Note 7 recall, chips, and Samsung's China conundrum

China as a market, China as a competitor, and rising US-China tensions will all remain the South Korean tech giant's biggest challenge yet in the coming years.

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Samsung's chip business is half its profits and China is looking for its own success in chips.

When a Chinese Baidu user alleged that their Galaxy Note 7 exploded, Samsung Electronics was swift in conducting its internal investigation and denying the allegations.

In its recall announcement for the handset earlier this month that followed reports of the phones catching fire, Samsung Electronics singled out China as unaffected by the recall because batches there did not use faulty batteries. A relatively small recall of 1,858 units there was from pre-order batches, it said.

China will also likely get a powered-up Note 7, with 6GB RAM, 128GB memory as opposed to global's 4GB, 64GB memory, according to mobile chief DJ Koh, because of intense competition there.

Samsung is on high alert when it comes to the world's second-largest economy. But why the extra care for China?

Samsung, like its rival Apple, is facing a profit decline due to the rise of local competitors there and a maturing market. Cupertino is smartening up, as its $1 billion investment into Didi Chung shows, to better adapt and learn to the changing atmosphere.

The South Korean tech giant now faces a dual challenge in China: Competing in mobile and in components, especially semiconductors. The rise in tension between US and China may also pull South Korea, and Samsung with it, into an international dispute with economic consequences. ZDNet takes a look at Samsung's China problem.

Reviving mobile

Samsung was one of the first Korean conglomerates to enter China. and made itself a household brand of sorts there. Because Samsung, in Korean, is based on Chinese characters, many there recognize it as a "local" brand. Samsung established itself there against Nokia in the mid-2000s in the feature phone era and won over buyers completely with the Galaxy smartphones, defeating Nokia and Apple to take the top post.

But China changed fast. Then-newcomer Xiaomi's aggressive use of online sales channel caught the company off guard, which relied still on the conventional sales channel of using distributors.

Samsung has faced a steep decline in market share in China. After Xiaomi took over as leader back in 2014, Samsung has never fully recovered, and has since been pushed out of the top five, a steeper drop than rival Apple.

The company's own sustainability management report shows the decline: China accounted for 15 percent of its revenue last year, down from 18 percent in 2013. South Korea consistently accounted for 10 percent, despite being a population of 50 million compared to China's 1.4 billion.

The problem, however, isn't just about online marketing and sales. Chinese vendors make better products now, and Samsung's attempt to tap into mid-tier there is failing. Its reliance on premium phones, such as the Galaxy Note 7, will only increase going forward, which is why the recall and its affect on the brand is so damaging.

It remains to be seen whether Samsung's brand will survive the recall, with its third quarter results to take a hit as a result, according to analysts. Hopefully, Samsung will be recognized in China as a top brand within the year.

China: the chip frienemy

Semiconductors is half of Samsung's profits, and China has announced it wants to make its own. With its multi-billion-dollar purse, Tsinghua Unigroup is eyeing US and South Korean tech giants for technology and is planning to build its own factories.

China was mostly a customer until recently, and Samsung built its third semiconductor plant at Xi'an to meet local demand. The country will remain a customer for high-tech goods, as Samsung SDI's building of electric car batteries there suggests. But from the bottom-up, local firms in China have steadily decreased imports and become self-sufficient.

Samsung's Chinese clients used to buy display panels in packages, together with the module and peripheral components. This allowed Samsung to make high profits there in the 2000s. But now clients are only buying the display and making the rest themselves. This is reminiscent of what Samsung did when it was catching up to Japan, learning from the bottom-up, and eventually winning over them through price-competitiveness and evolution in design.

Chinese government and companies have requested technology migration, especially in chips, in the past. According to company insiders, until last year Samsung resisted such demands. However, recent competence rise in China's self productions, and an internal assessment that showed companies there were in a trajectory to catch up, the South Korean tech giant has decided to change strategy. The overall strategy is now to cede technologies if need be and cement stronger partnerships there.

This puts Samsung in a tricky position of competing and co-working with potential competitors there -- a fine line that was illustrated this week by a company executive attempting to share technology to China before being arrested.

Not only this, but the company's own demand for Chinese-made components is rising: Local vendor ATL is the secondary supplier for the Note 7.

Time it ticking, and Samsung needs to maintain its technological edge while maintaining Chinese clients. Its investment into China's BYD is part of this co-opt strategy, sources say, and the biggest partnership announcement will be on the horizon.

Chips are the crème de crop of Samsung's components, especially memory products. But this extends to all components: modules, displays, processors, and batteries -- all areas China is investing in with a bigger purse. Maintaining the bleeding edge to stay ahead will be the only way to keep the country as a customer, which looks increasingly more challenging.

US-China tensions: the wild card

Rising tensions between the US and China may also negatively affect South Korea -- an ally of the former and one of the biggest trading partners with the latter. Due to North Korea's recent provocations, South Korea has been sucked into the G2's internal spats. The worst part about this problem is its uncertainty.

When South Korea announced earlier this year that it will install THAAD -- or Terminal High Altitude Area Defense -- to protect stationed US troops in the wake of North Korea's nuclear tests, China reacted strongly and opposed the installations. Korean businesses voiced strong concern that China will retaliate with official and unofficial sanctions against them.

As of 2014, according to Korea International Trade Association, trade between China and South Korea was $235.4 billion. It will most likely exceed $300 billion in the coming years. Semiconductors and handsets take up a huge portion of that, both Samsung's mainstay. Export-dependent South Korea and its companies are relying on the world's second-largest economy for profits.

China has blocked Korean imports before, though not due to conflict with the US but due to direct conflict. In 2000, Korea raised the taxes in Chinese garlic from 30 percent to 315 percent, to protect local farmers. China, in retaliation, halted imports of handsets and petrochemicals. South Korea was forced to concede to lower the taxes again.

The US-China spat has affected Apple before, and it does now. Cupertino became a "victim" of China's nationalism and citizens' anti-US sentiments, following the perceived injustice of Hague's rejection of China's territorial claims of the South China Sea against the Philippines. Apple's stores have also been targeted by Chinese youths for protests and picketing.

An aggressive North Korea and China's own growth puts high tension in the Korean peninsula. A political crisis can escalate into economic crisis, and Samsung may be on the receiving end of it. Keeping a rainy day fund, such as its $60 billion cash pile, and an MO of fast but measured response to such sudden incidents must be prepared.

And still the world's fastest growing market

China, is in its own terms, is deploying more "free market" like measures to offset growth decline. A day before the G20 summit, the country's commerce ministry unveiled new laws that eased requirements for foreign firms to enter the country in a likely bid to increase foreign direct investments in the wake of slowing growth.

And despite the fall in GDP growth rate, 6 percent of an $8.9 trillion economy still makes China the most dynamic market in the world. Samsung, like any other global company, cannot miss out on that.

Samsung has weathered many storms to come out stronger. It survived the Asian Financial Crisis in the 1990s to lead in semiconductors and displays. When Apple launched the iPhone, Samsung survived the paradigm shift to be its only real competitor in smartphones. 2016, and the coming years, will show whether the South Korean tech giant has enough to survive, and overcome, the rise of China.

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