Welcome to the Royal Philips conference call on Wednesday, the 11th of October, 2017. During the introduction, hosted by Mr. Frans van Houten, CEO, and Mr. Abhijit Bhattacharya, CFO, all participants will be in listen-only mode. After the introduction, there will be an opportunity to ask questions. If any participants have difficulty hearing the conference at any time, please press the star followed by the zero on your telephone for operator assistance. 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 Preesman, 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 Bhattacharya. After some introductory remarks by Frans, there will be an opportunity to ask questions. Over to you, Frans.
Yeah. Good morning, everybody. This morning, we announced that we have reached agreement on a consent decree with the U.S. government. The decree is related to compliance with Current Good Manufacturing Practice requirements arising from past inspections in and before 2015. 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 Regulation. 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. 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 facilities' 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 consent decree, Philips anticipates an EBITDA impact of approximately $20 million in the fourth quarter of 2017 and approximately $60 million 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 adjusted EBITDA in 2017 and 2018. The combined sales of the external defibrillator product lines affected by the terms of the consent decree was approximately EUR 35 million per quarter in 2016. Finally, I would like to stress our commitment to our customers and their patients. We will not let the consent decree 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. With that, ladies and gentlemen, we are ready for your questions.
Thank you, sir. If any participant would like to ask a question, please press the star followed by the one on your telephone. If you wish to cancel this request, please press the star followed by the two. Would you please limit yourself to one question with a maximum of one follow-up? This will give more people the opportunity to ask questions. If you are using speaker equipment today, please lift the handset before making your selections. There will be a short pause while participants register for a question. 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 EUR 290 million, with the U.S. being 40%, but that would have been EUR 115, so I might have that wrong. I just wanted to understand, if EUR 140 million is the perimeter that is affected, AEDs, can you say how much the AED U.S. revenue is that is not affected?
Yeah. The scope that is affected is a bit smaller. It's this EUR 35 million per quarter, or let's say, approximately EUR 140 million 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. Since the manufacturing lines are not segregated, we first need to separate them into domestic and export. 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. There are quite a number of exceptions to the scope.
Therefore, the impact of this EUR 35 million per quarter will quickly taper down to a much smaller number in the course of 2018.
That's very helpful, thanks. 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? Thanks.
This is a one-time charge, which is above the threshold of our EUR 20 million 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 EBITA. The specific costs that we incur for either the profit disgorgement or the additional inspections, et cetera, we consider it one time, and it's above the EUR 20 million threshold, and therefore, we adjust it out.
Oh, I see. The $80 million you talk about is the sort of one-off, but there's also an operational impact from the production absorption. If that's right, could you help us quantify that?
Yeah, that is a minimal amount, which we believe we will compensate anyway from our normal operations. We have not put a big number on that.
Okay, thank you.
The next question comes from Ms. Veronika Dubajova from Goldman Sachs. Please go ahead, ma'am.
Good morning, gentlemen, and thank you for taking my questions. My first one is, I just want to confirm, in your press release, 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? I guess what the financial impact of that scrutiny might be in your view, and how confident you are that increased scrutiny will not lead to any further regulatory action.
Hi, Veronika. Basically, the scope is of our business group, patient care. Defibrillators are part of the suspended activities. The other businesses in the patient care business group are not subject to a production stop. The normal operations will just continue. We need to demonstrate, let's say, compliance to all the regulations, and we will have additional inspections for a period of time in Andover and Bothell. Examples of products that are in that scope are, for example, blood pressure cuffs, ECG cables, sensors, related to the patient care businesses, Holter monitor. It's a list of products that fall within the PCMS scope. The FDA typically takes a hierarchical view towards what falls under a certain leader and leadership, and then put all of that into scope. What it also means, of course, is that ultrasound is not affected.
Our Sonicare toothbrush business is not affected. This is really only limited to what we do with patient care in Andover and Bothell.
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. There is no immediate manufacturing consequence. We believe we are in good shape for those inspections. We also think that we should not, let's say, detail out the consequences. The cost related to the additional efforts to be made are all included in the $80 million EBITDA that Abhijit just spoke about.
Excellent. Thank you, Frans. If I could just, one final question. In terms of, 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? What's your degree of confidence that this is indeed the right time frame for resolution?
No, I'm happy with the question. There are two big differences with regards to Cleveland. First of all, we have now three years of progress. We believe that we are in much better shape. Secondly, in Cleveland, we had to recertify products. 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. In order to recertify products, we had to redesign products. We had to involve suppliers in the whole value chain of re-qualification. It was a much, much bigger effort. It took us a lot of time to redesign and requalify those products. It is a quite different situation. The products here are all great.
If we, let's say, execute on these inspections, we should be back in business in the course of 2018 on the domestic sales. Of course, as I elucidated before, we quickly will separate the export production line. 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 Spillaert. Please go ahead.
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 the broader picture of the FDA. Are there any new FDA issues that have arisen this year? And maybe you could give us some timeline 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. Thank you.
Well, I don't know exactly the words that I used in January, but I think your memory is even better than my memory. 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 2009, 2015, on our defibrillator business, where the FDA asserted that we were non-compliant to good manufacturing processes. They had handed that dossier apparently, after that early 2015 inspection to the DOJ for an enforcement action. Obviously, when the DOJ contacts you for an enforcement action, you have a disagreement. You either can go to court or you can enter into a settlement. We said we are not litigating with the U.S. government, we have entered into a settlement, and that settlement is called a consent decree.
Therefore, we now have agreement on the scope of that consent decree and how we need to deal with it. What is good is that the scope of that consent decree is much more narrow. 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 Bothell, but not globally. Therefore, we believe we have a decent outcome of that prolonged period of discussions. We need to live up to the agreement and demonstrate that we are as good as we believe we are. 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.
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, then once you go through that gate, the FDA will come back. It will take several months before we get back to, let's say, a normal situation. Then, of course, the consent decree has a period of five years, there will be some probation in that sense for that period. You ask about Cleveland. We already earlier said what is the difference between the Cleveland situation and this one. Quite a 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, you first get a draft findings that needs to be discussed with the FDA before they finalize their report. At this time, that report is not finalized. It can still take a couple of months before they do. 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 get ahead of ourselves, and 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. 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. I mean, for me, that is an indicator of the progress that we have been making.
Thank you very much.
You're welcome, Andreas. Who would like to go next?
The next question comes from Mr. Scott Bardo of Berenberg. Please go ahead.
Yeah. Thanks very much for taking my questions. 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 contract and agreement you've entered into? Or is that still a potential scenario for the organization, subject to certain regulatory hurdles being overcome? I just wonder if you could sort of delve into that a little bit more, please, Frans.
No, the consent decree is clearly scoped 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 consent decree. Now, obviously, we need to demonstrate that we are as good as we believe we are, consent decree is precise in its scope.
Thank you. 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 in 2018. Can I understand then that if there is this, say, EUR 140 million impact or maybe a little bit less next year, will it be difficult for you to grow your CCHI business next year to understand? 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 can still grow both profitability and the top line of that division next year?
Absolutely. First of all, I would like to underline that we are not changing our overall guidance. The 46% growth, the 100 basis points per year, that commitment stays and is unchanged. The affected business, I mean, the EUR 35 million 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, the export starts again, so that's relatively quickly. Moreover, the consumable and accessory product sales will also continue, and that is pretty significant. It is then primarily the domestic ECR sales that is under suspension for expectedly a couple of quarters, and the resumption of that in the course, let's say, in the second half of 2018.
The sales effect should be maybe smaller than what you implied. Now I look to Abhijit, whether you have anything else to add.
No, I think that's a 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 timelines 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 million range, the $20 and the $60, 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.
Okay, thanks very much, guys.
Once again, if you would like to ask a question, please press the star followed by the one on your telephone. To cancel this request, please press the star followed by the two. We will now take our next question from Mr. Ben Uglow from Morgan Stanley. Please go ahead.
Yeah. 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. Just what is it about the documentation, or what was not done correctly in the past that this is still a sort of ongoing issue, a few years down the road? 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 MRx. Are we 100% sure that there's no risk here at all of a product recall? I see that in your press release, but I just wanted to confirm it.
Then the final thing, I'm by no means an expert on FDA notices, 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 non-compliance 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, 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? 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. Your reference to Cleveland, I think you're referring to what was said by Berenberg. There is no published 483. 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.
That's a way to create interest for when the report is published, I think FDAzilla, it's called. I wasn't aware of the fact that that business exists. It's a heads-up outside of the FDA that a report may become available, as we have just discussed earlier. From a physical inspection, the next step is that the FDA prepares their report, discusses it with us, and eventually issues that report. That has not yet happened. Right? We can really not get ahead of ourselves as to possible findings and possible outcomes. It's really too early. As I said, there is no published report.
Okay. Just on the product recall question?
Well, 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. 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. Again, that's under FDA regulations, called a recall, but it was not a physical recall. We believe that we have highly reliable products. There is absolutely no patient safety issues in relation to this decree.
Thank you very much, Frans.
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. I was looking back at some Capital Markets Day notes, and I 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 mention 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 for Philips. I cannot confirm your numbers. We are not detailing out the export versus domestic at this time.
Okay. Just the other one was on Massachusetts and Bothell. I don't know these plants. 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. The widened scope that they can look at is more than half of those two plants.
Yeah. It's not so easy, James, because the scope covers the products in those locations, but not the global business. Right?
Yeah
If there are certain products that are part of a larger project, then you could influence 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. We're talking about patient monitoring and ventilation as well as AED.
Yeah, 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. We look forward to speaking with you again at the third quarter results soon.
This concludes the Royal Philips conference call on Wednesday, the 11th of October, 2017. Thank you for participating. You may now disconnect.