After dominating the mobile market with smartphones and tablets, Samsung Electronics (OTC:SSNLF) is looking to lead the mobile foray into wearable devices. Barely six months into the launch of its first smartwatch, the Galaxy Gear, Samsung is out with its second generation of wearables – the Gear 2, the Gear Neo and the Gear Fit. Designed and targeted for different market segments, the three smartwatches are Samsung’s way of testing out a nascent market with a strategy that has worked well for the company so far in smartphones. The Gear 2 and Neo are clear successors to the Galaxy Gear, with the former likely to be marketed as the more premium offering for high-end users. On the other hand, the Gear Fit has a narrow focus on fitness, and targets the niche market of health-conscious consumers. More importantly, Samsung is branching out into a new territory by dropping Android in favor of its open-source Tizen platform and a more power efficient custom-built RTOS for the new devices.
The market flooding strategy might work for Samsung but the watches, in their current form, are compatible with only a select few Galaxy smartphones (and in the case of Fit, a few tablets as well) which limits their appeal. Priced at an expensive $299, the Gear 2 is not built for the mass-market and seems to be just an experiment by Samsung to see if it can increase the appeal of its Galaxy smartphone brand in a high-end market that is nearing saturation. The Neo and the Fit are priced at a more palatable $199, but the fact that the entire Gear refresh is not based on Android, and will therefore have limited app availability in the near future, could make them a hard sell. However, given that the smartwatch industry is still in its infancy, Samsung can afford to experiment with its products as it looks to create a new mobile OS ecosystem of its own by leveraging the existing popularity of its mobile devices.
A $5 Billion Market Opportunity
Assuming that Samsung restricts the Gear’s compatibility to its own smartphones, it would be apt to size the market opportunity in terms of its smartphone sales mix. We estimate that Samsung sold around 445 million mobile phones in 2013 at an ASP of over $250. If we divide the phones that Samsung sells into two categories – the high-end ones with an average ASP of $600 and the low-end ones an with average ASP of $150 – we see that the sales mix of the former has to be close to 23% for our overall ASP assumption to hold. This means that Samsung is likely to have sold a total of about 100 million high-end smartphones and the rest at the low- and mid-ends last year. The Galaxy S3 launched in 2012 sold as many as 50 million units in a year, and the S4 breached the 40 million mark about six months into launch last year. Even if the S4 did not sell as well in the back half of the year, sales of other high-end smartphones such as the Galaxy Note should have helped it easily reach our estimate.
In order to gauge Samsung’s smartwatch potential, we assume that about 20% of Samsung’s high-end customers and almost none of the low-end ones buy the Gear smartwatches, considering the high starting price. This brings the Gear’s market opportunity to only about 20 million unit sales, assuming that Samsung quickly makes the smartwatches compatible with the rest of its smartphone portfolio. At an average selling price of $249, the Gear family could net Samsung additional revenues of almost $5 billion annually. Considering that the global watch industry is expected to generate around $60 billion in revenues this year, Samsung could capture about 8-10% of this market if the above scenario materializes. Any upside or downside to our estimates would depend on whether or not Samsung decides to make the smartwatches compatible with rival Android smartphones to incentivize app development for smaller screens.
Limited Impact To Valuation
Going forward, if Samsung is able to lure 30% of its high-end customers into purchasing its smartwatches, there could be an upside of about $1-1.5 billion to our long-term EBITDA forecast. This translates into a value addition of only about $5 billion, or $35 per share (2.5% of our current price estimate). If the respective percentages were to increase to about 50% for the high-end, Samsung would see additional EBITDA of $2.5 billion in the long run which translates into a $7.5 billion value opportunity, or value addition of about $50 per share (4% of our current price estimate). The underlying assumption is that Samsung’s smartwatch ASPs decline to about $200 over time and that the company is able to generate a healthy EBITDA margin of about 20% – close to its current mobile EBITDA levels. Even competing watch manufacturers such as Movado and Fossil have similar EBITDA margins. Considering the amount of technology that has gone into the Gear smartwatches, they are unlikely to have gross margins higher than the 50-60% that watchmakers generally command.
While the value-addition due to the smartwatch alone doesn’t seem to be much for a $200 billion company, Samsung will intangibly benefit from having a broader hardware ecosystem with multiple mobile product categories doing well in the market. This halo effect could further drive the adoption of Samsung’s other more valuable mobile devices such as smartphones, and prove to be even more value-accretive to shareholders. Also, the fact that the smartwatches do not run on Android points to Samsung’s ambitions of creating a new software ecosystem to rival Android and iOS in the long run. This could mean that the new devices are more a strategic ploy to experiment with new products and operating systems, rather than one that will drive the company’s valuation directly.
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