Samsung’s Galaxy Gear Would Broaden Its Mobile Ecosystem But Add Little Value

Having established a dominant position in the smartphone industry, Samsung Electronics (PINK:SSNLF) is looking to lead the mobile foray into wearable devices by potentially unveiling a smartwatch next week. The South Korean giant said earlier this week that it will introduce a brand new “wearable concept device” called Galaxy Gear at a Berlin press conference on September 4th. Although no details about its launch were forthcoming, it is interesting to note that the smartwatch was called a concept device which could mean that it might not be ready for launch soon. However we can say with some certainty that the smartwatch will be based on Google’s (NASDAQ:GOOG ) Android platform so that it is compatible and easier to sync with Samsung’s existing line of smartphones. Since Samsung doesn’t have a software ecosystem of its own, it will look to market the smartwatch as an extension of its smartphone experience, creating an ecosystem of mobile hardware around the Galaxy brand.

Our $1350 price estimate for Samsung is about 15% ahead of the current market price.

See our full analysis for Samsung Electronics

A $6 Billion Market Opportunity

Samsung has done really well to capture almost a third of the rapidly expanding smartphone market. But, with competition increasing at the low-end of the smartphone spectrum and saturation seeping in at the high-end, it will be tough for Samsung to maintain its past growth. Samsung has acknowledged the same, saying that while the smartphone market will grow in the third quarter, it would do so at a slower pace than before. To be sure, the smartphone market is still expected to expand 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 low-end in the emerging markets where profit margins are low and being rapidly eaten into by rising competition. Samsung will also be wary of the fact that Apple is gradually increasing its smartphone focus in the emerging markets, and could launch a cheaper mid-range version of the iPhone to mitigate its own growth concerns.

The company is therefore looking to expand the mobile market by exploring opportunities in new device categories. The reason why smartwatches sound attractive is because of the potential to have high margins similar to smartphones. The global watch industry is expected to generate around $60 billion in revenues this year with gross margins as high as 50-60%, as evidenced by Movado and Fossil’s recent financial statements. While Movado’s gross margins last quarter was at around 54%, Fossil’s was a little higher at 57%. The reason we have chosen these companies is because they have limited presence in the under-$75 mass-market category, which Samsung is also not likely to target with its initial smartwatch launch. If Samsung manages to capture about 10% of the watch market, it could amount to additional revenues of only about $6 billion and gross profits of $3-$3.5 billion. From an operating perspective, EBITDA margins could range anywhere between 15-20%, again assuming operational parity with Movado and Fossil.

Small Impact On Valuation

Another way to look at the smartwatch market opportunity for Samsung would be to consider its smartphone sales mix. We estimate that Samsung will sell as many as 450 million mobile phones in 2013 at an ASP of over $250. If we divide the phones that Samsung sells into two categories, the high-end ones with an average ASP of $600 and the low-end ones an with average ASP of $150, we see that the sales mix of the former has to be close to 25% for our overall ASP assumption to hold. This means that Samsung will likely sell a total of about 110 million high-end smartphones and the rest at the low- and mid-end this year. The Galaxy S3 launched last year sold as a many as 50 million units in a year, and Samsung has set a lofty target of selling more than 100 million units of the more recently launched S4. Even if we assume that Samsung doesn’t meet this target, sales of other high-end smartphones such as the Galaxy Note should help it easily reach our estimate.

In order to gauge Samsung’s smartwatch potential, we make the assumption that about 20% of Samsung’s high-end customers and 5% of low-end ones will buy the Galaxy Gear. This brings Gear’s market opportunity to about 40 million unit sales. Assuming an average ASP of $150 (competitors such as Pebble and Nike FuelBand are priced at $150), Samsung’s additional revenue potential would be close to only about $6 billion – the same figure that we’d arrived at earlier. Any upside or downside to this estimate will depend on what percentage of Samsung’s high-end and low-end smartphone buyers see the smartwatch as a decent accessory addition due to the halo effect of its popular smartphones.

Going forward, if Samsung is able to lure 30% of its high-end customers and 10% of the rest into purchasing its smartwatch, there could be upside of about $2 billion to our long-term EBITDA forecast. This translates into a value addition of only about $7 billion, or $50 per share (3.4% of our current price estimate). If the respective percentages were to increase to about 50% for the high-end and 15% for the low-end, Samsung would see additional EBITDA of $3 billion in the long run which translates into a $10 billion opportunity, or value addition of about $70 per share (3.4% of our current price estimate). We do not change our EBITDA margin estimates since our long-term forecasts are already in the 15-20% range.

While the value-addition due to the smartwatch alone doesn’t seem to be much, Samsung will intangibly benefit from having a broader hardware ecosystem with multiple mobile product categories doing well in the market. This halo effect could further drive the adoption of Samsung’s other more valuable mobile devices such as smartphones, and prove to be even more value-accretive to shareholders.

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