Samsung Q3 14A – Deer in the headlights

Samsung does not seem to have any idea what to do.

• Samsung reported awful Q3 14A results as profitability in the handset business collapsed far below RFM’s bearish expectations.
• Q3 14A Revenues and operating profit were KRW47.45tn / KRW4.06tn compared to RFM forecasts at KRW49.86tn / KRW6.84tn.
• The biggest problem was the IT and Mobile Coms unit (almost all handsets) where EBIT margins fell to 7.1% from 15.5% in Q2 14A.
• This is already way below RFM’s long-term estimate of 11%-12% and there is every sign that things are about to get worse.
• Elsewhere, Consumer Electronics also had a difficult quarter with margins falling to break-even while Device Solutions (Semis and panels) fared a little bit better than forecast.
• The one bright spot was cash flow where KRW10.44tn was generated from operations from good working capital management.
• In handsets, market share has been lost again with 78.1m smartphones being shipped compared to RFM’s forecast of 83.7m.
• Furthermore, most of this weakness has come at the high end where Samsung has really been benefitting from the profitability of selling huge numbers of highly priced products.
• Once the R&D and marketing costs on a high-end device have been covered, the profitability increases significantly as more devices are shipped.
• This has been the secret of Samsung’s success but equally, it is the also the main reason for the sudden weakening over the last three months.
• Something has to change if this rapid decline is to be halted.
• Samsung gave away the one chance that it had to differentiate its devices through the ecosystem (see here) which has substantially limited its options.
• Samsung can focus on differentiating through hardware and on this basis it could make 11%-12% margins in the long-term as long as it can hold onto volume.
• The problem is that it has lost significant share over the last two quarters despite every effort it has made.
• The more share that is lost, the lower the margin it will be able to make on commodity products as the scale advantage is less.
• There is a real risk that it ends up in-line with the rest of the Android industry at around 2%-4% in the best instance.
• Listening to Samsung on its conference call it is the clear that beyond trying to differentiate in hardware and cost reduction, it has no idea how to halt the rapid decline.
• I have heard all of this commentary before from Ericsson, HTC, Motorola, BlackBerry and Nokia and what followed in every case was a collapse into loss making territory.
• Samsung is relying on the Galaxy Note 4 to restore its business mix in Q4 14E allowing its ASPs and its margins to increase.
• However, this quarter the iPhone 6 and 6+ will be available for the whole quarter.
• While the iPhone 6 and 6+ screens are not as good as the Note 4, I think that they are good enough and the iOS ecosystem that it offers is much easier and more fun to use.
• Hence, the Note 4 looks unattractive against the iPhone 6+ and I suspect that users are going to continue switching.
• Consequently, I think that market share in the high end is going to fall again which means that margins in Q4 14E are likely to be even lower than they were in Q3 14A.
• Samsung has not done or said anything that leads me to think that it can avoid the fate of all market leaders before it and I remain fearful that the vicious cycle is only just beginning.
• Against this backdrop, there is only bad news in the pipeline as I do not think that the worst is over.
• Consequently, I think that earnings can fall further and continue to see downside to KRW1m per share.
• I prefer Google, Microsoft and Apple to Samsung.