RPT-Fitch Street interView - Samsung: Agile Adaptor; Not True Innovator

Fitch Ratings says that Samsung Electronics' (Samsung, A+/Stable) strong financial performance is likely to continue over the next two to three years based on its leading component technology, strong vertical integration behind its core products, and ability to quickly adapt and evolve to meet changing consumer preferences. Samsung's brand power has significantly improved over the past three years, but the company is yet to prove that it can be a "true innovator". Despite impressive performance, Fitch is unlikely to upgrade Samsung due its reliance on the relative fickle markets of consumer electronics, in particular mobile handsets.

In this Fitch Street InterView, Alvin Lim, Fitch's technology analyst based in Seoul, answers some key questions regarding Samsung's credit rating and the strategic challenges facing the company. Q. Samsung's financial performance has been very strong over the past three years, yet Fitch's credit rating has not changed from 'A+'. Could this change in the near future?

We believe that Samsung's significant exposure to macroeconomic cycles, volatility risk and reliance on relatively fickle, fast-moving, investment-intensive markets is inconsistent with a 'AA' category rating and therefore we are unlikely to upgrade Samsung in the medium term. In particular, the company's cash flows continue to be dominated by the handset market. The company's 'A+' rating is clearly supported by its technology leadership, dominant market positions, and some diversification offered by non-handset businesses. However the volatility inherent in its core operations (particularly the cyclicality of its semiconductor and display panel businesses), as well as the rapidly changing fortunes of global handset manufacturers, remain significant risks that are not commensurate with a 'AA' category rating. For similar reasons, Fitch has stated that it would be unlikely to rate Apple above 'A+'.

Q. Apple is cutting its reliance on Samsung for various components including LCDs and processors. How will this impact Samsung?

Apple's reduction in its components order from Samsung is negative for the latter, but the impact should be limited. Apple has already substantially cut its orders for memory chips and display panels for iPhones and iPads but we have not seen any significant negative impact on Samsung's financial profile as its internal demand has grown steadily.

In addition, it has been reported that Apple will source its application processors, which had been exclusively supplied by Samsung, from Taiwan Semiconductor Manufacturing Company (TSMC). However, we think Apple will continue to source some application processors from Samsung to ensure adequate quality and stable supply. In addition, Samsung should be able to allocate more capacity to meet increasing internal demand which should mitigate the impact of lower sales to Apple.

Q. There is a view that the smartphone market is likely to be saturated within the next 12 months. Do you still expect smartphones to remain the main growth driver and cash-generator for Samsung over the next two to three years? In short, yes. We expect Samsung to continue to enhance its profit and cash generation in the medium term mainly led by smartphones. In addition, improving industry conditions for semiconductors and display panels are also positive compared with 2012.

However, as the smartphone market matures, the technological gap with the second-tier makers may narrow leading to more intense price competition. In addition, should Apple launch low-end iPhones as reported, this is likely to erode some of Samsung's market position, especially in emerging markets. Therefore, we expect Samsung's high handset margins to decline over the medium term.

Q. What does Fitch view as the next major developments in the global IT industry and how is Samsung positioned to manage the transition?

We think "connectivity" will remain the theme of the industry over the medium term. The IT industry has strived to provide an ecosystem where consumers can seamlessly experience/utilise contents and information through various devices under an integrated platform. A smart watch, which many expect Apple, Samsung, and other technology leaders to introduce soon, is an example of this trend.

Fitch believes that Samsung is capable of introducing attractive products given its advanced manufacturing technology. However, whether the company can lead the trend itself is questionable due to its weak platform competitiveness. This may limit its ability to expand "connectivity" into other devices.

Q. Following on from this, Samsung is trying to transform itself into an innovator. Do you think this is working?

Samsung has demonstrated an ability to develop market-leading products in a number of categories, through sizable investment in R&D and capex. In addition, vertical integration with strong component businesses, such as semiconductors and display panels, has allowed efficient and timely development of advanced products, most notably the Galaxy smartphone series.

However Samsung's success story has been largely based on excellence in innovating to improve products already in the market. For example Samsung's Galaxy Note series illustrates how the company successfully identified a growing market need for larger sized smartphones including a stylus pen. Samsung has yet to prove its "creative" innovation, that is, launching a product or a market segment that has not existed before in addition to prowess in manufacturing technology. But to be fair if we were to review all of the global consumer technology successes of the last 10 years, the overwhelming majority would be developments based on existing products.

Presently Samsung's over-reliance on the Android platform due to the absence of its own competitive operating system clearly reflects this relative weakness. In addition, this may be a threat should competitors catch up on hardware technology or should industry hardware competence reach a common level and product differentiation is driven by competition in software offerings.

Q. Samsung's brand has improved significantly over the last few years. Is the company transforming into a marketing-led company?

We do not believe the company will become a marketing-driven firm shifting its strategic focus away from product competitiveness. We agree that the marketing is an integral part of operations to manage global market share but it will not be effective without leading products. In that regard, Samsung's main cash outlays will continue to be on R&D and capex rather than marketing. Nevertheless, we acknowledge that Samsung's marketing strategy has transformed the brand over the last five years; according to Interbrand in 2012, Samsung was the ninth most valuable brand in the world. In 2008 it was outside the top 100. The fall of Nokia, Blackberry and the Japanese consumer technology giants illustrates that strong brands can struggle, regardless of how much they spend on marketing, if they fail to develop technology-leading, desirable products.