Lee Kun-Hee, the man responsible for transforming Samsung into one of the world’s biggest TV and phone brands, believes a sense of “perpetual crisis” is vital when it comes to staying ahead of rivals. What he means is that a healthy sense of insecurity keeps a company hungry and on its toes. Being too comfortable leads to complacency.
What he definitely did not mean was for Samsung to be at the centre of a slew of negative headlines. Indeed, we have recently seen faulty batteries that led to an expensive recall of the Galaxy Note7 smartphone and Lee’s son and anointed heir, Jae-Yong, is on trial for bribery in a case linked to the downfall of South Korea’s president. Business may also be hit by a growing diplomatic spat with China after Korea decided to install a US-made missile defence system.
We are following developments closely because Samsung Electronics, the crown jewel of the Samsung group, is the third-biggest investment in our Asia Pacific ex-Japan fund. It is a business we know well, having been invested in it since the 1990s.
So, what makes this company special? Samsung is best known for manufacturing phones, TVs and a variety of home appliances under its own brand. But a big part of its business comes from making components such as computer chips, displays and flash memory for other companies. For example, the firm will supply the bulk of the organic light-emitting diode screens to be used in Apple’s new iPhone due later this year.
It is this mixture of own-brand consumer gadgets and high-end components manufacturing that makes Samsung Electronics unique and very profitable. It made a gross profit of 81.6trn South Korean won (US$72.1bn) last year, the highest since 2013. As a rough comparison, Apple – the world’s most valuable brand from 2012 to 2016 – reported gross profit of $83.7bn in its latest full-year results.
The business generated the local currency equivalent of $20.5bn in free cashflow in 2016. Meanwhile, the balance sheet shows cash and cash equivalents worth some $83.9bn in various currencies. Against total debt that is equivalent to around $13.5bn.
Cash flows back
The company has consistently demonstrated an ability to break into new product areas and build superior competitiveness through accelerated research and development and good execution. A net cash balance sheet, strong cashflow and big profits provide financial buffers in tough times.
But what has got investors really excited is the company’s pledge to return around 50 per cent of free cashflow to shareholders via dividends and share buybacks. It paid out the equivalent of $3.5bn in dividends last year, an increase of 30 per cent compared with the previous 12 months, and a further $8.2bn has been set aside for buying back its own shares from the market.
That is why (as at 11 April) Samsung’s share price has gained more than 15 per cent since the start of the year and is up the best part of 10 per cent since the younger Lee was arrested on 17 February.
“The company has consistently demonstrated an ability to break into new product areas and build superior competitiveness through accelerated research and development and good execution.”
Company faces big tests
That said, the company does face big tests this year. These are not so much from a revenue perspective – the firm said earlier this month it expects Q1 operating profit to be almost 50 per cent more than the same period last year. Forecasts of surging memory prices (Samsung is the world’s biggest manufacturer) are a boon.
But the pressure is on for a successful rollout of the new Galaxy S8 smartphone launched at the end of March. The faulty battery episode was out of character and did not damage sales of Samsung’s other phones but any problems with this new model will be a serious blot on the company’s reputation for quality. Happily, the initial reviews have been largely positive.
The bribery trial is a setback for corporate governance. Over the years we have seen the company become more open to investor feedback and improve financial transparency. But this could also provide an impetus for further change as public perception starts to play a bigger role in shaping corporate behaviour. Samsung has denied any suggestions of wrongdoing and we are inclined to reserve judgement until more details emerge.
Meanwhile, a deep pool of capable senior executives ensures there is minimum disruption to the business. A search for a high-profile foreigner to sit on the board – almost unheard of in corporate Korea – continues, and a shareholder suggestion to simplify the Samsung group’s complicated corporate structure is being studied.
South Koreans go to the polls in early May to elect a new president. All the candidates have expressed a desire to ease tensions with North Korea and there are hopes a new leader will offer an opportunity to reset relations with China, a market which accounted for just over 15 per cent of Samsung Electronics’ revenues in 2015.
History has shown that, despite the rhetoric, China has never allowed politics to get in the way of business for too long.
Crisis, regardless of how it is defined, often leads to change. A higher level of scrutiny will ultimately benefit corporate Korea and the country’s financial markets. What will not change is Samsung’s ability to deliver high returns for its shareholders.
Hugh Young is managing director of Aberdeen Asset Management Asia