This Gadget Maker Is Diversifying

Sarfaraz is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Earlier in June, the South Korean consumer electronics behemoth Samsung Electronics (NASDAQOTH: SSNLF) shed $12 billion in market cap after several analyst downgrades due to fears regarding the slowdown in sales of its Galaxy S4 smartphone.

Unlike Apple, Samsung manufactures a large variety of phones, of which the low-end ones have been doing great around the world, effectively fending off competition from the Chinese rivals, but the growth of its higher margin high end smartphone -- the Galaxy S series -- has been waning. The brisk growth of the lower margin operation could eventually drag Samsung’s profitability lower.

The fears were confirmed in its second quarter results which came in below estimates (that led to even more downgrades), but the company is now eyeing growth in the lucrative storage devices industry that is expected to grow rapidly in the coming years.

Smartphone Woes

Last year, Samsung became the world’s biggest smartphone maker, ahead of Apple (NASDAQ: AAPL), thanks to the phenomenal success of its Galaxy S series. However, investors now fear that like Apple, Samsung will now also find it difficult to maintain its margins.

Meanwhile, the much awaited results of Apple are due on July 23. The company has been facing margin pressure from higher sales of lower-margin tablets and lower sales of higher-margin iPhones. Like the Galaxy S4, there have been fears regarding weakening demand of the iPhone 5.

Although, I am not too optimistic from this week’s earnings announcement but Verizon’s 3.9 million activated iPhones, which shows a 44% year-over-year increase, coupled with better performance from the App Store could translate into an earnings beat (although the key to a significant upside lies in a new product launch). Add Friday’s 1.6% drop to the equation and you have a tech giant trading at a discount at $425.

Samsung has a history of beating analysts’ estimates, but for the quarter ended in June its operating income came in at $8.3 billion, below the market’s expectations of $8.9 billion. The company also missed the sales estimates while smartphone shipments were 2 million below the consensus. JPMorgan Chase and Morgan Stanley have now lowered their Samsung's annual shipment estimates by 20 million and 10 million respectively. 

Samsung serves customers belonging to all income groups by selling an array of products at different price levels and therefore markets were expecting Samsung to deliver results in line with estimates. 

The memory “drive”

Besides smartphones, Samsung is also the global leader when it comes to NAND flash memory chips used in phones and solid-state drives, or SSDs. An SSD is a memory storage device that is far more efficient and durable than a conventional hard disk commonly found in a PC. The company has recently unveiled some new SSDs, according to its official press release, “to expedite transition to SSDs.” 

With the saturation coming in the smartphone market, the SSD market is expected to grow at a much faster pace than smartphone NAND chips. This year, the SSD demand will grow by an impressive 75% while the demand for smartphone NAND chips will grow by just 41% -- coming down from 58% two years ago.

However, the biggest challenge here is to convince clients to switch to SSDs, which is six times more expensive than a traditional hard disk drive manufactured by Western Digital. However, I believe that with the slowdown in prices and the emergence of hybrid devices, SSDs, which are mainly used in high end laptops, will eventually dominate this market. This is also reflected in the booming growth of the SSD market, which, according to data provided by the research firm IHS, will become a $22.6 billion industry in the next four years from less than $7 billion last year. The adoption rate of SSDs used in laptops, in particular, will grow steadily from around 10% this year to more than 30% in the next couple of years.

However, unlike NAND, where Samsung competed with Toshiba, Micron Technology and SK Hynix, in SSD, Samsung’s rivals will be industry titans such as Intel and Sandisk (NASDAQ: SNDK).

Sandisk released its quarterly results on Wednesday, in which it met the revenue and beat the earnings estimate by a big margin. The company has been operating under a positive supply/demand balance which has translated into a 47% increase in its stock this year. Although it is trading near its 52-wek high but I am bullish on this stock and it could go much higher. Its current PEG ratio, based on estimated data for the next five years, is 0.47, which indicates that the stock is still undervalued and a bargain.

Conclusion

Despite missing estimates, Samsung is still making record profits and is still growing. I believe that with new product arrivals and strong prices of memory chips, the company could very well continue to post record levels of profit, therefore the outlook is stable. The company is not just about smartphones but has a diversified business .

However, Samsung is certainly not growing as quickly as investors would have liked. Then there is some uncertainty surrounding some of the new products, such as the wearable gadget Samsung Gear and the open-source operating system Tizen-based device. Nobody knows how they are going to perform, but I believe that they would, at best, compliment the current earnings. 

SSDs on the other hand is far more reliable. Investments here will allow Samsung to tap into a market that will show robust growth in the coming years. This could also allay the investors’ fears coming from the weakness in its logic chip business.

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Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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