Why Samsung's Galaxy Note 7 recall will have temporary impact on earnings

Why Samsung's Galaxy Note 7 recall will have temporary impact on earnings

The fallout from Samsung's ongoing recall of its faulty Galaxy Note 7 devices will be temporary, with robust performance in the components business expected to limit the damage to earnings in the second half of the year and in 2017, according to analysts.

Samsung's semiconductor business, which makes memory chips for technology brands including Apple, and its display business are set to receive a boost from better pricing and strong demand across major applications, cushioning the blow from the expensive recall, experts said.

That's not to say the company will escape unscathed. Most analysts expect Samsung to book a one-off recall cost anywhere north of 1 trillion Korean won (S$1.2 billion) and reduced margins in its third quarter numbers.

Strong prospects for component business

According to Deutsche Bank analysts Seung Hoon Han and Caroline Kim, stronger component pricing would partially offset the impact of the Galaxy Note 7 recall, a stronger Korean won and the Hanjin shipping bankruptcy, which likely led to higher transportation costs, on Samsung's overall earnings.

"We remain positive on [the] memory [business], with continued capex discipline, stronger demand from spec upgrades and tight supply," said Han and Kim in a note on Monday.

They highlighted several positive factors leading to higher demand for Samsung's memory chips, including an improvement in the personal computers (PC) business, aggressive restocking demand from Chinese smartphone makers, significant increase in iPhone memory content and the continued rise in server dynamic random access memory (DRAM) content.

The display panel business was also set to benefit from secular growth in organic light-emitting diodes (OLED) technology - which powers the display in many television and handsets today - and a turnaround in liquid crystal display (LCD) segment, based on improved industry dynamics such as strong LCD panel pricing, said Citi analysts in a note last week.

Han and Kim added that Samsung's shutdown of its existing LCD capacity could help drive higher profitability in the LCD segment as higher prices offset a decline in volumes. "Samsung's large size LCD capacity is expected to be down 13.6 per cent year-on-year in 2017, which will contribute to further supply tightness," they said.

Local news site Hankyung reported in July that Samsung planned to halt production of LCD panels on a production line at its number 7 plant in Asan in South Chungcheong province by end of 2016 and turn it into an OLED line.

In its second quarter earnings, Samsung's memory business saw a 6 per cent growth on-quarter in sales, while the overall semiconductor business grew 8 per cent. The display business grew 6 per cent for the same period.

There were also other factors working in favour of the South Korean manufacturer.

Final impact of the Note 7 recall

On Tuesday, Samsung said that more than 60 per cent of all recalled Galaxy Note 7 phones sold in the US and South Korea have been exchanged through the programme, while nearly 80 per cent of the customers in Singapore have participated in the programme.

Earlier this month, Samsung announced a global recall of its faulty Note 7 devices, just weeks after its launch, due to reports of batteries catching fire. Reuters reported the recall was estimated to involve at least 2.5 million handsets in 10 markets.

Keon Han, a research analyst at Credit Suisse, said in a Monday note he expected the final number of Note 7 devices recalled and replaced to be less than the initial estimates.

"First, Galaxy Note 7 devices shipped to China, installed with ATL batteries, were not recalled," he noted. "Second, not all consumers who have already purchased the product will participate in the recall." Han said Samsung also recalled handsets from channel partners, which could "swing the magnitude of the losses more favourably" as unopened models that are deemed safe could potentially be reshipped.

Others, however, felt Samsung needed to do better and get customers to recall more of the affected devices given the safety concerns. Bob O'Donnell, founder and chief analyst at Technalysis Research, told CNBC's "The Rundown" on Wednesday, "Remember, this is a device that can start a fire."

The general consensus among analysts, however, is that issues surrounding the faulty batch of Note 7 handsets should tide over by the fourth quarter, when pent-up demand would likely normalise the model's sales.

Note 7 issues won't affect other models

The problems facing the initial batch of Note 7 models were not expected to affect Samsung's broader range of handset products in the long run, which include the flagship Galaxy S7 and S7 Edge.

Samsung attributed strong sales in both models to its strong second quarter results earlier this year.

Technology research firm Gartner's lead analyst for Samsung, Tracy Tsai, told CNBC by email the problem with the Note 7 would be confided to a single model. "There may be some buyers switching from Note 7 to iPhone 7," said Tsai. "This should be just a short term impact, resolving once the issue is fixed through recall."

As for existing users, Tsai reckoned they would continue to use their Samsung handsets.

But Technalysis' O'Donnell said the likes of LG, Lenovo and Xiaomi, might receive a boost from users wanting to switch away from Samsung to other Android vendors in the aftermath.

Samsung still has a solid lead over second-placed rival Apple in terms of market share.

The latest numbers from Gartner showed in the second quarter of 2016, Samsung owned 22.3 per cent of the smartphone market, compared to Apple's 12.9 per cent.

Analysts said there was also a possibility Samsung could bring forward the launch of its next flagship model, the Galaxy S8, to minimise the reputation damage from the Note 7 recall. The company was expected to employ additional quality control on the S8 to avoid repeating a similar incident.

A director for Handset Country Share Tracker at Strategy Analytics, Woody Oh, told CNBC by email, "I bet that Samsung will be strengthening its quality control process both internally (set-wise) and externally (chipset-wise) from now on, to stop this sort of issues from happening again. [They] will make sure that upcoming Galaxy S8 is very safe, stable and high-performing."

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