Description

(N.B. the financial figures above are in Bn KRW. The Market Cap and TEV are the calculated effective values for the preferred security)

Samsung Electronics

Overview

Samsung Electronics is a global semi-conductor and electronics manufacturer with dominant market shares in the majority of the fields in which it operates. The company traces its roots back to 1969 when Samsung Electric Industries was established as a subsidiary of Samsung Group in Suwon, South Korea.  The company’s early products included electrical appliances such as televisions, calculators, refrigerators, air conditioners and washing machines.  In 1974 the group expanded into the semi-conductor industry by acquiring Korea Semiconductor, one of the first chip manufacturing operations in Korea.  In 1988 Samsung Electric Industries was merged with Samsung Semiconductor & Communications to form Samsung Electronics. 

The company has a track record of dominating the industries it chooses to focus on.  Typically the company’s strategy has been to identify attractive industries which it then enters starting out as a supplier developing key components for companies further up in the value chain.  This gives the company insight into how the industry works.  When Samsung decides to expand operations and start competing with the companies it has been supplying, it makes massive investments in plants and technologies, leveraging its foothold into a position that other companies have little chance of matching and dominating the entire value chain.

“In 2000 Samsung started making batteries for digital gadgets. Ten years later it sold more of them than any other company in the world. In 2001 it threw resources into flat-panel televisions. Within four years it was the market leader. In 2002 the firm bet heavily on “flash” memory. The technology it delivered made the iPhone and iPad a reality, and made Samsung Apple's biggest supplier—and now its biggest hardware competitor.” - The Economist, ‘The Next Big Bet’ Oct 1st 2011

The company currently breaks down its operations into the following four reporting units:

Net Revenue (Bn KRW)                     2013                            2014E

IM ⁽¹⁾                                               138,817 (54%)           114,025 (49%)

Semi-conductor                                  37,436 (15%)              39,670 (17%)

CE ⁽²⁾                                                50,331 (20%)              51,500 (22%)

Display                                             29,837 (12%)              25,493 (11%)

Operating profit (Bn KRW)                 2013                            2014E

IM                                                   24,958 (68%)              14,207 (58%)

Semi-conductor                                   6,888 (19%)                8,671 (35%)

CE                                                      1,673 (5%)                  1,317 (5%)

Display                                                2,981 (8%)                    469 (2%)

(1)     IT & Mobile Communications (2) Consumer Electronics

The company’s IT & Mobile division which produces its ubiquitous smartphones (as well as cameras and printers) generated 54% of revenue and 68% of operating profit in 2013.  Although the company’s market share in mobile phones has declined from a peak of 32% to 24% it still remains the global leader.

The company’s semi-conductor division generated 19% of operating profit in 2013.  This division is the world’s largest manufacturer of memory (both DRAM and NAND) with ~40% and ~38% market share in DRAM and NAND production respectively.  In addition the company is one of the top three chip foundry companies in the world (excluding Intel) and is gaining market share in the latest generations of chip fabrication technologies. 

The company’s two other divisions Display, which produces flat screen displays and LEDs, and Consumer Electronics which manufactures TVs, Household appliances and medical equipment accounted for 8% and 5% of operating profit respectively.  The company has stated it wants to further develop is market share in household appliance to be the number one player by the end of 2015.

Sources of competitive advantage

Economies of Scale

“If Samsung’s business lines or products are not number one or the only one in their industry, they will not survive. In the past, companies could survive in second place by imitating advanced products. Today, however, it is almost impossible to survive in the market in second place.” — Chairman Lee Kun-Hee

The semi-conductor industries have significant economies of scale as the costs of building leading edge semiconductor plants have grown exponentially and the leaders continue to benefit from their progression down the experience curve.  The company is well aware of the requirement to be a leader in order to be profitable in these industries.

The high fixed costs underlying the economics of the industry have forced the smaller players with limited scale to exit or merge with competitors.  Currently just three semiconductor companies (including Samsung) account for 50% of global semiconductor capital expenditure, down from ten at the beginning of the decade.  The number of semiconductor companies with factories at the leading edge has declined to five from twenty over the same time period, with this number likely to reduce further as the marginal players struggle.  As a result of this industry consolidation there are signs that capacity expansion and pricing is becoming more rational.

Economies of scale creates an advantage in Research and Development:  “Apple has been trying to reduce its exposure to Samsung as a supplier but is forced to use Samsung memory components in their cutting edge products such as MacBook air because of superior performance.” – IDC industry expert

Synergies between business units

We believe that synergies between these divisions provide one area of competitive advantage.  Since almost 90 percent of its customer base in the LCD and memory semiconductor businesses overlap, Samsung has been able to use a combined marketing network to provide customers with one-stop service, boosting its bargaining power with customers while simultaneously reducing marketing costs.  In addition 63 percent of the components and materials for Samsung’s mobile phones are purchased internally which suggest competitors in smartphones have limited opportunities to undercut Samsung on a significant part of their cost structures.

Management style / bold decision making

Professor Katsuya Okumura at the University of Tokyo argues that it was the ability to make quick and bold decisions that enabled Samsung to leapfrog larger Japanese competitors in the memory business in the early 80s.  In the 1980s, Japanese chip makers dominated the market, but they soon found themselves rapidly losing ground to Samsung, which did not begin dynamic random access memory (DRAM) production until 1983.  Professor Katsuya Okumura argues that the Japanese lost their ability to compete when required capex grew from 10 billion to 20 billion yen in the 1980s to over 100 billion yen.  At this capex threshold the sign off for investment decisions moved from the head of business divisions to a consensus agreement across senior executive management.  As a result Japanese firms lost mobility in their capex spending and continually fell behind in the timing of their investments.  This decision making process precluded the high speed needed for success in the semiconductor industry.

The company employed a similar strategy in the 1990s to overtake Japanese competition in LCD manufacturing which is also a capital and R&D intensive industry.  Due to a prolonged slump in the thin-film-transistor LCD (TFT-LCD) market, Japanese companies that had been focused on producing 12.1-inch panels were reluctant to invest in next-generation panels. In contrast, Samsung invested aggressively in facilities to manufacture 13.3-inch and larger panels.  Later, as the new size became the industry standard, Samsung was able to surpass Japanese producers and grab leadership of the market.

The reason the stock is cheap

The main bear case argument against Samsung Electronics is that the company’s current market share and margins in smartphones will not be sustainable as new entrants to the market (in particular Chinese players with Xiaomi being the most notable) catch up in terms of technology and brand recognition.  We do not disagree with this thesis.  Our research and discussions with industry participants indicates that Samsung Electronics’ current market share and operating margins will continue to contract as competition in smart phones only intensifies further and opportunities to differentiate between products diminish.  The company itself is aware of this issue.

“The majority of our products today will be gone in ten years,” – Lee Kun-Hee, Samsung Electronics Chairman, 2011

Competitors such as Xiaomi who don’t pay royalties on intellectual property, use social media and consumer interest to reduce marketing spend and sell direct to cut out the retailer’s margin will be very tough to compete with going forwards.  However Xiaomi's business model is unproven outside China.  A recent ruling by a high court in India putting a temporary ban on sales of Xiaomi products due to a patent infringement dispute with Ericsson could be a sign of further troubles ahead as it tries to compete on a fairer playing field outside of its domestic market.  As such much of the damage that this competitor has done to Samsung may have already have played out. 

Having modelled various aggressive downside scenarios for the decline in the company’s smartphone business (market share declining to 10% and operating margin to 5% within 4 years) we believe the discounted free cash flows the company is still able to generate are significantly greater than the current valuation the market is assigning the company, in particular the company’s preferred shares. 

In addition to fears over the decline of the smartphone business, there are a couple of technical factors that we believe are reducing demand from investors for Samsung Electronics.  The company’s dominate weighting in the domestic Korean market (greater than 25%) makes it difficult for portfolio managers to be overweight Samsung as they are constrained to hold not more than 5-10% of their funds in any single security.  Also unlike other large technology companies Samsung Electronics is not listed on a US exchange which potentially reduces the interest of US investors.  For example US investors hold ~70% of Google’s shares and ~55% of Apple’s shares versus only ~10% of Samsung Electronics.   

Upside from our conservative model

Our modelling also gives no credit to potential returns from the huge capital expenditure it invests and the R&D it expenses as it targets new industries to dominate.  With an R&D budget of US$13.7Bn in 2013 the company spent more than other technology giants such as Intel, Microsoft, IBM, Google and Apple.  In 2013, Samsung registered 4,676 patents at the U.S. Patent and Trademark Office.  Since 2006, it has continuously placed second in patent registrations in the United States, surpassed only by IBM.  The company’s Advanced Institute of Technology has been developing “seed businesses”; these are businesses that are expected to bear fruit within five or ten years and require immediate investment in technology, capital, and personnel.  In 2010, for instance, Samsung identified five businesses that it will intensively foster at a group level: light-emitting diodes (LEDs), rechargeable batteries for automobiles, solar cells, medical equipment, and biosimilars.  Given the company’s historic track record of successfully executing on its goals this pessimistic view should prove to be too conservative.  Also unlike many other technology companies Samsung does not have a history of ‘buying’ and capitalising it’s R&D by acquiring other companies but rather develops it in house.  Ideally though we would like to see the company return more cash to shareholders.

Risks

The most significant risk to our thesis is the succession from Chairman Lee Kun-Hee to his largely unproven son Lee Jae-Yong.  Much of Samsung Electronics success appears to be tied to Lee Kun-Hee and the culture he ingrained in the business.  Chairman Lee’s style was to present a challenging vision and make bold decisions on investments, while stoking a sense of crisis throughout the entire organization.  As discussed above, the bold decision making style of Samsung which has come from the top has helped the company to dominate industries in which it was a later comer.

The preferred stock provides the best value

As part of its capital structure the company, in addition to its common stock, has issued a class of preferred shares.  Although the preferreds do not carry voting rights they have the legal right to the common’s dividend plus a small premium.  We believe these preferreds are priced at an irrationally large discount to the already attractively priced common shares.  By buying the preferred shares, which are currently trading at a 22% discount to the common, an investor is able to acquire a holding in Samsung Electronics for an effective EV/FCF (2013) multiple of 4.9x and an EV/Net Income multiple of 3.5x.  An alternative conservative way to look at this investment is to give no credit to the declining smartphone business and view it as an opportunity to purchase the world’s leading memory producer and number two chip fabrication company for an effective EV/EBIT multiple of ~10x.

Although Samsung Electronics appears to lack a long-term durable business model in some of its core businesses like smart phones, it does have unique characteristic which mean that it should be able to retain a leading position in this market (but at lower margin than in the past); Samsung will retain the number one spot in the memory chip industry, which it has held for more than 20 years and the economics of which will continue to improve from consolidation and given its history, it is likely to make headway in some of the new markets it is targeting - we model neither success in these investments or the cashflow advantages, Samsung could attain overnight by cutting these projects, this part of their business only offers upside in our modelling.  Combining this strong cash generating capability with its balance sheet provides a margin of safety against permanent capital loss with the likelihood of a satisfactory return on investment.

Catalyst

Any further moves to increase the return of cash to shareholders following the company’s announcement in December 2014 that it will increase its year-end dividend and repurchase US$ 2Bn worth of stock (both common and preferred) should heighten demand for the shares.  A move to list the shares on a US exchange would have a similar effect.