-20%, we are doing better than the market decline, and this is the prime objective of that business. It is to gain market share and to be the last standing man. This is actually happening and we are making this happen. Could we see the Lamps decline faster in the future? Well, there are clearly some technologies that are going to be banned, at least in Europe, to start with in 2018, which is halogen. What we also see, we also see that the cannibalization, especially on the consumer business for the technology that is compact fluorescent lamps is at this point in time happening quite fast because the prices of LED are reaching also the price point of compact fluorescent lamps.
All these are factors that we need to take into account. We still believe that we should be around the same level of decline, maybe on the higher end of the range. We said 15%-20%. This is something that we monitor. Once again, in the Lamps business group, the main objective for us has always been to reduce cost before the volume come down. As you can imagine, we're looking at that on a very regular basis to see how we need to adapt our cost base, depending on how we see the volume going down. These are very dynamic also exercise that we have to make in a declining environment.
Thank you. That's very helpful. If I can just come back on the LED Lamps business. I think you said in the prospectus that you thought the market would peak in volume terms at about 2020, and then go into decline because you have longer lifetime, therefore, a lower replacement rate. Is that still your view that 2020 is the volume peak or given a arguably more rapid shift towards LED, maybe the volume peak is earlier than that?
Yeah, we are keeping the same view. It was between 2019-2020. This is when you look at the market of non-connected LED Lamps. If you were looking at that market in a different way and saying, okay, it's not only about non-connected Lamps, it's also about the simple connected Lamps, so the wide connected lamp. If you add to the market of Lamps the connected part, and if you add also to that market part of what is going to cannibalize the non-connected LED Lamps, which is what we call the LED luminaire, the luminaire, the functional ones, then we believe that that market has the potential to grow beyond that point. Otherwise, if it's strictly talking about non-connected LED Lamps, we are pretty much always on the same time horizon in terms of market peak.
The LED Lamps in the LED business, they're all non-connected because they get reported in Home and in Professional, or am I missing something there?
Yes, you're right. At this point in time, they are non-connected.
Thank you very much.
Thank you. Moving around to the line of Marc Hesselink, ABN AMRO. Please go ahead. Your line is open.
Thank you. My first question is also on the free cash flow. On the provisions, you talked about the pension one. There are also some other provisions that changed, and you will have the restructuring charges in the final quarter. I'm not sure if that's already also cashed out in the same quarter. Can you talk about what you're going to see in provisions in the coming quarter, but also in the coming years? My second question is on Saudi Arabia. Still a very big impact, if I'm correct. It started a bit over a year ago. I was actually expecting that it would ease off a bit in the year-on-year comparison. Can you talk about what's still further deteriorating in that market and what's the outlook there?
Let me take the one on the free cash flow and the provision. First, when you look at Q3, for sure the comparison to last year is quite different. As you said, this year there is the impact of pension, which was not last year. Also the other thing is that last year, as you saw, the net provision movement was positive EUR 7 million. This is because we took last year a large restructuring charge during the quarter, which of course we have not cashed out during the quarter, hence the positive impact on the provision. This was not the case this year. In the fourth quarter, we expect to take a significant amount in restructuring as a charge. We will not spend the cash on that charge during the quarter.
This is cash that will be spent in 2018 and probably also for some of those initiatives in 2019. It will hit the P&L, but not the free cash flow in the fourth quarter. Moving forward, again, we've said that overall, again in 2018 and 2019, we expect to book P&L charges in the range of 1.5%-2% of sales so that we tackle the optimization of our manufacturing footprint, especially in the Lamps area. Later on that amount will go down, and we are still on track for that. To answer to your question on KSA, I would echo what you have said. The impact has been worsening in Q3. We should expect, and we should have expected also in Q3, an impact closer to what we have seen in Q1 and Q2.
There's a very specific thing that has happened in Q3, where we have really continued to apply our rules of prudence on that market, especially when it comes to credit management. There's a very specific issue that I cannot comment on in Q3, but the normal trend should be what we have experienced in Q1 and Q2.
Okay, that's clear. Maybe just a short follow-up on the provision. On the year-on-year comparison, is the change of provision except for the pension, is that a net inflow or outflow?
When you say year-on-year?
Yeah, for the full year.
Oh, for the full year. Based on what we will take in the fourth quarter, that should be an inflow, meaning we're going to book more provision than we're going to cash out.
Okay. That's clear. Thanks.
Thank you. Moving on to the line of David Vatman with KBC Securities. Please go ahead. Your line is open.
Thanks. Good morning. First question on the LED business, particularly on the LED electronics. You've been saying that the LED electronics were lower. Could you kind of tell us, I think I didn't hear correctly, the breakdown in sales in the LED division between LED lamps and LED electronics, and maybe then give us some indication on the impact of the weaker LED electronics on the margin for the division? Because I guess the LED electronics is higher margin. Second question on the Professional margin, could you give us a very rough indication of the trend, not maybe the absolute level, but the trend in margin between Europe and U.S. and maybe the KSA, Saudi Arabia impact on margin. Thanks.
Let's start with the LED part. As I have said previously, when you look at the overall LED business group, slightly less than half of that business group is LED electronics. There's no substantial impact in terms of mix between the two businesses when you reconsolidate at the global business group level. For Professional, the margin in Europe is above average and the margin in U.S. is below average. The impact of KSA on the margin has been quite substantial. We don't disclose it, but it has been quite substantial also in Q3.
To come back on Europe and the U.S., maybe the trend. I understand that Europe is above average, but has, for instance, Europe been improving faster than U.S. given the difference in the market conditions?
Well, we see a positive trend in that business in terms of margin due to two factors, this is valid in Europe as much as it is also valid in the Americas, which is that when we sell an LED luminaire, we sell it at a higher margin than a conventional luminaire. Whenever we sell systems, which is the part which is growing the fastest in that business, it also trends at a higher margin than LED luminaires. The combination of the growth of LED luminaires as well as connected lighting and systems and services is having a positive impact on the margin, and this is valid in Americas as much as it is valid in Europe.
Okay. Thanks.
Thank you very much. We now take the last question from the line of Timm Schulze-Melander with JPMorgan. Please go ahead. Your line is open.
Hi there. Good morning. It's Timm Schulze-Melander on the (inaudible) . Thank you for taking my question. It was really just a clarification. Eric, I think you talked about this large U.S. project, where you said that you are invoicing and you are being paid, but you're not recognizing revenue. The question is really two parts, just, A, that seems a slightly strange situation, if you could just provide a bit of clarification. Number two, that would suggest that that project has not been a material influence on your working capital and cash flow metrics in Q3. Could you just confirm that? Thank you.
Let me confirm all these elements. Yes, it has an impact on our cash flow. As it says, since we have produced the goods in inventory, so it has a material impact on the cash flow. That's one. Second, the way the contract is basically done is in the following fashion. We have to produce against some given schedules. Whenever we meet those schedules, we are invoicing, and then there is, after the invoicing, a delay in order for us to be paid. All that is happening exactly according to plan. Now, the revenue recognition or the transfer of title of the product was linked to the start of the installation and the product being taken by the installers to start the installation. As this is not happening, according to the accounting rule that we have to follow, we cannot recognize.
Okay. Very clear. Could you give us some scaling of how significant a contribution that was into the Q3 working capital, please?
No, we cannot do this for obvious reasons. I'm sorry, Timm, if we highlighted starting in Q1, continuing in Q3, that we had been able to get a substantial project, the substantial size, it was also to be able to guide you towards the fact that this is something which is quite sizable for Philips Lighting.
Okay, that's great. Worth a try. Thank you.
Thank you very much. With that, I would like to return the conference call back to the speakers.
All right, ladies and gentlemen. Thank you very much for attending the call and for taking part in the discussion about our results. If you've any additional questions, please do not hesitate to contact investor relations, and we're happy to answer your questions. Again, thank you very much and enjoy the rest of your day.
Ladies and gentlemen, this concludes today's conference call. Thank you very much for attending. You may now disconnect your lines.