Smell burning? Samsung’s 'Death Note 7' could still cause a contagion

The trouble doesn't stop here. It starts here

Analysis Samsung’s rivals in the cut-throat flagship phone market shouldn’t pop open the champagne just yet. While in the short term, Sony, HTC and Google could see some upside from Samsung’s now-deceased “Death Note”, in the long term the market and the consumer benefit from a high margin leader.

But it would be a dead cat bounce: a demise of Samsung would merely prolong the agony for a fleet of Android OEMs for whom profit is a stranger.

It sounds counter-intuitive, but as we’ll explain, without a high margin 800lb gorilla stomping about, rivals will have a much harder time differentiating themselves on price alone. They’ll need to spend much more on marketing to make themselves known. This will erode their margins, if they are Tier 1 OEMs, and slash away at their only advantage - price - if they are upstarts.

Today Samsung confirmed it is killing off the Note 7 completely. By the general consensus, this was regarded as the best Android phone ever made when it was unveiled two months ago. From a technical and design point of view, Samsung had lined up all the ducks. The Note 7 smashed it out of the park.

According to the latest analyst guesstimates, the Note 7 fiasco could cost Samsung almost $17bn. The figure has been rising since the initial Note 7 recall in September. Initial estimates of the cost were around $5bn in missed sales and recall costs. But then things got farcical, as replacement units caught fire. Samsung had then reportedly halted production of the Note 7, but not yet announced it was discontinuing the product.

The Death Note saga reflects badly on the company. At the end of August, reports emerged from South Korea of Note 7s catching fire. Samsung put on its concerned face, briefly, and pressed ahead with a global launch. It was forced to undertake a global recall in mid-September, shifting the blame to its battery supplier.

In a cack-handed press release, it even tried to turn the recall into a happy song.

Um, are you sure you meant to say that, Samsung?

And then replacement Note 7s - with a battery provided by its new supplier - also went fizzle and pop. Hmmm.

Take the hit, Samsung

Samsung Electronics should just about be able to absorb an expense that would capsize other companies, because of the chaebol’s sheer size. The phone division (“IT & Mobile Communications”) is an important part of a larger electronics business that ranges from components (LCDs and semiconductors) to white goods. The phone unit brings in half of the Electronics division’s revenue and profits. Those will see some impact from the Note 7 debacle too, because the device uses Samsung’s LCD and chips. And don’t forget that most (some 70 per cent) of Note 7 batteries come from Samsung SDI, in which Samsung has a 30 per cent stake.

Samsung’s phone unit is both a margin and a volume business, but those margins matter: Samsung is unique in being the only big brand Android maker from the first wave of Android OEMs to turn a profit. An often-quoted factoid is that only two companies (Apple and Samsung) make a profit in the smartphone business - but we’re wary of quoting this now; it comes from one source (the equity research division of a bank, Canaccord) that only examines public financial results - privately held Huawei makes profits on its phones, but only Huawei knows what this is.

Despite a broad portfolio, the fortunes of flagships matter a lot: Samsung’s revenue and margins collapsed with the lacklustre Galaxy S5, leading to the appointment of a new boss. D.J. Koh only took over in December. But the unit’s gradual return to form with the S6, and particularly the S7, saw revenues rise again. LG has been able to absorb wildly fluctuating fortunes of its annual flagship with steady gains at the low-end of the market. So Samsung needs the hits.

Across the Galaxy

The $882 Galaxy Note 7 is already Samsung’s most expensive and highest margin phone, and was expected to ship around 20 million units over the product’s lifetime. But the catastrophic dual-recall may have a "contagion" effect on the chaebol's reputation. The Note 7 as a product is no more, but who’d trust a Galaxy Note again? Will punters now also be wary of the “Galaxy” brand too? Or even become leery of trusting Samsung phones?

The FT notes that operators have reported some "contagion" affecting Galaxy S7 sales. The S-flagship has been the best selling phone in the world (although not in the last quarter) so this was a risk Samsung couldn’t take.

But let’s take the worst case, and least likely scenario, and assume that the Burning Note story depresses demand for Samsung devices in general.

Trying on Samsung's crown for size

To oversimplify things (but not by much), today the Android phone market consists of three groups: profitable higher margin vendors (Samsung alone), unprofitable high margin vendors (such as Sony, HTC) and low-or-no-margin upstarts who undercut the first two. (Under Lenovo, Motorola moved from the second to the third category.) The proposition offered by recent entrants such as Huawei is: if you’re prepared to forego a high margin flagship, the less lustrous “flagship-killers” can save you £150 to £200, and are almost as good.

Samsung’s continuing profits, albeit on much lower margins, have been necessary for stimulating investment and innovation. But Samsung’s margins don’t come cheap: maintaining that profile costs over $10bn in marketing every year. Overtaking Samsung is something Huawei would like to do, hence its splashy partnership with Leica.

But if you take Samsung out of the picture, then a lot of these low-profile and no-profile brands have to win the public trust, which is not cheap. Many of these upstarts were deluded by the lower cost of word-of-mouth marketing on the internet, and thought they could run the whole operation on the cheap, without spending any money. But logistics don’t really scale like that. They’re expensive, and this keeps margins on Androids low. A fair chunk of Samsung’s marketing spend would be assumed by the upstarts, who would very soon be selling "bargains" which weren’t such bargains any more. In any case, perhaps only Huawei is really in a position to pull it off.

So the Note 7 could start a real contagion across the industry - and a shake-up of the over-saturated smartphone market in a way we’ve been expecting for ages - ever since Shenzhen generics first burst on the scene with the OnePlus One. ®

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