A DRAM glut and nimbler rivals will clobber profits for the Korean giant this year. Can it bounce back?
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.
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.
On the other, oversupply means that, although seasonal demand for the chips will kick in for the summer as computer and electronics makers begin building inventory ahead of the yearend sales surge, supply will still outpace demand. "I don't see a significant recovery in the third quarter," says Song Myung Sup, a chip analyst at CJ Investment & Securities in Seoul. "A real improvement will have to wait until the second half of next year when overcapacity problems will have been curbed."
Looking to Notebooks
At least the outlook for NAND flash memory chips, the next largest segment of Samsung's semiconductor business, is brighter. The chips, which are widely used in handheld products such as music players, digital cameras, and portable media players, provide an alternative profit driver when DRAM prices are heading south.
"The South Korean DRAM suppliers will shift capacity away from DRAM toward NAND, which is expected to be more profitable over time," Derek Lidow, chief executive of market research firm iSuppli, said last month. Korea's Hynix Semiconductor (HXSCF) is the world's second-largest memory chip maker after Samsung.
Samsung executives hope that one eventual driver of demand will be notebook PCs, which will be equipped with NAND-based drives, called solid-state drives or SSDs. Although more costly than conventional hard drives, flash drives are faster, more reliable, and consume less power (see BusinessWeek.com, 6/11/07, "How Flash Will Change PCs").
But even in flash memory production, competition is heating up, and margins are being squeezed. On June 12, Japan's Toshiba (TOSBF), the second largest NAND chipmaker after Samsung, announced it is boosting capacity by 70% by June, 2008. Toshiba's U.S. partner, SanDisk (SNDK), major U.S. memory chipmaker Micron Technology (MU), and Korea's Hynix also have plans to expand flash memory (see BusinessWeek.com, 4/12/07, "Toshiba's Flash New Look at Chips").
An Air of Confidence
And just as with DRAM chips, that could lead to Samsung's competitive lead being whittled away. "Samsung used to skim the cream as an early mover, but with rivals having caught up, future benefits will be shared and limited," says Shinyoung's Lee. He reckons Samsung's earnings from NAND will be halved to $640 million this year from $1.4 billion last year.
Still, Samsung can't complain too loudly about rivals increasing their NAND supply. On June 14 it opened a $3.5 billion state-of-the-art NAND plant in Austin, Tex., where it already has a memory chip factory.
That could also be because the company remains confident about its chip business. That's certainly the impression given by company executives. "It's true the gap between ourselves and our rivals has narrowed, but there's no other company that could provide as comprehensive solutions as we do," says one Samsung senior manager. Just don't expect to hear Hwang gloating again anytime soon.