Philips' Future Gets Smudged

Dutch electronics giant Philips (NYSE: PHG) surpassed expectations of its profitability last week, but apparently failed to satisfy Wall Street regardless -- its stock has fallen 5% since the second-quarter earnings report came out. Like peers Intel (Nasdaq: INTC) and AMD (NYSE: AMD), Philips' semiconductor business posted strong sales (rising 28%), which returned that business to profitability. But unlike those companies, Philips struggled a bit under the weight of an unfavorable foreign exchange environment. While its "comparable sales" year-over-year should have been up 14%, Philips recorded only an 11% increase because of the fact that its dollar-denominated sales lost value when translated into euros.

Overall, the company recorded profits of 0.48 euros per share -- a marked improvement over the second quarter of 2003, in which it earned a mere 0.03 euros per share. (And for American investors, each of those fractions of a euro is worth more in dollar terms today than they were a year ago.) These results were good enough to outdo even the most optimistic analysts, who expected the company to earn no more than 0.45 euros.

Well over a third of Philips' profits from the quarter originated from its 50% ownership of liquid crystal display-producing joint venture LG Philips LCD (co-owned with South Korea's LG Electronics and, incidentally, scheduled for initial public offering later this week). You can read all about the IPO, and what analysts think of LG Philips' potential to continue sending profits Philips' way, right here. But the short story is this: Analysts expect a glut to appear in the production of LCDs for use in devices such as Motorola (NYSE: MOT) cellphones, Hewlett-Packard (NYSE: HPQ) computer monitors, and Sony (NYSE: SNE) flat-panel televisions within the next year or two. For this reason, the analysts are not being kind in valuing LG Philips' IPO, and their sentiment is likely spilling over and affecting their expectations for Philips' continued profitability as well.

Of course, there are other reasons for concern. Take Philips' free cash flow situation, for example. While Philips made impressive strides in turning around its net income, the actual cash that its business generates -- its cash from operations -- slumped mightily last quarter. Whereas in Q2 2003, the company generated 148 million euros in cash from operations, in Q2 2004, that number dropped to just 62 million euros. Meanwhile, its capital expenditures climbed from 220 million euros to 350 million euros. That made an already free-cash-flow-negative company more so. It also made Foolish investors justifiably wary of the company's future.

Fool contributor Rich Smith owns no shares in any company mentioned in this article.