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Samsung's leader is facing arrest as the company is facing a huge strategic challenge

Samsung Vice Chairman Lee Jae-Yong Arrives At Court
Lee Jae-Yong, vice chairman of Samsung, is gradually taking over control of the company from his father.
Photo by Chung Sung-Jun/Getty Images

A South Korea court has approved the arrest of Lee Jae-yong, the heir to the Samsung fortune and the company’s de facto leader. It’s another piece of bad news for a company that was already struggling to recover from last fall’s catastrophic meltdowns of batteries in its Galaxy Note 7 phones.

Samsung faces huge challenges maintaining its perch at the top of the global smartphone industry, including competition from cheap Chinese handset manufacturers and Google’s new Pixel smartphone. Its leadership appears to be struggling to meet them.

Lee Jae-yong represents the third generation of his family to lead Samsung. Samsung’s success in the smartphone business was driven by his father, Lee Kun-hee, who took over the company from his father in 1987. Lee Kun-hee shook up the company in 1993 with a new management philosophy that helped Samsung become an iconic global brand. Today, Samsung is a market leader in the smartphone business, and financial results released this week show that the company enjoyed strong profits in 2016 despite the battery fiasco.

Unfortunately, the elder Lee had a heart attack in 2014, and since then, the company has had something of a leadership vacuum. Lee has been grooming his son to take over his leadership of the company, and having the son face bribery charges isn’t going to help. The situation is made even worse by Samsung’s unusual corporate structure, which prizes intense internal competition and needs a strong referee to keep that competition from becoming dysfunctional.

Internal competition helped Samsung dominate smartphones

Ex Samsung Chief Handed Judgment For Tax Evasion
Lee Kun-hee, who guided Samsung to global prominance over the past 30 years.
Photo by Chung Sung-Jun/Getty Images

In 1993, Samsung was a massive Korean conglomerate that — among many other things — manufactured electronics components. Lee Kun-hee, then the company’s chair, announced an ambitious plan to remake Samsung’s insular and stodgy corporate culture and turn Samsung into a globally known brand like GE or Sony.

Lee pressed Samsung’s subsidiaries to hire more Western managers, and he began sending out promising young Korean managers to spend time in Western companies. He also began to introduce more Western management practices. Samsung started paying employees based on their own performance and the performance of their divisions.

Lee tried to expose as many parts of the company as possible to competition. When one part of the company needed a component that was available from another Samsung division — for example, if Samsung’s mobile phone division needed to buy LCD screens for its handsets — it was encouraged to acquire these components from two different suppliers, one internal and one external.

“Samsung affiliates do not receive special treatment when making deals with other Samsung affiliates,” wrote scholars Jaeyong Song, Kyungmook Lee, and Tarun Khanna in a deeply researched 2016 paper on Samsung’s culture. “They must be prepared to lose out to external suppliers if they are not competitive in quality, price, or time to delivery.”

Employees at the most successful divisions got bonuses that represented as much as 50 percent of their base salaries. Conversely, Samsung had a policy that “any business that incurred losses for three straight years (excluding new businesses) should be sold or liquidated,” Song and his colleagues wrote.

These Darwinian corporate policies help to explain Samsung’s success in the early years of the smartphone wars. Demand for smartphones was booming, and Google was offering the Android operating system for free to anyone who wanted to use it. Samsung seized this opportunity.

Because Samsung made so many of its own key smartphone components, it was able to develop these models more quickly than other smartphone makers, and to constantly improve them as new chips became available. At the same time, Samsung’s ruthlessly competitive culture prevented these internal suppliers from becoming complacent. By 2012, Samsung was the world’s leading smartphone maker with about 30 percent of the market.

Samsung’s model requires strong leadership from the top

The Samsung Experience At The PGA Championship 2016, Saturday, July 30 Photo by Ilya S. Savenok/Getty Images for Samsung

The basic idea here — having a company’s business units compete with one another and with external suppliers to ensure they stay on the cutting edge — sounds like common sense. But making it work in practice is surprisingly tricky.

Healthy internal competition can keep everyone at a company on their toes. But if competition becomes bitter or gets out of control, it can be ruinous. If people feel they’re being unfairly compared to other parts of the company, they may be tempted to sabotage their rivals. They might withhold crucial information from rivals or blame failures on them, making the company as a whole less successful.

To avoid this outcome, the elder Lee cultivated a cadre of Samsung executives who were more loyal to Samsung as a whole — and to him personally — than to any specific business unit. Rising stars within the company spend time in Samsung’s Corporate Strategy Office, which has authority over promotion and transfers of senior executives.

“Senior managers in the finance and human resource management departments of affiliates check counterproductive behavior of senior executives,” Song and his co-authors write. “Most of those managers have work experience at the Corporate Strategy Office and maintain strong ties to the Office. Those managers directly report the counterproductive competitive behaviors of their senior executive to the Office.”

Of course, this approach only works if there’s a universally respected — or at least feared — figure at the top of the corporate hierarchy. Without it, the Corporate Strategy Office could simply become another battleground for infighting among Samsung’s many divisions.

Indeed, Song and his co-authors write that “when the voluntary cooperation proves infeasible but the stakes are huge, Chairman Lee and the Corporate Strategy Office are directly involved in major decisions and decide whether those business units should compete against one another or cooperate with others.”

This points to a real danger for Samsung: If the younger Lee lacks his father’s managerial skills, he could fail to maintain the delicate balance between competition and cooperation that makes the Samsung model work. Samsung’s units could become embroiled in turf battles instead of working together to pursue shared opportunities. Or, conversely, they could lose their competitive spirit altogether, becoming bureaucratic and complacent.

So far, the younger Lee has taken a more hands-off approach than his father.

“While he has taken on more responsibilities, South Korean cultural norms dictate that he doesn’t succeed his father while the 74-year-old is alive,” Bloomberg reported last September. As the Wall Street Journal put it in October, the son “remains distant from day-to-day decision-making, largely delegating the handling of the Note 7 fiasco, for instance, to executives” like D.J. Koh, Samsung’s mobile chief.

Samsung is being squeezed from above and below

2016 IFA Consumer Electronics Trade Fair
Samsung faces strong competition from low-margin Chinese firms like Huawei.
Photo by Carsten Koall/Getty Images

Strong leadership is especially important right now because Samsung needs to make a major strategic shift to maintain its leading position in the smartphone market.

Samsung thrived between 2009 and 2014, an era when the smartphone market was expanding rapidly and Samsung’s decentralized, merit-based structure allowed it to launch many different products simultaneously. The company is still enjoying healthy profits — operating profits were more than $25 billion in 2016 — but in the past three years, its smartphone market share has slipped from a high of 32 percent in mid-2013 to about 20 percent today.

Samsung’s smartphone business is being squeezed from both ends of the smartphone market. On the low end, scrappy Chinese smartphone makers keep pushing down the cost of entry-level Android phones. Samsung has been forced to steadily cut the average price of its phones.

This is a lot like the trap that ensnared PC makers like Dell and HP 15 years ago. Over time, hardware became a commodity and profit margins got thinner and thinner. Most of the profits flowed to companies that provided software and services on top of that hardware. In the PC era, that was Microsoft. In the smartphone era, it’s companies like Google and Facebook.

In both the PC and smartphone eras, Apple has escaped this trap by making its own software, which differentiates it from the commodity PC market. Google is now trying to differentiate its own Android phones with its recently announced Pixel smartphone, Google’s first serious attempt to make a phone itself.

If Samsung wants to maintain its status as a premium smartphone maker, it needs to find a way to differentiate its phones from the dozens of bare-bones Android phones on the market. Over the years, it has made various efforts to either create its own operating system or offer Samsung-branded services on its phones. But so far, none of them has really caught on with consumers.

Apple has a big advantage here because it is organized to throw the full weight of the company behind every new product or service it announces. When the company introduced Apple Pay, for example, people knew that it would soon be supported by tens of millions of iPhones, giving the platform a sense of momentum.

Samsung’s approach is just the opposite. It always keeps its options open, developing many products in parallel and promoting the ones that catch on in the marketplace. Again, leadership appears to be hindering the company in that strategy.

“Interviews with former and serving employees paint a picture of confusion and overlap between competing divisions, where the short-term interests of promoting hardware trump long-term efforts to build platforms that would add value for customers and increase their loyalty to the brand,” wrote Jeremy Wagstaff and Se Young Lee in a December 2015 report for Reuters.

“One said he only learned from someone outside the company that the hands-free app his team was updating for the upcoming Galaxy S4 launch had competition — from inside Samsung.” The manager became frustrated the software was seen “as little more than a marketing tool” within Samsung.

Addressing the problem may require another big culture shift, of the kind Samsung went through after 1993. But that kind of cultural shift only works with a strong, charismatic, and widely respected leader at the top of the organization.

The younger Lee could still beat the rap. His well-connected father got a pardon in 2009 after being convicted on similar charges, and other senior business leaders have gotten similar favors from the government. Samsung is so big that the government is skittish about taking steps that could destabilize the company and take the Korean economy down with it — a problem Finland is currently dealing with after the decline of Nokia.

Even if Lee is ultimately acquitted — or gets a pardon — he might simply lack his father’s managerial talents. A lot is riding on whether the son can step into his father’s very big shoes in the next couple of years.