Description

Samsung Electronics Co. Ltd. (5930 on the KRX, SMSN on the LSE) is the largest member of the Samsung Group, Korea’s largest chaebol. On a global basis, Samsung Electronics (Samsung) is the largest producer of smart phones (30% share), flat panel TVs (31% share), side-by-side refrigerators (33% share), DRAM chips (41% share), NAND chips (40% share), CMOS image sensors (26% share) and processor chips for mobile phones and tablets (72% share). Historically, Samsung consistently grew earnings; the market for its highest earning product, smart phones, appears likely to grow rapidly for the next several years (e.g., the Ericsson Mobility Report dated 11/2013 estimated that smart phone subscriptions will grow from 1.9 billion in 2013 to 5.1 billion in 2018). Interestingly, Samsung is valued at 2.9x trailing EBITDA, 6.5x trailing earnings, 7.6x trailing free cash flow and 1.5x tangible book value, i.e., a bargain on an absolute basis and about half the valuation of its peers. Samsung is vertically integrated yet consistently generates high returns on capital, e.g., median pretax return on invested capital was 15% over the last decade (about twice the returns of its peers). If Samsung’s financial statements (audited by Sami PricewaterhouseCoopers) are roughly accurate (an assumption we will explore below), Samsung is a bargain. 

Valuation

Samsung has two classes of stock: common and preferred.  Common shares have voting rights and trade on the Korean Exchange, ticker 5930; preferred shares have no voting rights, receive a slightly enhanced dividend based on par value (e.g., the current dividend yield on common is 0.6% while the preferred yields 0.8%) and trade on the Korea Exchange, ticker 5935.  Both securities have dollar denominated GDRs that trade on the London Stock Exchange (ticker SMSN for the common and SMSD for the preferred security).  Both the common and the preferred GDR are equivalent to ½ of the respective underlying share and are entitled to receive dividends pro rata. The preferred currently trades at a 22% discount to the common, so if it meets your liquidity requirements, that is the way to go.  

Note that Samsung’s capital structure is quite conservative, i.e., net cash of 37.7 trillion won ($35 billion). This conservatism is likely the result of the company’s difficulties during the Asian crisis when they found themselves with a deteriorating business and net debt of 11.6 trillion won (12/31/1997, $10.8 billion), about twice the company’s book value at the time.  As an aside, in the heat of the Asian crisis (circa July 1998), Samsung was losing 170 billion won per month.  During the crisis, Lee Kun-hee, Samsung’s chairman then and now, sold more than 100 non-essential businesses and laid-off 30% of Samsung’s workforce (neutron Lee?).

Segments

Samsung is organized into two business groups:

• Digital Media Communications (DMC). This group makes products sold to end-users.
• Device Solutions (DS). This group makes products sold to original equipment manufactures (OEMs).

The following table summarizes Samsung’s EBIT contribution by business group and segment since 2010.

Samsung EBIT Contribution by Segment

Beyond the initial observation that DMC products are sold to end users while DS to OEMs, note that Samsung is vertically integrated. Vertical integration is somewhat unique in the consumer electronics industry and suggests Samsung may enjoy distinct competitive advantages we will discuss below.  Note, however, as a result of its vertical integration, the attribution of earnings between Samsung’s segments is somewhat arbitrary. For example, 60% of 2010 EBIT came from their semiconductor business while 16% came form their IT & Mobile business. The semiconductor segment makes DRAM chips, NAND chips, CMOS image sensors and processors - all used by the IT & Mobile segment to make cell phones.  In fact, half of the revenue from their semiconductor business in 2009 was from internal sales, which suggests the question, – how was the transfer pricing determined for internally consumed semiconductors? Since the IT & Mobile business buys its chips from the Semiconductor business, the earnings recognition between the two segments is somewhat arbitrary. The same can be said about Samsung’s display panel business, which furnishes displays to both the CE segment (TVs and monitors) and the IT & Mobile segment (cell phones and smart phones).

Of course, Samsung’s DS business also sells its products to third parties, many of whom are competitors. This suggests that Samsung enjoys two distinct competitive advantages vis-à-vis several of its consumer electronics competitors:

1. Early look – Developing new smart phones, cameras, MP3 players, Google Glass, etc. takes time and requires detailed discussions between customers and suppliers.  As Samsung works with customers on new products, it gains market intelligence it can use for its own products.

2. Pricing flexibility – Samsung is in a position to sell chips (processors, memory, CSMOS image sensors) from its DS group to its DMC group under more favorable terms than it offers to third-party competitors. Samsung can also do the same with its LED panels, which it makes for third parties as well as its own needs.

Let’s consider pricing flexibility in relation to Samsung’s IT & Mobile segment, which generated 70% of the company’s earnings during the 6 ME 6/302013. The IT & Mobile segment makes and sells cell phones, cell phone network equipment and digital cameras. Focusing on cellphones (currently the most important product in this segment from an earnings perspective) the following table summarizes the relative market shares of the ten largest cell phone suppliers during Q3 2013.

Global Mobile Phone Sales by Manufacturer (Gartner) 

The table shows that Samsung has a 26% market share of cell phones, up from 23% during the same period last year and nearly twice the share of its nearest competitor, Nokia. Apple is number three with a 7% share.

Interestingly, Apple buys processors, memory and CMOS chips for its iPhone from Samsung.  While Apple’s asset-light manufacturing strategy has served it well in the past, and setting aside for a moment Samsung’s larger market share, who’s position would you rather have, Apple’s or Samsung’s? One would think that Samsung enjoys the better position because it has a window into Apple’s future product plans (even if Apple decides to use another vendor going forward, this information is of competitive use to Samsung). Samsung is also in a position to sell processors, memory and CMOS sensors to itself cheaper than it sells to Apple. Given this, it is not surprising that Samsung’s Galaxy S4 smartphone comes with 2GB of DRAM vs. 1GB DRAM in the Apple 5S.    Regarding valuation (Apples and Samsungs), Samsung is valued at 3.4x trailing EBITDA while Apple is valued at 8.1x trailing EBITDA: Samsung’s is trading for less than half Apple’s valuation!

Notice also that Samsung currently holds a 72% market share for mobile application processors (APs)– the central processor of smart phones (they achieve 46% share just from their own consumption plus the Apple account). Processors tend to be a winner-take-all business due to economies of scale. In this instance, the analysis is a bit more subtle in that Samsung’s APs are based on ARM Holdings architecture, so their position isn’t as strong as say Intel’s market position in computer processors, but 72% share is not too shabby. To make matters more interesting, note that the DRAM portion of their memory business, a notoriously money consuming industry, is in transition.  The plethora of DRAM suppliers of yesteryear has recently consolidated down to three: Samsung, Hynix and Micron. Reduction to three competitions is often the magic number to improve industry profitability.

Regardless of the commodity nature of some of Samsung’s businesses and Samsung’s proclivity toward vertical integration in extremely capital-intensive businesses, Samsung consistently earns high capital returns. The following table summarizes Samsung’s capital returns over the last decade.

Samsung’s Capital Returns since 2004, no adjustments

An 18% return on equity over the last decade with an unlevered balance sheet is quite good, especially when coupled with Samsung’s bargain-basement valuation.

Governance

So far we have endeavored to show that Samsung is modestly valued (less than half the value of its peers), is well positioned in its most important market (cell phones, a market that appears to have several growth years in front of it) and consistently generates high capital returns.  How can one explain Samsung’s modest valuation?  One explanation may be that Samsung’s governance is somehow lacking. First note that as a Korea’s largest chaebol, Samsung and its sister companies produce 17% of South Koreas GDP. With so much power, who can say no to Samsung?  In point of fact, Samsung’s chairman since 1987, Lee Kun-hee, the architect of Samsung’s success over the last 25 years, was convicted of bribing two presidents of Korea - he was later pardoned by another president of Korea –  hmmmmmm. Lee was also convicted of embezzlement and tax evasion in 2008 and forced to pay a fine of $100 million and step-down from his position as Samsung Chairman. Again, Lee was pardoned by yet another president of Korea and he returned to his position at Samsung in 2009. By comparison, Marc Rich only received one presidential pardon! Clearly, Mr. Lee wields more power than the average corporate captain, but are Samsung’s accounts reliable? While we cannot attest to the veracity of Samsung’s accounts, a look at their cash flow statements over the last decade suggests that the company does produce large amounts of cash.  The following table summarizes the company’s cash from operations and capital spending habits over the last decade.

Samsung Cash from Operations and Capital Spending since 2003

Note that while Samsung generated 206 trillion won of cash from operations ($194 billion at current exchange rates) since 2003, they spent 148 trillion won ($140 billion) on capital expenditures and acquisitions. During this period, the company’s net cash from finance was negative 20.3 trillion won. Since vendors need to be paid, these figures suggest that Samsung does produce large amounts of cash, i.e., at least 169 trillion won spent on capital expansion, acquisitions and financial operations. This is also consistent with Lee’s business philosophy: “Pre-emptive investment is critical to success in the semiconductor industry.” While we don’t think Samsung will win any governance awards, we suspect the business’s accounts reflect its economics.

Conclusion

A review of Samsung’s income statement indicates that the company is growing rapidly – a pattern that has been in place for decades.  This presents a conundrum for the value investor – are we paying a low multiple on peak earnings?  Note, however, that the markets that Samsung dominates tend to grow at world GDP level with some exceptions, such as the smart phone market, which is growing much faster. Also note that it appears that we are in the early stages of the smart phone market – a market that got its start in 2007 with the introduction of the iPhone. Indeed, if the predictions expressed in the chart at the top of page one of this report are remotely accurate, the best is yet to come in the smart phone business.  But let’s suppose for a minute Samsung’s Mobile & IP business went to zero while its other businesses continued to perform as they did during the first half of 2013.  Under these assumptions, Samsung would generate about 11 trillion won of EBIT and 25 trillion won of EBITDA annually, suggesting that the company is trading for 15.6x trailing EBIT and 6.8x trailing EBITDA. While not nearly as exciting a bargain as Samsung’s current valuation, one would be hard pressed to make the case that paying 6.8x trailing EBITDA for a company with a global footprint is a crazy valuation. We conclude that Samsung is a bargain.   

Samsung Market Share by Product line

Catalyst