Back in November of 2015, I highlighted how Samsung SDI (OTC:SSDIY) - a major subsidiary of Samsung Electronics (OTC:SSNLF; OTC:SSNNF) that produces small-scale and automotive lithium-ion batteries and other electronics products - had significant upside momentum due to its relative undervaluation and its shift from chemicals to batteries and electric materials. After having sold off most of its chemical assets to Lotte Chemical for ~$2.6 billion and allowing Lotte to attain majority stakes in both Samsung Fine Chemicals and Samsung SDI's chemical division (31.5% and 90% respectively), Samsung SDI looked to be poised to launch higher, especially after the market had apparently reacted negatively to the smart divestment of assets. Bernstein Research firm had even issued a price target of 160,000 won, or $140.22, representing a 50% upside for the equity.
Unfortunately, Samsung SDI and the entirety of Samsung Group is now in hot water, with the shares of Samsung SDI down 13% since that call on November 1st. There has been:
- ... the controversy regarding the Samsung Galaxy Note 7's overheating batteries, of which Samsung SDI manufactures 70%, which has ended in Samsung having to permanently halt sales and production of the Note 7...
- ... not to mention Samsung Group's seemingly never-ending battle with Apple (NASDAQ:AAPL) over alleged design patent infringement, which has now ended up in the U.S. Supreme Court...
- ... Samsung's exploding top-load washing machines...
- ... and a high-profile investigation which revealed Samsung had colluded with South Korean authorities to conceal more than 200 cases of major illnesses including leukemia, lupus, lymphoma and multiple sclerosis among former Samsung semiconductor and LCD workers.
Samsung management has so much to answer for; however, considering Samsung Group's inane corporate structure, I doubt management would even be able to answer shareholder concerns. These questions include but are not limited to the following:
- Is Amperex (a unit of Japan's TDK Corp. (TTDKY; TTDKF)) or Samsung SDI subsidiary responsible for the battery issue? Or is it an underlying major design flaw relevant to all Samsung batteries or all lithium-ion batteries?
Take note, future CCOs. Samsung's battery controversy and management's (lack of) communication is how not to handle public relations. Not only has management failed to adequately explain to its customers or shareholders the nature of the battery issue, it has also failed to inform major wireless carrier partners, such as AT&T (NYSE:T) or Verizon (NYSE:VZ), leaving them to handle with recall and replacement.
Most of what we do know is thanks to U.S. investigators and anonymous partner executives. It has taken weeks for Samsung to officially halt sales and production of the Note 7, meaning weeks of continued brand degradation while they remained silent.
As mentioned before, 70% of the Galaxy Note 7's batteries were manufactured by Samsung SDI with the remainder being produced by Amperex. With Bloomberg now reporting that "...investigators believe the latest incidents of Samsung Electronics Co. smartphones overheating... may be the result of a flaw different from the one that caused the device's original recall last month...", this means that both companies' batteries are responsible. The question that needs to be asked of all battery producers now (at least of the small-scale) is - is this a problem endemic to Samsung batteries or a possible problem with other designs?
In any case, as reported by Credit Suisse analysts, Samsung will now lose out on about 19 million phone sales or about $17 billion in revenue.
- Has Samsung sufficiently hedged against the possibility that all if not a considerably majority of its profits may be stolen in this egregious patent battle in the Supreme Court?
Much has been made of this final Supreme Court battle versus Apple, the first such design patent case the court has heard in over 100 years. However, what some analysts and the media fail to focus on is that Samsung will be paying a price regardless of the result of the case - the Supreme Court is merely deciding whether Samsung owes Apple all of the profits it made on disputed devices (about 11 devices worth $399 million in net profit) or only profits attributable to the apparently infringed design features, such as the phone's "rounded corners" or "distinctive front face".
Samsung has been quite vocal in explaining to the press and media about how it feels about the dispute; in which case, I, along with major tech companies such as Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG), agree with them. However, Samsung has not been clear to shareholders about how it is prepared to handle the financial consequences should the worst possible scenario occur and Samsung be forced to hand over all of its profits to Apple.
- Why is the Samsung Group corporate structure so tangled and messy to begin with; why not restructure as a holding company like many Japanese corporations?
Want to be the chairman of Samsung? Well, have fun learning about everything from manufacturing semiconductors to creating life insurance packages to running a hospital. Samsung has over 80 subsidiaries and affiliates, of which about 75% are unlisted, spread across virtually every sector and industry you can imagine.
This would be fine if Samsung Group was structured as some sort of holding company or parent holding company comprised of smaller holding companies, as most large corporations of this sort do in Japan; however, Samsung organizes itself as a conglomerate, meaning subsidiaries do not cooperate with any unified strategy. Nor does Samsung reap any of the liability or tax benefits that holding companies enjoy; so, losses in the SDI company or Heavy Industries company are shared rather than limited.
This is a major systemic flaw in Samsung's corporate strategy and one that will negatively affect how Samsung operates. I suspect we are already witnessing the consequences of Samsung's labyrinthine structure in this latest Note 7 controversy.
In any case, to conclude, Samsung Electronics investors have little to look forward to; Samsung SDI had previously had some upside potential due to the outlook on automotive and small-scale battery demand, however as we've seen, that story is ruined. Now, what some analysts in the financial media have brought up is how all of this negative pressure on Samsung could be a boon for Apple. This thinking is correct.
Combined, Apple and Samsung account for somewhere between 90-95% of the global smartphone market. With Samsung out for the count, albeit temporarily, Apple could reap the benefits of a void in the market; it seems Apple was already keenly aware of this as the controversy first started when it upped its order volumes for the new iPhone 7. To be clear, Apple will profit in the short-run; however, I believe some caution is in order.
Apple is not that different from Samsung. While Apple does not have dozens of subsidiaries (in fact, Apple goes out of its way to not have controlling stakes in any of its suppliers), it does organize its supply chain the same exact way, in that any disruption in one of its partners down the chain would have a negative effect on Apple's bottom line (e.g. through increased component costs), regardless of whether or not Apple had a stake in the firm. Especially with the decline of Sharp Corp (OTCPK:SHCAY) which was saved at the last minute by Foxconn (OTC:FXCOF), Apple is not exactly in a position to be losing any of its suppliers.
We still do not know the full extent of this battery issue, and whether or not it will remain contained to Samsung's suppliers. So, simply be wary: while this is definitely a temporary upside for Apple, I would not be going overweight the shares over this one catalyst.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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