Description

Recommendation Summary

Industry Leader: Samsung Electronics (“Samsung”) operates in three business divisions: Consumer Electronics (“CE”), Information Technology and Mobile Communications (“IM”), and Device Solutions (“DS”). Within these segments, the company holds market leading positions in the major products produced by each segment including televisions (CE), refrigerators (CE), mobile phones (IM), DRAM (DS), NAND Flash (DS), and display panels (DS).

Competitive Strategy Honed for Commodity Markets: Samsung operates in highly competitive markets where the end products sold are commodities. Samsung combines R&D and marketing strength along with vertical integration and a vast distribution network to historically build and defend its market share and to earn an acceptable rate of return for shareholders as a company.

Attractive Valuation: Samsung currently trades at an estimate NTM P/E of 12.1x, a P/B of 1.1x and an NTM EV/Sales of 0.7x. These metrics are near historical ten year lows and appear inexpensive compared to the ten year averages of 10.1x, 1.5x, and 1.0x, respectively. The stock also has an estimate ex-cash forward free cash-flow yield of 9.0%. Based on a sum-of-the parts analysis, I estimate an intrinsic value of KRW 1,805,000 (or 34.2% above current market prices).

Limited Downside: At current trading levels, the market appears to be pricing in a bearish scenario for the stock.

Multiple Ways to Win: I believe there is a potential for the company’s stock to revert to intrinsic value if 1) earnings hold up better than expected, 2) there is a shift in the company ownership structure, 3) there is an increase in the return of capital to shareholders, and/or 4) new product innovation occurs.

Business Summary

A summary of Samsung Electronics’ overall company results for the past ten years is shown in the table below:

Consumer Electronics (19.6% of 2013 revenue, 4.6% of operating income, 3.3% operating margin)

The Consumer Electronics segment manufactures and sells televisions (Visual Display Business), home appliances (Digital Appliance Business), printers (Printing Solution Business), and medical devices (Health and Medical Equipment Business). The Visual Display business has held the number one market share in all TV sales, flat-panel TV sales (27.9% share), and liquid-crystal display (“LCD”) TV sales every year since 2006. The television industry is fragmented with LG Electronics (16.6% share), Sharp (5.7%), Sony (5.1%), and a multitude of Chinese companies (TCL is the largest with a 5.9% share) being Samsung’s main competitors. The Digital Appliances business manufactures chiefly refrigerators, washing machines, and air conditioners. According to the company, in 2013, Samsung held the number one worldwide market share in refrigerators (15.9%) and was number three in washing machines (12.0%). The company’s main competitors within the digital appliance space include Whirlpool Corporation, Electrolux, General Electric Company, and LG Electronics. The Printing Solutions business was started in 1991 and now holds the number two spot (behind HP) in global laser printer sales and the number five spot in overall hardcopy peripheral market share.

The Consumer Electronics segment has historically out earned its peers, however, I estimate that it has likely been a net destroyer of value for the company based on its low returns and sizable asset base. The historical sales growth and operating performance of the Consumer Electronics division for the last five years is shown below:

IT & Mobile (54.1% of 2013 revenue, 68.4% of operating income, 18.0% operating margin)

Since the explosion of the smartphone, the IT & Mobile division of Samsung Electronics has become the cash cow of the company. Revenue from this division has grown from KRW 41.2 trillion in 2010 to KRW 138.8 trillion in 2013. The company has consistently maintained and built market share for the last decade (up until this past year) and today enjoys the industry-leading share in both total mobile phones (20.6%) and smartphones (24.4%) (based on estimated Q4 2014 sales). At present, Samsung and Apple account for over 100% of mobile phone industry profits and no other competitor holds more than a 5.3% market share in smartphones globally.

A summary of the operating performance over the last five years for this division is shown below:

Device Solutions (26.2% of 2013 revenue, 27.0% of operating profit, 14.7% operating margin)

The Device Solutions business manufactures the various components that are used in Samsung’s finished electronics. The segment also sells these components to third-party OEMs. The three major divisions within this segment are the Memory business, the System LSI business, and the LED business.

The Memory business consists chiefly of dynamic random access memory (“DRAM”) and NAND Flash memory sales. Samsung Electronics has held the number one market share in DRAM since 1992 and accounted for 39.1% of total industry sales as of the fourth quarter of 2013. After recent industry consolidation, the company’s main competitors are Micron Group (28.7% share) and SK Hynix (23.8% share). Samsung currently has a NAND Flash market share of 37.0% as of December 2013 with key competitors being Toshiba/SanDisk (36%), Micron/Intel (16%), and SK Hynix (11%).

The System LSI (“large scale integrated-circuit”) business manufactures a variety of components used mainly in smartphones, tablets, and other handheld devices. Additionally, the System LSI business contains Samsung’s foundry operations. This division was started in 2005 and provides manufacturing capabilities to third-party clients for the production of customized semiconductor solutions. Currently, Samsung Electronics is the fourth largest foundry in terms of sales with a market share of 9.2%. Taiwan Semiconductor dominates the industry with a market share of 46.3%.

The LED Display business produces LCD and OLED displays for use in TVs, computer monitors, and mobile phones. Samsung Electronics enjoys the number one market share of small-sized LCD displays (less than 9.1”) with a share of 23.5% and is also the market leader in small-sized OLED. Samsung Electronics currently holds the number two market share in large-sized LCD displays (9.1” and above) with a 20.2% market share, trailing only LG Display (26.7%). Other LED Display segment competitors include Sharp, AU Optronics, and Innolux.

A summary of the operating performance over the past five years for this division is shown below:

Competitive Strategy

Samsung Electronics has, historically, out earned its closest competitors across time within each of its business lines and its overall return on invested capital levels are indicative of a company building value for shareholders. Samsung management appears adept at understanding the commodity nature of the markets the company operates in and has designed a corporate strategy to best navigate these markets. This strategy involves the following components:

Research & Development: Samsung Electronics spent the second most money on R&D of any company in the world in 2013 (behind only Volkswagen) and has been in the top 15 globally in total R&D spend in every year since 2006. This R&D is especially important in the asset intensive Device Solutions product segment. Staying ahead of its competitors allows Samsung to charge a premium for its products and maintain superior profitability. Historically, Samsung has been successful in this approach and has indeed out earned the competition in DRAM and, to a lesser extent, NAND Flash. While I hesitate to project the path of future technological development in the semiconductor industry, it appears that Samsung has the R&D budget and the technological know-how to maintain their industry leading market positions going forward. I am further comforted by the fact that the company has held its leading market share for the past 21 years in the DRAM industry and the last 12 years in the NAND flash market.

Marketing: Similar to R&D expenditures, Samsung Electronics is able to leverage its size to dramatically outspend it competitors on marketing expenses. This strategy appears to be working as Samsung’s brand value has steadily climbed over time (from 19^th in 2010) and the company held the 8^th most valuable brand in the world at the end of 2013. According to Interbrand, Samsung has the number one global brand awareness in both TVs and smartphones.

Vertical Integration: Historically, vertical integration has given Samsung several key advantages over its competitors:

1. Speed to market: Vertical integration gives Samsung considerable flexibility compared to its consumer electronics counterparts who do not control their own supply chain. As a matter of fact, Samsung has its hand in producing components that represented over an estimated 60.0% of the cost of the Galaxy III smartphone.

2. Breadth of product line: Samsung’s vertical integration has given it the ability to develop and market products to all consumers. This has allowed the company to capture a portion of the profitable high-end smartphone segment while fighting off potential rivals at the lower end product spectrum.

3. Low cost operator: Samsung appears to have historically had a cost advantage relative to its other high-end smartphone competitors. I attribute this advantage to 1) the ability to control and minimize component costs through vertical integration, 2) the presence of economies of scale in spreading fixed costs over a larger volume of products, and 3) the development of leading edge technologies in components which allows the company to take advantage of lower cost, higher quality components before the rest of the market.

Distribution Networks: Samsung has a sales network that spreads across 53 countries and the company has been able to leverage its established distribution network for items such as TVs and home appliances to sell its smartphones. This distribution network puts Samsung at an advantage especially over many of the fast growing Chinese companies with global aspirations. Companies such as Xiaomi, now the fourth largest smartphone vendor in the world (based on estimated Q4 2014 sales), have found success by selling technology competitive phones at cost over its own website. Outside of China, this strategy may prove less successful.

Valuation

I’ve valued Samsung using a sum-of-the-parts analysis. Below are the historical and projected margins for Samsung’s closest competitors compared to each of Samsung’s business segments’ historical results. EV/Sales multiples have been selected based on historical and expected margins and future growth prospects for each segment.

A key valuation assumption is Samsung’s go-forward operating margin within their IT & Mobile segment. As seen below, the company has been able to consistently generate double-digit operating margins over time from its handsets. This is the company’s goal going forward as well.

Based on the above historical operating margins of Samsung and its peers and the current trading multiples, the following valuation is derived for the company on a sum-of-the-parts basis:

Risks

• Technology and the fickle consumer – One of the largest risks to Samsung’s profits is rapid technological development that catches the company off guard. Also, if the company were to swing and miss in too many different directions they would lose their cost advantages due to negative operating leverage.

• Commoditization – As discussed, Samsung’s end markets are ultimately commodity goods. Without continued innovation, the operating margins of these products march downwards over time towards the breakeven level.

• Phone subsidies – Samsung enjoys a large share of the high-end smartphone market. A cut in phone subsidies by mobile phone service providers may make the end consumer more price sensitive and high-end phone sales could suffer.

• Capital allocation risk – In the past, management has had a conservative policy with regards to acquisitions. However, I get the sense that management has recognized that growth has begun to slow and they may be tempted to use their sizeable cash position to reach for future growth.

• Management/succession risk – The circular ownership structure of the company gives rise to corporate governance risks. Also, Chairman Lee Kun-Hee’s recent heart attack brought to the forefront speculation of Samsung Electronics’ succession planning strategy.

• Litigation risk – Samsung is currently involved in multiple lawsuits across several countries.

• Appreciation of the Korean won – Appreciation of the Korean won makes Samsung’s exports more expensive to the rest of the world.

• Geopolitical risk – Samsung’s vast operations in South Korea and production facilities near the North Korean border make geopolitical instability a constant threat.

Downside

At current levels, the downside for Samsung Electronics’ stock price appears limited based on the following analyses:

1. Historical Price-to-Tangible Book: Samsung would have 26.2% downside if the stock were to fall to its all-time low price-to-tangible book ratio of 0.85x. This level of price-to-tangible book was seen during the Asian financial crisis (in fact, the only time the company has traded at less than 1.0x price-to-tangible book was during this time period).

2. Zero Value Attributed to IT & Mobile Division in Sum-of-the Parts Analysis: I took my sum-of-the-parts analysis and removed all the value from the IT & Mobile segment. Under this assumption, the stock would have an intrinsic value 12.1% below current price levels.

Catalyst

1.  Shift in the company ownership structure

2.  Increased returns of capital

3.  New products

4.  Value will out