This has been one of those “interesting” weeks for Philips (PHG), as increased scrutiny and criticism over the company’s ventilator supply contract with the U.S. Department of Health and Human Services ultimately led to the cancellation of that contract, with less than 30% of the ventilators delivered. At the same time, the company made an acquisition in its image-guided therapeutics business that didn’t get much attention but could drive some meaningful revenue down the road.

Philips shares are down about 10% since my last update (when I was basically neutral on the shares), and the shares have underperformed its medical device peers by over 15% over the past month. With that underperformance, these shares are worth a closer look as procedure counts continue to improve in the second half of the year.

The Controversial Ventilator Contract Is No More

Given that just about anything related to the current U.S. administration, particularly anything related to COVID-19, quickly becomes controversial, it is my intention to stick solely to the facts of the Philips ventilator contract.

This contract was established in April, a period when there was widespread fear that U.S. hospitals would not have enough ventilators to treat the expected surge in patients needing advanced respiratory support due to COVID-19. With the contract, Philips agreed to provide 43,000 ventilators at a price of $15,000, and the company has been aggressively ramping up its ventilator manufacturing capacity to meet the terms of this contract, as well as serve demand from other countries. To that end, the company tripled ventilator production during the second quarter and was on pace for a fourfold increase in capacity through the third quarter.

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The contract generated controversy at the time it was signed, and that controversy and criticism accelerated in recent weeks, with accusations that the government essentially signed the contract without negotiation and committed to pay an unreasonably high price for the ventilators. Philips has taken issue with that criticism, claiming they were charging the normal market price for the ventilators.

Whatever the case, the contract termination was announced on August 31, with Philips announcing it will only end up delivering 12,300 of the expected 43,000 ventilators. That will create a roughly $460 million shortfall in revenue, or a little more than 2% of expected 2020 revenue. Management has since acknowledged that comparable sales growth for the year will be “modest”, with no real improvement in underlying EBITDA.

How much this impacts the business beyond 2020 remains to be seen. Obviously, the company will have meaningful unused capacity for ventilators, and it seems unlikely that the capacity will be needed for ventilators. To that end, management will need to explain with its next earnings update how it will mitigate that excess overhead risk.

A Small Deal Today, That Could Be A Bigger Deal Down The Road

Prior to the HHS contract termination, Philips made a small acquisition that went almost unnoticed by the Street. Philips expanded its image-guided therapy business by paying $275M in cash and an $85M earn-out for Intact Vascular, a small private player in peripheral intervention.

Intact’s primary product is called the Tack Endovascular System, and it is meant to treat dissections created by balloon angioplasty procedures performed in the arteries of the leg (both above and below the knee). Balloon angioplasty is a very common procedure for dealing with atherosclerosis in the arteries of the leg, but it causes dissections in about 50% to 85% of cases, and the rates of re-blockage at those dissection sites are far higher.

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The Tack Endovascular System basically looks like a “sawed-off” stent, and it supports the vessel at the site of the dissection. The device can automatically adapt to the arterial anatomy while maintaining a consistent radial force – it’s not exactly “one size fits all”, but providers won’t need to keep a wide array of sizes on hand to deal with variations in patient anatomy. Importantly, clinical trials have shown that the Tack System leads to meaningful improvements in vessel/lesion patency and significantly lower rates of re-intervention (going back and basically re-doing the procedure to treat a new blockage at the site). While the device does add about $2,500 to the cost of a procedure, that cost is recouped by the lower overall rate of complications and “re-do” procedures.

With around 1M lower-limb procedures a year, most of which involve balloons (drug-coated or plain), this could over time become a meaningful contributor to the $2.5B image-guided therapy business, and it’s a logical follow-on to the company’s other peripheral offerings like atherectomy catheters and drug-coated balloons.

The Bottom Line

It’s going to take time for Intact to grow; no matter how good a new device may be, it takes time to change physician behavior. So, I’ve made no changes to my model based on this acquisition; it’s really more about long-term potential and a positive development in management’s ongoing strategy of growing its procedure-based business through selective M&A. With the aforementioned impact of the ventilator contract termination, my fair value falls slightly, but frankly, the share price has fallen far more than the financial impact of that development. With that, and the prospect of high single-digit to low double-digit annualized shareholder returns, these shares look considerably more interesting now, though sentiment has clearly weakened.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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