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Samsung Electronics:Valuation determined only as a chipmaker

2019-10-04 23:28

Semiconductors contribution nearing previous peak…: Shares in SamsungElectronics (SEC) have been approaching their all-time high while those in SK Hynix haveset new ones, with our forecasts having the former’s operating profit attributable to itssemiconductor operation coming in at KRW10t in 3Q, which would account for 69% ofour total quarterly estimate—vs 70% in 3Q04 and 3Q10, when such contributions peaked.

SEC, SK Hynix rally: Samsung Electronics (SEC) hit a record high yesterday, while SKHynix has been refreshing new highs for some time. We attribute the strength of Korea’slarge-cap tech stocks—despite a recent warning by Goldman Sachs over a Nasdaqbubble—to rising earnings anticipation for the two heavyweights. The boomingsemiconductor market has led consensus for SEC’s 2Q operating profit to be the world’slargest. Sell-side analysts have been upgrading their ratings of SK Hynix to reflectprospects that DRAM prices will stabilize or increase in 3Q.

    (Those contributions also peaked in 4Q04, but we exclude them from our calculations asthey owed plunging handset earnings.) The company was viewed as a semiconductor playamid sector booms of 2004 and 2010 as related earnings contributions exceeded 60%,while it was considered a handset stock during the handset booms of 2002-2003 and2012-2013, which is when over 70% of its earnings came from that business (chart 1).

    Hardware sector rerating: Since chips with higher processing power consume morebattery power and, chip demand tends to decline when prices rise, a debate over peakingearnings in semiconductor industry (which burdened shares of memory chip makers in1Q) is likely to start again. We thus believe current gains being driven more by the risingvalue of hardware, which was formerly discounted relative to market enthusiasm foralgorithms/software related to big data.

    …but more appealing as a handset player: Based on the average of six years ofcyclically-adjusted P/E (chart 2), SEC traded at 2STD above the market amid handsetindustry booms, but just 1STD above during semiconductor booms. We attribute suchdiscrepancies to the latter business requiring greater investments and thus bringing inrelatively limited cash flow. The firm’s handset operation requires fewer capitalexpenditures, however, and has been more noted for driving structural ROE growth.

    Global giants put hardware investments in high gear: Global giants are beefingup hardware investments. Google last week snagged a senior designer from Apple to buildchips for its Pixel smartphones, implying hardware innovation is a must for softwareinnovation. Playground, launched by Android creator Andy Rubin, invests in andincubates startups building software-based hardware.

    Rising penetration of AI should keep boosting the importance of hardware. AIapplications on smartphones use cloud computing to calculate and learn and then sendthe result to a handset. Manufacturers, however, are seeking on-device AI services toovercome ballooning data traffic and limited communication speed, and thereby achieveseamless connections. This should necessitate innovative software that slashes theamount of computation—key to killer apps—which should be preceded by innovativehardware that is faster, more energy-efficient, and/or capable of storing massive data.

    This is similar to the way augmented reality requires new higher-speed displays.

    Debate over peak to be meaningless: Given rapid technological advancements, itseems premature to predict how such a development will play out. Moreover, valuationsof Korea’s large tech firms should be revisited as hardware seems sure to generate solidearnings amid industry consolidation. SEC is likely to draw attention as its M&A effortsshould create synergies and add to its robust memory semiconductor business. Thecompany should report Harman’s results separately from 2Q, and the market shouldfocus on how SEC utilizes Harman’s hardware prowess in its mobile network operation.

    Anticipation of synergies should keep growing if the firm hikes investments. Meanwhile,SK Hynix seems unlikely to secure NAND solution technology via investing in Toshiba orentering alliances with third parties such as Seagate Technology, but sentiment on thechipmaker should improve considering favorable industry conditions and the firm’simproving NAND technology.

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