Ladies and gentlemen, welcome to the Philips Lighting Analyst Conference Call. 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're limited to one question and a follow-up per round. I would now like to give the floor to Jeroen Leenaers, Head of Investor Relations. Mr. Leenaers, please go ahead.
Yes. Thank you. Good morning, everyone, welcome to the Philips Lighting Analyst Conference Call for fourth quarter and full year 2016 results. With me are Eric Rondolat, CEO of Philips Lighting, Stéphane Rougeot, our CFO, and René van Schooten, Board Member and Business Group Leader of our business of lamps. Eric will give a brief introduction, followed by Stéphane, who will go through the highlights of Q4 2016. Eric will tell you more about the highlights of 2016 and our outlook for 2017. We will end today's conference with a Q&A session with all three gentlemen will be available to answer your questions. I would like to hand over to Eric.
Thank you, Jeroen. Good morning and thank you very much for joining us today. It's good to have you on the call today. Let's go to slide number three. In 2016, our businesses performed in accordance with their strategic objectives, despite, as we've mentioned, challenging conditions in some markets. We are pleased with the significant increase in profitability and solid free cash flow in our first year as a standalone company. These results also mark a continued action to achieve our strategic goals and medium-term financial objectives. More than ever, our team remains focused on the opportunities ahead and is committed to meeting the needs of our customers through innovation while we execute concrete actions to continue improving our growth profile. I will now hand over to Stéphane, who will tell you more about the highlights for Q4 2016. Stéphane, the floor is yours.
Yes. Thank you, Eric. Good morning, everyone. I'm now turning to page five, and you can see here the overall overview of our financial performance for the group and for our business groups. As you can see here, the comparable sales growth has declined by 3.2% for the quarter. This is mainly due to lamps, and we also have still the impact of some remaining macroeconomic uncertainty for some of our markets. You also see that each business group has contributed to the improvement of the adjusted EBITDA and also to the improvement of the adjusted EBITDA margin. Finally, overall for the group, the adjusted EBITDA increased by 18.2% and reached EUR 188 million, and the margin improved by 190 basis points and reached 9.7%. Turning to page six, you can see here the adjusted EBITDA bridge.
Like in Q3, our improvement in adjusted EBITDA has been driven by a continued improvement of our gross margin with an increase of 170 basis points, also the continued implementation of our cost reduction programs across the company. The improvement of the gross margin as a percentage of sales was driven by our ability to compensate the price decline by operational efficiency, procurement savings, again, that we are able to secure, also by the increased productivity that we have in our manufacturing plants. Outside of our gross margin, we have also continued to optimize and to reduce our cost base with a particular focus on SG&A. Despite additional cost in the fourth quarter of 2016 that we didn't have last year, like the brand licensing, we've been able to reduce the cost base.
Actually, we took EUR 43 million out of our cost base in the fourth quarter. This performance in the fourth quarter is consistent with what we have achieved in previous quarters, and it demonstrates our ability to take out costs above and also below the cost margin. Let me quickly walk you through our four businesses on slide seven. You can see that lamps improved its margin by 430 basis points with the ongoing cost rationalization and despite a decline in sales. As said, the sales declined by 18.5%. It's been driven, of course, by the technology transition to LED lighting. Overall, when you look at our CSG in the second half of 2016, this is minus 15.6%, and it's very similar to what we saw in the first half of 2016. We've been able to further improve our adjusted EBITDA margin to 19.1%.
Again, this is a result of the ongoing work done on the manufacturing footprint, on procurement savings, and also on the overall improvement of our industrial productivity. We took in the fourth quarter a EUR 17 million restructuring charge so that we can continue to rationalize our manufacturing footprint. Finally, you should note that again, we've rationalized our business portfolio in lamps, and we've successfully divested the cinema business in North America. Moving to LED on page eight, you can see that the sales growth in the fourth quarter is similar to what we saw in Q3, 11.3%. We saw robust volume growth in the fourth quarter. As you know, we consistently get significant procurement savings, which allow us to reduce price, and in turn, this is what fuels the volume growth.
In previous quarters, we talked about the softer performance in North America, and this continued in the fourth quarter. Accordingly, we have taken a number of measures, including the expanding and diversifying our distribution coverage in the Americas, intensifying also our marketing activities, and finally, continue to boost market-based product innovation. In terms of our profitability, as we had the positive impact of procurement savings and also increased volumes, this more than offset the negative impact of price reductions. So we managed to increase our adjusted EBITDA margin significantly by 320 basis points, and we reached a margin of 12% in the fourth quarter. Moving to Slide nine and Professional. We saw this quarter a stabilization of sales increase by 0.1% compared to last year, and this despite continued difficult market condition in Saudi.
In the graph, you can see that the situation in Saudi Arabia impacted our CSG materially during the year. We show you the difference with or without the impact of Saudi Arabia. Actually, if you exclude Saudi Arabia, we grew every quarter. For the fourth quarter, our growth without Saudi Arabia would have reached 3.6%. Overall, we had a good level of activity and also growth in Europe in Professional. On a comparative sales basis, in the Americas, we were stable. We increased our adjusted EBITDA margin in the fourth quarter by 30 basis points. This was mainly driven by the savings we continue to generate in procurement, the efficiency we have in our production, and also some mix improvement as we sell more LED and more system and services.
These are structural improvements. They allowed us to more than offset the negative impact of our business in Saudi Arabia, which is due to lower activity and also some write-down on bad debt. Moving to our Home business, which was profitable in the fourth quarter. You can see that our sales continue to grow at 8.8%, with all our markets contributing to growth, which has been supported by the Home Systems business. Home posted a EUR 3 million profit in the fourth quarter. This is, of course, the result of higher sales, but it is also the impact of the significant cost rationalization measure that we have implemented in 2016, and also the continued savings in our bill of materials. Let me now briefly focus on some of the financials for the quarter. First, our working capital.
On page 11, you can see that working capital as a percentage of sales improved by 180 basis points year-on-year. This is a tremendous performance. We have now reached a working capital that represents 9.3% of sales. This is a EUR 170 million reduction compared to the end of 2015. As importantly, you can notice from the graph that we have actually achieved this year-on-year reduction consistently quarter after quarter. We end the year 2016 with working capital needs, which are structurally lower. This improvement, as you can see on the right of the slide, was mainly driven by our focus on inventories, which represent, at the end of 2016, 12.5% of sales. This is a reduction of 70 basis points compared to the end of 2015. In absolute value, our level of inventory is EUR 102 million lower than the end of 2015.
Same as for the overall working capital, we have had a consistent performance throughout the year. All our businesses have contributed to this achievement. As said, you can see now that our working capital level is structurally lower. We will continue to focus on an efficient management of this working capital. Finally, turning to free cash flow on page 12. You can see that in the fourth quarter, we generated EUR 272 million of free cash flow. This was primarily driven by the improvement in our profitability and by the sharp reduction of our working capital and inventories. The comparison to 2015 is not relevant because following the separation from Royal Philips, we now incur several cash charges which were not applicable in 2015.
In particular, the brand license fee, higher interest since we had our new financing structure in place at the time of the IPO, and also higher taxes as an independent company, and some separation costs, which impacted us in 2016. Despite these new additional charges, we generated in the fourth quarter a high level of free cash flow. As a consequence of the robust free cash flow generation, we ended 2016 with a net debt of EUR 341 million. This is a material reduction compared to the level of net debt at the time of the IPO. It gives us a very healthy financial structure with 1 billion of cash and a net debt-to-adjusted EBITDA leverage of 0.5 times.
This is what I wanted to cover regarding the last quarter of 2016, and I will now pass the mic to Eric, who will tell us more about the highlights for the full year 2016.
Many thanks, Stéphane. Let me now turn to slide 14. Overall, we delivered a solid performance in our first year as a standalone company. Sales declined by 2.4% on a comparable basis, showing an improved trend compared to 2015, despite challenging macroeconomic conditions in some markets. Our adjusted EBITA margin increased by 180 basis points to 9.1%, in line with our medium-term path of gradual improvement with each business group contributing to the increase. Our solid free cash flow was the result of improved profitability and strict working capital, as Stephan has already outlined. This was offset by EUR 229 million of cash outflows following the separation related to the brand license fee, separation cost, pension de-risking, interest payments, and taxes. Let me now walk you through our strategic priorities, and our proof points in 2016, which is on the next slide.
Our priority to optimize cash from conventional products to fund growth was supported by an improvement of our free cash flow as a percentage of sales for by 12% in the year. Our LED share increased from 43% of total sales in 2015 to 55% of total sales in 2016, underlining our priority to innovate in LED products commercially and technologically to outgrow the markets. Our priorities to lead the shift to systems and to capture adjacent value through new services business models were both supported by a strong increase in sales of 51% in our professional systems and services business, and by a fast growth in the Home Systems sales. The growth rate increased by 40%, very specifically for our Home Systems business.
An improvement of our delivery reliability measure has also driven an improvement of our customer Net Promoter Score, which has improved by 3% for the year in 2016. We have focused on improving also our operational excellence as part of our strategy. The increase of 180 basis points of our adjusted EBITA margin is a testimony to that strategic priority. We successfully managed to reduce also our indirect cost base by EUR 96 million. Let's move now to the next slide, where basically, we are showing our total LED sales, and we are showing that they grew from EUR 2.2 billion in 2013 to close to EUR 4 billion, EUR 3.9 billion in 2016. In the left chart, you can see that our total LED sales grows with the CAGR of 28%, and now 55% of sales is coming from LED for the full year in 2016.
In the chart on the right, we show that 39% of our total LED sales come from our business group LED, 49% from professional and 12% from home. In each business group, we saw double-digit comparable sales growth in LED in 2016. Our next slide gives a zoom on our indirect cost base that has been reduced by EUR 96 million in 2016 and are now representing 31.7% of sales. This, of course, includes a brand license fee of EUR 36 million following the separation from Royal Philips. While indirect cost savings primarily came from a reduction of SG&A, and we see further cost reduction opportunities, of course, as we said many, many times, that should result in selling expense savings, IT rationalization, and other internal overhead saving, for example, in finance, HR, but also in real estate.
Let us have a look at the full-year performance by business groups in more detail, and I will immediately start with lamps on slide 18 for the full year. For the full year, we saw a decline of 15.8% in comparable sales due to the transition from conventional to LED lighting. The adjusted EBITA margin has seen improvement of 400 basis points, mainly driven by a lower-than-anticipated sales decline and an efficient manufacturing footprint rationalization and product and procurement savings. Restructuring costs for that business amounted to EUR 37 million and were primarily related to ongoing rationalization of the manufacturing footprint. The number of manufacturing site has been reduced from 45 in 2008 to 16 by the end of 2016.
In that business, active management of our business portfolio has also led to three successful divestments during the year: the ceramics, the cinema business, and the quartz business and special glass businesses. We sustained efficient working capital all throughout, as we have said previously, and overall, that performance supports our medium-term guidance to maintain our adjusted EBITA margin, at least at the level of 2015, which is about 16%. Let me move to the LED business on the next slide. Comparable sales have increased by 16.1% due to robust volume growth, with procurement savings enabling continued price reduction. The comparable sales trend in the Americas started softening in the second quarter. Some countries in Europe showed slower sales growth due to high LED penetration rates, while the rest of the world continued to deliver robust growth. We continued our strict focus on innovation in LED.
In 2016, we introduced many innovative products. SceneSwitch, which is a new LED bulb range with multiple light settings. Other examples can be the Dubai Lamp that we've commented quite extensively on today. We also introduced the Philips GreenPower LED flowering lamp, which is the next-generation energy-efficient LED lamps for horticulture. Last but not least, we also developed a high lumen LED alternative for popular high-wattage CFL bulbs. These LED retrofit bulbs, which put out up to 3,000 lumen and fit existing fixture and luminaires, are available not only in Asia but also in Latin America. We have improved for that business the adjusted EBITA margin by 390 basis points, driven by operational leverage, material procurement saving, and innovation. We saw material working capital improvements in 2016. Overall, our performance in LED illustrates the benefit of our strategy, which is focused on innovation and operational leverage.
We are on track, we believe, to achieve a margin of 10%-12% in the medium term. Let me move now to the Professional Business on slide 20. Our comparable sales declined by 0.5% for the full year. We have some market condition, namely in Saudi Arabia, had an impact of EUR 107 million on our performance, which is an equivalent to 410 basis points and negative contribution to the comparable sales growth. Growth in the Americas was offset by softness in some European countries. The systems and services business continued to grow rapidly with comparable sales growth of 51% for the full year. Our adjusted EBITA margin remained stable despite the negative impact of 160 basis points from Saudi Arabia, which you can see here on the slide, is amounting to EUR 47 million.
Restructuring charges mainly relate to a simplification of our business structure, a reduction of indirect costs, and footprint rationalization in the specific case of the Professional Business. To give you some examples of innovative projects that we've been working on in 2016, let me talk to you about the following. We have installed nearly 90,000 connected streetlights in Jakarta by using our Philips CityTouch streetlight system. We also implemented Philips Power over Ethernet technology for connected sustainable lighting, which made the skyscraper Torre Europa the smartest office building in Madrid. We also adopted connected lighting in the stadium of VfL Wolfsburg in Germany, which is the first German football club to use our connected LED lighting.
We also saw for that business robust working capital improvements. We have the initiative in place to improve the margin of that business, the operating margin of that business, to 11%-14% in the medium term. Let me move to our last business group, which is Home, on the next slide. Here, comparable sales growth of 11% has been driven by the growth in both Home Systems and Home Luminaires due to the continued focus on innovation. We saw fast growth in Home System sales. The growth rates increased by 40% in 2016 as said previously. We became profitable in the second half of 2016. Our adjusted EBITA margin improved significantly due to the benefits from sales growth and restructuring efforts.
Some of the innovative projects we have delivered in 2016 are Philips Hue was a debut partner with Google's new voice-activated speaker, Google Home, making it the first connected lighting system that can be used with all leading smart home platforms. Hue and The Voice of Germany started working together to expand the light effects of battle round and live shows to German living rooms, introducing an app that also viewers with a Philips Hue system and colorable lamp to bring the effect of the show directly into their homes. We introduced the Philips Hue motion sensor, very important and very successful offer for us during the year, enabling motion control of the connected lighting system. Our performance for the home business confirms our strategy to focus on consumer experience and leveraging our strengths in connected lighting systems.
We had also for that business, a solid working capital performance in 2016. We strongly believe that we are on track to become profitable for the home business in 2017. Let's look now at the next slide, which is about sustainability. It's a very important subject for us, and we wanted to communicate to you how we've performed in 2016 when it comes to the six targets that we had in our sustainability program. First, sustainability revenue. 78% of our revenues were sustainable in 2016, which is an improvement of 6% compared to last year and close to our 2020 target of 80%. The sale of 2 billion LED lamps. We sold to date 628 million LED lamps in 2016, which is an improvement of 44% compared to last year. We target to be carbon neutral by 2020.
We further reduced our CO2 emissions by 39% in 2016. 100% of our sites should be zero waste to landfill by 2020. This is basically a new KPI that we have introduced. This is why we have no base of comparison, but in 2016, 26% of our sites had zero waste to landfill. We are progressing according to the target. We also want to ensure a safe and healthy workplace for our employees. Total recordable cases declined by 24% in 2016. We have a sustainable supply chain objective. 100% of our risk suppliers have already been audited, so we have already achieved on that specific element of the performance our 2020 target. These were our highlights for 2016. I would like now shortly to move to the next topics, which are about our outlook for 2017. Three clear distinctive elements in our outlook.
To start with, we see a further improvement of our adjusted EBITA margin of approximately 50-100 basis points in 2017. This is in line with the medium-term outlook to gradually improve our adjusted EBITA margin to 11%-13% for the whole of Philips Lighting. We will again be committed to continue delivering solid free cash flow in 2017. While despite market uncertainties, we are cautious but remain committed to our ambition to return to positive comparable sales growth in the course of the year. Now, let me move to the next slide to talk about our capital allocation policy. First, we will continue to generate free cash flow, and we will manage our financial ratios to maintain a financing structure which is compatible with an investment-grade profile. This is extremely important to us.
In terms of cash uses, we will pay out annual regular cash dividends within 40%-50% of continuing net income, and we will continue disciplined management of balance sheet liabilities. We will return additional capital to shareholders as well as consider sizing non-organic opportunities, primarily through small to medium-sized acquisition. This is something that we had repeatedly said to all of you, but we wanted to materialize in writing and officially our capital allocation policy. I propose now that we move to the next slide and the last slide. Sorry it was a bit long. It's about an important subject, which is about our dividend. We propose to pay a dividend of EUR 1.1 per share, which basically reflects a payout of 52%, which slightly exceeds our guidance range.
We also consider returning an additional capital of up to EUR 300 million in the period of 2017 to 2018, primarily by participating in share disposals by our main shareholder. Once again, the decision that we are making both on the dividend payouts and the fact that we are going to return additional EUR 300 million to the shareholders is an illustration of our confidence in our capacity to generate free cash flow. With that, I want to thank you for your attention, and I'd like to open the floor for question. As we answer them, I will also, of course, invite Stéphane to contribute.
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 note that you're limited to one question and a follow-up per round. Let's wait for the first question. Our first question comes from the line of Andreas Willi with J.P. Morgan Cazenove. Please go ahead. Your line is open.
Good morning, Eric. Good morning, Stéphane. My first question is on Saudi Arabia. You provided a lot more disclosure there in terms of the big negative impact in 2016. Maybe you could give some more indication what of that was basically just operating leverage in the weak market, and what were the write-downs in 2016? If you look out to 2017, what do you see in the market overall, and how do you assess the remaining credit risk there? Should we expect this basically to be a positive contribution in 2017 in the bridge against the weak 2016?
Yeah. We have been commenting on a regular basis about Middle East and Turkey. We thought that at the end of the year, given the materiality of the impact of what has happened in that market, we needed to outline very specifically the situation in Saudi. It is mainly affecting the professional business, and it's basically for us, from a top-line perspective, a loss of around EUR 107 million and EUR 47 million on the bottom line. As you know, Andreas, when it comes to the bottom line, there are two components to it. One component is the fact that we have lost bottom line because we didn't get the top line. Additionally, you also have the accrual that we have decided to take for bad debts as we were not being paid according to the policy that we had decided to put in place.
We were, as we said previously, very strict and rigorous in the way we did this. I would say that starting 2016, Q1 2016, we decided to be very rigorous in stopping making business with customers that were owing us money and were overdue. We should, for that reason, maybe expect further impact on negative accruals, maybe in Q1 but not in the following quarters. Could there be releases of the existing provision that we have taken so far? We believe so in the course of 2017, but given the visibility that we have at this point in time, it's extremely difficult to tell you when and if ever it's going to happen in 2017. From a growth perspective, we do not forecast that specific market in Saudi to be extremely dynamic in 2017. Surely we are starting from a much lower base.
You've seen the degradation of our performance in 2016. It will surely not have the same impact than the one that it had in 2016. Andreas, I tried to be quite complete on the subject. I hope I've been answering to your question.
Yes, thank you very much. A follow-up question on cash flow for 2017, maybe you could help us a little bit on working capital CapEx or any other specific items we should take into account when we look at 2017, maybe some provision overhang from the restructuring you've taken. Is there anything specific we need to take into account when we estimate 2017 cash flow particularly? Is there a further working capital improvement expected or have you reached now relatively stable level? Thank you.
Sure. No problem. For this one, I will let Stéphane answer.
Sure. Andreas, yes, You saw that in 2016, there was a very strong performance overall in terms of free cash flow, and especially on working capital. As we highlighted in the presentation, these are really structural improvements. We've reduced the level of working cap and the level of inventory, and that's been the case across the businesses. Of course, given these very strong performances, I don't think we should expect such level of reduction every year. What is important for us is to continue to manage very efficiently our working capital, and we will do so in 2017 and beyond. With respect to the other items, CapEx, as you saw in 2016, we are very much under control, and we don't anticipate here any material evolution in 2017.
With respect to restructuring, we've been very clear, both in terms of the charge that we take and then in terms of the
Cash out. There's been cash out in 2016, there will continue to be cash out in 2017, nothing here that will materially differ and therefore impact the free cash flow.
Thank you very much. Very helpful.
Thank you very much. As a reminder, please note that you're limited to one question and a follow-up per round. We are moving on to the question from Martin Wilkie with Citi. Please go ahead. Your line is open.
Good morning. It's Martin Wilkie, Citi. Just a question on the end markets. We saw one of your competitors being quite cautious on the U.S. professional market, talking about a slowdown perhaps around the election in North American professional. Just in terms of how the quarter progressed for you there, did you see something similar? Did you see a sort of slowing early in the quarter and that's beginning to re-accelerate? Just if we get some more color around that North American business and just generally, as you look to rebuild the profitability at Genlyte, just how that performed in the quarter. Thanks.
We have seen a second semester which was softer in our North American professional business than the first semester. Indeed, I would say at the beginning of August until the back end of November, we felt that the market was softer than it used to be. We've seen in the course of December that market picking up again. That gives us quite a good understanding on how the market is moving up and down. We felt that too. Generally for us, for 2016, in North America, we've been improving our professional business, both in top and bottom line. We're not there yet. We know it. We are continuing our efforts to bring that business up, and that's going to be once again one point of attention and focus in 2017.
Okay, thank you. Can I ask a follow-up question, unrelated on the dividend, higher than I think most people were expecting and as a payout above the 40%-50% target range. In EUR terms, do you see this as a level you'd want to sustain, or should we read into it that the dividend is higher because the free cash flow was higher temporarily? Or in EUR terms, do you think this is essentially a level you'd want to sustain and build from?
Well, let's take one step, one after the other one. We thought that given our performance, we could propose a dividend of EUR 1.1 per share, which is indeed a payout ratio which is slightly above the interval that we had defined at the time. We want to have over the years, a consistent dividend policy, and that, of course, has also been taken into account and when we've made that decision.
Okay. Thank you very much.
Thank you very much. Moving on to the line of Lucie A. Carrier with Morgan Stanley. Please go ahead. Your line is open.
Hi, good morning, Gary. Good morning, Stéphane.
Good morning.
The first question I have is actually on the lamps business. It seems that the decline in this specific quarter was actually more pronounced than what we've seen throughout the rest of the year. I was wondering whether there was increasing pressure on the prices or whether that was really volume driven. On that basis, also, what was your assumption for the evolution of that business in 2017? That was question number one.
Lucie, at the end of the day, I said, a quarter doesn't make a trend. If you look at that business in H1 and H2, the decline has been fairly similar, and it's a business which is declining by 15.6% for the full year. This is the way we look at it. We are not specifically alerted what has happened in Q4. It also depends on the base of comparison of last year. What we see for lamps is that the business has declined at a rate which is lower than what the people that were doing estimates and predictions on that market were highlighting. We are quite happy with the performance, and we believe we have taken market share in the lamps business in 2016. Let's not take the quarter Q4 of 2016 as a trend moving forward.
Thank you. Just in terms of the follow-up, I was just wondering if you could give us a bit more color regarding your raw material set up for 2017. The reason why I'm asking is because we've seen metal prices, plastic prices increasing towards the end of 2016, we also hear from some of the manufacturers of LED chips and packages that the price decline is not as pronounced as before. I would like to have some details about your procurement as we go into 2017.
Yeah, that's a good question. Our first estimate is that effectively, as you mentioned it, the cost opportunities in 2017 may not be as pronounced as they have been in the past, which also will probably have a positive impact on the price. We will see our price erode less than it was the case in the past. We are monitoring this as we speak. For us, there's a very stretched connection between our
Very tight connection between cost and prices. We are monitoring this as we speak, I would confirm what you have just said, that we believe that costs are going to decline less in 2017 than it was the case previously.
Thank you.
Thank you very much. Moving on to the line of Nigel van Putten, ING. Please go ahead. Your line is open.
Hi. Good morning.
Good morning.
First off, thank you for providing more clarity on the returns to shareholders. Immediately a question, obviously. Why have you said you would limit yourself to up to EUR 300 million in share buybacks? If cash generation continues to be strong and looking at the current net debt balance, what are your possibility to do more?
Let me ask Stéphane to answer to that one. Sure, Nigel. When we prepared all this and thought about what should be our policy in terms of return to shareholders, in addition to the regular dividend, we took into account the overall financial structure of the company. We looked at the level of cash that we need to operate the business as a global company in many countries. We also looked at the level of net debt that we need in order to properly fit in our investment grade profile. Based on this, we thought that EUR 300 million was the right amount over the period 2017 and 2018. When you're looking at that amount in addition to the dividend, I think that's a pretty nice return to shareholder, especially for a company that has been on the market for the first year.
Yeah. Obviously that calculates to about almost 20% of your market cap currently. Perhaps then as a follow-up, could you give us the building blocks towards that EUR 300 million? What is the operating cash you would need on a regular basis, and what would be the net debt for your investment rating?
On the net debt for our investment rating, we think that a leverage of one times adjusted EBITDA is the right level. More or less. That's what we want to have in terms of financial structure. For the rest, in terms of free cash flow, we don't really look at it that way. We look at what is the free cash flow that we expect to generate given everything that we are doing in terms of our sales, in terms of our profitability, in terms of working capital. That's what we take into account. Based on all these elements, and including, by the way, of course, the level of cash that we need to maintain in order to operate, that's how we've defined that EUR 300 million.
All right. Thank you.
Thank you very much. Moving on to the line of Dennis Dinkelmeyer, excuse me, Goldman Sachs. Please go ahead. Your line is open.
Hi, good morning. It's actually Daniela Costa here from Goldman Sachs. My first question, now that you've reached profitability for the first time in Home, can you give us some light on how do you see the potential level of profitability medium term for this business? That would be my first one. Then I have a second one.
Okay. Yeah, good morning. For the Home business, given also the track record in the past years, we had a clear first step, which is to make sure that in 2017, the business goes back to profitability. As you've heard, we were profitable basically in the second half of 2016, which we believe is a good entry point in 2017 to achieve the outlook that we had given at the time. We believe that once we have reached a positive operating profit on that business, there is some margin up. I propose that we wait first to achieve what is our first commitment, to then be able to evaluate a bit better what could be the potential in the medium term, and then give a new outlook.
We want to proceed one step after the other one, and our first and fundamental first achievement in that business is to return to positive profitability while we invest also a lot in the Home Systems part of the business as well as in Home Luminaires to grow these businesses further.
Okay, thank you. Can I follow up on the indirect costs to sales, even pre the brand licensing, I guess there's still several of your peers that do a level which is much lower. Can you talk a little bit about the concrete actions that you're doing there, and ultimately what is your ambition in terms of level there? Thank you.
Okay. Stéphane, you want to take it? Yeah, sure. Well, first, if you look at what we've done in 2016, of course, from a headline number, taking out the impact of brand licensing, you can see EUR 96 million, which is close to 5% reduction. Actually, it's more than this because that takes into account inflation impact across our various businesses. Actually, the real reduction that we have achieved is of course higher than EUR 100 million. We have plans across our various activities and functions in order to deliver a continuous improvement on those cost reductions. That includes a lot of work being done on what you would call a G&A. So-called IT, which has contributed quite a lot in 2016 and has also some contribution to bring in the coming years as we become a standalone company and as we rationalize our overall IT systems.
It's the case also for more traditional functions like finance and HR, and we are working on each of these functions based on benchmark, so that in the next two to three years, we reduce their cost as a percentage of sales, and that brings down the overall cost and therefore generates some savings. Finally, we are also working on our SG&A in order to maintain the investment we need to do in order to support our growth in terms of activation, in terms of promotions, in terms of sales force, of course, but at the same time, be able to optimize them in our various markets and also globally. Finally, in terms of R&D, as you saw, we had R&D in the range of 4.5% of sales.
We make sure that we optimize and reduce R&D, especially in the businesses that are declining, and that also we maintain the level of investment in order to support the innovation and support the growth in our other businesses.
We have also said, Lucie, just to complement that, we see the rest of the industry being between 25%-29% in terms of indirect costs. We are not where we need to be. We know that, and we have outlined plans to be able to get there. 2016 is also a special year because of the brand license fee, which has impacted us, and we've also mentioned previously that we were hit by provisions for bad debt, which are also integrated in our cost base.
Thank you.
Thank you very much. Moving on to the line of Alok Katrey with Societe Generale. Please go ahead. Your line is open.
Hi, Alok Katrey from Soc Gen. Thanks for taking my questions. Just one follow-up, really. Just on the growth side. You have heard some commentary on the North American market, but perhaps you could talk a little bit about the different geographies and the different divisions and the moving parts within those as we look into 2017. What are the pluses and minuses as we look towards your ambition of returning to positive growth during 2017? That would be particularly great, and especially if you could talk a little bit about Europe. That's my first, and then I have a follow-up. Thanks.
Thanks, Alok. Talking about provisions on the world economy at this point in time is probably a big challenge. I'm questioning all the time, on how do I see all the changes that have already happened in the U.S. and the changes that can also potentially happen in other regions of the world. It's extremely difficult to predict. What I'm just saying is that, as a company, we think we have shown our capacity to adapt to whatever comes at us. If you want to have a closer look at Europe, I think we have been performing in Europe on the LED-based activities in general. We've seen on LED business group, which is LED lamps and LED electronics, that we continue to grow in 2016.
The growth of LED lamps specifically was also impacted by the fact that we start to have higher level of penetration in some countries of Europe, but that's pretty natural. Once LED are constituting the major part of our business, where they also will start to have a growth which is in line with the overall market growth. On the other hand, not only specifically in Europe, but it was also the case in Europe, we've seen a lot of dynamic on the systems and services parts of the business.
It's not anecdotal, that we have indicated also in Q4, the win in Spain, in Madrid, for Torre Europa, which is basically considered today the smartest building in the city of Madrid, where we have, with our alliance with Cisco, being able to deliver full powered over Ethernet lighting system, in conjunction with Cisco, who's providing the digital steering for that business. You see wins of this type have been happening in 2016, we believe that this is a market which will also have a positive traction in 2017.
Great. Thanks. Just to follow up in terms of the margin questions, I just wonder how you're positioned on the U.S. side in terms of input cost versus locally sourced components and services. The reason why I ask is all those noises that we're hearing from the new administration around the tax regime changes. I just wanted to get a sense of how you're positioned there.
Sure. When it comes to the tax regime, first, we're very pragmatic.
We have the taxes that we have today. If ever anything changes in the future, we'll see how we'll eventually need to adapt to upcoming changes. We are sourcing in Northern America, and we have manufacturing activities in Canada, in the U.S., and also in Mexico. All of these industrial and manufacturing implementations have a reason to be, and they generally serve beyond their own geography. Even people ask that sometimes, but the manufacturing entities that we have in the U.S. are serving also beyond the U.S. in the Americas.
Frankly, is it fair to then assume that if we do see those sort of tax changes, then it should still be pretty okay for you guys? I mean, or reasonably quick to adapt?
I think we will surely be extremely quick to adapt, as we have demonstrated that we could do that in the past. Once again, these are very hypothetical talks. Of course, we're looking at it, but we need things to be more concrete. If ever they happen, be sure that we will adapt and adapt quickly.
Sure. Thanks a lot.
Thank you very much. Moving on to the line of Peter Olofsen with Kepler Cheuvreux. Please go ahead. Your line is open.
Good morning, gentlemen. A question on pricing. Looking at the EBITDA bridge, it seems that pricing was a little bit more negative than what we saw in the previous two quarters. Is that entirely due to the LED segments, or have you seen some increased price pressure in some of the other segments? As a follow-up on one of the earlier questions on procurement. If I look at the cost of goods sold reduction in the last three quarters, it has been between EUR 120 million and EUR 140 million. One of your earlier answers seemed to suggest that it might not be sustainable at that level. Do you think it will be in excess of EUR 100 million per quarter in 2017? Is that still a doable figure?
Peter, thank you so much for the question. I will let Stéphane answer to the first one and maybe start on the second one, I could eventually continue.
Peter, on the pricing, as you can see from the bridge, EUR 149 million for foreign absolute value is higher than Q3. Q3 was EUR 123 million. As you know, in Q4, we have a substantially higher level of sales. If you look at it as a percentage of sales, actually it's a little bit higher, but it's not a major change. When you look at the various businesses, we haven't seen in Q4 any pricing trend or pricing evolution that is materially different than what we had seen so far. Of course, if you look at it product by product, there can be some difference. Again, overall in terms of our pricing trends, no major change compared to what we had seen in Q3. On the cost of goods sold, of course, we're not going to comment specifically about 2017.
As mentioned by René, yeah, we saw some prices for materials having less decline than what we had. As you probably know, we negotiate and we manage our pricing with our suppliers for the upcoming year in the last few quarters of the previous year. We have secured also some decreases for the course of 2017. Based on how those prices will evolve in the course of the year, we will see what is the impact that was mentioned by Eric. There is also a link here with the end price.
Yeah, absolutely. Just a small complement. It's very difficult for us to, because this is the aggregation of so many different elements to be able to tell you precisely where we're going to be. What is very important though is what you also see on the slide and on which we've been able to deliver consistently over the past quarters and years. Whatever is eroding in terms of price, we need to be capable to compensate in procurement savings. We've done that in the past, we are confident that we're going to be able to do that again in the future and into 2017.
Okay, thank you.
Thank you very much. Moving on to the line of Sven Weier, UBS. Please go ahead. Your line is open.
Yeah, good morning. Just one question on my side. It's just focusing on Lumileds. If you could remind us what the procurement volume was from Lumileds last year, and if you see that relation changing now that the majority has been sold. If your purchasing terms or any kind of agreements are impacted by the disposal. Thank you very much.
Yeah, no problems Sven. What we've said previously is that basically 50% of our volume in the past of our LED need was purchased from Lumileds. On the other side, 50% of what Lumileds was selling to the customers was going to Philips Lighting. That's the type of ratio that we were looking at previously. We will see how they evolve in the future. I don't have a clear visibility on that at this point in time. What is sure is that our policy doesn't change. We need suppliers, reliable suppliers to bring to us the technology. We need also suppliers with which we can co-innovate in order to bring to the market the latest innovation that is a clear lever for differentiation for us. That's also the role that Lumileds play, not only a supplier, but also a partner that we can co-innovate with.
That relationship stays, and it's maintained for the future.
Is it fair to say it gives you also more flexibility to join with others?
No, I don't think we were hampered to work with others. Once again, our suppliers need to be competitive in order to work with us. That's the case for Lumileds, and that's the case for others. It's not that previously we were hampered and that we're going to be free to do more with others. The policy in itself doesn't change much. Whenever we can extract competitiveness because we work with suppliers who bring to us competitiveness, we do it. That's the case of Lumileds, and that's the case of the others. We never had to work with Lumileds at the detriment of our own competitiveness.
Could you share with us what your LED procurement volume actually is in euro terms? Could you share that with us?
I'm sorry, Sven, these are information that we're not disclosing.
Okay. Thank you very much. Thanks.
Thank you.
Thank you very much. Moving on to the line of Marc Hesselink, ABN AMRO. Please go ahead. Your line is open.
Yeah, thanks. My first question is on LED. In the past, you talk about the medium-term growth of around 15%, now you're a bit below that, mainly because of the price erosion. Is that something that structurally changed now also because we've reached the maturity levels in the European market?
Let me highlight the nature of the performance of our LED business in 2016. We had a stronger first semester in terms of growth than the second one. Overall, still delivering double-digit growth. I would say that when we look at the performance in 2016 to try to understand where it can go in 2017, you have the following factors. First, we have been indicating since Q2 that we had a softer performance in the U.S., which was linked to a very specific situation on that market that was touching one specific go-to market we have in the United States. Since that time, we have put in place corrective actions in order to improve our performance in that specific region. The actions have been put in place. They are being implemented.
We believe that in the course of the end of Q2, maybe the second semester, they will probably deliver some fruits. The second point that is important to understand when it comes to the performance of the LED business group is what you have mentioned, is also the price erosion. Also extremely important, and that's the third element that needs to be well understood. We've commented on it already in the past quarter. It's the mix impact. Meaning that in 2016, we are selling more lamps of a lower value. The essential LED lamps, which is also a sign that the market is also moving towards LED lamps given the price points. That also has affected our top line in 2016. If we look at the prospects, making sure that the actions that we have implemented in the U.S. are going to deliver fruits, that's one.
Maybe given the trend we see today on procurement, we believe that we may see less price erosion in 2017. We are already starting with a mixed base, which is different for 2017 than it was when we started 2016. These are elements that need to be taken into account when it comes to trying to assess what the growth of LED is going to be in 2017. We still believe that that business will deliver a strong growth in 2017 and will be leading the way when it comes to growth.
Thanks. That's clear. A follow-up is on the margin. You're guiding for just EBITDA margin improvement between 50 and 100 basis points. Looking at the mix, it will probably down the impact from the lamps division. That implies that professional is probably the big upside in that mix. You already talked about Saudi Arabia being positive. What else is there that's going to push up the margin in the professional?
Let me first take the question from a general standpoint and see if Stéphane wants also to complement. When you look at the performance in 2016, we're talking about 180 basis points. If you also correct that number from the brand license fee, which was not in our numbers in 2015, we're talking about roughly two points or 230 basis points improvement in 2016. When we were questioned on how we were seeing our capacity to achieve our return targets, we were very often asked whether we would be back-end loaded or not. We always said, no, we're going to do an important part of the improvements early on, and this is exactly what we have delivered on in 2016. We see further potential for improvements.
We think it's going to come from all the businesses, or to say, at least, the LED, the home, and the professional business. Growth is one element which will help to dilute cost and to create operational leverage, while at the same time, yes, the further improvements or the continued improvements in our North American operations, specifically for the professional business, is also a clear lever. I don't know if Stéphane wants to add a few things.
Maybe just to your comment on Prof. As usual, we gave the figures without the impact of Saudi, that actually you can see the structural improvements that we are doing in terms of the profitability of Prof. It has been driven by two fundamental elements that we expect to continue in 2017. The mix in that business is growing, driven by LED and driven by system and services, and that is improving and having a positive mix impact on the division, and therefore on the adjusted EBITDA. Number two, we are taking measure to rationalize our cost base, especially when it comes to manufacturing. You saw what we did, for example, in France in 2016.
We are having actions across the globe on our operations in professional, this is also helping both above the gross margin and below the gross margin to improve our profitability in that business. We did it in 2016, we intend to continue to do it in 2017.
Okay, clear. Thank you. Thank you very much. Moving on to the line of James Stettler, Barclays. Please go ahead. Your line is open.
Yes, good morning. Thank you for taking my question. If you could talk a bit about LED growth. Where was the market growing in 2016? You talk about, obviously, rising penetration. Can you talk about where we are in terms of Americas, Europe, rest of the world in terms of penetration rates? Thank you.
It's not This is general. It's the LED business group, LED lamps and electronics that you want to know.
Correct. Yeah.
Yes. Basically, we've seen, as we've mentioned previously, less growth than what we expected in Northern America for the reasons that we have already commented. In Europe, we've seen a growth that was slightly below what we had expected, specifically in Q2, and to a given extent, in Q3. Also led by the fact that those markets start to be quite penetrated, and I'm going to come to the second part of your question later down the track. We have, in Europe, I believe, also reacted by looking at, very specifically, our go-to-markets and find also new routes. What we have discovered is, since the LED lamps for the consumers, specifically, when the price points are coming down, they open new channels. We need to make sure we are also present in those new channels to drive our top-line growth.
I think that has been well done, specifically in Europe. We've also seen some positive outcome of the action that were implemented already in Q4. When it comes to the two other geographies that we're looking at, specifically Greater China and the rest of the world that we call growth markets, we've seen a sustained, consistent, strong double-digit growth in all these regions. That's to give you an understanding of how our growth has been spread over the geographies and the continents in 2016. In terms of penetration, we have the highest penetration rate at this point in time in Europe, then followed by the Americas and Greater China. The growth markets and the rest of the world are, at this point in time, at a lower penetration rate, which is also explaining why they differentially grow more.
Can you give us any numbers on those penetration rates?
Well, it's very difficult to say because, first of all, we're not specifically disclosing. While at the same time, it really depends on the market. I can talk to you in Europe at large because that's really the case. If I go to Northern Europe, we probably see higher penetration rates than it is the case in the southern part of Europe. Or I could give you another indication, is that at this point in time, we sell more LEDs than conventional in that specific part of the business in LED lamps in Germany. All the countries have got their own dynamic, but Europe as a whole has a higher penetration rate.
Thank you.
Thank you.
Thank you very much. As there are no further questions, I would like to return the conference call to the speakers.
Okay. Ladies and gentlemen, thank you very much for attending the call and for discussing our results. If you've any additional questions, please don't hesitate to contact Investor Relations. We're happy to answer your questions. Again, thank you very much and enjoy your day.
Ladies and gentlemen, this concludes today's conference call. Thank you very much for attending. You may now disconnect your lines.