Samsung Is Briefly the World's Most Profitable Company, Because in the Phone Business the Money No Longer Comes From Selling Phones

Samsung's profit machine overtook Apple's in the second quarter that just ended.

Samsung's profit machine overtook Apple's in the second quarter that just ended, making it the company with the highest operating profit in the world.

According to Samsung Electronics' earnings report, released this Thursday, net profit for the three months ending in late June rose to a record US$9.6 billion (10.8 trillion won), US$1 billion above the average Wall Street estimate.

Leave out expenses unrelated to the core business, such as investments and acquisitions, and look only at operating results: Samsung's operating profit reached US$12.67 billion, up 72% from a year earlier.

That is US$2 billion more than analysts expect Apple to have earned over the same period.

For years Apple has held the title of the world's most profitable company. Its second-quarter earnings report comes out next Tuesday, Beijing time.

It has been less than a year since the Note 7 explosions, and Samsung's de facto head, Lee Jae-yong, is still in detention on bribery and other charges, awaiting trial next month. How did a company in this much turmoil become the world's most efficient money-making machine?

The Galaxy S8 Gave Samsung's Phone Business a Lift — But That's Not Where the Money Comes From

The Samsung Group looms large in South Korea's economy: the combined revenue of its affiliates comes to roughly 15% of the country's GDP. Most of that comes from Samsung Electronics, the world's largest smartphone maker.

The second quarter coincided with the launch of the Galaxy S8, the first flagship phone Samsung released after the Note 7 disaster, and the one carrying the company's hopes.

From April to June, Samsung sold 93 million phones for about US$25.7 billion in sales — its largest source of revenue.

Samsung said that "revenue increased significantly due to the strong sales of the Galaxy S8 and S8+ smartphones." Koh Dong-jin, who runs the company's mobile communications business, said that since April, cumulative sales of the S8 and S8+ have run 15% ahead of the S7.

That is not hard to understand, because this is the best phone Samsung has made in years.

A single curved screen covers 84% of the phone's front, which makes it look like nothing else on the market.

Samsung's curved screen is now in its fourth generation, and the S8 has none of the stiffness of earlier versions: the curve melts into the body, on a more natural arc.

The Verge's review, for instance, said, "The S8 and S8+ aren't perfect, but they're damn close." That is roughly where most reviews landed.

The biggest problem with Android phones used to be that they were all alike. A 5,000-yuan Samsung and a 2,000-yuan Xiaomi felt no different to use; both could run WeChat and Honor of Kings.

Being different brought growth back to Samsung's phone business. Phone sales reached US$25.6 billion, up 10% from a year earlier — that is, up from before the Note 7 fiasco.

But the phones earned less than they did a year ago. The profit margin of Samsung's phone business has kept sliding for three quarters running. Against the same period last year, profit was down 5%.

That is because the S8's sales growth was bought with heavy subsidies.

This year Samsung left dealers plenty of margin, which let them cut the S8's price. The suggested retail price in South Korea is 935,000 won, about 5,800 yuan. Subtract the subsidies and discounts that dealers or carriers hand buyers, and an S8 in South Korea costs about 4,700 yuan. Dealers pay far less than that wholesale, and they often sell lower still to get cash back quickly.

Samsung also ran buy-one-get-one-free deals with U.S. carriers: buy an S8 at T-Mobile before June 25 this year and Samsung threw in a second one. On Taobao's overseas personal-shopper stores, a gray-market S8 now goes for under 4,000 yuan.

The S8 has been on sale for three months.

In several of the world's major markets, the S8 has not pulled Samsung clear of its rivals.

In August 2016, Samsung had the largest market share in Western Europe's five biggest markets: Germany, France, Spain, Italy and the UK.

By December, in Italy and Spain, Samsung was going through its steepest drop in market share ever — down 7.6% in Italy and 5.6% in Spain.

Across Europe as a whole, Apple's share passed Samsung's in the fourth quarter of last year.

At home in the United States, Apple has far more users than Samsung: nearly 70 million Americans use an iPhone, 50% more than use a Samsung.

Scientiamobile data show that as of May this year, the phones Americans used most were the iPhone 6, iPhone 6s, iPhone 7, iPhone 7 Plus and iPhone 5S. The Samsung S7 ranked 7th and the S8 ranked 30th, and Samsung's overall phone share is trending down.

Lower down the price ladder it is worse. Samsung's low- and mid-range phones have no beautiful curved screen to set them apart. Revenue rose this quarter but unit sales stayed near the previous quarter's level, mostly because those cheaper phones sold poorly. The attack there comes from Chinese manufacturers.

In China, the largest single phone market, Huawei, OPPO and vivo were the three top-selling smartphone companies as of the first quarter of this year. Samsung was filed under "others." Three years ago it was No. 1, with 30% of the market.

India takes more of Samsung's cheap phones than anywhere else. Samsung displaced Nokia as the market leader there in 2013 and is still the country's best-selling phone brand.

But its lead is not what it was two years ago. In 2014, Samsung's share was bigger than the No. 2 through No. 4 brands combined. Today Chinese brands hold more than half of India's market, and Huawei and Xiaomi have closed the gap with Samsung to single digits.

With Apple taking most of the high end and Chinese manufacturers taking the new low- and mid-range share in emerging markets, Samsung's phone business has yet to recover.

The screen advantage will not last forever either. More and more display factories are getting ready to make curved screens.

But the gloom around phones has not dented Samsung's ability to make money, because its semiconductor business is doing extraordinarily well.

Chips and Screens Supply More Than Half of Samsung's Profit

From April to June this year, the chip division's profit hit a record US$8.6 billion, four times what it was a year earlier. Measured by operating profit, Samsung passed Intel to become the most profitable semiconductor company in the world.

Samsung's semiconductor business alone earned about twice the combined profit of Baidu, Alibaba and Tencent this quarter, and roughly twice Huawei's entire operating profit for the first half of the year.

After 2014, the internet-phone marketing playbook ran out. Everyone looked for ways to sell more expensive phones, and the common answer was to pile on higher-spec hardware.

To stay competitive, every major manufacturer's flagships have been doubling storage with each generation.

On a phone priced around 2,500 yuan, flash storage has gone from a standard 16GB in 2014 to 64GB now — four times as much. That describes almost every Chinese flagship. Apple changed the iPhone 7's low-high storage pairing from 16GB and 64GB to 32GB and 128GB.

Starting in the second half of 2016, Chinese brands kept shipping sharply more phones in every major market, and the iPhone 7 sold well; both ate up a great deal of flash capacity. RAM went the same way: most phones today start at 4GB, and the more aggressive makers start at 6GB.

Supply, meanwhile, was shrinking.

Samsung, SK Hynix and other chipmakers have been upgrading their memory processes step by step, with the process node shrinking to 20 nanometers, which pushed yields down. With supply short, both flash and RAM prices rose. IC Insights forecasts that RAM prices will climb 39% in 2017, and flash prices as much as 25%.

Revenue is rising across the global semiconductor industry, and because the chip business is so concentrated, Samsung, which has been in it for many years, holds 50.2% of the market. The same thing is happening in PCs, where solid-state drives are spreading — more revenue for Samsung again.

Displays are Samsung's other business whose profit jumped this quarter, by more than 1,100%. OLED is still scarce: it is the only mass-produced display material that can make a phone screen curve. Samsung has 95% of that market.

But this surge may be cyclical, and it will not go on forever.

Apple, having settled on OLED for the iPhone 8, has placed two rounds of orders with Samsung for OLED screens, as many as 160 million panels in total. That has to do with how Apple runs its supply chain and inventory.

Every year, from September through the Christmas holiday at the end of December, is when new iPhones sell most. Apple buys materials far in advance so that supply is reasonably ample when the time comes. In other words, Samsung has caught the crest of one of Apple's big buying cycles. Once Christmas passes, Apple's purchasing may not be so aggressive.

Samsung's Semiconductor Edge Comes From 20 Years of Steady Investment

AMOLED has long been treated as the display technology of the future. It emits its own light, showing different colors through combinations of red, green and blue emitters. Because it needs no backlight, screens can be thinner and use less power.

LCD works the other way: a backlight unit supplies the light, liquid crystals let it through or block it, and red, green and blue color filters produce the colors. Because of the backlight unit, an LCD panel is somewhat thicker overall than AMOLED, and it cannot be bent.

For a long time, though, phone makers disliked AMOLED screens. Colors came out oversaturated, ghosting kept appearing, and the material's subpixels had such short lifespans that manufacturers had to fall back on a PenTile layout, which left the screen looking grainy.

After Apple introduced the Retina display on the iPhone 4, some manufacturers with in-house semiconductor divisions, Sony among them, chose LCD outright in pursuit of higher resolution. AMOLED could not raise resolution as fast as LCD, and Samsung was left as the only company still pushing it.

But after 2015, nearly every brand's mid-range and better phones had Retina-class displays. Demand for ever-higher screen resolution hit its ceiling. There is no point in a 4K display on a 5-to-6-inch screen: the eye cannot tell the difference, and it only adds cost and power draw.

Now that almost every manufacturer wants thinner, bendable AMOLED screens, Samsung's head start has turned into real profit. Its display business earned US$1.53 billion this quarter, up 157% year on year.

Samsung's display division alone makes more profit than all of Tencent. That is the result of long-term investment, which now lets Samsung sell hardware nobody else can and make money on it. To meet the booming OLED market, Samsung Display plans to spend another US$21 billion on the world's largest OLED factory.

The chip business is the same story. Samsung began putting money into semiconductors and screens very early.

In 1996, a fire nearly burned down Samsung Electronics' plant. The company rebuilt and set its sights on a path that could bring it profit over the long run.

Several large investments that followed all involved semiconductors: US$3.6 billion for the Austin chip plant in 2011, with another US$4 billion added in 2012; and US$14.7 billion for a semiconductor plant in South Korea in 2014.

But while Samsung collects the profits of moving into a market first, the chip industry carries no less risk than the phone industry.

Samsung Leans More and More on Chips — But Staying Away From Consumers Is Risky

Chip profits swing with demand. From October 2014 to June 2016, an oversupplied PC market drove contract RAM prices down 62%. Samsung's semiconductor profit fell with them, dropping 23% from the previous quarter in the fourth quarter of 2016.

That risk may still be there. In an interview with CNBC, Mehdi Hosseini, vice president of the semiconductor group at Susquehanna Financial Group, predicted at the time that RAM prices would peak this September, and that Samsung could enjoy two more quarters of growth.

Samsung itself disagrees. Rising demand for high-end chips from corporate customers has helped it shake off the drag of the smartphone slump, and it expects those customers to raise their chip spending sharply again this year, to its own benefit.

In May, Samsung decided to spin off its chip foundry business. The goal is to become, within five years, the world's second-largest chip packaging plant, behind TSMC.

Samsung now depends on chips more and more.

But the world's five most valuable companies — Apple, Google (Alphabet), Microsoft, Amazon and Facebook — all, without exception, deal directly with users.

Semiconductor companies matter, but they have never been the most valuable companies. Once the PC lost its place and users stopped caring which brand of CPU they had, Intel's growth fell behind that of several tech giants.

People will keep buying phones; that will not change. Which supplier a phone maker buys its memory from can change, and users do not much care. Apple, for one, has always insisted on buying its main components from several companies, and is now investing in AMOLED displays with LG and others to lean less on Samsung.

With semiconductors alone, Samsung probably could not hold the size it has today.

One Thing Is Certain: Most of the Money in the Phone Business Now Goes to Channels and the Supply Chain

What matters most in hardware is being different — through better software, a better brand, or the hardware itself.

But the gap between Android makers' software keeps narrowing. Differentiation has moved to hardware, which is why Samsung's business is good.

The research firm IHS expects the entire memory chip industry's revenue to grow 32% this year, possibly past US$104 billion.

As high-end phones adopt the OLED technology Samsung dominates, Samsung's share of the hardware cost in those phones can reach US$60, close to a third of the total. That is more than any company other than Apple makes in net profit on a single phone.

Samsung is not the only one making money; other chip and screen companies are doing well too.

BOE swung to a profit in its first-quarter results this year, from a 1.3 billion yuan loss in the same period last year to a 2.4 billion yuan profit. BOE's Gen 5.5 AMOLED line is already running, and its Gen 6 line starts next year.

Micron's business spans several kinds of semiconductors, including RAM and flash. With RAM prices up and flash shipments rising, Micron's revenue has exploded over the past few quarters. Most investors had expected Micron to go through another boom and bust, as it did with fast growth in 2013-2014 and a crash in 2015.

Beyond the chip companies, marketing is the other big expense.

Take Samsung. In the second quarter its cost of sales came to US$28.4 billion, more than half of revenue. Its chip business needs no marketing, so the great majority of that US$28.4 billion went into pushing phones through one channel or another.

Chinese companies spend no less. Airports in China's first- and second-tier cities are covered in OPPO and vivo ads. The commission phone makers pay dealers can exceed a quarter of the retail price. Even Xiaomi, which once boasted that it spent nothing on marketing, has started signing endorsers and buying billboards and variety-show slots.

But companies like Samsung and Apple, while spending on marketing, also put more than US$10 billion a year into R&D. Samsung builds wafer fabs and display lines; Apple designs its own chips and the tooling its phones need to be made.

They do it to keep their products different, so they can charge more. It is not that phone companies cannot make big money now. It is that phone companies that do not control enough of the supply chain cannot.

Because for companies without that ability, most of the money goes to the supply chain and the distributors.

Right now, the world's largest phone company makes less than 40% as much selling phones as it does selling parts to other phone makers.

Cover image/VCG