All roads point to Samsung (OTC:SSNLF) maintaining its technology leadership in memory (server DRAM and 3D NAND), with its latest 1Q20 preliminary results indicating an above-consensus result. From here, I see semiconductor earnings moving higher on strong data-driven computing demand, particularly from enterprise servers and data centers, as capacity demand rises amid the global stay-at-home period. With ample cash holdings and abundant free cash flow generation to boot, Samsung also has a scope for higher capital returns, which should drive its appeal to an income-oriented shareholder base. I would be a buyer at these levels.
Reviewing Samsung’s 1Q20 Preliminary Results
Samsung released its 1Q20 preliminary revenue at W55 trillion (in line with consensus’ W55.3 trillion), with operating profit coming in above consensus at W6.4 trillion (vs. consensus at W6.1 trillion). The reported numbers were a positive surprise in light of a worsening outlook amid the uncertainty of the COVID-19 demand impact, as solid semiconductor results and a resilient smartphone business offset negative display earnings.
While details of divisional performance will not be disclosed until the 1Q20 earnings call (end-April), the negative display earnings were largely expected, given weak OLED demand from Apple (NASDAQ:AAPL) and Chinese smartphone makers. While smartphone shipments could also move below expectations due to production disruptions in several manufacturing sites globally, lower marketing expenses may also have cushioned the bottom line somewhat. That said, I think it is worth keeping in mind that the resilient IM and semiconductor earnings may be partly due to the COVID-19 impact not yet fully materializing in 1Q20. The Harman division also likely swung to losses on weak auto demand.
Memory Trends to Remain Strong on Cloud and Work-from-Home Demand
SEC’s semiconductor division (~51% of the company’s operating profit as of FY19) is likely to spearhead company-wide earnings improvements in FY20. Early signs have been promising, leading Trendforce forecasts for overall DRAM and NAND prices to reach +LSD % and +5%, respectively, in 1Q20.
Source: Storage Newsletter
Pricing has continued to be solid on the back of tight supply, with demand increases in servers and PCs. Those trends support strong growth in memory revenue and earnings in 2Q20 against near-term uncertainty, and a pullback in discretionary spend globally, that may start to impact Samsung’s mobile business. Thus, the memory buffer should adequately compensate for earnings declines at the IT & Mobile (IM) and consumer electronics (CE) divisions given its relative contribution.
Although there is some downside risk to 2Q20 end-demand given the global spread of COVID-19, which will eventually affect component demand, I think the impact on the memory supply-demand balance will ultimately be less severe than for other components given the supply dynamics. Not only is supply growth limited by cuts at Samsung and Hynix (OTC:HXSCF), as well as Micron (NASDAQ:MU) in 2019, but the resulting healthy inventory levels in the channel should also put a floor on the price. Meanwhile, longer-term tailwinds such as 5G-driven content growth and structural hyperscale datacenter demand remain intact, which should drive the quarterly earnings momentum for semiconductors throughout FY20.
GS20 Volumes Likely to Disappoint
Flagship GS20 volumes are, expectedly, selling below expectations, with smartphone total estimates coming down to 20 mn for the year (vs. 35 million previously). Expect the product mix to weaken going into 2Q20, which should weigh on blended ASP and overall profitability of smartphones. Though price cuts could be used to boost volumes, I would caution that price cuts alone may not be sufficient to stimulate demand, given the global consumer lock-down. Instead, we could see inventory problems in 2H20, as consumer sentiment continues to deteriorate. A further risk to volumes could arise from production site shutdowns – thus far, plants in Korea, India, Brazil have been closed for a number of days related to COVID-19 cases, though overall production has not suffered a material interruption. Going forward, Vietnam remains the key production site, though a recent worker infection risks further disruption ahead.
Potential Upside to Shareholder Returns
Longer-term, I see a compelling capital return story playing out at Samsung. For context, Samsung announced its dividend distribution, which reached W9.6tn in 2018, and will stay locked at this level for a further two years. However, it will use buybacks or special dividends to drive a >50% FCF payout (ex M&A). Thus, the upside case to Samsung’s future capital return boils down to the FCF generation outlook at Samsung over the next three years – as of FY19, Samsung’s FCF payout ratio stands at ~48%.
Source: Company Filings
Scrapping of the “30% Weighting Cap Rule” to Ease Volatility Concerns
On a positive note, the Korea Exchange has decided against implementing a “30% market cap ceiling” that was meant to limit the market cap weight of large caps such as Samsung Electronics within an index to 30%. The cap would have entailed a significant overhang from shares being sold off from passive investors whenever the weight of SEC within a portfolio exceeds the 30% mark. If the 30% cap rule is abolished, however, concerns around a potential sell-off volume from passive trading should ease, which should allow investors to re-focus their capital allocation decisions around fundamentals.
Takeaway – Buy Samsung
Shares have outperformed YTD on a relative basis, thanks to its well-diversified business portfolio, growing exposure to secular opportunities in 5G, foundry, and its sound balance sheet. Potential accretive M&A opportunities could also emerge in automotive components, given SEC’s decent free cash flow and ample cash position. Along with additional shareholder returns in FY20, I think Samsung shares are well-positioned for recovery when COVID-19 fades. On the back of the strong 1Q20 preliminary results, I would be a buyer at these levels.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.