Samsung’s Weak Earnings Reflect Tough iPhone Competition Amid Rising Chipset Prices

SSNLF: Samsung Electronics logo
SSNLF
Samsung Electronics

Samsung Electronics (PINK:SSNLF) announced a weak set of Q4 2013 results Friday, as operating profits dropped by over 18% sequentially on nearly flat revenues. The company attributed the sharp decline in profits to a negative currency impact of 700 billion Won due to a stronger Won and a one-time expense of  800 billion Won, likely because of a special bonus handed out to employees to mark the the 20th anniversary of Chairman Lee Kun-hee’s “New Management” initiative. Excluding these factors, Samsung’s operating profits declined sequentially by about 3%. The biggest reason for Samsung’s lackluster earnings in the fourth quarter was the under-performance of its mobile division, which posted its first sequential revenue decline in nearly three years. Despite operating in what is usually a strong quarter for the company due to the holiday season, the company’s smartphone sales seem to have been somewhat subdued by heightened competition from Apple (NASDAQ:AAPL), which launched its latest iPhones just ahead of the fourth quarter.

Some of that impact was offset by the company’s chipset sales, which grew by 9% over the same period last year on strong sales of mobile devices during the holiday season. Chipset prices have also been supported in recent quarters by a supply crunch brought about by years of cautious investment, and smaller players such as Micron consolidating and optimizing factory capacity for profits. A recent fire at a Chinese plant owned by SK Hynix in early September further compressed supply, causing prices to shoot up towards the back end of Q3. With Hynix unable to restore normalcy by the end of December, the supply crunch lasted the full quarter and supported Samsung’s overall margins in Q4. Our $1,400 price estimate for Samsung is about 10% ahead of the current market price.

See our full analysis for Samsung Electronics

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Smartphone Momentum Hits A Wall

In recent years, Samsung’s mobile division has proved invaluable in offsetting the negative business environment in which its other segments have been operating. While the semiconductor division was reeling under the impact of overcapacity and pricing declines, the economic slowdown in many parts of the world had reduced the demand for PCs and TVs, and therefore display panels as well. The growing demand for mobile phones, especially smartphones, and Samsung’s increasing dominance in the market served to more than make up for the weakness coming from the TV and PC side.

However, with competition increasing at the low end of the spectrum and saturation seeping in at the high end, it has become tough for Samsung to maintain its past mobile growth. Samsung has acknowledged this much, saying that it expects “price/product competition to intensify” further in 2014. To be sure, the smartphone market is still expected to grow at a faster rate than the overall mobile phone market as smartphones cannibalize feature phone sales. However, most of that growth is going to come from the lower end in emerging markets, where profit margins are lower and being rapidly eaten into by rising competition. Apple’s decision to not enter the sub-$400 smartphone market so far has mitigated some of Samsung’s near-term concerns, but the iPhone maker is facing its own growth concerns and looking to aggressively pursue growth opportunities in emerging markets. It recently signed a deal with NTT Docomo and China Mobile to sell both the iPhone 5S and the 5C, thereby unlocking a huge subscriber base of over 800 million that has so far been outside Apple’s reach.

The South Korean conglomerate is therefore  looking to extend market share gains at the high end by aggressively marketing the S4 in developed markets such as the U.S. Its decision to hold the S4’s launch event in New York last year pointed to this strategy (see Samsung Has Its Sights Firmly On Apple With Galaxy S4 Launch). The S4’s initial sales milestones suggested that it was selling about 70% faster than its predecessor, the S3, but that sales growth seemed to have tapered off in the following months as the initial launch euphoria died out and Apple launched its next-generation iPhone in September. Samsung is therefore looking to widen its hardware ecosystem of companion wearable products as a means of promoting its high-end S4 and Note 3, as evidenced by its launch of the Galaxy Gear smartwatch last quarter (see Samsung’s Galaxy Gear Would Broaden Its Mobile Ecosystem But Add Little Value). The company is also focusing on driving sales of large-screen mobile devices such as tablets and phablets, especially in the developed markets.

Chipsets Benefit From Mobile Demand And Tight Supply

With smartphone profits peaking, it is a good sign that overcapacity concerns in the chipset market are decreasing and prices are stabilizing after several years of contraction. In 2013, the semiconductor division saw its operating profits increase by 65% over the same period last year. The transition to mobile devices has created a welcome shift in mix towards mobile DRAM, thereby limiting the impact from declining demand for PCs. The overall capital investment in the semiconductor industry is likely to be flat in 2014, with Samsung joining TSMC and Intel in guiding for flat capex this year. We therefore expect the tightness in supply to continue in the near-term, allowing prices to continue to improve from current levels and limiting any near-term demand impact on chipset sales.

Apart from memory chipsets, Samsung also builds app processors, including its Exynos line which is used in both the Galaxy S series and the Note phablets. The growing demand for smartphones and tablets should help keep sales of mobile app processors high, allowing Samsung to benefit from this transition so long as it meets its capacity build-up targets.

Sales of consumer electronics, such as TVs, in developed markets have shown signs of improvement with decreasing macroeconomic uncertainty. However, high TV inventory levels have pressured pricing. Samsung has been tackling the weak TV market with greater focus on large-sized models and higher-value premium products. The LED portion of the market is growing more rapidly than the rest, helping Samsung increase shipments of its high-end products. Samsung’s sales of 60+ inch TVs and smart TVs increased by about 80% and 63% sequentially. The company is investing in large-screen TVs with value-added features to protect ASPs and margins. It recently finished building a new LCD plant in China, which it plans to put to use in making 48- and 55-inch large screens for TVs, with value-added features such as ultra high-definition (HD) resolution.

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