OREANDA-NEWS. Fitch Ratings has downgraded Netherlands-based diversified manufacturer Royal Philips' (Philips) Long-term Issuer Default Rating (IDR) and senior unsecured ratings to 'A-' from 'A'. The Outlook on the Long-term IDR is Stable.

The downgrade reflects the company's recent financial performance, which falls short of Fitch's expectations and ongoing risks around the profitability of its core healthcare segment.

KEY RATING DRIVERS
Continued Healthcare Margin Deterioration
Healthcare EBITA margins were down to 5.4% in 1Q15 from 8.8% a year ago and from 6.7% in 2014, significantly below our double digit margin expectations. The deterioration was mainly driven by Cleveland's shipment discontinuation, along with additional remediation costs. Although top-line profitability was dragged down by certain one-off or extraordinary restructuring and separation costs, Fitch believes that they also suggest a weak operational profile.

Fitch believes that profitability improvement is going to be more gradual than previously expected, as the Chinese and North American healthcare markets are expected to be under continuous pressure from macro-economic and regulatory conditions. Fitch believes that the current healthcare profitability metrics, which are expected to be the core of the business, are not commensurate with industry peers with the same rating, and further deterioration could lead to additional negative rating pressure. Although the ramp up in its Cleveland facility looks on track, Fitch will also continue closely monitoring the possible effects on pricing and market share.

Fitch has revised its healthcare EBITDA margin expectations down to 10.5% for 2015, as Philips continues investing in improving profitability. We expect gradual profitability improvement towards 2017.

Increased Leverage
Funds from operations (FFO) adjusted net leverage increased to 3x at end-2014 from 0.9x at end-2013, mainly driven by increased restructuring and litigation costs and the impact of declining profitability on FFO margins. Fitch expects FFO net leverage to drop back to 1x in the medium term as the sale of Lumileds is expected to be completed in 3Q15. Without any cash proceeds from the Lumileds sale, FFO adjusted net leverage would hover well above 1.5x over the same time frame, which is weak for the ratings.

HealthTech New Core
In 2014 the group announced the split of its business into HealthTech, combining in its healthcare and consumer lifestyle divisions, and Lighting. HealthTech will not benefit from the same multi-sector diversification as the existing Philips group, which is exposed to the healthcare, consumer and lighting markets. However, given the challenges, increased competition and penetration rates in the lighting business, Fitch believes the new core business's profitability margins have room for improvement in the long term. Additional proceeds coming from the potential separation of the Lighting business through an IPO or sale, which is expected to happen in 1H16, could provide extra capital for inorganic growth and margin improvements for Philips' new core business lines. However, any delay in the process, along with higher than expected restructuring/separation costs negatively affecting cash flow could put additional pressure on leverage metrics.

Sizeable Shareholder Returns
The group's current financial policy is shareholder-friendly, but compatible with its ratings. The group is continuing with its three-year EUR1.5bn share buyback programme, following the completion of a EUR2bn share buyback programme in mid-2013. These shareholder returns more than offset the credit benefits of its dividend scrip option since 2010, which has historically been the method of payment for more than half of the group's dividends.

Healthy Liquidity
Philips has historically kept more than 80% of its unadjusted debt as cash on its balance sheet and maintains healthy liquidity. Liquidity at end-1Q15 totalled EUR3.5bn, comprising EUR1.7bn in cash and a EUR1.8bn long-term credit facility that has been undrawn since it was first established in the mid-1990s. This compares with EUR392m of short-term debt at end-2014.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Muted organic growth environment in North American and Asian markets.
- Group profitability margins to rise but remain subdued by restructuring & separation costs.
- Marginal working capital unwinding from Cleveland.
- Capital expenditure broadly in line with historical levels.
-No significant M&A in the forecast period.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- FFO margin above 10%
- FFO adjusted net leverage below 1x
- FCF margin above 5%
- Fixed charge coverage above 8x

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- FFO margin below 8%
- FFO adjusted net leverage above 1.5x
- FCF margin below 4%
- Fixed charge cover below 6x