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Samsung's New Challenge: Rising Component Costs; As Samsung Tries to Keep Profits Up, Component Costs Present Unexpected Challenge.

Cheng, Jonathan.

Wall Street Journal (Online); New York, N.Y. [New York, N.Y]. 29 Apr 2014: n/a. 

Abstract

According to a teardown by market research firm IHS this month, Samsung's new Galaxy S5 with 32 gigabytes of memory costs $251.52 to manufacture.

SEOUL–As the world's biggest smartphone maker tries to keep profits up in its mainstay mobile phone business, one key challenge will come from an unexpected place: the rising costs of the components that go into its devices.

On Tuesday, Samsung Electronics Co.'s first-quarter earnings showed that its smartphone margins remained flat from a year ago, highlighting the need for the South Korean technology giant to keep costs low amid uncertain demand for its new flagship Galaxy S5 smartphone.

Samsung executives said that the Galaxy S5 smartphone, which officially went on sale earlier this month, was received positively by the market and would likely do better than the previous model, without elaborating. But analysts said margins could well slip this quarter.

The company packed its latest phone with pricey features–such as an improved camera, a fingerprint scanner and a heart-rate sensor–hoping to give it a leg up against a crowded field of rivals that, like Samsung's devices, run Google Inc.'s Android operating system.

"Despite increasing sales volumes, a decline in profits seems inevitable due to falling prices and intensifying competition," said Greg Roh, an analyst with HMC Investment Securities in Seoul.

In the first quarter, the sale of mobile phones accounted for 60% of Samsung's revenue and three-quarters of its profits. Samsung said its profit margins for that unit came in at 19.8%, unchanged from a year earlier. But margins were higher than the fourth quarter due to one-off "adjustments to reserve items," the company said, declining to elaborate.

But the pressure on margins is only likely to get more intense as Chinese rivals, including Huawei Technologies Co., Lenovo Group Ltd. and ZTE Corp., crank out increasingly competitive smartphones. In the first quarter, Samsung saw its global smartphone market share slip to 31.2% from 32.4%– the first annual decline in four years–at the expense of rivals Lenovo and Huawei, according to data from Strategy Analytics.

Mr. Roh said he expects operating profit margins at Samsung's mobile division to fall to 15.9% in the third quarter and 13.5% in the fourth quarter.

Samsung on Tuesday said net profit rose 5.9% from a year earlier to 7.57 trillion won ($7.32 billion) as strong chip sales helped cushion slowing sales at its key mobile unit. Sales rose 1.5% to 53.7 trillion won.

Not helping Samsung's cause is the company's continued reliance on its massive advertising budget to keep its sales humming, and the rising cost of making its own devices.

During a conference call with analysts on Tuesday, Samsung executives said that they were working to keep marketing costs in line with sales. They said they would sell more phones for less than $100 to target the portion of the market most under threat from low-cost Chinese competitors.

But at the higher end, Samsung's relatively high manufacturing costs restrict the company's ability to compete on price at a time when selling prices continue to fall.

According to a teardown by market research firm IHS this month, Samsung's new Galaxy S5 with 32 gigabytes of memory costs $251.52 to manufacture. That sum handily outstrips Apple Inc.'s iPhone 5S, which contains $207.00 worth of components, and is a far cry from ultracheap Android smartphones sold in China and India, some of which can be manufactured for as little as $35.

IHS says its preliminary analysis is based only on hardware and manufacturing costs, and excludes software, licensing and other costs. A Samsung spokesman declined to comment on the teardown.

The high costs come amid the company's stated goal of simplicity and moderation with the Galaxy S5, a device that company executives characterized as a "back to basics" device rather than one with any flashy but little-used features.

In a February interview previewing the device, Samsung executive vice president Lee Younghee said that the company was steering clear of gimmicky new features in favor of a simple device that would offer "very competitive pricing."

On AT&T Inc.'s website, the Galaxy S5, with 16 gigabytes of memory, sells for about $650 without a contract, while Verizon Communications Inc.'s Verizon Wireless website sells the device for about $600–about the same as for the Galaxy S4 when it first went on sale.

While Samsung's profit margin has been squeezed amid a decline in the average selling price of its smartphones, the company has more control than most of its rivals over the cost of manufacturing its devices and components because it makes semiconductors and displays internally.

Samsung's latest smartphone has about 10 sensors, including the ones that underpin the heart-rate and fingerprint scanners. It also includes a camera that Samsung executives say can match the functions typically found on the chunky digital SLR cameras favored by professional photographers.

But that camera may pose a headache for Samsung, after the company confirmed reports of camera glitches plaguing an undisclosed number of Galaxy S5 smartphones which render the smartphone's shooter useless.

Credit: Jonathan Cheng