Samsung Electronics – an unlikely flame-out
“Samsung’s latest invention: a fireproof box for Note 7 return.”
Reuters headline, October 2016
The largest position in the BT Global Emerging Markets Opportunities Fund – Wholesale is Samsung Electronics (SEC). One of SEC’s flagship products, the Galaxy Note 7 smartphone, has become infamous for its tendency to catch fire. The company’s attempt to satisfy Note 7 owners with at first a repair and then a recall has been poorly executed, and the Note 7 is being cancelled as a device, with production ended and a full recall. SEC’s share price has been volatile during September and October.
SEC remains one of our highest conviction holdings in the Fund. We wanted to highlight the reasons why that is the case, given the recent negative commentary on the company.
Firstly, it is worth revisiting exactly what SEC is. The company is a multi-faceted conglomerate across various consumer electronics and information technology products. Using its first-half results as a guide, the largest division by revenues is IT & Mobile, which produced Korean won (KRW) 8.2 trillion of operating profits on KRW 54.2 trillion of revenues, with a margin of 15.2%. The next largest division is Semiconductor products, which produced KRW 5.3 trillion of operating profits on KRW 23.2 trillion of revenues with a margin of 22.8%. There are also smaller units producing display products and consumer electronics; these together produced KRW 1.9 trillion in operating profits.
The problems in the smartphone operation come at an unfortunate time, as that unit had been making good progress in 2016. In 2015, the operating margin for IT & Mobile had fallen to 9.1% as the unit tried to compete with cheap, low-end Chinese handsets, but a refocus towards high-end products (particularly the flagship S7 and, sadly, Note 7 devices) had driven a strong recovery in the first half of 2016. It is clear that previously optimistic forecasts for IT & Mobile will need to be scaled back. In our model we have assumed that smartphone volumes fall sharply in the second half of 2016 and stay flat (at 250 million units p.a., compared to 323 million units in 2015), we have assumed no recovery in smartphone ASPs from 2015 and taken operating margins down to 10%. These are drastic and almost certainly excessive cuts, assuming that the Note 7 failure affects sales of Samsung handsets across the product range for the next three years. Our 2017 estimate of operating profit from the IT & Mobile unit is KRW 5 trillion lower than pre-Note 7 crisis.
What has been missed by the negative commentary about SEC as a whole is the change in the semiconductor market in the last three months. Strong global demand for handsets, particularly the more demanding 4G devices, has tightened the supply/demand balance for high performance memory chips. The spot price of the benchmark 4GB DRAM chips has moved from US$1.50 at the end of May to US$2.21 at the time of writing. We have increased our forecasts for 2017 operating profits for the Semiconductor division by KRW 0.7 trillion; again we feel this is probably conservative.
SEC is at the cutting edge of the technology of designing and manufacturing chips. The company has been appointed by Qualcomm to manufacture its top-of-the-range Snapdragon 820 chip using SEC’s revolutionary 14nm FinFET 3D transistors. FinFET production allows for smaller chips, faster processors, lower power consumption and cooler temperatures. Elsewhere, the group continues to develop its own powerful Exynos system chips, foldable displays and the next generation of semiconductors.
Additionally, we feel that the group is significantly undervalued, to the extent that the downturn in revenues and margins in the IT & Mobile division does not affect our overall conviction in the investment. If we value SEC’s operating units from quoted peer companies, we value (on latest estimates), the Semiconductor unit at KRW 108 trillion, IT & Mobile at KRW 89 trillion and the smaller units together at KRW 60 trillion, for a total of KRW 258 trillion. The group has KRW 65.trillion in net cash and investment worth a conservative KRW 8 trillion, valuing the entire group at KRW 331 trillion. The company has 170 million shares in issue, but owns 24 million of its own shares, implying a value per outstanding share of KRW 2.268 million. The share price after the Note 7-related volatility is only KRW 1.577 million, implying very significant upside from here.
Crucially, corporate restructuring continues, with cash returns to shareholders both through buybacks and dividends. Despite the recent volatility, SEC has outperformed the MSCI Emerging Markets index by 17.7% in US dollar terms over the last year, and 69.4% in US dollar terms over the last five years. We expect continued outperformance from this strong and attractively valued business.