Samsung Q2 – Sign of things to come.

If the smartphone market fragments it will hurt Samsung’s margins.

• Samsung reported weak results and as expected it was the handset business that was mostly to blame.
• Revenues / Net Income were KRW 57.5tn / KRW7.58tn compared to consensus of KRW58.6tn / KRW8.02tn.
• The biggest problem was the slowdown in the high end of the smartphone market where estimates for Galaxy S4 shipments have been falling for some time.
• This caused the mix to move towards lower priced models which resulted in weaker than expected sales.
• Mobile revenues / margins were KRW34.58tn / 18.2% compared to KRW31.77tn / 20.5% in Q1 2013.
• Samsung blamed the margin decline on increased costs from new product launches and on-going investments in R&D and distribution.
• The outlook is uncertain.
• The company expects to grow faster than the market but it is very clear that things have meaningfully slowed.
• This is not a problem as long as the market remains concentrated with a few models shipping most of the volume and generating most of the revenues.
• This is because Samsung’s R&D model runs along the lines of one development team per handset SKU.
• If the smartphone market fragments (as the voice phone market did in 2003-2006) then Samsung will need to increase the number of handsets it makes in order to meet demand.
• This will result in flat revenues but higher costs which will then put margins under sustained pressure.
• There are signs that this is beginning to happen and Samsung’s recent launch of 4 Galaxy S4 variants is a worrying sign of this trend.
• For the short-term, I am less concerned, as this will be a gradual trend, and so for the balance of this year I think Samsung will be able to hold onto 17-20% EBIT margins in handsets.
• However, if this trend takes hold, I can see Samsung’s margins in handsets decreasing to 10-12% which is where they were the last time the handset market fragmented leaving Samsung with rising costs relative to revenues.
• The stock is cheap but it is not going anywhere while concerns circulate. These have been exacerbated by Apple’s strong iPhone shipment numbers in Q2 2013.