(This content was originally published as an Action Alerts PLUS Alert on Sept. 26, 2016. Stock prices, shares held and portfolio positions may have changed.)
-- We believe Samsung's Galaxy Note 7 scandal is a result of cultural, structural, and behavioral factors
-- Samsung's ambitious attempt to best Apple in premium smartphones backfired as a result of these self-inflicted issues
-- Samsung's brand will struggle to recover long term, gifting Apple an enormous market share opportunity over next several years
Samsung Electronics has learned the hard way just how quickly and dramatically one company's fortunes can change. In a matter of one month, the South Korea-based global electronics titan has experienced an Icarus-like fall from the heights of prominence to the depths of humiliation amidst what is increasingly emerging as one the biggest public fallouts in recent corporate history. We have spent the lion's share of the past two weeks digging deep into Samsung's recent troubles, evaluating both the cause and consequence, near- and long- term, for the company and, laterally, its chief smartphone rival Apple (AAPL:Nasdaq).
Our verdict? The issues at the heart of Samsung's Galaxy Note 7 scandal (which involves hundreds of its recently launched phones literally exploding) are not a result of an incidental battery defect, nor contained to the 2.5 million devices in circulation. Rather, we believe they represent a convergence of cultural, behavioral and structural risks, each of which combusted, creating management's worst nightmare: gifting Apple an enormous market share opportunity within high-end smartphones at the behest of Samsung's (arguably) self-inflicted brand degradation.
First, some history. The South Korean electronics conglomerate sells an infinite scope of consumer products (smartphones, TVs, laptops, printers, telecom equipment for 3G/4G, air conditioners, even refrigerators) and technological components (3D Nand, DRAM flash memory chips, storage chips, LCD for displays/monitor, and batteries, among other parts). Samsung is a one-stop shop for consumers and manufacturers, offering not only a wide range of product categories but product quality and pricing.
Samsung also hates Apple. The two companies have dueled it out publicly in the court room (dozens of major patent litigations) and board room (leaked slide from board meeting literally said "Beating Apple is No. 1 Priority: everything must be in the context of beating Apple," per figure below) while exchanging blows upon each major product launch. Their respective premium smartphone market share changes hands following each respective release, iPhones for Apple and the Galaxy series for Samsung. The below slide from 2012 demonstrates the magnitude of Samsung's obsession with Apple, so much so that its entire company-wide strategy was underpinned by a unilateral goal: crushing Apple.
Samsung's Leaked Presentation: '2011 Summary & Lessons Learned/2012 Business Forecast'
We think the above slide offers insight into Samsung management's thought process, strategic priorities, tactical urgency and, ultimately, the highly emotional component driving future initiatives. It is interesting to note Samsung's dramatically underestimated internal projections around iPhone sales, which fell more than 100 million units short of the 150 million smartphones Apple ultimately sold (Samsung projected ">40 million units").
Samsung's strategic insight is not without merit, however, as it pinpointed strong relationships with carriers as strategic priorities. Apple may dominate the market for high-end smartphones, but unlike Samsung it pinches carriers' margins, which is why Samsung has long enjoyed a profitable, mutually beneficial relationship with AT&T (T) , Verizon (VZ) , Sprint (S) , and T-Mobile (TMUS) in the U.S. Since the carriers buy Samsung's phones directly and influence pricing, marketing and awareness, it is not surprising to see that the company devotes 80% of its roadmap to supporting carrier initiatives, thereby buttressing Apple's prominence.
The graph below (created by analysts at Canaccord Genuity), shows that, although Samsung may be the global market share leader for the total smartphone market (including low- and mid-tier phones), Apple sweeps up all others on profitability, capturing more than 90% of 2015 smartphone profits vs. 14% for Samsung.
Prior success is never a proper indicator of future success. One month ago, it appeared Samsung had not only matched Apple but eclipsed its chief rival, having just launched the Galaxy Note 7 series to blockbuster reviews (the Galaxy Note 7 is completely separate from the Galaxy S7, which is Samsung's best-selling series. The Note, by comparison, is a largely niche product with a cult-esque following, differentiated by its large screen size, smart pen, and highest price point, retailing above $800). The Note 7 launch came on the heels of a remarkably successful March launch of its Galaxy S7, which blew away sales expectations and drove the company's record second-quarter results. The results, outperformance, and strong guidance suggested Samsung had reversed its fortunes after watching its profits and market share squeezed from both the high-end, middle-end, and low-end over the course of the past five years.
Indeed, Samsung appeared to be moving in the opposite direction from Apple, which reported record-low iPhone 6 sales for the second quarter while witnessing its global high-end market ($500+ phones) share drop to 50% from 60% while Samsung's rose, gaining six percentage points in share to 36%. Investors were affected as well: From the beginning of the year to the end of July, Apple's stock had dropped nearly 8% vs. a more-than-20% advance for Samsung.
In the wake of this success, Samsung's management decided to expedite the launch of the Galaxy Note 7, pulling its release date 10 days forward while adding 10 features to the phone, dismissing concerns voiced by suppliers that rushing such a feature- heavy launch would overextend the already-strained manufacturing bandwidth. Once it learned that the iPhone 7 launch would lack major announcements, management made the decision to focus on rapidly producing and releasing a spectacular, feature-packed smartphone ahead of Apple's product event in order to finally lift its brand into global relevance and validate once and for all that its high-end devices beat Apple on an "apple to apples" basis. In doing so, it pressured suppliers to meet impossibly accelerated deadlines and suffocated the very integrated supply chain it relies upon.
See, Samsung relies on a rare model in which it is vertically integrated (it manufactures the parts for most of its consumer products itself, rarely relying on outside suppliers) and horizontally exposed via significant end-market exposure. Samsung's greatest competitive advantage has been its economies of scale and manufacturing capabilities, yet its most recent push cracked the fragile balance between speed, quality and oversight.
This is where the cultural dynamic comes into play. Samsung's leadership team has demonstrated a self-protectionist attitude throughout the entire process, seemingly placing its pride ahead of its customers since the onset, waiting 15 days in between the Note's Aug. 19 launch -- as 35 confirmed reports of the phone blowing up in the U.S. alone occurred -- before even acknowledging the issue, lest claiming responsibility. Instead of working with regulators to manage a recall, Samsung chose to circumvent regulatory processes by announcing a vaguely defined "global recall" on Sept. 2, which did nothing other than buy time to coordinate PR efforts. In fact, Samsung largely denied any culpability, noting that "there was a tiny problem in the process of manufacturing battery cells."
We believe Samsung's ability to bypass convention is a product of management's hubris/inability to admit culpability and enabled by government-sponsored insulation (the company is the bellwether for the South Korean economy) and, finally, structural control over the entire manufacturing process.
But it turns out that in its rush to get an iPhone killer into the market, Samsung made some serious design mistakes. The crux of the problem is that the Galaxy Note 7's lithium-ion batteries were squeezed into the devices way too tightly. What's wrong with that? Like any battery, these have a positive electrode and a negative electrode, with a separator keeping them apart, because if the two electrodes touch they'll overheat and then catch fire on exposure to oxygen. By squeezing its batteries into the phone too tightly, Samsung made it much easier for that separator to melt down, which ultimately leads to an explosive reaction.
As confirmed incidents increased in intensity and frequency, various authorities across the world were forced to step in: on Sept. 9, the U.S. Consumer Product Safety Commission issued a formal warning around the severe danger inherent to Note 7s, while the Federal Aviation Administration outright banned Note 7s on all flights. In response, Samsung published a blog post urging users to power down as soon as possible and return their phones to point of purchase.
Amid more reports and scrutiny, Samsung took out a front-page advertisement in a South Korean newspaper announcing a software update for the Note 7 was available for users who disregarded its recall notice and continued to use the smartphones. The company told Note 7 users that they could continue using their phones if they limited charging to 60%.
Finally, on Sept. 15, the CPSC announced an official recall. The reason mechanisms like the Consumer Product Safety Commission are established is to expedite coordinated, proactive responses to product issues while providing independent diagnosis and clear "next-steps" guidance.
Although the U.S. market is critical for Samsung's premium smartphone efforts, China represents the world's largest smartphone market, with the top-five vendors comprising more than 110 million in annual shipment volume (and Samsung comprising 7 million annually). Samsung's soft recall did not include China or Hong Kong and it continued shipping the devices to the region under the pretense that the batteries sold to the Chinese markets were "problem-free." Within days of shipment, Chinese media reported multiple Note 7 phones had burst into flames, along with Samsung's credibility with Chinese officials and media outlets.
Samsung tried to deny any culpability, blaming "external factors" for the incidents. By attempting to hide the issue from China, its chances of gaining traction in the region slipped away. In fact, a survey over the weekend suggested nearly 40% of current Samsung smartphone owners would consider buying an iPhone to replace their Samsung smartphone.
We are a decade removed from Sony's personal computing battery scandal, where the world saw, heard or read about consumer products overheating and exploding, leading to a massive product recall while tarnishing the company's brand. The comparison nearly begs itself -- horizontal product/end markets and vertical integration, coupled with a weakened competitive positioning, leading management teams to make poor decisions under pressure and overstretch the supply chain past its breaking point.
Enter Apple. The company's patience, tactical discipline and ultimate willingness to lay the bricks for introducing new features strategically and methodically over multiple generations speaks volumes to the staying power of its iPhone device across nine years of cycles. Management is constantly balancing opportunities vs. risks and making each product event relevant is a tall task.
Apple has prioritized patience over rush-to-market in order to ensure that once it launches a new product or feature, it does so knowing that its capability is superior to its competitor (Samsung on the high-end & no one else). Management's lack of desperation -- and proper sense of security amidst constant innovation -- allows the company to play for the long term, using incremental share gains in the smartphone market to fuel the flywheel effect that is their Services businesses.
The acceleration toward more active devices, upgrades to higher-end phones and ability to take share previously outside of its reach will inevitably lead to higher switch rates, increased profitability and greater bargaining power with carriers. The iPhone 7 launch wasn't flashy, but even its biggest pessimists were positively surprised. Apple now has a major opportunity to take high-end share in the U.S. as well as China.
Samsung's blunder: By trying to do everything and appeal to everyone, while failing to remove emotions from competitive battle, Samsung's management made a major strategic error that failed to measure risks against benefits. A decade-long identity crisis between how Samsung wants to be perceived and how it actually is perceived has reached a tipping point, with the end result likely meaning the company remains stuck in the middle of the road, squeezed by shrinking share on both the low- and high-end.
The long term is a greater risk for Samsung, as half of its high-end smartphone users are die-hard customers (and will not change sides) with the other half being anti- Apple (not wanting to conform to Apple's domestic dominance and mass-market appeal as the world's largest company). The latter camp is far more likely to switch sides as Samsung's brand has now been tarnished and the company exposed for poor practices, which the owners despise. With roughly 300-400 million premium smartphone devices up for grabs between now and the end of next year, we expect Apple to capture the vast majority.
Samsung's greatest competitive advantage has been its economies of scale and manufacturing capabilities, all under its vertically organized supply chain, but the recent push toward feature innovation overstretched bandwidth, which precipitated a snap, crackle and ultimately pop. Delicately woven credibility as a provider of luxury smartphones is at stake, and Samsung will have to shift the message fast in order to salvage its reputation.