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Why Did Apple Just Pay Samsung Nearly $700 Million?

Leo Sun, The Motley Fool

Apple (NASDAQ: AAPL) and Samsung (NASDAQOTH: SSNLF) are fierce rivals in the smartphone market, but the latter still supplies displays and memory chips for the iPhone maker. The iPhone X, which was launched nearly two years ago, included $110 in Samsung components, according to The Wall Street Journal.

Apple gradually reduced its dependence on Samsung by tapping other chip suppliers and producing more first-party components, but most of its current-gen iPhones still use Samsung's OLED screens. The details of the contract weren't disclosed, but it reportedly included a sales target guarantee for Samsung.

A woman uses an iPhone XS Max in the rain.

Image source: Apple.

Apple's iPhone X and XS devices, which both sport Samsung's OLED screens, didn't sell well due to the saturation of the smartphone market, long upgrade cycles, a lack of compelling new features, and competition from the cheaper iPhone XR, which used a cheaper LCD screen. Apple repeatedly cut orders for the two higher-end devices, which recently caused Samsung to demand compensation for unfilled OLED orders.

Apple reportedly complied, according to South Korean outlet ETNews, and paid Samsung 800 billion won ($681 million) for its trouble. The report was supported by a footnote in Samsung's earnings guidance for the second quarter, which included "a one-time gain related to the display business."

What does this mean for Apple?

That $681 million represents less than 0.3% of Apple's projected revenue this year, so it's safe to say that this one-time payment won't hurt the tech giant. However, recent reports claim that Apple might add OLED screens to other future devices -- like the MacBook Pro and iPad -- to appease Samsung.

However, KGI Securities analyst Ming-Chi Kuo believes that Apple's next-gen MacBook Pros and iPads will use microLED screens instead of OLED ones. This indicates that MacBooks and iPads using Samsung's OLED screens probably won't appear in the near future, if at all.

It's unclear if Apple's one-time payment squares things with Samsung, but it highlights two issues with its hardware business. First, Apple is too dependent on smartphone rivals like Samsung and LG for displays. It's reportedly developing its own microLED displays to cut them out of the loop, but Samsung -- which has much more experience in the display market -- is also producing its own microLED screens. If Apple's first-party displays fail to match Samsung's quality, it could be a costly and humbling mistake.

Second, Apple's sluggish iPhone sales weaken its clout with suppliers. In the iPhone's heyday, Apple could easily secure sweetheart deals from smaller component makers. But with a company like Samsung, which dominates the display and memory chip markets, Apple is in a weaker position -- especially if it can't even meet its own sales targets. That's why Apple is constantly touting the expansion of its services ecosystem as its hardware sales decelerate.

A woman takes a picture with an iPhone XS.

Image source: Apple.

What does this mean for Samsung?

A payment of 800 billion won accounts for about 0.3% of Samsung's estimated revenue this year, so the payment won't alleviate its other headaches in the smartphone and memory chip markets.

Samsung's smartphone unit is struggling with the saturation of the market and competition from cheaper Android device makers. As a result, its IM (IT and mobile communications) revenue fell 4% annually last quarter as its operating profit plummeted 40%.

Samsung's semiconductor business, which mainly produces DRAM and NAND chips, is also struggling with the ongoing declines of memory chip prices worldwide. That's why its semiconductor unit's revenue fell 30% annually last quarter as its operating profit plunged 64%.

Samsung's IM and semiconductor businesses generated 80% of its revenues and more than 100% of its operating profits during the quarter, so it desperately needs new sources of growth. One of those units was originally its DP (display panel) unit, which previously set up a manufacturing facility that exclusively produced OLED screens for Apple.

That plant was set up to produce 100 million OLED iPhone screens annually, but its capacity fell under 50% last year as iPhone sales decelerated. That slowdown, along with soft sales of Samsung's own Galaxy devices, caused the DP unit's revenue to decline 19% annually last quarter and post an operating loss. That's probably why Samsung demanded that big reimbursement from Apple.

Big challenges for both companies

Apple's payment to Samsung doesn't matter much financially to either company. However, it highlights the serious challenges for both companies' core businesses. Apple's hardware business is losing its mojo and most of Samsung's businesses are moving in the wrong direction, and these brutal headwinds won't fade anytime soon.

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Leo Sun owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.