MEMO

*This case study is for academic purposes. Its a simulation. DATE: April 21, 2011 TO: Kun Hee Lee, Chairman, Samsung Group CC: Samsung Senior Management FROM: Tina Khaladze RE: Reaction to Chinese Competition

Executive Summary The memory chip industry is expected to experience a cyclical downturn in 2005. Samsung has survived with the best performance in the industry the past two downturns. Product differentiation, design, experience, knowledge and even low cost production and production efficiency make Samsung the worlds leading memory producer for consumer electronic products. Will Chinese entry fundamentally change industry conditions in the years ahead? The answer is yes. Even though they do not have necessary experience and expertise, they have been forming alliances with well-established companies and making progress at a very high pace. There is no doubt Chinese companies are going to be successful. The questions is weather Samsung is able differentiate itself from them and sustain itself long term. The safest route is to acquire Chinese company SMIC utilizing its facilities in China.

Table of Contents
Problems at Hand ................................................................................................................................ 3 Memory Industry Whats to come? ............................................................................................. 3 DRAM Market....................................................................................................................................................3 Innovation, Flash Memory Chips and Nanotechnology ......................................................................4 Competition ........................................................................................................................................... 5 New Chinese Entrants ....................................................................................................................................5 Samsungs Competencies and Competitive Advantage ........................................................... 6 Possible Options for the Samsung .................................................................................................. 7 Comparative Evaluation of Alternatives ...................................................................................... 7 Recommendations - Implementation Plan.................................................................................. 8 Appendix...............................................................................................................................................10

Problems at Hand
The major problem Samsung is confronting today is uncertainty in the competitive environment of semiconductor industry. While we have been a leader in DRAM industry for decades, today we are facing possible changes that could have a crucial impact on the future success of our business. Chinese entrants are attacking the DRAM market in a similar way to Samsung twenty years ago. First of all, we have to identify, weather competitive environment has changed dramatically in 2005 and if this change requires Samsung to modify its strategy. Chinese companies are potential threat with low cost labor, government support and streams of funds pouring into emerging companies. We should examine how Samsung should react to the threat of Chinese competition. I will address these questions throughout this memo. I will closely observe industry trends and competitive environment, discuss alternative strategies and finally, define the best course of action for the sustainable future.

Memory Industry Whats to come?

DRAM Market
Sales of DRAMs for PCs have declined from 80%-67% between 1990-2003 as computer markets have matured. However, there has been a significant increase in consumer spending power in home computers and mobile phones following the global market decline of 2001-2002.

This should be an indication of strong growth in the semiconductor industry. It is important to acknowledge however, that considerable region-to-region variation of growth rates is predicted. Computer and consumer electronics products are much more saturated in Europe, the US, and Japan and therefore, demand is predicted to be stronger in Asia-Pacific and other developing economies. It is estimated that over 64% of the global semiconductor markets revenues will come from Asia-Pacific by 2010. Even though sales of DRAMs for PCs have declined, they are not going to decline as much in the years to come. More people will want to purchase new computers due to increasing innovation in computer technology and besides, these machines are depreciated and most people replace computers in about 3-5 years. What does this mean for Samsung? It means that DRAMs are going to be a good business for Samsung for at least few years and that the company should particularly concentrate on Asia-Pacific markets.

Innovation, Flash Memory Chips and Nanotechnology

At present, there are no significant substitutes for semiconductors. However, technology is dynamic and the situation is not guaranteed to stay the same. Thats why its important for Samsung to stay ahead of its competitors in innovation, R&D and product advancement. Innovation is crucial in semiconductor industry. Technology must be developed quickly to keep up with the demand. However, it is possible that physical limits on miniaturization with current technology are being approached and more radical advances might be necessary. Flash memory chips have had increasing success for the past years and could greatly contribute to Samsungs success. Samsung has competitive profit margins with this product as well even though Toshiba has higher average selling price. There are no substitutes to challenge DRAMs or Flash memory. However, memory based on nanotechnology is being contemplated.

Large companies could be slow to react to change. Samsung should focus on all the innovation in the industry including nanotechnology.

Competition
Buyer power is moderate in the semiconductors market. A wide range of customers and strong innovation helps competitors to differentiate their products. There is a strong rivalry between a small number of semiconductor companies present in the market. Though, fairly strong growth has eased competition. However, all of the major competitors have started Therefore, fierce

investing and building new production facilities for the last few years.

competition is expected due to potential increase in our competitors product quality and production efficiency. We will have to strategically respond to the competition.

New Chinese Entrants

Chinese competitors are one of our most major threats. They brought fierce rivalry by large-scale entry. Samsung had to drop prices due to increase in industry capacity and normal cyclical downturn. Only our high-end products are priced high. Chinese competitors are

sacrificing profits for market share. However, as it is very costly to build a new fab ($3 billion in 2004), they are having a hard time raising funds. Besides, Chinese have trouble to produce frontier products because they lack organizational experience and expertise. They need someone to teach them and master design and production process. There is however, real potential of building necessary skills over the next decade due to talented engineers and access to outside finance. SMIC has been forming alliances with Infineon and Motorola, licensing technologies and rapidly increasing revenues. Chinese companies are raising billions of dollars from outside investors to build production facilities. China does not

lack critical infrastructure anymore and it is becoming more attractive to the investors. This is also due to support by Chinese government, which has been very committed in subsidizing infrastructure, needs. Many companies will be tempted to form partnerships with them to save costs, raise funds with cheap credit, take advantage of abundant land, cheap utilities, engineering talent and tax incentives.

Samsungs Competencies and Competitive Advantage

Samsung has always been an industry leader with the highest number of DRAM production, revenues and net income since the 1980s. Our net income declined only when the industry as a whole suffered losses. Moreover, Samsung hit its highest yearly net income in 2002, when most of the companies in the industry were in decline (Exhibit 1). Samsung has had the highest Average Selling Price (ASP), price premium and operating margin in the industry. Even though its competitors have low cost strategy, Samsung has had the lowest operating and fully loaded costs in the industry at all times. The company has been able to combine low cost production with great operational efficiency, high premiums and differentiation. The company differentiated itself with innovation and quality. It is a leader in innovative and quality products producing the highest number of 256Mbit, 512Mbit and 1Gbit DRAMs in the industry (Exhibit 2). Other companies are also catching up with the production of high capacity DRAMs. However, Samsung has the lowest percentage of low capacity legacy products 16Mbit and 64Mbit DRAMs and the highest percentage of frontier products 512Mbit and 1Gbit DRAMs among competitors, thus demanding the highest prices for its products. Samsung is also producing the highest number of specialty products for niche markets (DDR2 SDRAM).

Samsung is superior in product design and process efficiency. Quality and reliability have always been extremely important for us. We have to keep differentiation strategy, as well as low cost production and production efficiency in order to remain competitive. Our other core competence is our corporate culture and human resource management. We would not be able to achieve so much without great human capital, necessary award systems and proper management. No matter what decision we make, we cannot give up our corporate culture.

Possible Options for the Samsung

One of the routs for Samsung is to collaborate actively with a Chinese partner. It is projected, that by 2010, China will become the worlds second largest purchaser of semiconductors after the US. However, major producers still hold back from major new investments in China despite the fact that the overall memory chip industry has been growing modestly over 2004. Samsung could license products to Chinese companies for a share in their company, acquire a Chinese company or form a joint venture. In case of an acquisition or a joint venture, we could utilize current Chinese facilities, share technologies or build a new plant. An alternative option is staying on our own and increasing our investment in cutting edge memory products, particularly new niche markets, put our resources into R&D and innovation rather than pouring funds into Chinese companies. We could give up the lower end of the market to the Chinese and try to develop high end products ourselves.

Comparative Evaluation of Alternatives

Even though it seems that our competitors have not yet started aggressively investing in China, they are starting to show the interest in the giant market. Infineon and Elpida sold their

license rights to SMIC. The risk however, is very high. Their intellectual rights will not be protected fully and sharing blueprints and expertise with them could lead to the potential partner becoming a rival some day. Companies however, could form joint ventures or acquisitions in order to avoid this risk. Hynix recently entered into a joint venture with ST Microelectronics to build a memory production fab near Shanghai, China. If industry picks up sharply, major DRAM producers will look into partnering up with Chinese companies and establishing joint ventures. This could result in massive attack by Chinese companies, a huge threat for Samsung. On the other hand, Samsung is a market leader in terms of low cost and productivity and by no means should teach Chinese companies how to achieve that advantage. Samsung could continue its product differentiation strategy, put more efforts into growing high-value niche products and cede the lower end of the market to the Chinese. However, if we acquire a Chinese company instead of licensing or forming a joint venture, we would not be at risk of our partner becoming our rival some day. There is another danger for Samsung in case we decide to acquire a Chinese firm or form a joint venture. We could potentially compromise our corporate culture. If Samsungs

competitive advantage has come from our unique corporate culture at the main R&D production site in Soul, moving production to China could potentially threaten our culture and business. We might have trouble finding and retaining talent in China. Our management techniques and western approach might not be suitable for Chinese culture. Quality and reliability is crucial in our industry and we would not want to give that up.

Recommendations - Implementation Plan

My recommendation for the plan of action in this situation is to acquire Chinese, already well established company SMIC. The risk of Chinese competitors taking over the market is so 8

high that we should put a lot of effort in establishing our corporate culture and quality control in Chinese facilities. We would be best able to achieve full control with acquisition of a Chinese company rather than licensing or forming a joint venture. Building our own plant in China would be the best solution for this matter, but we would not be able to take advantage of already established facilities and many incentives from Chinese government. We would also be loosing time in building plants from scratch. Acquiring a company is expensive, however we are in a great financial standing and would be able to afford acquisition of SMIC. Not only that, we will not need to pull out our funds from R&D, rather stress innovation in Seoul facilities. By acquiring SMIC we will take advantage of its current facilities, its large inflow of funds from operations as well as from investors, companys experience in Chinese market and its distribution channels. Initially, we will produce legacy products in China and when the quality of production process is up to par with our production in Seoul, we will move on to frontier products here as well. Samsung should slow down the pace of decreasing DRAM production as a percentage of manufacturing line sharing. The computer industry has matured however it is still growing in Asia-Pacific and other developing regions. We should keep increasing Flash production. It has a huge potential as growth is predicted in digital cameras and camera phones. Flash production should be 35% of our manufacturing line sharing within next three years and DRAM production should be 20%. We should focus on frontier products, innovation and nanotechnology. This way we will be able to maintain premium prices and stick with our product differentiation strategy.

Exhibit 1. Net Income of Samsung and its competitors (USD, millions) 1995-2003

Appendix

8000 6000 4000 2000 0 -2000 -4000 -6000 Samsung Micron In:ineon Hynix Samsung Micron In:ineon Hynix

1995 3234 844 0 0

1996 194 594 0 -474

1997 87 332 -95 -599

1998 259 -234 -775 -129

1999 2768 -69 60 167

2000 4775 1548 1199 -2280

2001 2222 -521 -663 -3844

2002 5875 -907 -974 -1560

2003 4975 -1280 -345 -1770

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Exhibit 2. DRAM Production Volume by Density in 2003 (million unit, 256Mbit equiv.)
695.8
700

540.1
600

479.5
500

374.2
400

4Mbit 16Mbit

300

200

151.6

30.4 1 88.1

0.1 13.7 0.6 11.5 96.8 0 68.2 0 6.8 0

64Mbit 128Mbit 256Mbit 512Mbit 1Gbit

100

16.4 29.7 1.3 1 0 0 0

1Gbit 512Mbit 43.7 256Mbit 0 0 128Mbit 33.6 0 0 64Mbit 0 10 16Mbit 0 0 4Mbit

Samsung 4Mbit 16Mbit 64Mbit 128Mbit 0 1.3 16.4 151.6

Micron 0 1 29.7 88.1

In:ineon 0 0 0 43.7

Hynix 0 10 33.6 96.8

SMIC 0 0 0 0

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