Note: This article was published prior to Samsung's reported 24% drop in operating income, a two-year low.
A year ago to the day, Apple (NASDAQ:AAPL) investors were in a panic. The stock closed June of last year trading below $400 per share; this after cresting past $700 on the day of the iPhone 5's release just nine months earlier. Apple was still very much the most dominant company in tech, but doubts around the company ruled the day.
Where would Apple's future growth come from? Had the company peaked? Had it lost its magic?
In the previous quarter -- ending March 2013 --- Apple's earnings dropped 18% from the previous year. Just a year earlier, it had shown 94% growth. It seemed Apple was finding the limits on its ability to grow.
Today, the story looks much brighter for Apple. The company's stock recently split, but sits just 2.3% below its all-time highest closing price. Instead, a different company faces the same questions Apple faced a year ago.
Apple's rival Samsung (NASDAQOTH:SSNLF) is starting to show signs of its own struggles, and investors are betting Samsung's fall has begun. In spite of being the second most-profitable smartphone company in the world -- a technology set to rule for years to come -- investors have made Samsung perhaps the cheapest company in the entire market.
Samsung -- a stunningly dominant company
While the smartphone wars are most commonly framed as Google (NASDAQ:GOOG)(NASDAQ:GOOGL) vs. Apple, when it comes to which company has profited from the growth of smartphones, there's no question the top two companies are Apple and Samsung. More than being just the two most-profitable smartphone companies, their success has pushed them to the top of the world's most-profitable companies of any kind.
The list of most-profitable companies in the world is an eclectic mix. In total, nine companies booked profits of more than $25 billion in the past year. You have Vodafone, which recorded its sale of Verizon Wireless as a one-time profit last year. Then you have four Chinese banks that are essentially government-controlled, and a Russian energy company with ties to Vladimir Putin. The three remaining companies on the list are are Exxon, Apple, and Samsung.
The big three at a glance
Net Income [LTM]
The dominance of Apple and Samsung has been made possible by the rapid ascent of smartphones. A visual comparison between the growth of PCs after the mid-90s Internet boom and smartphones after the iPhone launch is startling.
And, almost all the profits from this growth went to two companies: Apple and Samsung. Canaccord Genuity estimated that, in the third quarter of last year, Apple and Samsung captured 109% of all mobile industry profits.
That's not a typo.
Pretty much every other company -- including Blackberry, HTC, Nokia, and Motorola -- lost money on their mobile divisions that quarter. So, that meant Samsung and Apple's share of profits went higher than 100%. Apple captured 56% of mobile profit, while Samsung captured 53%. The remaining competitors lost 10% of mobile value thanks to negative profit margins.
Even relative to Google -- the company that created Android -- Samsung has done astonishingly well. During the past two years, Samsung has collected 117% more profits than Google. In both years, its rate of earnings growth was markedly higher than Google, as well.
Remarkably, in spite of all its success, there is a pretty strong case to be made that Samsung is the absolute cheapest stock in the market.
Yes, it's that cheap
Currently, the S&P 500 trades at about 19 times its trailing earnings; in the case of Samsung, that number is just 6.5. To stack Samsung up against a few peers: Apple's P/E is 15.5, Microsoft is at 15.8, and Google is at 32.5.
It's hard to find any stock valued near the same level as Samsung. Most of the companies at similar P/E levels are state-owned Russian and Chinese companies. No other major tech company is close.
What's even more astonishing is that Samsung has a very impressive balance sheet. It currently maintains a net cash position of slightly below $60 billion, meaning that, ex-cash, it trades for 4.2 times earnings.
When Apple bottomed out in April of 2013, it was astonishingly cheap. Its market capitalization went as low as $360 billion, leaving it at a P/E of nine. Ex-cash, that number was 5.4 times earnings.
Apple turned out to be a stunning deal at those levels; its shares have jumped 74% since their April 2013 lows. Could Samsung be a similar bargain from today's levels?
Samsung against Apple: 2010 to 2013
Samsung is reaching the same point Apple faced in 2013: it's hitting the smartphone growth wall. Smartphone growth has been nothing short of remarkable in recent years. Yet, while the years of 2010 and 2011 were ones of growth across all countries and smartphone price points, today's smartphone landscape has become much more nuanced.
Let's look at a chart that stacks up the quarterly profit growth rates of Samsung versus Apple. As you can see, across 2010 and 2011, Apple rode the expansion of iPhone sales to huge profit growth rates. In that same phase, Samsung saw declining profitability as it rebuilt itself from a company that was a distant No. 2 in mobile phones behind Nokia to one that aspired to be the world's leading smartphone company.
Quarterly profit growth rates of Samsung and Apple (versus prior year)
As Apple got bigger, not only did its size catch up with it, but there were fewer first-time smartphone buyers to sell to. Profit growth went from 94% versus the prior year in March 2012 down to 21% the next quarter. That's still a very respectable growth rate for a company Apple's size. Yet, by the December quarter of 2012, all the growth was gone. The company grew earnings 0.1%, and then spent the next three quarters with negative growth.
The smartphone wall: Apple edition
Apple had hit its own wall. While smartphone shipments grew an incredible 39% in 2013, those sales were increasingly to cheaper segments of the market. That's a segment in which Apple is relatively uncompetitive. Apple kept the iPhone growing in 2013, with 16% more phones sold; but that growth increasingly lagged the total market. Declining margins on its phones more than counteracted the increasing total number of phones, and resulted in declining profits.
The culprit for Apple's tough year? Growth in Apple's strongest markets like America, Europe, Japan, and China slowed. North American smartphone growth will be in the single digits this year. Not only that, but people aren't upgrading their phones as quickly. According to researcher BTIG, the annual phone upgrade rate went from about 35% in 2011 to less than 30% in 2013 at AT&T and Verizon. China, a land of seemingly limitless opportunity for Apple, saw sales growth fall from 83% in fiscal 2012 to 14% in 2013.
This is a unique situation. Again, look back at that smartphone versus PC comparison. There was no "wall" for PC growth for 30 years. Between 1980 and 2010, the PC's growth hit some potholes along the way; but its march was relatively consistent.
The wall is unique. It's what made Apple and Samsung among the 10 most-profitable companies in the world in such short time. Yet, having such amazing growth packed into a few years also means that growth can rapidly stop just years into wide-scale smartphone adoption.
The most difficult part of the wall is that it's incredibly difficult to see. With smartphones, you just see the chart of exponential growth, up and to the right of the chart at a furious pace, it looks like a market with limitless potential. Apple investors knew the company's growth was slowing; it simply couldn't continue. Yet, the speed at which Apple decelerated was surprising.
So, it caused investors to overreact, which is what we saw across early 2013. The reality of Apple's situation is that most of the company's growth from today's levels will come from taking market share in slow-growing smartphone markets like Europe, the U.S, and Japan. It'll come from new products, and it'll come from areas like sales on the App Store continuing to grow.
Samsung hits its own wall
Look back at that chart comparing Apple and Samsung, and you can see that Samsung's past four quarters almost perfectly mirror Apple as it hit the limits of its growth. While Apple struggled in late 2012 and 2013 as smartphone growth moved to markets buying cheaper phones, Samsung excelled.
Let's look at India as one example. In the third quarter of 2013, smartphone shipments to the country increased 229% over the prior year according to researcher IDC. The market went from a quarterly total of 3.8 million smartphones to 12.8 million. Samsung controls 32.9% of the Indian smartphone market, nearly double the second-place vendor; so as this market soared, Samsung was able to maintain really strong profit growth.
However, the company now faces a few key problems. First off, while smartphones grew 39% in 2013, that figure is falling to a forecasted 19% in 2014. Second, that growth continues moving to cheaper and cheaper phones. While Samsung -- unlike Apple -- has product lines to address $200 or $250 smartphones, as growth moves into consumers buying $100 smartphones, the company becomes more uncompetitive.
Third, local companies in markets like China and India are beginning to capture more market share. In China, Xiaomi sold 26 million smartphones in the first half of the year, up 271% from 2013. While Xiaomi's phones are relatively inexpensive, they're not cheap. And while Xiaomi is often called "The Apple of China," its phones pose the most direct threat to Samsung.
Likewise, at Google's I/O conference that was held last week, the company unveiled a specific program known as Android One that aims to bring sub-$100 phones to consumers. Companies that Google named as initial launch partners -- Micromax, Karbonn, and Spice -- all happen to be low-priced Indian smartphone companies that have been nipping at Samsung's market share in the country.
Finally, while the growth rate of high-end phones began hurting Apple in late 2012, that trend also hurts Samsung. The company's Galaxy line-up came to dominate the market for expensive Android phones. With Apple set to release possibly two larger iPhones this fall -- reportedly a 4.7" and 5.5" model -- it'll push even further into the "phablet" space that Samsung has been so dominant in.
More competition, smartphone growth moving to lower price points, and overall slowing smartphone growth are all combining to plummet Samsung's profits at an even more rapid pace than Apple saw during 2013.
Just how bad will it get?
Last week, Samsung's CFO said its second-quarter earnings were "not that good." IBK Securities estimated its phone sales slipped to 78 million in the second quarter, from 87.5 million the quarter prior. Estimates for the company's second quarter continue falling; the company will likely see operating profit down 15% from the prior year.
Apple took three quarters to shake off its funk and stem its profit declines. At what point could Samsung stabilize its year-over-year declining profits?
The difference between Apple and Samsung is that Apple controls its own smartphone platform. At its World Wide Developers conference this year, it unveiled new programs built around wearables, health, and smart homes. Apple can better control its vision for the future if it finds itself falling behind.
In Samsung's case, while it has profited more from Android than Google has, it's also reliant on the company. A recent Bloomberg article showed how Samsung's own attempts to differentiate its Android tablets by creating a new interface, called Magazine UX, was squashed by Google, as the company thought Samsung was pushing Google's services to the background.
In wearables, Google purposefully built its new operating system Android Wear in a way that smartphone vendors like Samsung would have less control to differentiate the user interface on their watches.
While Google realizes Android's fate is intertwined with Samsung, that doesn't stop it from pursuing its own self interests. Programs such as Android One will drive adoption of Android across the world; but they also commoditize smartphone makers like Samsung that sell phones for a premium.
The best hope for Samsung is a company it ruthlessly helped destroy -- Nokia. Despite producing phones that used the same clunky carrier-based interfaces as other phones, Nokia dominated the mobile industry for a long stretch. In 2007, the company booked $10.5 billion in earnings; its $74 billion in sales were a 37% jump from the prior year.
We all know Nokia soon fell, but it fell because a new paradigm entered technology: Smartphones began replacing the "dumb phones" that Nokia had found success in. Prior to the emergence of smartphones, Nokia had dominated a very competitive mobile industry for more than a decade.
The hope for Samsung is that it can repeat Nokia's success. It can dominate smartphones through sheer scale. Samsung spends about $12 billion per year on marketing on top of $13.5 billion in research and development. The company makes the chips that go into its phones. Also, it has $75 billion in cash.
Samsung can outspend its competitors. Innovate where needed. It can outlast competitors in court. It can pay carriers to promote its phones, and spend many more multiples on advertising. Also, it can build its own phones cheaper by buying its own chips.
Plenty of factors seem stacked in Samsung's favor.
Samsung: Do you get its smartphones business for free?
If Samsung can stem its losses in smartphones, it could very well end up a remarkable value. Beyond smartphones, the company also has a business that makes chips and displays for phones and other consumer electronics. Last year, that business made about $9.3 billion in operating profit.
Its biggest competitor in the chip space is a company named Taiwan Semiconductor. That company made $7 billion in operating profit last year. Taiwan Semiconductor is worth $115 billion, and has roughly equal levels of cash and debt.
Because Samsung is worth $110 billion after its net cash, the argument is that by buying Samsung today, you're essentially buying its chip and foundry business and getting its smartphone operations for free. That's a pretty nice deal, as its smartphone business recorded more than $23 billion in operating profit last year.
It's like a value investor's dream.
Of course, many logical investing ideas have crashed on the rocks of "getting things for free." There's a very likely chance Samsung is at "peak earnings" -- that its smartphone business will never see the profitability heights reached in 2013. If Samsung sees profits continue to fall, it could easily trade closer to 10 times trailing earnings by the end of the year. That would put the company relatively equal to the Korean KOSPI index, which trades close to 10 times earnings itself. Samsung's failing fortunes in smartphones could hurt its own chip business, which builds many of the chips for its smartphones and other consumer electronic offerings. Also, Samsung is only lightly traded in the over-the-counter (OTC) markets in the United States. To buy shares in the company, you'd need a broker that trades on the Korean Stock exchange.
Finally, the ownership structure of the larger Samsung group, where Lee Kun Hee stands as chairman, is a hurdle. He has been loathe to return cash back to shareholders. The company returned just $1.2 billion in dividends back to shareholders last year.
Yet, even without investing directly in Samsung, its story helps tell a fascinating story of the mobile phone market. Apple investors who felt the company was unfairly oversold last year are now seeing the same story played out in its greatest rival.
No tech industry has ever grown as fast as smartphones. As we passed the initial growth phase of the market, both of the leaders -- Samsung and Apple -- were sold at astonishingly low levels relative to their earnings. Apple bounced back, in part because investors feel the iPhone 6 can help the company regain share of high-end phones.
However, it's also bouncing back because the company can control its own vision of future consumer technology markets like wearables and smart homes. With Samsung having to rely on Google, and Google pushing an agenda where Samsung can differentiate itself less in these markets, the next phase of the mobile revolution seems to be in Apple's favor.