Samsung Q3 Review: How The Smartphone Business Could Get Back On Track

Samsung Electronics (PINK:SSNLF) published its Q3 2015 earnings on Thursday, October 29, reporting that operating profits grew by about 82% year-over-year to about 7.39 billion won ($6.5 billion), marking its first profit gain in over a year. ^[1] While the results were primarily driven by the semiconductor unit – which saw stronger demand for both logic and memory chips – and foreign exchange tailwinds, there were some noteworthy trends in the company’s beleaguered smartphone business, which finally saw shipments grow after several quarters of declines. In this note, we review the results of Samsung’s mobile division and look at some of the strategic changes that the company could be taking to improve its performance going forward.

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Smartphones Earnings Expand

Revenues from the mobile division grew by roughly 8% year-over-year to 26.61 billion won ($23.4 billion), while operating profits grew by 37% year-over-year to 2.40 trillion won ($2.1 billion), ending a streak of six straight quarters of declines. The growth was partly driven by an easier comparison with Q3 2014 – which was one of the division’s toughest quarterly reports in recent years. Despite the growth, the smartphone unit is actually playing a diminished role in Samsung’s earnings mix, accounting for just about a third of Samsung’s overall quarterly profits, about half of what it contributed at its peak. Moreover, the division still appears to be weighing on Samsung’s overall growth. Samsung’s consolidated operating profits rose by 82%, while smartphone profits only grew by 37%. Now, although we believe that the division’s best days are behind it, smartphones remain crucial to Samsung (they account for half the company’s revenues) and the company does appear to be tweaking its strategy to adapt to current industry trends.

Samsung Plays The Pricing Card

The biggest problem facing Samsung’s smartphone division is weak product differentiation. While Apple has been relatively immune to the trends in the broader smartphone market, leveraging the solid software and ecosystem differentiation of its iOS platform, Samsung has to slug it out in a crowded Android smartphone market where vendors compete largely based on specifications and price, as software and design differences are fairly limited. Although Samsung has made attempts at creating some distinction for its products, with features such as curved screens and metal casings on premium devices like the S6, the move hasn’t really paid off yet, as customers have been increasingly opting for the iPhone, which they perceive as being more premium and differentiated.

Now it appears that Samsung is honing its smartphone strategy to drive volumes, while taking a cut on pricing. During Q3, the company noted that it shipped a larger mix of mid-range handsets (such as the J and A series) while reducing prices on the flagship Galaxy S6 devices to drive volumes. Although Samsung does not disclose smartphone shipments, IDC estimates that the company moved a total of 84.5 million smartphones (for 23.8% market share) during Q3, up 6.1% year-over-year. ^[2] Samsung noted that average selling prices for its devices fell to between $180 and $190 during the quarter.

Revisiting Product Positioning And The Cost Base

While the company has been making adjustments, it’s unlikely that it will to go toe-to-toe with Chinese value handset vendors on pricing. Instead, we think the company would do well to focus largely on a category of handsets that leverage the latest hardware features at price points that sit below Apple’s iPhone to drive volumes, while banking on a few niche high-end devices (such as the Galaxy Note) to drive margin upside. This is something that Samsung is perhaps best positioned to do, considering its scale and vertically integrated model, which gives it access to the latest technologies from the device solutions business which supplies components ranging from displays, application processors, RAM, NAND memory and modems. For instance, Samsung already sources more than 60% of components (by value) for the S6 Edge handset from the components business, and the vertically integrated model should afford it flexibility in managing margins. ^[3]

Cost management will also play a much larger role in driving smartphone profits going forward. For example, Samsung is streamlining its product portfolio by focusing resources on better-selling models, in a move that could help reduce procurement and manufacturing costs, while making inventory management easier. The company had previously noted that it intends to nix 25% to 30% of its smartphone models in 2015. Samsung may also have to get creative when it comes to its marketing and distribution activities if it wants to better compete with smaller and nimbler rivals such as Xiaomi, who keep costs low by selling online and by eschewing conventional advertising in favor of flash sales and social media marketing.

A Note On The Capital Return Program

Samsung finally relented to investor pressure by taking some small yet encouraging steps to return some of its growing cash pile to investors. The company plans to buy back 11.3 trillion won ($9.9 billion) worth of its stock over the next year, amounting to roughly 5% of the company’s market cap based on current prices. Samsung has also said that it would return between 30% to 50% of its annual free cash flow over the next three years via dividends and share buybacks. Separately, the company is also considering paying dividends on a quarterly basis. Samsung’s stock trades at a forward P/E of roughly 9.5x, which is almost 30% below rivals such as Apple and LG, which may indicate that investors no longer view Samsung as a growth stock. The increased buybacks should boost investor sentiment and valuations, while driving EPS growth for the company.

Key Earnings Takeaways:

• Revenues grew by 9% year-over-year to about 51.68 trillion won ($45.4 billion)
• Net profits rose 29% to 5.46 trillion won ($4.8 billion)
• Semiconductor sales grew by roughly 30% to 82 trillion won ($11.26 billion), while operating margins expanded to 28.5%.
• Cash and investments stood at about 84 trillion won ($73.5 billion)

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More Trefis Research

1. Earnings Release Q3 2015, Samsung [↩]
2. Smartphone Shipments Reach Second Highest Level for a Single Quarter as Worldwide Volumes Reach 355.2 Million in the Third Quarter, According to IDC, IDC, October 2015 [↩]
3. Samsung Galaxy S6 Edge Teardown, IHS, April 2015 [↩]