Is Corning Cheap Enough Yet?

By Tom Gibbs - June 4, 2012 | Tickers: AAPL, GLW, HPQ, NOK, SNE | 0 Comments

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One of the key companies that tends to operate behind the scenes of the consumer electronics industry is 160 year old glass-maker Corning Inc. (NYSE: GLW).  Corning, which operates under five reportable operating segments, is the producer of key glass and ceramic-based input parts for many of today’s hottest consumer electronics – most famously, its tough Gorilla Glass protective screens are used in the production of Apple (NASDAQ: AAPL) iPhones and iPads.  However, Corning is instrumental in other key product segments like HP (NYSE: HPQ) notebooks, Sony (NYSE: SNE) LCD televisions, and Nokia (NYSE: NOK) smartphones.  With sales nearing $8 billion in 2011 and with control of more than 50% of the display (below) market, Corning is one of the several key Levi Strauss parallels that now are key players in the consumer electronics industry. 

Corning’s key operating segments

• Display Technology: Represents 40% of sales, down from 45% in 2009 and 2010.  Includes glass substrates for liquid crystal displays (LCDs) that are primarily used for notebook computers, flat panel desktop monitors, and LCD TVs. 
• Telecommunications: 26% of sales, down from historical average of around 30%.  Products include optical fiber and cable for the worldwide telecommunications industry, used in fiber-to-the-home, metropolitan, long-haul, and submarine applications.
• Environmental Technologies: 13% of sales, includes ceramic substrates and filter products for emissions control (i.e. catalytic converters in automobiles).
• Specialty Materials: 14% of sales, up from nil five years ago.  Includes more than 150 material formulations for products in many applications in aerospace, astronomy, telecommunications, and other consumer electronics.  Flagship product is the aforementioned Gorilla Glass, which is used as a protective covering in over 600 products.
• Life Sciences: 8% of sales, includes scientific laboratory products

One of the primary points of attraction behind Corning’s operations is not the fact that it is an industry leader in many key glass/ceramics applications, but that its operations are extremely scalable.  Of course, there are very large fixed costs in the way of factories and glass furnaces (PPE of $10.7 billion represents half of the company’s net worth), yet innovations in new glass technology can lead to new offerings across many different product lines, and similar machinery can be used to produce those products.

The caveat, obviously, is that Corning’s operations remain at full capacity and it can push out glass at a fast rate once its furnaces are lit.  As demand for its products have been robust, and as Corning management has optimized its product mix, SGA expenses as a percentage of sales have experienced huge improvements over the past ten years.

The Flip Side

An investment in Corning contains everything that most investors would look for in a given investment opportunity – huge economies of scale (through its consolidated operations and its joint venture with Samsung, Corning controls more than 50% of the display market), efficient assets (Corning has a huge fixed asset base but has been able to reap huge efficiency gains through the sheer glass volume it handles), growing markets (its specialty materials segment has grown more than 45% per year over past four years, from $375 million to $1.1 billion), and a relatively attractive entry price (trailing twelve month EV multiple 6.75x).  However, the corporation’s performance until now does little to describe the changing dynamics of several key product markets.    

Although Corning has made significant steps in diversifying away from the LCD market, the display technology operating segment still represents a very meaningful 40% of total revenues.  Likewise, four key customers comprise more than three-quarters of the sales in this category. 

The company has begun to experience the huge strain affecting the LCD display market, whereby excess supply of goods in the industry has far outstripped demand.  This is in spite of a 25% demand improvement in the international sector since the 2009 recessionary trough.  Although end-product manufacturers are experiencing the brunt of the oversupply issue – Sony’s consumer products division, which is comprised of more than 33% LCD sales, has experienced operating losses of nearly 170 billion yen since Q2 2009 – those in the middle of the supply chain have not gone unscathed.  Corning’s gross margins in the most recent quarter ending December 31, 2011 of 43.7% are down meaningfully from the 50%+ margins enjoyed in pre-recessionary periods. 

What should be most troubling to investors is that management obviously has no way of estimating when LCD TV and input display prices will improve, and the mitigating steps to spur an improvement are long term in nature.  First, the corporation plans to cut a significant amount of its manufacturing capacity, which represents an extremely large cost considering it controls over half the market.  A closer convergence of supply and demand of the displays will naturally act to correct market pricing, yet management expects the shift to be relatively slow as cutting that level of capacity is difficult and market forces do not always correct themselves over a projected timeframe. 

Second, Corning is making a shift towards thinner glass products.  Such a transition would naturally reduce costs, as more input materials can be melted to produce more square footage of finished glass product.  However, similar to the cutting of capacity, this is also a relatively long-term industry shift.  Not only will consumers need to adjust their own machinery to be able to handle the thinner glass, but Corning will also need to gain acceptance of the product.  Company management has stated that the market is not necessarily ready for such advanced product improvements, and instead of moving from the industry standard of 0.7mm thick glass to the target of 0.4mm, most consumers are likely to follow a gradual step function towards the target (i.e. hit 0.6mm and 0.5mm first). 

Lastly, and probably most importantly, many of the key end-product producers with which Corning deals in the display market are not in an ideal financial position.  As illustrated with the opening gold rush anecdote, many of the gold miners in this industry are definitely not generating a disproportionate amount of the profits.  Companies like Sony, as highlighted previously, are operating on razor thin margins in their general consumer electronics businesses, and Corning has experienced very meaningful roadblocks to pricing increases simply because consumers cannot handle such increased costs.  In looking to maintain its dominant share in the market, Corning has had to suffer reduced margins to maintain the relationships. 

On the surface, with a 6x enterprise value multiple, Corning stock does not appear to be glaringly expensive.  However, what does a realistic scenario look like for the company over the next several years?

The company is shooting for $10 billion in annual revenues by 2015, up from $7.9 billion in 2011.  Management has made it clear that the bottom of the price declines (LCD display prices dropped 15% in 2011) has not yet been reached, and has frequently used the phrase, "We will form a bottom, and grow from there."

It could be quite a few more quarters before any of the mitigating steps will naturally improve the price, and during that time prices could very well continue to decline, end-product manufacturers can continue to experience squeezed retail prices, and Corning’s other operating divisions will only slowly reduce the company’s reliance on display technology.  Giving Corning the benefit of the doubt and projecting that operating margins will be relatively similar to the near 20% margins experienced in 2011 (implies no further price declines), at current valuations investors are paying almost 9x enterprise value at the three year target of $10 billion in sales.  This is by no means a dirt cheap entry price, and investors could very well be holding onto a stock that will remain stagnated for a prolonged period of time, with no estimable timeframe for recovery. 

Corning is by no means a bad company; quite the opposite is true.  The corporation is the market leader in several swiftly growing consumer electronics segments, it contains the size and R&D funds to be able to scale operations, and its maintenance capital expenditures of $600 million annually (per management discussion) is relatively low considering the corporation will hit nearly $10 billion sales as its robust growth phase begins to slow.  However, because Corning is highly exposed to the very unfavorable shifts that several of its key markets are experiencing, and because the company cannot efficiently shift the majority of its operations to other product offerings with speed and ease, it is extremely likely that the stock will have a much more attractive entry point in the near future before its inevitable mean reversion alongside the general improvements in the economy.

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