Do You Believe Samsung's Mobile Phone Business Is Worth More Than Zero?

| About: Samsung Electronics (SSNLF)

Summary

Samsung has underperformed the S&P 500 by nearly 1000 basis points over the past year. Today, Samsung shares trade at just 7x earnings.

Samsung has an incredible track record of profitable growth over the past decades.

Samsung shares are priced as if its handset business is worth 0. There are good reasons to believe this is not the case.

When investors begin to believe that the handset business will continue to generate meaningful profits in the future, Samsung shares could rise 60%.

Samsung (OTC:SSNLF) shares have significantly underperformed the market over the past year, with a total return of -1% whereas the S&P 500 has returned nearly 10% after accounting for dividends (I use the S&P 500 instead of the Korean Index because Samsung is a truly global company earning 90% of its operating profit from markets other than Korea). The market is clearly concerned about the contraction that Samsung has seen in handset operating margins. At today's price, Samsung trades at just 7x 2014 EPS (and less than 6x after deducting the company's substantial net cash balance) which is a substantial discount to the S&P 500 which sells for almost 16x. Looked at another way, the market is essentially assigning zero value to a business which produced ~$21 billion in operating profit last year (shown below). Even with significant contraction in handset revenue and margins, Samsung has 60% upside. With 1/3 of its market cap in cash and three profitable other business segments, downside is limited.

Samsung is one of the greatest success stories I have ever witnessed. In the 1990s the company had virtually no market share in TVs and semiconductors (and absolutely no position in handsets or LCD panels) and today is the dominant player in all three of these industries. There have been several reasons for this success including:

  1. Samsung has been led by a far sighted management team/stable ownership (Lee family) which has led to continued investment across the cycle rather than focus on meeting or beating quarterly results
  2. Samsung has a history of innovation (more of a fast follower than a true innovator) and quickly moving into fast growing areas and creating competitive advantage
  3. Samsung has maintained a strong balance sheet which has facilitated investment across the cycle - Today Samsung's balance sheet may be a little too strong with about $60 billion in net cash and investments
  4. The company has a continuous focus on operational excellence to achieve cost leadership in its core businesses
  5. Samsung has a strong reputation in Korea which allows the company to attract the best and brightest graduates

This has led the company to grow revenue at a mid-teens CAGR (from a high base) while earning a 15-20% ROE (weighed down by cash & investments) and a consistent 16-22% return on capital employed. Despite this tremendous success, the company trades at a meaningful discount to the market which I attribute to three main factors:

  1. Concern about the handset business - people fear that Samsung may become the next Nokia and see its handset business squashed. Given that this accounted for over 60% of 2013 consolidated operating profit, it would have a hugely detrimental impact on the company's value per share. However, as I will explain below, while I expect that margins will contract, there are good reasons to believe that Samsung will not suffer the same fate as Nokia.
  2. To some extent Samsung suffers from the Korea discount. The Korean market has historically traded at a 30-60% discount to the US market. Some of the reasons for this are 1) high family ownership/lower transparency and (2) higher perceived cost of capital. While transparency is low for some companies in South Korea, Samsung's disclosure is comparable to US listed companies. Similarly, with 90% of operating profit coming from outside South Korea, I believe Samsung's discount rate should be comparable to any multinational.
  3. What will Samsung do with the cash? While Samsung has never squandered investor cash via large acquisitions, it seems investors are loathe to give the company credit for the cash until they see it returned to shareholders (anyone remember this with Apple (NASDAQ:AAPL) 12-18 months ago?). Over time, I expect to see a higher dividend and the resumption of buybacks (Samsung did buy back shares between 2001-2005).

Valuation

Samsung Normalized Earnings Estimate
Operating Profit by segment (In KrW trillion)
Semiconductors 8
Consumer Electronics 2
Display Panel 3
Mobile Phones 12 10% OPM on W120 trillion in revenue
Total Operating Profit 25
Less: Taxes -5 20% rate consistent with history
Net Income 20
Shares o/s 150 million shares
EPS 133,333
Net cash & Investment 63 trillion (est for end of 3Q)
Shares o/s 150 million shares
Cash & Investment per share 420,000
P/E multiple Value per share (P/E multiple + net cash)
10 1,753,333
11 1,886,667
12 2,020,000
13 2,153,333
14 2,286,667
Today's Price 1,263,000
Upside 60%
Click to enlarge

The semiconductor business has inherent volatility so I've used a mid-cycle operating margin of 20%. Given the consolidation which has occurred, this could prove conservative. The other key assumption is that I assume that the handset business can earn a 10% operating margin on a base of W120 trillion in revenue. This represents a revenue base that is 10% below 2013 and an operating margin 800 basis points below last year's 18% and near the low point of Samsung's historical handset margins of 8-22% over the past decade. What makes me so confident Samsung won't suffer the same fate as Nokia? There are two main points I'd like to make here: 1) Nokia fell apart when it missed the transition to smartphones (tried to develop its own operating system called Symbian; a similar fate was suffered by BlackBerry (NASDAQ:BBRY)) - it is unlikely we will see a similar paradigm shift in the next decade which lowers the risk of a handset blowup in my opinion. 2) The second key factor is that Samsung internally produces the most important component of handsets (chips) which positions it well in terms of seeing and staying current with emerging trends, again de-risking the business. Today, Samsung is priced as if the handset business is worth 0:

Samsung Normalized Earnings with Handsets at 0
Operating Profit by segment (In KrW trillion)
Semiconductors 8
Consumer Electronics 2
Display Panel 3
Mobile Phones 0 Zero
Total Operating Profit 13
Less: Taxes -2.6 20% rate consistent with history
Net Income 10.4
Shares o/s (NYSE:MN) 150
EPS 69,333
Net cash & Investment 63 trillion (est for end of 3Q)
Shares o/s 150 net of treasury
Cash & Investment per share 420,000
P/E multiple Value per share (P/E multiple + net cash)
10 1,113,333
11 1,182,667
12 1,252,000
13 1,321,333
14 1,390,667
Today's Price 1,263,000
Upside -1%
Click to enlarge

While Samsung's second quarter results were below those reported last year, the company is still highly profitable and I expect it to remain that way for the foreseeable future. When investors realize that the handset business is worth more than zero, I expect to see significant appreciation in Samsung's share price.

Disclosure: The author is long SSNLF, AAPL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.