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Weak demand led to shortfall in orders from Samsung's semiconductor division which Apple relies upon

A rather gloomy weak earnings outlook has been issued by South Korea's Samsung Electronics Comp., Ltd. (KRX:005930) (KRX:005935).  But the news from Samsung hints at a potentially troubling calendar Q2 2014 for other premium smartphone makers -- such as Apple, Inc. (AAPL) -- as well.
 
I. Warning -- Slow Lane Ahead
 
In its cautionary earnings guidance, Samsung Electronics cited the strong value of South Korea's currency, the Won, as one key factor.  But it also pointed to a broader slowdown in Q2 in the global electronics market.
 
Samsung -- like Apple -- has been struggling to balance the equation of growth in tablet demand versus the less favorable upgrade cycle of the device.  Both Apple (#1 in tablets) and Samsung (#2) have discovered that consumers are buying tablets less frequently than smartphones.  Samsung's guidance said that tablet sales "declined more than the expected level" thanks to the sluggish pace of upgrades.
 
The OEM also saw some troubles on the smartphone front.  Samsung is currently the world's top smartphone manufacturer, well ahead of second place Apple.  Samsung's flagship Galaxy S5 smartphone has been one positive spot in a generally troubled earnings outlook; it has been selling relatively well.  However, sales on the budget side have been weak for a variety of reasons.

Samsung Galaxy S5
The Samsung Galaxy S5
 
One factor has been stronger-than-expected competition from Microsoft Corp.'s (MSFT) Nokia Devices (which recorded 10 million preorders for the Nokia X alone) and domestic OEMs in India/China.  Another factor has been weak demand in Europe, where Samsung commands a dominant 40 percent share of the smartphone market.  In China -- another top market -- others factors came into play as sales of 3G handsets dipped as citizens awaited the activation of new LTE networks in China in H2 2014.   Q2 is also traditionally seasonally weak in China.
 
Samsung says it committed to inventory reduction efforts to prevent a buildup of devices on low demand, but that these efforts hurt its profitability.  It writes:

Therefore, the second quarter earnings were negatively affected by substantial increase of marketing expenses from the previous quarter due to strong sell-out promotion to reduce channel inventories in addition to marketing promotions for new smartphone and tablet launch.

World Cup
Samsung is a major advertiser at the World Cup in Brazil. [Image Source: Jason Mick/DailyTech LLC]

Among its big marketing expenses in Q2 2014 was a major World Cup advertising campaign.
 
II. What's Bad for the Goose is Bad for the Gander: What Outlook Says About Apple
 
For those Apple fans that might grin at Samsung's misfortune, the outlook carries troubling signs for its competitor as well.  Samsung writes:

The weak demand for smartphones also affected the System LSI and the display businesses that provide key components, which led to decrease in shipments and lower than expected profitability.

Apple has long been Samsung's largest semiconductor business client.  While it has tried to move away from Samsung's DRAM and NAND amid the pair's legal spat, Apple continues to largely source its processors to Samsung.  Estimates from 2012 value the pair's mutual business at $8-12B USD.  Estimates of the payments for system-on-a-chip (SoC) processors vary greatly.  A research note by Hong Kong, China-based Sanford Bernstein analyst Mark Newman claimed $5B USD in total SoC business, while IC Insights suggested just under $3B USD in mutual SoC business.
Apple A7
The Apple A7 -- the brains of the iPhone 5S -- is produced by Samsung Electronics. [Image Source: iFixit]

More recent estimates indicate that roughly 80 percent of the SoCs Samsung manufacturers go to Apple, which pays between $10 and $15 USD per chip.  And SoC business is on the rise, according to some.  Despite Apple's hopes of sourcing production to rival foundry Taiwan Semiconductor Manufacturing Comp., Ltd. (TPE:2330) (TSMC), Samsung remains Apple's most cost-effective solution for SoC production.  IC Insights estimates that shipments grew from $2.962B USD in 2012 to $3.413B USD in 2013.
 
Profit-wise that relationship may actually be hurting Samsung; a report from Mar. 2014 suggested that Samsung's Austin, Texas plant -- dedicated heavily to producing SoCs for Apple devices -- was a money loser according to regulatory filings.  While Apple pays a lot for chips, it is reported that Samsung may be spending even more in capital investments (including research and development) to try to maintain those contracts, leading to a net loss.
 
In some ways Apple has actually grown more reliant on Samsung.  Samsung now supplies an estimated 60 percent of 9.7 inch so-called "Retina Displays" (2048x1536 pixels), shipping 5.2 million units in Q1 2014 according to DisplaySearch (via ZDNet Korea [translated]).  As that display size is virtually exclusive to the iPad, this would indicate Samsung is Apple's top supplier for the display found in recent iPad models.
iPad Air
Roughly 3 out of every 5 large Retina Displays (9.7-inch) -- like the one in the iPad Air -- came from Samsung in Q1 2014.

Samsung's chief rival in this class is another South Korean firm -- LG Display Comp., Ltd. (KRX:034220).  But LG Display has recently been struggling to keep up with the bargain that Samsung Electronics is able to offer.  In Q1 Samsung earned an estimated $385M USD from selling Retina Displays to Apple.  Together, Apple's SoC and display orders -- along with smaller orders for NAND and DRAM -- could be worth an estimated $1.5-2.5B USD per quarter for Samsung.
 
In Q2 2013 the semiconductor unit accounted for 8.68T Won (~$8.6B USD) of Samsung Electronics' total revenue, while the display unit accounted for 8.18T Won (~$8.1B USD).  Excluding the 5.7T Won ($5.6B USD) in memory revenue, Apple orders may have accounted for up to a quarter of Samsung's total Display panel, SoC, and IC orders.
 
That strong link means that Samsung's warning of a "decrease in shipments" in the "System LSI and the display businesses" hints at iPad sales sliding further after dipping 16 percent on a year-to-year basis in calendar Q1 2014 (Apple's fiscal Q2 2014).  It could also hint that iPhone growth -- 17 percent from Q1 2013 to Q1 2014 -- could have stalled or even followed the iPad in its reversal.
 
Also bad news for the iPad is Samsung's note that the market shifted away from tablets, towards large smartphones (which Apple doesn't have -- yet).  Samsung wrote:

The demand for 5-to-6 inch smartphones also cannibalized the demand for 7-to-8 inch tablets.

Nothing is certain, but either way, the nature of Samsung's guidance warning seems to clearly indicate a warning to not have overly high expectations for Apple's earnings either.
 
III. Rebound Looming in Q3?
 
Samsung predicts it will see a profit of 7.2T Won ($7.1B USD) on sales of approximately 52.1T Won ($50B USD).  For comparison, in Q1 2013 Samsung earned 8.4T Won ($8.1B USD) on sales of 53T Won ($51B USD).  In Q2 2014, Samsung earned 9.5T Won ($9.3B USD) on sales of 57.5T Won ($54B USD).  Together the past earnings and the current guidance suggest that Samsung's revenue declines are stabilizing, but its decline in profitability is continuing to undo the two years of continuous profit growth Samsung had enjoyed up until the Q4 2013 downturn.
 
One piece of good news is that Samsung says it's "cautiously optimistic" that its situation will improve on a number of fronts in Q3 2014.  It writes:

The Company expects additional appreciation of won to be limited compare to the second quarter.  For the IM business, Samsung expects marginal marketing expenses related to inventory reduction in the upcoming quarter, while the Company cautiously expects a more positive outlook in the third quarter led by increased shipments of the coming release of its new smartphone lineup.

Samsung GS5 LTE-A
The Samsung Galaxy S5 LTE-A will be crucial to revitalizing sales in Q3. [Image Source: Samsung]

In Q3 2013 sales of the Galaxy S5 LTE-A -- a refreshed version of Samsung's flagship device -- will begin.  Sporting a Snapdragon 805 processor (with 3GB RAM) from Qualcomm Inc. (QCOM), 3 GB of DRAM, and a fancy new 2560x1440 pixel QHD (Quad HD) display, the refreshed GS5 variant has the hardware power to keep up with LG Electronics Inc.'s (KRX:066570)(KRX:066575) flagship device, the LG G3, and Apple's upcoming eighth generation iPhone 6.  A Google Inc. (GOOG) Play Edition GS5 (or GS5 LTE-A) is also rumored to be forthcoming.

Galaxy W
The Galaxy W launched in June in Asia. [Image Source: Samsung]

A fourth generation Galaxy Note with a 5.7-inch QHD display is expected in September.  The massive 7-inch Galaxy W (not to be confused with the GSII "Galaxy Wonder" variant) launched last month in Asia, and may come to the U.S. sometime in H2 2014.  Despite its massive size, its hardware spec is relatively underwhelming with a 720p display, 1.2 GHz quad-core processor, and 1.5 GB of DRAM.

Samsung also just launched new 8.4" and 10.5" Galaxy Tab S tablets, which should revitalize its slumping tablet sales.

The 10.5-inch Galaxy Tab S

In terms of its ongoing legal dispute, Samsung appears in relatively good shape. The company fought Apple to what basically amounts to a draw, with a jury in May finding mutual guilt and ordering both OEMs to pay each other damages over various "stolen" technologies.  The verdict was still narrowly in Apple's favor with Samsung's infringement being deemed "willful" and Apple's infringement "accidental" (hence the difference in damages, in part).  However, Apple is now under much greater pressure to settle with its rival to save face and avoid the appearance that it's "stealing" technology.

Sources: Samsung [1], [2], [on NewsWire.kr]





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