BEIJING/SEOUL/TAIPEI -- Samsung Electronics' preliminary second-quarter financial results, released July 8, shocked industry observers.

     The global smartphone leader reported its first drop in profit and revenue in nine years. The numbers underlined the magnitude of the so-called Samsung shock.

     "As competition intensified in the low- and midtier handset market, chiefly in China and Europe, we saw inventories swell and sales drop," Kim Hyun-joon, senior vice president of mobile communications, said in a July 31 conference call.

     According to final figures for the second quarter, released the same day, Samsung's April-June operating profit for smartphones tumbled 30% from a year earlier to 4.42 trillion won ($4.26 billion). The display division, which supplies organic light-emitting diode, or OLED, panels for use in its smartphones, posted an 80% decline in operating profit.

     Samsung's disappointing results indicate that its business model -- in which smartphones and in-house made parts for the devices are the key drivers of growth -- could eventually become a burden, hitting the company's bottom line.

     In April-June, Samsung's consolidated operating profit declined 25% from a year earlier, and sales were down 9%. Its operating profit margin stood at 13.7%, down 2.9 percentage points from a year earlier. Investors had concerns about the company's performance before the release of the results. Samsung shares are trading at the 1.3 million won level, down 10% from a recent peak about two months ago.

     The company's deteriorating performance reflects changes in the global smartphone market. U.S. research firm IDC said July 29 that Samsung captured 25.2% of the global smartphone market in terms of shipments in the second quarter of 2014. Although Samsung remains the top smartphone vendor, its share fell 7.1 percentage points, and shipments shrank 3.9% to 74.3 million units in April-June.

     Samsung's Chinese rivals are making significant gains. Huawei Technologies jumped into third place, boosting its market share 2.6 percentage points to 6.9%. Lenovo Group moved into fourth with a 5.4% market share, up 0.7 point. Apple of the U.S. saw a dip in its second-quarter market share as consumers wait for the launch of the iPhone 6. The U.S. handset vendor, however, saw shipments increase 12.4%. The sales slump at Samsung came during a quarter when global smartphone shipments grew 23.1% compared to the same period a year earlier.

     Sales are not the only problem. Korea Investment & Securities, a South Korean stockbroker, estimates the average price for a Samsung smartphone dropped 9% to $295 in the April-June quarter. Behind the decline are global consumers who are increasingly willing to settle for low- and midrange smartphones.

     "We will take advantage of our advanced technologies, such as 4G-compatible mobile phones," Kim said, "to ensure sustainable growth also in the high-end category." He also indicated in the conference call that the company will compete on price with low- and midtier rivals. Samsung appears poised to introduce a product mix designed to compete simultaneously with high-end and low-cost rivals. "It is difficult to expect an improvement in earnings," Kim admitted.

     Some industry observers point out that Samsung lacks more than just an effective product strategy. "To maintain its position at the top, Samsung needs to focus on building momentum in markets dominated by local brands," IDC said. In other words, Samsung's sales strategy needs to be sharpened.

     What markets are dominated by domestic brands? China, which accounts for about one-third of global smartphone demand, is one. "Xiaomi is aiming to build a global smartphone brand that Chinese people can be proud of," said Lei Jun, chairman and CEO of China's low-cost smartphone maker, at a July 22 product launch in Beijing. Although the company has announced plans to expand into 10 countries within the year, it was the first time the head of Xiaomi had publicly declared his global ambitions.

     The event marked the launch of Xiaomi's latest flagship smartphone, the Mi 4. The handset is compatible with 4G, or fourth-generation, mobile services. In China, the number of 4G subscribers is growing. The device features the latest and most powerful central processing unit, or CPU, from Qualcomm of the U.S. The processor makes the phone the world's fastest, according to Lei.

     Xiaomi gave the handset a high-end design. Pricing starts at 1,999 yuan ($322), less than half the price of Apple's iPhone 5s, the handset Xiaomi is targeting with the Mi 4.

     In sports, game changers often come off the bench and flip the flow of play. Newcomer Xiaomi, founded in April 2010, could be a game changer for the smartphone market.

     TrendForce, a market research company in Taiwan, said Xiaomi's global smartphone share reached 4.5% in April-June. It stood in sixth place in the world, surpassing Japan's Sony for the first time on a quarterly basis. Xiaomi will "ship at least 60 million smartphones this year," Lei said.

     Xiaomi aims to grow more than 220% compared with 2013 in terms of shipments, which would push the company past the $10 billion milestone in annual revenue. If the five-year-old company joins the 10-billion-dollar club, it would be a milestone for global industry.

     Lu Jingyu, an analyst with Chinese research company iResearch, describes Xiaomi as a new breed of business. "As a company with strong Internet genes, Xiaomi takes a totally different approach to management," she said. Xiaomi's CEO long served as head of Kingsoft, a Chinese developer of security and other software.

     The seven other co-founders of Xiaomi have all had long careers in Internet-related industries, working for companies such as Google and Microsoft. This differentiates Xiaomi from cellphone companies such as Huawei, which initially focused on telecommunications and networking equipment, and Lenovo, which used to focus on PCs.

     Xiaomi's Internet pedigree is reflected in its marketing. Its primary method of communicating with customers is China's Weibo microblogging site, which encourages the Internet-savvy to forward posts, boosting the buzz around its smartphones. Chinese search engine Baidu consistently ranks Apple or Xiaomi as the most searched for smartphone brand.

     Sales are also a part of Xiaomi's online strategy: 70% of its products are shipped via the company's shopping site, in a country where the number of people hooked up to the Internet reached 632 million at the end of June.

Android attacks

Other Chinese smartphone manufacturers are also growing fast. A TrendForce study comparing global smartphone market share between 2012 and the second quarter of 2014 shows the number of Chinese manufacturers in the top 10 increased from four to six.

     What are the key factors enabling Chinese growth?

     Sui Qian, an analyst at U.S. research specialist Strategy Analytics, points to "widespread use of the Android operating system for smartphones, and the establishment of a global supply chain centered around companies in Taiwan" as contributing factors.

     Between 2012 and 2014, Finland's Nokia -- whose handset business is now handled by Microsoft -- and Canada's Research In Motion (now BlackBerry) disappeared from the top 10 smartphone makers' ranking. Nokia's Simbian and RIM's BlackBerry operating systems were mainly developed for their own smartphones. The architecture was closed to third-parties. If third parties want to use these two companies' operating systems, they have to pay.

     Chinese companies therefore used Google's Android. The free operating system dramatically lowered the barriers to entering the smartphone market.

     In 2014, nine of the top 10 smartphone makers use Android. The exception is Apple, which also uses an operating system closed to third party manufacturers.

     "Android users do not stick to one manufacturer," said an executive with a Japanese smartphone component supplier. "They easily switch. Samsung is having a hard time competing with Chinese makers that use the Android operating system."

Left in chains

Supply chains are also playing a part in the Samsung shock. Xiaomi's product launch helps explain what is happening under the hood of smartphones.

At the July 22 product launch in Beijing, Xiaomi's CEO explained the importance of Qualcomm, Foxconn, Inventec, and Sharp.

     "Although we have business with 500 suppliers, I'd like to give special thanks to four companies," Xiaomi's CEO said at the July 22 product launch in Beijing as the logos of Qualcomm, Taiwan's Foxconn and Inventec, and Japan's Sharp appeared on a screen behind him.

     Qualcomm is the world's leading maker of smartphone processor chips. The company's processor effectively serves as the international standard for Android-powered high-performance smartphones. If a smartphone producer procures components for a handset as recommended by Qualcomm, it has basically completed the initial phase of device development.

     A fabless company, Qualcomm outsources semiconductor manufacturing to foundries such as Taiwan Semiconductor Manufacturing Co. and United Microelectronics. These two Taiwanese companies command a 55% share of the global foundry market.

     CPUs produced by TSMC and other chipmakers go through several processes, including sealing, before being delivered to smartphone assembly plants operated in China by Hon Hai and Inventec. Hon Hai, as Foxconn is also known, has more than a million Chinese assembly line workers mass producing smartphones. Inventec has followed Hon Hai's lead.

     Many Chinese-made handsets, such as the Mi 4, take advantage of the Taiwan-centered supply chain. Sharp, which supplies high-definition LCD panels to smartphone assembly factories, is one Japanese link in the chain.

     Xiaomi has been able to grow fast in part because of the industry's supply chain. It operates on the fabless model, as does Apple. The U.S. company relies on TSMC and Hon Hai for production of its iPhone.

     Winners and losers are emerging in this new smartphone landscape. Taiwanese fabless chipmaker MediaTek, for example, has gained the upper hand over Qualcomm in shipments of processors for middle- to lower-cost handsets, such as the Xiaomi Hongmi, which costs 699 yuan. "We will revise upward our projections for smartphone chip shipments in 2014 from 300 million units to 350 million units (up 60% on the year)," Hsieh Ching-jiang, president of MediaTek, said in a July 31 conference call.

Visitors try out the Huawei's new smartphones during their launch in Singapore last year.      © Reuters

     The same day, MediaTek reported an 86.9% jump in net profit to 12.5 billion New Taiwan dollars ($379 billion) in the April-June period compared with a year earlier. The company's bottom line was partially boosted by its merger with a competitor at home.

     MediaTek's supply of affordable smartphone chips has lowered the barriers for Chinese companies entering the smartphone market, according to Strategy Analytics analyst Sui Qian.

Multiple devices

Contract manufacturers in Taiwan benefited from a 2001 change in government policy that lifted a ban on building assembly plants of notebook PCs in China. Taiwan's contract manufacturers by that point had sewn up their U.S. customer bases, but were struggling to cope with soaring domestic labor costs.

     Many of Taiwan's companies shifted production to China, where labor costs were still cheap. More than 90% of the world's notebook PC output was assembled by 2007 in China. Cheap labor was thus intertwined into the global supply chain for small, lightweight digital equipment, leading to constant downward price pressure.

     LCD TVs followed PCs into the deflationary quicksand. For many years, analog technologies were essential to TV development. However, as the digital era arrived Japanese TV manufacturers lost their edge to other Asian companies. An analyst at a high-tech research company in Taiwan said the TV supply chain initially under Japanese control fell apart.

     Digital sets took off around 2008. MediaTek and other companies started volume production of CPU units for TVs. By that time, Taiwanese and South Korean manufacturers had joined the LCD panel supply chain. In this business environment, major Chinese consumer electronics manufacturers, including TCL and the Hisense Group, introduced LCD TVs at lower prices, using the same supply chain as PC manufacturers. Prices plummeted, badly bruising Japanese companies such as Sony, Panasonic and Sharp.

     Major players in the supply chain around 2010 started looking at mass production of other digital equipment, such as smartphones and cameras. Prices of these products have since dropped.

     PCs and smartphones use similar software and components. When it comes to PCs, the Microsoft Windows operating system and Intel CPUs are most widely used. LCD panels and memory chips are produced under common specifications for PCs; several suppliers from Japan, the U.S., South Korea and Taiwan provide them. PCs became commodities 30 years after hitting the consumer market in the 1970s. Smartphones are fast becoming commodity items seven years after the first iPhones reached store shelves.

     "It has become possible to make most digital equipment within the Taiwan-centered supply chain," an executive at a Japanese parts maker said.

Where next?

Samsung's second-quarter performance suggests the company has been snagged by the deflationary trap. It escaped once before, moving from LCD TV sales to smartphones.

     Digital equipment supply chains have evolved to the point where smartphones are fair game. The Android operating system has also greatly reduced barriers to production. There are as many as 400 government-approved smartphone producers in China. They started by making shanzhai, or knockoff, handsets. Now, Chinese manufacturers are ready for the big time.

     Xiaomi has achieved great success domestically by making full use of the Internet to promote devices that rival Apple and Samsung models. Indian phone makers such as Micromax and Karbonn also procure key parts for smartphones and the finished goods from China. The Xiaomi fast-growth method has spread to other brands.

     In the beginning, there was Apple. Then Samsung, a worthy rival, got in the U.S. company's way. The South Korean company gained an edge by producing components in-house and entering emerging markets such as China and India where Apple did not have strong presence.

     Now, upstarts such as Xiaomi and Micromax are backed by world-class executives who know how to make the most of supply chains. Apple continues to forge its own path and has so far performed solidly. Samsung, by contrast, has little to set it apart from newer and nimbler rivals. Its in-house supply chain has turned burdensome, hindering the company's flexibility.

     Japan dominated consumer electronics until the 1990s. At that time, a dormant Samsung was investing heavily to bolster its capabilities in areas such as semiconductors and LCD manufacturing, ignoring profitability in the near term. Samsung was later able to rake in huge profits. That money went back into the company, helping further enhance the Samsung brand and strengthen research and development. Its efforts hammered Japanese rivals. Samsung was a game changer.

     Even if Samsung's smartphone profits have stalled, the company today has deep financial foundations. It had around $60 billion in cash on hand at the end of March. Investors and consumer electronics industry players are now watching what Samsung does next. Will it leverage its cash hoard for smartphones, or focus on identifying the growth engines for a new Samsung era?

Kazunari Yamashita, Nikkei staff writer in Taipei, contributed to the story.

Original link: http://asia.nikkei.com/magazine/20140807-Smartphone-game-changers/Cover-Story/The-Taiwan-centric-way-of-making-smartphones