May 31, 2017 / 6:13 AM / 2 months ago

Samsung gambles on an heirless future

6 Min Read

FILE PHOTO - Samsung Group chief, Jay Y. Lee arrives at the office of the independent counsel team in Seoul, South Korea, February 22, 2017.Kim Hong-Ji

HONG KONG (Reuters Breakingviews) - Samsung looks unprepared for a future without a prince firmly on the throne. The sprawling business empire, facing unprecedented legal risks, is preserving a structure that lets the Lee family keep nominal control of its $289 billion crown jewel via a small stake, despite an activist investor lobbying for an overhaul. The decision makes the group harder to steer, and the iconic South Korean brand owes much of its success to two generations of charismatic, if autocratic, rule. Without a decisive leader, the conglomerate risks strategic drift.

Samsung Electronics, the 60-company conglomerate's most valuable business, in April definitively ruled out a restructuring proposal from U.S. hedge fund Elliott that would have given the founding Lee family more control. At present, the family holds less than 5 percent in the flagship; designated heir Jay Y. Lee himself owns only 0.6 percent – the same as Elliott. Instead the clan controls the company through holdings among the broader Samsung group companies.

The activist hedge fund argued Samsung Electronics' awkward structure makes the tech giant's shares undervalued. Simplifying it could both improve shareholder returns and also give Lee an easy way to clarify his formal control of the flagship. The first step would be to convert Samsung Electronics into a holding company after splitting out an operating entity. Then treasury stock – shares owned by the company in itself - would be converted into voting shares in the electronics manufacturer owned by the holding company. Lee would swap his shares in the new carved-out unit for a bigger piece of the parent. A subsequent merger of Samsung Electronics and the current de facto holding company, Samsung C&T, would strengthen his grip on the broader group.

But a massive corruption case in South Korea that deposed the country's sitting president seems to have rattled management. Understandably so: Lee is now on trial for bribery related to the scandal, while other key executives under investigation have resigned. Outraged voters elected left-wing President Moon Jae-in, who has pledged to rein in powerful business interests. Confronted with this explosive cocktail of uncertainty and risks, Samsung Electronics decided to permanently punt on restructuring. This looks hasty.

Half Measures

The company is trying to appease shareholders by other means. It will cancel more than $35 billion of treasury stock after buying back more shares from the market, which will increase the value of outstanding shares held by outside investors. The broader group also dismantled the "Control Tower", its controversial and secretive strategy office.

The boost from buybacks and treasury share cancellations is welcome. Analysts at Bernstein reckon the latter will deliver a cumulative 15 percent boost to earnings per share over the next two years. And profit at the smartphone-to-chips maker is soaring. Annualised total returns on the electronics giant's stock topped 80 percent over the past twelve months ending May 26, trouncing the KOSPI's 21 percent, Eikon data shows. But this looks like poor consolation for sacrificing an opportunity to unlock value. Even after the rally, Samsung Electronics shares still traded at around 8 times forward earnings at market close on Friday, compared to 15 times for Apple.

Taking down the Control Tower might have also been premature; the vast conglomerate now has no nerve centre. It could use one. Legal problems aside, Lee is relatively young at 48, lightly tested, and in a tenuous position in the hierarchy. Although he was groomed for years as the third-generation leader, he currently only has a board seat and a co-vice chairman title at the electronics business, with no clearly defined operational responsibility.

With the Elliott option now off the table, Lee lacks an easy way to increase his influence. Buying more stock will cost a fortune: boosting his Samsung Electronics holding by just 1 percentage point would cost him around $3 billion at current prices. Inheriting the 3.5 percent stake held by his father, who has been incapacitated since a heart attack in 2014, may bring billions in tax charges. Combining Samsung Electronics with an affiliate where Lee has a larger stake would deliver marginal benefits, given the sheer size of the former; similarly, anticipated regulatory changes might make it harder to consolidate control indirectly via his father's 21 percent interest in insurer Samsung Life.

Samsung competes in cut-throat industries like consumer electronics and semiconductors, and decisive leadership at the top is vital to taking on the likes of Apple and Intel. Finding new areas of growth will also mean quickly exploiting opportunities in sectors like biotech, and shedding underperforming businesses as quickly. The failure of brands like BlackBerry and Nokia shows how critical constant innovation and investment is to competitiveness. An empire without an emperor risks being overthrown.

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