Why Samsung Will Outperform Despite Shrinking Profits

In early January, Samsung Electronics (NASDAQOTH: SSNLF  )  reported its first profit decline in the past nine quarters. The company had announced record operating profit of $9.6 billion in the third quarter of 2013, officially becoming more profitable than Apple (NASDAQ: AAPL  )  in terms of net income. However, as it was reported on Jan. 7, Samsung's operating profit for the fourth quarter came in at $7.79 billion, down 18% from the previous quarter. The figure is also lower than the most bearish forecast among 23 analysts polled by Reuters.

Samsung's disappointing earnings caused a sell-off that has taken shares down by roughly 9% so far. However, considering this is one of the most innovative tech companies in the world, with direct exposure to not only the fierce smartphone arena, but also to the promising NAND memory industry, displays, cameras, and apps processors, patient investors could regard the recent sell-off as an attractive market entry point. Is Samsung really in trouble?

Samsung achieved record profit in the third quarter of 2013 | Source: Statista.

Explaining the poor quarter
The Korean giant's profitability was damaged by falling smartphone prices in China, the increasing popularity of Apple's latest iPhones, and an estimated $1 billion expenditure due to extraordinary bonuses to mark 20 years since Samsung chairman set the company on the way to become a global tech leader.

Notice that China is extremely important for Samsung's margins, as the company gets 20% of its total smartphone shipments from China. Sales of the company's flagship smartphone --the Galaxy S4-- slowed amid competition not only from the iPhone 5s and 5c, but also from Chinese makers, which are selling handsets for as low as $100. Moreover, both Huawei and Xiaomi released new budget smartphones at the end of 2013. Samsung is expected to face even fiercer competition in this region, because China Mobile -- the largest carrier in China -- will start offering subsidized iPhone plans at the end of January.

Like Apple, Samsung is all about innovation
Despite facing intense competition in the smartphone world, Samsung's strong economic moat should help the company to gradually improve its profitability.

Although the Korean giant has long been criticized for copying everything that Apple does -- it had to pay Apple over $1 billion in damages after losing a patent lawsuit that claimed Samsung knowingly copied hardware and software designs of the iPhone -- the reality is that Samsung will be at the forefront of technology for the near future. Devoting more than 5% of its total revenue to research, Samsung actually ranks second in research and development spending for 2013, and has exposure to every emerging tech segment, from wearable computing to NAND flash memories. 

Moreover, as a manufacturer of NAND memories, processors, and displays, Samsung does control every key aspect of the manufacturing process behind its smartphones and gadgets. It even built the A7 processor for Apple's iPhone 5s. This allows the Korean giant to operate under a highly efficient cost structure. On the other hand, Apple relies on Samsung for key parts used in its flagship product, and is more vulnerable to fluctuations in the price of components. 

Final Foolish takeaway
Samsung reported its weakest year of profit growth in its mobile phone business since it began in 2007. This was mainly caused by a price war among smartphone manufacturers in China, where competitor Xiaomi is selling smartphones competitive with Apple's iPhone 5C features, for less than $150.

However, in the long run, Samsung should see improvements in profitability. The company is still a formidable competitor to Apple in terms of innovation, enjoying one of the biggest research and development budgets in the world. Moreover, unlike Apple, Samsung manufactures most of the components used in its smartphones, and has direct exposure to several promising tech trends, from NAND memories to wearable computing.

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