OREANDA-NEWS. Recovery in the smartphone business is likely to be short-lived despite Samsung Electronics Co., Ltd.'s (SEC, A+/Stable) stronger-than-expected 1Q16 results, and its semiconductor business will face challenges which may pressure profitability over the long term, says Fitch Ratings.

Strong sales of SEC's new flagship model - Galaxy S7 and Galaxy S7 Edge - boosted operating performance in 1Q16. The handset margin improved to 14%, the widest since 2Q14. However, we think that a meaningful improvement in the smartphone business over the long term is unlikely due to ever-increasing competition and narrowing product differentiation as lower-cost competitors' handsets improve. We expect handset margins to decline, reflecting greater competition and weaker demand growth.

The slowing market growth for both DRAM and NAND will gradually affect SEC's semiconductor business over the long term, although we expect the company will continue to maintain a leading position in the memory sector with its advanced technology. SEC, the second-largest player in the global semiconductor industry, is the only company which improved operating profit among the top manufacturers in 1Q16, despite the seasonal weakness in demand and a decline in the price of PC DRAM. Enhanced product mix, yield improvement in V-NAND and favourable foreign-exchange impact helped SEC secure a solid EBIT margin of 23.6% (1Q15:28.4%).

Overall, SEC's 1Q16 revenue and operating profit increased to KRW49.8trn and KRW6.7trn, respectively, from KRW47.1trn and KRW6trn in 1Q15. The EBIT margin also improved to 13.4% compared with 12.7% in the previous quarter.

We continue to believe that SEC will be the major beneficiary of the increasing adoption of organic light-emitting diode (OLED) displays in smartphones, as the company is a pioneer in this segment with technology leadership. The first-quarter results revealed that its OLED business remained resilient amid a structural decline in the liquid crystal display (LCD) industry, compensating for operating losses in large-size LCD business. Possible use of OLED displays by Apple Inc. could further boost demand for OLED panels. However, SEC's display division turned in an operating loss in 1Q16, and revenue fell by 12% yoy.

Samsung's 'A' category credit profile is clearly supported by its technology leadership, respective dominant market positions, and a well-diversified business portfolio, which help to mitigate earnings fluctuations to a certain extent. However, risks to its ratings remain from the volatility inherent in its core operations, particularly the cyclicality of its semiconductor and display panel businesses - as well as the rapidly changing fortunes of global handset manufacturers.