August 8, 2012 9:23 pm

Samsung – biting the Apple

Weak profit margins explain the South Korean group’s modest valuation

Reading this on the move? If so, the chances are you are using an Apple or a Samsung Electronics device. By the time you have finished (we give you 10 minutes), the two companies will have sold almost 5,000 smartphones. Everyone knows about Apple. The iPhone has been flying off the shelves since 2007. But it is currently being outsold by Samsung. Of every five smartphones sold by the two companies, three will be a Samsung. Most impressively, South Korea’s largest company only began to gain traction in this market in 2010.

That was also the year it became the world’s biggest technology company by sales, leapfrogging the likes of Hewlett-Packard and Hitachi. Its $4.5bn in net profit last quarter would rank it number two in the Nasdaq Composite – behind Apple, but ahead of Intel, Google or Oracle. Closer to home, Samsung’s size is starker again; it made more in the quarter to June than all of Japan’s blue-chip tech stocks together.

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Proving it has arrived, Samsung is now facing the ultimate accolade (and nightmare): battling Apple in a Californian courtroom over claims its success is based on copying Apple’s designs. Investors stand to learn whether Samsung is a new breed of deep-pocketed, creatively-minded Asian giant genuinely challenging Apple, or merely a more successful version – for now – of the likes of Sony, Sharp or Panasonic, Japan’s one-time cutting-edge electronics giants whose decade of decline is only worsening.

Samsung, different lyrics

If California’s technology giants began with student geeks in basements, the Asian equivalent started off with more basic products, if a little more organised. Samsung began making transistor radios in 1969. As late as the mid-1990s it was still so stuck in a mid-market mass- production mindset that Lee Kun-hee, son of the founder, and chairman since 1987, made a bonfire of 150,000 mobile phones and threatened to do so again unless workers did better.

This is a company with dynamic leadership and a long-term vision. But sending $50m of inventory up in smoke is hardly a sign that Samsung worries much about shareholders. Welcome to Korea’s chaebol, the linked groups of companies that dominate business life, of which Samsung is the biggest. Companies named Samsung, or linked to it, make up about a quarter of Seoul’s Kospi benchmark index.

Any investor’s first task, therefore, is getting to grips with Samsung Electronics’ place in the group. For starters, other parts of the Samsung empire, as well as members of the Lee family, hold about 30 per cent of Samsung Electronics, the group’s flagship. The company, in turn, holds big stakes in Samsung Heavy Industries, Samsung Card and Samsung Electro-Mechanics, among many other group enterprises. Then there are the joint ventures. Samsung Biologics, for example, an unlisted unit developing biosimilar drugs (one of the group’s five main development projects), is owned by Samsung Electronics, Samsung C&T, a trading company, and Samsung Everland, the group’s theme park and resorts unit, whose biological knowhow is meant to come from its zoo.

Confused? You are not alone, hence Samsung Electronic’s valuation discount. Fans of conglomerates argue that grouping different businesses – say the ports, pharmacies, property, telecoms, utilities and supermarkets held by Li Ka-shing’s Hutchison Whampoa, which typifies Asia’s family-controlled business empires – should produce steadier earnings. The flip side is that investors can more efficiently pick and mix their own businesses themselves. Hard luck with Samsung: shareholders get an opaque maze controlled by one family.

This set-up is typical of Korea and elsewhere in Asia. However investors seem to feel it more in Korea – stocks there trade on eight times forward earnings, according to Bloomberg data, compared with 11 times for Asia-wide indices. This discount is even more pronounced for Samsung itself: it trades on seven times forward earnings, half the multiple of Nasdaq-listed groups.

What is more, this conglomerate discount is even more pronounced relative to assets. For example, Apple’s share price is more than five times its book value, yet more than two-thirds of its assets consist of cash and safe securities such as Treasuries and corporate bonds, which are unlikely to produce dramatic returns. Samsung trades on almost two times its book value, yet half of its book is made up of inventory and property – including factories and equipment – which should generate fresh revenues.

All of which does not make Samsung necessarily undervalued relative to Apple. What also matters is how well Samsung manages these sprawling operations.

Look at all my capex

If there is a high-tech acronym, the likelihood is that Samsung dominates it. In addition to its top spot as a smartphone seller, it is also number one in D-Ram (memory chips for PCs) and in LCD (liquid crystal display) TVs, and is joint leader in NAND flash memory (for mobiles and tablets). Samsung has come a long way from middle-of-the-range mobiles, for sure. But this sort of leadership costs serious money to maintain – before even factoring in the ever-shorter product cycles and the need to be consistently developing the next big thing.

Samsung labours hard at this. About a quarter of its 220,000 employees work in research and development, and it has been the second-biggest filer of tech patents in the US, behind IBM, for each of the past six years (take note, Apple).

In addition to R&D spending, each year Samsung announces a capital expenditure budget so large it appears partly designed to terrify rivals into throwing in the towel. This year it has already spent $12bn and is only just over halfway through its planned budget. Capex has accounted for about 11 per cent of sales per year for the past five, only trailing Intel’s spending by 3 percentage points. Tellingly, Sony – whose capex has been declining over a decade of persistent restructuring – uses just 5 per cent of sales on capex. If one considers Samsung to be the industry benchmark for Asian tech conglomerates, then Sony’s spending retrenchment bodes ill for its turnround promises.

Still, it is not just what you spend, it is the way you spend it. And compared with peers, Samsung seems to work its resources hard, generating about $1.40 of revenues for every dollar of assets. Intel, for example, makes 70 cents for every $1 of assets. Apple is in a class of its own with about $4 per dollar spent, although it is worth noting that until 2004, it generated only about $1.30. Sony, meanwhile, perhaps the most fitting comparison, managed just 80 cents of revenues per dollar of asset dollar back in its late 1980s glory days, even as sales were growing by an average 25 per cent each year.

All of which suggests Samsung has not allowed recent success to go to its head and stopped spending on future growth. This is just as well because although the company is feeding its top line, the returns it makes from those revenues is woeful. For example, profit margins are about half the level of the biggest US tech giants, including Apple, its nemesis, and returns on equity are at the same depressed levels as its Asian rivals.

From courtship to court

Unfortunately, whether Samsung will be given a chance to catch up with Apple here (if it even wants to) may be decided in court. Apple taking on Samsung is not just fascinating because the world’s two biggest tech companies are facing off in public, but because the outcome could lead to one of the messiest business divorces. This is because the two, as well as competing, depend heavily on each other.

Samsung estimates that it provides about a quarter of all the components inside the iPhone and the iPad, including the much talked-about retina display and the processor and memory chips. Apple is also Samsung’s single biggest customer. Neither can walk away from this relationship quickly, however nasty the court battle gets – and this is only the latest of many.

For investors, the case may also help answer whether Samsung is simply a clever copier or a genuinely innovative firm. History suggests the former; its name means three stars, which is widely seen as a challenge to Mitsubishi’s three diamonds logo. Certainly, Samsung’s earliest years were spent in the shadow of Japan’s electronic giants, such as Sony, Panasonic and Sharp.

The truth is probably somewhere between Samsung being an Apple and a copier. It is an early adopter – but rarely a first-mover – and a fast innovator.

Samsung will not change the game like Apple, but it will be the company that rapidly deploys its resources and execution ability to produce the iterative innovations now driving new phone models, such as large, sharper screens and more powerful chips.

Love Lee?

But any company wanting to be the biggest, fastest follower requires its management to make consistently brilliant bets on the next big thing. In Samsung’s case, this means investors have to trust that the Lee family will make the right calls.

Granted, Mr Lee has an impressive record from his quarter-century at the helm. Company lore says he personally made the critical decisions on which particular semiconductors would become indispensable.

So far, investors have been rewarded for their trust. Over the past five years, the Samsung stock has returned 125 per cent. While that pales next to Apple’s 360 per cent, it is great versus the flat performance of the Kospi or the S&P 500.

Mr Lee is now 70, however. His son and heir apparent, Jay Lee is currently chief operating officer. Can he spot the next big thing as his father has? Who knows? The group has pledged $21bn of investment by 2020 in five promising areas: solar cells, rechargeable batteries for hybrid cars, LED technology, biopharmaceuticals and medical equipment. Each involves Samsung Electronics, or a unit it is heavily invested in. That gives another five businesses investors must get to grips with – assuming they work out.

Still, having the nerve to try new areas shows that Samsung is not relying on blockbuster smartphones to carry the company forward. The Lees are also clearly signalling there will be no change in the group’s essential model. They identify a potentially game-changing industry then produce innovations, rather than taking the risk of trying to change the game itself.

That makes Samsung one of the world’s best at what it does but not a world leader, like Google or Apple. Investors understand the difference and Samsung is priced accordingly.

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