Samsung's Vertical Integration Challenges

Hilary Tuttle


December 1, 2016

samsung galaxy note 7 recall

When companies attempt to generate explosive sales, they never mean it quite as literally as what Samsung accomplished this fall. Just a month after releasing its most advanced smartphone to date, the Galaxy Note 7, the world’s largest smartphone manufacturer recalled its new flagship product after dozens of reports of spontaneous explosion.

Scrambling—and, by all accounts, failing—to conclusively diagnose the problem, Samsung blamed defective batteries produced by its subsidiary, Samsung SDI, initiated a recall of one million phones, and continued shipping replacements it deemed safe, powered by components from another manufacturer.

By all public reports, the company’s engineers have still not been able to reproduce the dangerous defect or identify its cause, but incidents of the phones smoking and catching fire have continued, even with the supposedly safe replacements. One such replacement device smoked and popped during boarding of a Southwest Airlines flight on Oct. 5, forcing a full evacuation of the plane. On Oct. 11, Samsung announced the drastic decision to not only recall all of the devices (approximately 2.5 million units overseen by consumer safety agencies around the world), but to cease production and shipment of the Galaxy Note 7 entirely.

By the end of October, Samsung had received 96 reports of the phones overheating in the United States, including 26 reports of burns and 55 reports of property damage, according to the Consumer Product Safety Commission. A number of customers have ended up in hospitals for burns or smoke inhalation, at least one of whom has already sued the company, and class action suits may well follow.

After many airlines banned customers from bringing the phones aboard and the Federal Aviation Administration warned against using them on planes, the U.S. Department of Transportation and other agencies issued an emergency order on Oct. 14 banning the devices from all aircraft in the country, whether carried on or stowed in checked baggage, citing the high risk of personal injury or “catastrophic incident.”

Frustrated consumers have struggled to figure out how to dispose of the dangerous devices, with many travelers expressing fear and confusion about how to balance the critical need for their phones with the regulations. Samsung has shipped many customers specially designed fire-proof packaging in which to send the units back, and even announced pop-up booths in select airports to help heed the flight ban and speed the exchange process.

Smartphones play a massive role in Samsung’s annual bottom line. Of the $178 billion in revenue posted in 2015, the company reports 46% came from mobile communications including information technology, and 21% came from consumer electronics, including televisions and appliances. As the New York Times reported, the impact of killing the Galaxy Note 7 could prove especially significant company-wide as the manufacturer’s smartphone business buys the memory chips and panel screens made by other divisions. Even before the decision to discontinue the product, Samsung shares dropped more than 8%, losing $17 billion in market value. Some analysts estimated the initial recall alone might result in losses of more than $10 billion, while a Reuters calculation pegged the lost revenue at up to $17 billion after Samsung scrapped the Galaxy Note 7, previously expected to translate into sale of 19 million phones.

In a press release, Samsung announced an estimated negative impact of about $3 billion in operating profit from the fourth quarter of 2016 through the first quarter of 2017 due to discontinuation of the model. The company added that it plans to expand sales of flagship models like the Galaxy S7 and Galaxy S7 Edge and to “focus on enhancing product safety for consumers by making significant changes in quality assurance processes.”

In the case of the Galaxy Note 7, quality assurance may have been compromised early on by a drive to gain further market share in the increasingly tight smartphone space. According to a September Bloomberg report, the desire to innovate ahead of Apple’s newest release, the iPhone 7, may have led executives to accelerate the launch of a new phone with more ambitious, innovative features and to push suppliers to meet tighter deadlines.

Vertically Integrating Risk

Much of Samsung’s success in the smartphone game can be attributed to its vertical integration. Originally a components manufacturer, the company designs and manufactures not only its phones, but many of the individual parts in them. This approach may help mitigate some traditional supply chain risks, but it also creates significant exposure to less obvious risks inherent in vertical integration itself, making the crisis a valuable case study for entities in other sectors as well.

As companies become their own suppliers and assume responsibility for the foundational elements of their products, they reduce their ability to find relief in the event of a recall. Without a supplier, the vertically integrated company has no other entity to which to turn to offset either the reputational or financial damage caused by defective products.

Contracts with suppliers or manufacturers typically hinge on limitation of liability, and as liabilities have grown more damaging and products more complex, companies are increasingly specific in constructing terms to assign suppliers full responsibility for the consequential damages should a given component cause the final product to fail. Broadly speaking, a company that serves as its own supplier may find recovery options significantly limited and both financial and reputational risk amplified in the event of a recall, according to William Harrison, product recall practice leader at Marsh. “If the product is purely made by the insured—totally integrated—then there is no one to go to, so it just magnifies the risk to the balance sheet and brand,” he said.

This does simplify the insurance recovery process, but as that stems from the restricted number of parties to a claim, that comes at the expense of added risk to the manufacturer, which will have to foot far more of the bill.

“Product recall insurance can cover some of the losses, but with complete vertical integration there is nowhere else to go to be indemnified—the company is going to recover costs from the insurer or they are not going to recover them from anyone else,” he said. “In many cases, companies have multiple potential options to turn to, from the insurer to the supplier or contract manufacturer.”

According to Harrison, sourcing insurance coverage can be more complex for companies taking steps to vertically integrate because it may impact the level of quality and removes the possibility of subrogation for underwriters, but the risk exposure may be underappreciated by both sides. “It is a factor in the underwriting of a product recall policy that is, in many cases, undervalued by the underwriters, but it’s an important one,” he said.

As a result, Harrison noted that some companies, particularly in the food industry, have actually moved to add additional parties to their supply chains, going through large wholesalers rather than buying directly from smaller sources, to insulate themselves from some financial risk. “Instead of buying directly from the source, they buy through a large wholesaler so that they have a deep pocket to go after should that ingredient or component be contaminated or fail. Many of the suppliers you deal with are small companies and can’t possibly take financial responsibility for the losses they can cause,” he explained. “There is a cost to it because wholesalers bump up the base costs, to a degree, but there is a level of security you can get by adding a deep pocket to the procurement process.”

Hilary Tuttle is managing editor of Risk Management.