Status Update

Oct 11, 2017

Welcome to the Royal Philips Conference Call on Wednesday, 11th October, 2017. During the After the introduction, there will be an opportunity to ask questions. Please note that this call will be recorded and is available by webcast on the website of Royal Philips. I will now hand the conference over to Mr. Pim Prezmann, Head of Investor Relations. Please go ahead, sir. Good morning, everyone, and thank you for joining this call. I'm here with CEO, Frans van Houten and CFO, Abhijit Patasharia. After some introductory remarks by Frans, there will be an opportunity to ask questions. Over to you, Frans. Yes. Good morning, everybody. This morning, we announced that we have reached agreement on a consent decree with the U. S. Government. The degree is related to compliance with current good manufacturing practice requirements arising from past inspections in and before 2015, and it is focusing primarily on our emergency care and resuscitation business operations in Andover and Bothell in the United States. The decree also provides for increased scrutiny for a period of time of the compliance of the other patient care businesses at these facilities with the quality system regulations. Let me stress that there is no concern on product quality. Our products are market leading also in the area of quality and reliability and are highly appreciated by our customers. Over the past years, we have made significant investments in our quality management system and put in a lot of hard work to significantly enhance it across the company. Therefore, we believe we are fully prepared to fulfill the terms of the decree, and we hope to resume the suspended defibrillator production in the course of 2018. Let me now walk you through some of the details of the agreement. Under the decree, Philips will suspend the manufacture and distribution of external defibrillators manufactured at these facilities until the FDA certifies the facility's compliance with the necessary regulations. We are permitted to continue the manufacture and distribution of certain automated external defibrillator models. We will also continue to service ECR devices and provide consumables and the relevant accessories. This is to ensure uninterrupted availability of these highly reliable life saving devices in the United States. Philips will continue to export ECR devices once certain requirements have been met. Additionally, Philips will continue to manufacture and distribute the products of all other patient care businesses at these facilities. As a consequence of the decree, Philips anticipates an EBITA impact of approximately €20,000,000 in the Q4 of 2017 and approximately €60,000,000 in 2018. These impacts relate primarily to the suspension of production, profit disgorgement payments and the incremental cost to prepare for and handle the regulatory inspections. These amounts will not impact These amounts will not impact adjusted EBITDA in 2017 'eighteen. The combined sales of the external defibrillator product lines affected by the terms of the decree was approximately €35,000,000 per quarter in 2016. Finally, I would like to stress our commitment to our customers and their patients. We will not let the consent degree detract us from the upward trajectory that we are on. We have made great progress over the past years, and we will demonstrate that to all our stakeholders. And with that, ladies and gentlemen, we are ready for your questions. The first question comes from Mr. James Moore from Redburn. Please state your question, sir. Good morning, everyone. Good morning, Frans. Thanks for the description. I just wondered if you could help me understand the defibrillator business a bit better. I think from memory, we talked about global sales of €290,000,000 with the U. S. Being 40%, but that would have been €115,000,000 So I might have that wrong. And I just wanted to understand if €140,000,000 is the perimeter that is affected, EDs, can you say how much the AED U. S. Revenue is that is not affected? Yes. So the scope that is affected is a bit smaller. It's €35,000,000 per quarter or, let's say, approximately €140,000,000 on an annual base. That is the total scope of the defibrillator business affected. Initially, we need to shut the plant. Then quickly, we can resume the export because the decree in principle is focused on the domestic U. S. Business. But since the manufacturing lines are not segregated, we first need to separate them into domestic and export. Then very quickly, the export will resume. And then once next year we have satisfied the initial inspections on the defibrillator domestic production, we can also resume the production and delivery in the U. S. Market. Moreover, consumables and so on are not affected. We can continue to service the entire installed base. So there are quite a number of exceptions to the scope. Therefore, the impact of the €35,000,000 per quarter will quickly taper down to a much smaller number in the course of 2018. That's very helpful. Thanks. And if I could just follow-up, how does that taper look? And why is this below the line and not in adjusted EBITA? Isn't it operational? We've this is a onetime charge, which is above the threshold of our $20,000,000 range, and that's why we've taken it out of the adjusted because it's not an operational cost that will continue forever. It's a fixed duration till the end of next year. Operating charges or operating losses that we may incur for this will be as part of the adjusted EBITDA, the specific cost that we incur for either the profit disgorgement or the additional inspections, etcetera, we consider it onetime. And it's above the €20,000,000 threshold, and therefore, we adjust it out. Oh, I see. So the €80,000,000 you talk about is the sort of one off, but there's also an operational impact from the production absorption. If so if that's right, could you help us quantify that? Yes. That is a minimal amount which we believe we will compensate anywhere from our normal operations. So we have not put a big number on that. Okay. Thank you. The next question comes from Ms. Sveriniket Zubacova from Goldman Sachs. Please go ahead, ma'am. Ma'am. Good morning, gentlemen, and thank you for taking my questions. My first one is, I just want to confirm, I mean, your press release say you stated that the decree also provide for increased scrutiny for a period of time in terms of the other patient care businesses at the facilities. Can you help us understand what other businesses will be under review? And I guess what the financial impact of that scrutiny might be in your view and how confident you are that, that increased scrutiny will not lead to any further regulatory action? Yes. Hi, Veronika. Well, basically, the scope is of our business group patient care. So defibrillators are part of the suspended activities. The other businesses in the Patient Care business group are not subject to a production stop. So the normal operations will just continue. But we need to demonstrate, let's say, compliance to all the regular all the regulations, and we will have additional inspections for a period of time in Andover and Bossel. So examples of products that are in that scope are, for example, blood pressure curves, ECG cables, sensors related to the patient care businesses, Holter monitor. I mean, it's a list of products that fall within the PCMS scope, right? So the FDA typically takes a hierarchical view towards the what falls under a certain leader and leadership and then put all of that into scope. Now so what it also means, of course, is that ultrasound is not affected. Our SonyCare toothbrush business is not affected. So this is really only limited to what we do with Patient Care in Andover and Basel. And can you give us a sense for that broader revenues? What is the totality of the revenues that the FDA will now be looking at more closely? No, we are not detailing that out. Moreover, we have multiple factories in the world. So there is no immediate manufacturing consequence. We believe we are in good shape for those inspections. Therefore, we also think that we should not, say, detail out the consequences. The costs related to the additional efforts to be made are all included in the €80,000,000 EBITDA that Abhijit just spoke about. Excellent. Thank you, France. And if I could just one final question. In terms of the you've estimated you think you can resolve this by the end of 2018. I guess if I look back at Cleveland, you had some pretty ambitious timescales initially for resolution that you failed to deliver on at the time. How is the process of you estimating the impact here different? What were some of the differences in the assumptions that you've made? And what's your degree of confidence that this is indeed the right time frame for resolution? Yes. No, I'm happy with the question. There are 2 big differences with regards to Cleveland. First of all, we have now 3 years of progress, and therefore, we believe that we are in a much better shape. Secondly, in Cleveland, we had to recertify products, and that is not the case under this consent decree. All products are in good standing. It is, let's say, a documentary regulatory compliance issue, whereas in Cleveland, we had to recertify products. And in order to recertify products, we had to redesign products. We had to involve suppliers in the whole value chain of requalification. And therefore, it was a much, much bigger effort. And it took us a lot of time to re qualify those redesign and re qualify those products. So it is a quite different situation. The products here are all great. If we, let's say, execute on these inspections, then we should be back in business in the course of 2018 on the domestic sales. And of course, as I elucidated before, we quickly will separate the export production line, and therefore, the export production will resume even much faster. Understood. Thank you very much, guys. Really appreciate it. Okay. Thanks. Who's next? Our next question comes from Andreas Willi. Please go ahead. Yes. Good morning, Frans, Abhijit and Pim. My question is when you first disclosed this in January, you basically said you had a discussion, a disagreement with the FDA about it. What was the disagreement? And why basically now the change? Or what couldn't you convince them of during the period? And the second question is on a broader picture of the FDA. Are there any new FDA issues that have arisen this year? And maybe you could give us some time line about when you expect to be able to talk about the audit of the FDA at Cleveland this summer, when you should get a, basically, resolution around that and what the initial feedback maybe was from the FDA about that audit? Yes. Well, I don't know exactly the words that I used in January, but I think your memory is even better than my memory. So I think we disclosed in January of this year that we were in dialogue with the DOJ on findings that the FDA had done in the period 2,009, 2015 on our defibrillator business, where the FDA asserted that we were noncompliant to good manufacturing processes. And they had handed that dossier apparently after that early 2015 inspection to the DOJ for an enforcement action. Now obviously, when the DOJ contacts you for an enforcement action, you have a disagreement. I mean, then you either can go to court or you can enter into a settlement, right? So we said we are not litigating with the U. S. Government, so we have entered into a settlement. And that settlement is called a consent decree. So therefore, we now have agreement on the scope of that consent degree and how we need to deal with it. What is good is that the scope of that consent degree is much more narrow. It is it only, let's say, implies the production stop of the domestic manufacturing for defibrillators. And it has as a consequence this heightened scrutiny of the Patient Care businesses in Andover and Basel, but not globally. So therefore, we believe we have a decent outcome of that prolonged period of discussions. Now we need to live up to the agreement and demonstrate that we are as good as we believe we are. So I what you can tell from the way I talk about it is that I believe that we can have good confidence, a very good confidence that we will stand up to that heightened scrutiny. But it's still going to take us a lot of effort to demonstrate it because in such a process, you first go with independent third party auditors. And then once you go through that gate, then the FDA will come back. So it will take several months before we get back to, let's say, a normal situation. And then of course, the consent decree has a period of 5 years. So there will be some probation in that sense for that period. You asked about Cleveland. We already earlier said what is the difference between the Cleveland situation and this one, so quite significant difference. Cleveland was much more complex. We have made a lot of progress in Cleveland. We did have the FDA doing an inspection over the summer. As is normal in that process, then you first get kind of a draft findings that needs to be discussed with the FDA before they finalize their report. At this time, that report is not finalized, and it can still take a couple of months before they do. So therefore, it's difficult for us to disclose anything other than telling you that indeed they have been on the location for a couple of weeks and that we are currently discussing with them the findings that they had. Is there anything in these findings that makes you particularly worried? Or is this just business as usual? I think we cannot go get ahead of ourselves. We first need to give the FDA a chance to talk to us. We have not had a meeting with them since the, let's say, the physical inspection on-site. So it is really too early to speculate on that. I do believe that we have made a ton of progress, both in Cleveland as well as globally, on our endeavors to improve regulatory compliance. If I switch to, let's say, the global picture, we had numerous inspections over the last two and a half years, and none of them resulted in a warning letter. So I mean for me, that is an indicator of the progress that we have been making. The next question comes from Mr. Skarsha Bardo of Berenberg. Please go ahead. Yes, thanks very much for taking my questions. Yes, just really wanted to follow-up on the precise nature of the consent decree related to primarily the defibrillator products. I just wanted to understand, is there full confidence within the organization that this consent decree will not be extended to other facilities? Would that now be an unusual process given the contracts and agreement you've entered into? Or is that still a potential scenario for the organization subject to certain regulatory hurdles being overcome? And so I just wonder if you could sort of delve into that a little bit more, please, France. No. The consent decree is clearly scoped and to the two sides only and to the product scope as defined, the defibrillators plus the Patient Care business. Therefore, there should not be, let's say, a scope creep in the scope of the concentric. Now obviously, we need to demonstrate that we are as good as we believe we are, but Cosentygry is precise in its scope. Thank you. And just a quick follow-up just to And just a quick follow-up, just to understand some of the financial guidance that you've mentioned. And obviously, contingent on you satisfying these hurdles, you look to resume production CCHI business next year, will it be difficult for you to grow your CCHI business next year to understand? And also with respect to margin progression for that business, I think Abhijit mentioned that there would be some operational disruption over and above the outlined disgorgement costs. Is it your expectation you could still grow both profitability and growth of that and the top line of that division next year? Yes, absolutely. First of all, I would like to underline that we are not changing our overall guidance. So the 4% to 6% growth, the 100 bps per year, that commitment stays and is unchanged. The affected business, I mean the €35,000,000 per quarter is just to give you a feeling of the scope and the size of the business. As I mentioned, the export will almost resume immediately As soon as we have separated the production line for domestic and export, then the export starts again. So that's relatively quickly. Moreover, the consumable and accessory product sales will also continue, and that is pretty significant. And it is then primarily the domestic ECR sales that is under suspension for expectedly a couple of quarters and then the resumption of that in the course, let's say, in the second half of twenty eighteen. So the sales effect should be maybe smaller than what you implied. And now I look to Abhijit whether you have anything else to add. No, I think that's proper scoping. We've given the full scope of the business. The affected part in the U. S. Will be smaller. Once we know the time lines of when we can restart shipping internationally, which should be soon, as you mentioned, the overall cost that we still believe we will take, is in the €80,000,000 range, the €20,000,000 the €60,000,000 and the operational impacts that we may have due to the stoppage of production that is something we will make up through other productivity measures. We will now take our next question from Mr. Ben Uglow from Morgan Stanley. Please go ahead. Yes. Good morning, Frans and Abhijit. I had a couple. Frans, could you just give us a little bit more color on what the specific nature of the problem is? I understand that it's not so much product and it's more in documentation. But just what is it about the documentation or what was not done correctly in the past that this is still sort of ongoing issue a few years down the road. So any more kind of specifics around what is actually non compliant would be helpful. The second issue, I may be completely wrong on this. I was under the impression that there earlier had been a product recall. I think it was the HeartStart Max. Are we 100% sure that there is absolutely no there's no risk here at all of a product recall? So I see that in your press release, but I just wanted to confirm it. And then the final thing, I'm by no means an expert on FDA notices, but I believe that there was a 483 notice issued last week in respect of Cleveland. Can you give us any more color on that and if it's in any way shape or form connected to what we're seeing here? An example of the nature of the noncompliance prior to 2015 is to be found in the complaints handling process. That has been, let's say, historically a weakness in our quality management system. It's also, by the way, an area of changing regulation. So it's much more the requirements have gone up a lot in that area, maintaining records of every product in the field and so on. That all falls under this good manufacturing practices, right? So manufacturing practices is the name of the regulation. It doesn't mean that it is only manufacturing. In our case, complaint handling was certainly a part of it. Then your reference to Cleveland, I think you're referring to what was said by Berenberg. There is no published 483. There is I've looked up this site myself. There is a placeholder on a intelligence site that an inspection has taken place and that the report is not available. But that's a way to create interest for when the report is published. I think FDA Zillow, it's called. I wasn't aware of the fact that, that business exists. But so it is a heads up outside of the FDA that a report may become available. As we have just discussed earlier, from a physical inspection, then the next step is that the FDA prepares their report, discusses it with us and then eventually issues that report. That has not yet happened, right? So we can really not get ahead of ourselves as to possible findings and possible outcomes. Is really too early. And so there is no as I said, there is no published report. Okay. And just on the product recall question? Well, I mean there have been for all defibrillator businesses, not just Philips but also competitors, there has been a lot of discussions as to exactly what happens. And we also have had our share of issues where we had to enhance the instructions for use. Under FDA regulation, that's called a recall. Even though that was not a physical recall, we have just elucidated the instructions to check the availability of the batteries, that the batteries were fully charged. But again, that's under FDA regulations called a recall, but it was not a physical recall. So we believe that we have highly reliable products. There is absolutely no patient safety issues in relation to this decree. Thank you very much. You're welcome. The last question comes from Mr. James Moore from Redburn. Please go ahead, sir. Thanks for taking a follow-up. It's just a quick one to try and understand the scope. And I was looking back at the Capital Markets Day notes And just wondered if it's fair to say whether AED is 40% consumables or 60% device and 20% export, 80% domestic. Is this what we're talking about when you mentioned consumables and export will come back up? Is that a fair scaling of that? I don't have those percentages as readily as you have, James. It almost sounds like you work with Philips. But I cannot confirm your numbers, and we are not detailing out the export versus domestic at this time. Okay. And just the other one was on Massachusetts and Bothell. I don't know these plants. I mean, is defibrillator more than half? Is it all of the business? Or are these other things that you were mentioning earlier actually more than half of these plants' activities? No. The defibrillator business is the smaller part of that business. Okay. So the widened scope that they can look at is more than half of those two plants? Yes. It's not so easy, James, because the scope covers the products in those locations but not the global business, right? Now of course, if there are certain products that are part of a larger project, then you could influence other that larger scope. That is not my current understanding. There is no suspension of production in those related businesses. It is just that it falls under the heightened inspection, and we believe we are in good shape. I also value to emphasize that, let's say, ultrasound, Sonicare, which are also produced at these locations, are outside of the scope of the consent decree. I see. So we're talking about patient monitoring and ventilation as well as AED? Yes. We are talking about the patient care business as we report on. Thank you very much. You're welcome. Thanks very much. Okay. I think I was expecting the operator to close, but let me then close. Thank you all for joining us today. This was not the best news, but at least we have now clarity. And we look forward to speaking with you again at the 3rd quarter results soon. This concludes the Royal Philips conference call on Wednesday, 11 October, 2017. Thank you for participating and you may now disconnect.