[THE INVESTOR] Samsung Electronics (“A1” stable) announced on Oct. 11 that it would cease production and was recalling its latest smartphone, the Galaxy Note 7, because of faulty batteries that were causing handsets to burst into flames. The production halt and associated product recall are credit negative, but we expect Samsung’s strong financial profile to continue to support its “A1” rating and stable outlook.

Samsung launched the Galaxy Note 7 in mid-August and announced a recall in September after having shipped more than 2.5 million units to more than 10 countries. Samsung decided to halt production and recall all of the phones following reports that replacement units had similar flaws. 




We expect that the cash costs of the production halt and recall will exceed our original estimate of 1 trillion won (US$900 million) to 1.5 trillion won when the product recall started in September. Samsung has announced that expected operating profit for third-quarter 2016 would be about 5.2 trillion won, down from its previous forecast of 7.8 trillion won. The company added that the discontinuation of Galaxy Note 7 sales would reduce operating profit by approximately 3.5 trillion won between fourth-quarter 2016 and first-quarter 2017.

Still, the cash costs of the production halt and recall are manageable given the company’s substantial liquid holdings and cash flow. At 30 June 2016, Samsung had liquidity holdings of around 77.1 trillion won, while for the 12 months that ended June 2016, adjusted free cash flow was 21.3 trillion won and total debt was only 12.2 trillion won.

However, the production halt and recall is likely to reverse improving profitability at Samsung’s IT and mobile communications (IM) segment, which accounted for about 55 percent of total operating profit in first-half 2016. Since the introduction of the Galaxy 7 line of products this year, reported operating margins in the IM segment have improved to more than 16 percent as of second-quarter 2016 from about 10 percent in 2015. That level of improvement now appears unsustainable.

Although Samsung had been using its advantage in hardware technology to take market share from Apple (“Aa1” stable), the initial recall, followed by the production halt, threaten to have a more lasting negative effect on the Samsung brand and require significant marketing expense to regain consumer confidence.

Source: Moody’s Investors Service

(theinvestor@heraldcorp.com)