LG – Safety in low numbers

LG trades margin upside for safety.

• LG has struck a patent deal with Google which looks to be almost exactly the same as the deal struck with Samsung on 27^th January 2014.
• I continue to believe that this deal was a huge strategic blunder for Samsung (see here) but in LG’s case there is little to lose.
• Although the headlines of this deal are all about patent cross licensing, the substance of the agreement is all about the ecosystem.
• In Samsung’s case it agreed not to compete with Google ecosystem on its devices and has since ceased all attempts at developing its own ecosystem.
• Samsung at the time has 30% smartphone share and 18% EBIT margins and its only hope of preserving this profitability was to develop its own ecosystem.
• If successful, this would have allowed it to differentiate its fast commoditising products, keep pricing high and thereby earn a high margin.
• Unfortunately, strife inside Samsung and a lack of understanding of software kept Samsung from understanding this reality, and it believed that it had nothing to lose by ditching its own ecosystem.
• The last two quarters have shown how fragile Samsung’s business is without something to differentiate it from the competition.
• In LG’s case, this is much less of an issue as it only has 5% smartphone market share and 3.9% EBIT margins.
• Over the last 10 years, LG has really struggled with handset software and has never come close to embracing the idea of an ecosystem.
• Consequently, ceding this possibility to Google represents no real loss although it severely limits LG’s margin upside.
• It will now be forced to compete on hardware specification and price only, meaning that its margins are unlikely to rise above current levels unless it materially increases its share.
• To make a decent return on smartphones, LG will need to more than double share from where it is today and in that instance profitability would start to benefit from increasing scale.
• However, for the last 10 years, LG has been unable to get past where it is today, and I see nothing to change that outlook.
• Signing with Google gives LG the safety in being a preferred partner of Google’s but it also ensures that the real return from its handsets will earned in Mountain View.