Thursday, February 23, 2012

Considerations on a Commodity Business

"Don't fool yourself and you are the easiest person to fool." — Richard Feynman

Samsung’s (PINK:SSNLF) board of directors has given the company the go-ahead to spin off its money-losing liquid crystal display (LCD) TV business – confirming rumors that the Korean-based company believes its future in TVs is with LED and OLED technologies. ...

A lot of people avoid thinking about bad businesses. I think that's a mistake. You can (cheaply) learn quite a bit from thinking through bad businesses. We can start with why these companies are bad, the impacts of this on the income statement and balance sheet, and how management (and the industry) likely react to these things.

As a (very) quick example let's think about Samsung's LCD business.

The product is a commodity which means the company exerts little to no pricing power. I assume—although don't know—that the lowest-cost producer sets the price. And these prices are almost always moving lower, not higher. LCD prices have dropped over the last number of years, so not only do you have no pricing power but your inventory is declining in value.

To counter this the company probably tries to buy "efficiency" resulting in new manufacturing facilities/techniques which result in increasing capital expenditures and increasing capital requirements. (This means that cap-ex will outpace depreciation.)

Meanwhile all of these "efficiency" gains are available to your competitors as well. The efficiency is nothing more than an illusion because everyone upgrades (because they all want to buy efficiency too). The result is lower prices for the consumer without the company capturing any addition margin/profits (remember, commodity biz.)

Now the business is in arguably worse shape because you have higher cap-ex, increasing invested capital (with declining inventory prices — resulting from both technological obsolescence and your newly discovered productivity increases which only speed price decline) and worsening returns.

In the end you get one or two marginally profitable companies with all of the others losing money.

Perhaps in 5 years we're going to read the same story except "money losing LCD division" will be replaced with "money losing OLED division." Who would have seen that coming?