Samsung's Chip Business: What Happened?

A DRAM glut and nimbler rivals will clobber profits for the Korean giant this year. Can it bounce back?

by Moon Ihlwan

Just six months ago, life seemed so good at Samsung Electronics' (SSNGY) semiconductor unit that the division's chief declared it would no longer be subject to the industry's notorious boom-and-bust cycles. Hwang Chang Gyu, who has presided over Samsung's chip business since January, 2004, argued that explosive growth in demand for memory chips for use in mobile phones, music players, and other consumer products had changed the industry's dynamics.

Just as important, Hwang reckoned that Samsung's superior product mix—the company's memory chip business is the biggest in the world—would allow it to pull away from the rest of the pack even if demand for computer memory chips, something of a commodity product, subsided. That, he said, was because Samsung was capable of delivering custom-made memory devices for game consoles, such as Sony's (SNE) PlayStation 3 and Microsoft's (MSFT) Xbox 360; handsets doubling as music players; and high-end servers—that all allow fatter profits. "The boom will continue in 2007 and 2008," Hwang boldly predicted in December.

Well, think again. Rather than extending the good times, the first half of 2007 has been characterized by a race among industry players to add capacity, driving prices—and profitability—downwards.

Blame the DRAM Slump

For Samsung, which earned $5.4 billion, or more than 70% of earnings, from its chip businesses in 2006, that's going to hurt. "The golden days of Samsung's memory business are over," says Park Kyung Min, chief executive at fund manager Hangaram Investment Management. "I don't think the unit will account for two-thirds of the company's profits any longer." Indeed, local brokerage Daewoo Securities reckons Samsung's chip unit will pull in just over 50% of its earnings this year, or $2.8 billion.

How did Hwang get it so wrong? One big factor has been the slump in price of dynamic random access memory, or DRAM chips, of which Samsung is the leading manufacturer. They earned the company $3.7 billion last year.

Amid a global capacity glut, prices for DRAM chips, which are widely used in PCs, have fallen 70% this year. Just as worrying for Samsung, its technological lead in DRAM production has been reined in as rivals such as Japan's Elpida Memory (ELPDF) and Germany's Qimonda (QI) have also developed custom-tailored products at a time when Samsung has been placing more emphasis on developing NAND flash chips, which can store information even when the power is switched off.

Bottomed Out?

Slower-than-expected sales of PCs using the Microsoft Windows Vista operating system have also added to the oversupply problem, particularly as few manufacturers—that includes Samsung—are willing to cut back on output. "Samsung is no different from its competitors in selling chips below manufacturing costs," says Lee Seung Woo, semiconductor analyst at brokerage Shinyoung Securities, who expects DRAM profits to dwindle to $817 million this year (see BusinessWeek.com, 10/16/06, "Samsung: Huge Profit Jump").

Just as worrying, a recovery in DRAM prices in the second half of 2007 is expected to be limited. On the one hand, prices appear to have bottomed out at around $1.80 (after hitting a low of $1.68 on May 21), down from $6.32 at the beginning of the year for the 512-megabit DDR2, the most commonly used DRAM chip.