Samsung Electronics. A (Mostly) Bullish Investment Thesis.

Samsung Electronics, referred to as Samsung for the remainder of this report, is the flagship company within the eponymous conglomerate (chaebol), the largest in South Korea. With over 320,000 employees and $220 billion in 2018 annual revenues, Samsung has long established itself as the premier global manufacturer of consumer and household electronic goods with leading market share positions in both TVs and refrigerators. When it comes to smartphones, Samsung has been the market leader in terms of unit volumes since 2015. In addition, Samsung has a roughly 93% share of the market for the screens, whether LCD or OLED, for those smartphones. As for the DRAM and NAND chips used in those smartphones as well as servers, tablets and PCs, again Samsung has long held the leading market share position. Last but not least, Samsung foundry now stands at number two behind TSMC, although from a process technology and roadmap perspective, both are roughly equivalent.

While Samsung’s origins back in the 1940’s are of little more than a historical curiosity today, the company’s history over the course of the past five decades is replete with examples of ambition, innovation, vision and fortitude which combine to chart the inexorable evolution of modern day technologies, most notably those with a firm foundation in semiconductors.

Along the way, Samsung accumulated an astonishing array of accomplishments. It took the company just ten years from starting its own DRAM production to becoming the world leader in terms of both market share and revenue in 1993, a position it has easily maintained to this day. Remarkably, Samsung replicated that very same accomplishment upon entering the NAND Flash business in 1992 and again they have retained their market leadership position until now.

In spite of missing the opportunity to purchase a startup called Android when it was little more than a concept developed by an eight person team, Samsung was quick to spot its potential in the wake of the astonishing success of the iPhone. The company rapidly devoted all of its attention to the fledgling OS and went on to surf the golden wave of the smartphone era, taking the title of the world’s leading mobile phone manufacturer by unit volume first from Nokia in 2012 and again from Apple in 2015.

Having accumulated vast experience in semiconductor manufacturing dating back to the early seventies, combined with having invested heavily in manufacturing capacity in the early 2000’s, Samsung quietly began offering foundry services in 2005. They hit the jackpot with Apple in 2007 when they signed up to manufacture the processors, DRAM and NAND chips for the launch of the iPhone. The unprecedented success of the original iPhone along with its subsequent generations established Samsung as a leading foundry, albeit still well behind market leader TSMC. While the loss of Apple’s business in 2013 due to the protracted legal disputes between the two companies dealt their foundry ambitions a severe blow, they retained old customers like Qualcomm while finding new ones like NVIDIA.

Samsung relaunched their foundry initiative in 2017, largely to alleviate customer concerns about competition, but also to allow them to count the revenues generated by the processors they manufacture for consumption by their own internal IM (smartphone) division. The net effect was a doubling of their annual revenues to around $10 billion, catapulting them into second place behind TSMC. Perhaps more importantly, Samsung Foundry stands alone with TSMC in terms of proven ability to successfully achieve volume production on a 7nm process technology. Indeed, Samsung’s proces prowess in some ways matches, if not exceeds, TSMC in so far as it has taken the lead in terms of incorporating EUV into its 7nm lithography. Furthermore, as outlined in their latest 4th annual technology forum in Santa Clara, Samsung’s process roadmap is as impressive as it is ambitious.

With its conglomerate structure and dizzying range and diversity of products, Samsung is at first glance complex and difficult to grasp from an overall business perspective. However, at its essence, Samsung’s business over the course of the past decade can be boiled down to just two simple charts, namely revenue and operating income by five key segments, and two basic stories, the golden era of the smartphone, followed by its subsequent and rapid decline, and the semiconductor supercycle followed by its subsequent and rapid decline. Those segments, used by Samsung in their financial reporting, are SEMI (DRAM, NAND and Foundry), DP (Display Panel), IM (Smartphone, Tablet, Wearables, PC’s etc), CE (Consumer Electronics) and Harman (acquired in 2017).

With regard to revenues, there are two things to note. Firstly, the remarkable rise in quarterly IM revenues from ₩10.8 trillion in Q3 2010 to a peak of ₩36.6 trillion in Q3 2013 followed by a sequential decline to ₩24.6 trillion one year later in Q3 2014. We refer to this as Samsung’s golden smartphone era followed by its subsequent, dramatic retreat. Secondly, the equally remarkable rise in SEMI revenues from ₩11.2 trillion in Q1 2016 to a peak of ₩24.8 trillion in Q3 2018, followed by a sequential decrease to ₩14.5 trillion in Q1 2019. We refer to this as the semiconductor supercycle and subsequent, dramatic retreat. Thus it was that Samsung’s SEMI revenues rose to match its IM revenues in Q3 2018 for the first time in a decade.

Switching to operating income, during its golden smartphone era, Samsung’s IM division contributed the bulk of the conglomerates profits during that time. At its peak in Q3 2013, IM operating profits of ₩6.7 trillion were more than three times greater than its next best-performing division, SEMI.

During the period Q3 2014 through Q3 2016, operating profits from both the IM and SEMI divisions were roughly comparable ranging between ₩1.8 and ₩3.7 trillion at the extremes. Things changed rapidly with the onset of the semiconductor supercycle in Q3 2016 when SEMI operating operating profit rose from ₩3.4 trillion to ₩13.7 trillion in Q3 2018. During that same time period, IM operating profits remained largely stagnant, dropping to a low of ₩0.1 trillion in Q3 2016 (due to the exploding battery recall) and peaking at ₩4.1 trillion in Q2 2017. Since its peak in Q3 2018, SEMI operating profit has collapsed to ₩4.1 trillion in Q1 2019. We project that it will continue to fall through the remainder of 2019 to reach ₩2.53 trillion in Q4, when we expect it to once again match the IM segment operating profit.

As for the other divisions, Harman’s contribution is miniscule in terms of either revenues or profits, CE has been largely range bound between ₩10 and ₩14 trillion in quarterly revenues for a decade with DP largely the same, range bound between ₩6 and ₩8 trillion, albeit exhibiting more seasonality in the past two years due to the contract to supply OLED screens to Apple. In other words, the Samsung story essentially revolves around its semiconductor and smartphone divisions with the company’s fortunes rising and falling according to how they are performing.

While Samsung’s journey has been an incredible one, it’s patently obvious that they haven’t gotten everything right along the way. In spite of their smartphone leadership in terms of unit volume, they garnered just 17% of global smartphone profits compared to Apples’ 62% in Q2 2018, a percentage which remains remarkably consistent from quarter to quarter. This situation is unlikely to change any time soon due to the fact that Samsung missed the boat with Android back in 2005, effectively ceding control of the lucrative Apps Play Store ecosystem to Google. Their prized Display Panel business periodically dips into red, most recently in Q1 2019. While impressive from a technology perspective, their foundry business is still just one third the size of TSMC’s. The exploding battery issue back in 2017 was a significant and costly setback while their long-delayed launch of the Galaxy Fold is an embarrassment for now.

Furthermore, it has to be acknowledged that there have been investor concerns related to Samsung’s corporate structures and governance. Back in 2016, Hedge Fund Elliott urged Samsung to undertake measures to address those concerns with a view to unlocking greater shareholder value. Elliott’s proposals were outlined in detail in this SEC presentation. Those proposals fell on deaf ears. In August 2017, Samsung chairman and de-facto leader Jay Y. Lee was sentenced to five years in prison on bribery charges, only to be released six months later when his sentence was suspended by a South Korean court.

Against this backdrop of incredible technological accomplishments over the course of the past five decades coupled with their more recent challenges, how should investors think about Samsung today?

For starters, it’s important to recognize the unique position which Samsung occupies in the industry. While other companies can supply DRAM, NAND, display screens, 5G modems, application processors etc, Samsung is the only one which can supply them all, and at volume. Without Samsung, the latest iPhones would be largely restricted to LCD screens instead of OLED. Indeed, without Samsung’s foundry capacity, Apple would never have been able to meet the supply required to satisfy the demand for the original iPhone models. Add to this the fact that Samsung is one of only two companies in the world to have demonstrated volume production on a 7nm process, with an impressive and credible roadmap all the way to 3nm. We believe that the true value of this capability will still take some years to be realised.

The current semiconductor downturn will not last forever. DRAM and NAND ASPs will increase again and with it, the profitability of Samsung’s SEMI division. Samsung can extract more profitability from its IM division and it eventually will. Samsung can better leverage its position as a critical supplier to some of the most profitable companies in technology and extract more value from its IP and manufacturing scale, and it eventually will. Critically, Samsung could better organize its corporate structure, making it more investor friendly and extracting greater shareholder value, and it eventually will.

Underscoring their confidence in the role that semiconductor technology will play in the company’s future, Samsung recently announced an unprecedented level of investment in April 2019, committing to spend over $9 billion annually through 2030 on its foundry and system LSI divisions.

All in all, Samsung is a play on the value of the most advanced and complex products and processes at the heart of our technological futures, all at a scale that no other single company can likely ever match.