Samsung's Weak Earnings Forecast Heightens Smartphone Worries Even As Chipset Prices Soar
Samsung Electronics ( SSNLF ) issued weak preliminary guidance for the fourth quarter of 2013, predicting a sequential drop in operating profits of over 18% on nearly flat revenues. The company said that its Q4 operating income will decline to 8.3 trillion Won at the midpoint of guidance - down from about 10.2 trillion Won last quarter and 8.84 trillion Won during the same period last year. Although Samsung gave no reason for the sharp decline, there is speculation that a special employee bonus, marking the 20th anniversary of Chairman Lee Kun-hee's "New Management" initiative, contributed significantly to the increase in costs. Still, given the magnitude of the decline, which pushed Samsung's operating profits down to its lowest level in over a year, it is likely that sales in the company's handset division were somewhat subdued by heightened competition from Apple's iPhone during the holiday season and margins by a rising mix of emerging market smartphone sales.
Some of that impact is likely to have been offset by its supply-side divisions - chipset and display - benefiting from the overall growth in smartphone sales 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 the Hynix fab unlikely to recover fully from the fire damage until mid-January, the supply crunch is likely to have lasted the full quarter and supported Samsung's overall margins in Q4. Our $1,420 price estimate for Samsung is about 10% ahead of the current market price.
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 hence 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 smartphone spectrum and saturation seeping in at the high end, it will be tough for Samsung to maintain its past mobile growth. Samsung has acknowledged this much, saying that while the smartphone market would benefit from seasonality in the fourth quarter, competition is likely to intensify further. 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.
This is why the South Korean conglomerate is increasingly 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 mobile 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). Sales of the Note 3 phablet are likely to have been key to Samsung's performance in Q4.
Business Environment Improving On The Supply-Side
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 the first three quarters of 2013, the semiconductor division saw its operating profits increase by almost 78% 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. However, the company could fall short of demand if it fails to ramp up production adequately. Samsung's new NAND flash fab in China is expected to start production early this year and help it capitalize on the future mobile demand. However, the tightness in supply may continue in the near-term, allowing prices to continue to improve from current levels and limiting any near-term 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 continue to pressure pricing. Samsung is looking to tackle 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. As a result, its sales of 60+ inch TVs last quarter increased in mix from 12% in 14% sequentially. Samsung 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.