|Shares Out. (in M):||1,480||P/E||7.1x||0.0x|
|Market Cap (in $M):||16,430||P/FCF||7.1x||0.0x|
|Net Debt (in $M):||2,940||EBIT||0||0|
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Corning has never been written up on VIC despite its huge fluctuations over the years. On one hand, the company can easily be dismissed as unpredictable and hard to value due to their fast-evolving product line. Many of its products went through huge booms and busts of varying sizes. On the other hand, its160-year old history, continuous R&D, long-term focus and large patent portfolio qualify it as a stalwart. Therefore, any short-term issues that lead to a stock price decline could lead to a potential opportunity to bet on a stalwart turnaround.
I see such an opportunity today in GLW, which is trading at 2-year lows and 7x earnings due to various issues discussed below. The company has a conservative balance sheet and recently completed a share buyback, although insider ownership is not great.
Since I’m pretty macro-bearish and since GLW’s earnings are set-up to decline by $7mm for every 1% decline in the yen, I propose the following set-up:
Long $1.00 GLW
Short $1.00 consumer discretionary equities
Short $0.043 yen
---- Background ----
GLW has always been known for its glass products. More recently, it has been known for optical fiber and LCD glass substrates. Through its history, the company has invented products, launched many of them into what became fantastic growth and then watched as these products matured & declined, while at the same time inventing the next big product etc’. Note that what happened to them in 2000 was a cycle of unusual magnitude, so a decline in display glass or other segments won’t end up in a 2002-like disaster. As a matter of fact, following recent weakness, the company made a choice to diversify more across segments so as to give the company more stability.
So what is the latest weakness?
In 2011, weakening growth of end demand led to supply chain overcapacity in the LCD industry. Also, there were lower earnings from Dow Corning (owned 50/50 with Dow Chemical) because of raw materials prices and slowing demand for polysilicon, much of it due to the collapse in the solar panel industry.Corning, Dow Corning as well as the company’s 50/50 venture with Samsung (Samsung Corning Precision) have operating leverage and therefore supply/demand issues have a large impact.
The market also seems to have been taken by surprise by tax breaks abroad expiring. Taxes are expected to be at 19% this year, up from around 10%, and to eventually rise even further. Plus, unlike Mr. Market, GLW has been macro-bearish for a year. Some market participants may be viewing that as a fake excuse for micro weakness and selling the stock as result. The company is already seeing some stabilization in pricing of glass for LCDs and volumes are close to making up for that. At Dow corning, too, the weakness is behind.
In order to stabilize, it is trying to establish momentum in the LCD segment and balance it with a focus on growing other segments (not just organically, acquisitions too) and focus on staying a lowest-cost producer where possibly. GLW also has a bunch of technologies that are candidates to be the next big thing.
---- Segment Valuation ----
Corninghas 5 reportable segments + “all other” + the 50% stake in Dow Corning. Note that their 50% stake in Samsung-Corning Precision (SCP) is reported as part of the Display Technologies segment.
From the company’s 10-k:
Display Technologies - manufactures glass substrates for flat panel liquid crystal displays.
Telecommunications - manufactures optical fiber and cable and hardware and equipment components for the telecommunications industry.
Environmental Technologies - manufactures ceramic substrates and filters for automotive and diesel applications. This reportable segment is an aggregation of our Automotive and Diesel operating segments as these two segments share similar economic characteristics, products, customer types, production processes and distribution methods.
Specialty Materials - manufactures products that provide more than 150 material formulations for glass, glass ceramics and fluoride crystals to meet demand for unique customer needs.
Life Sciences - manufactures glass and plastic consumables for scientific applications.
GLW has the leadership position in glass for TVs and other displays, notably LCDs. The segment represents ~40% of sales, which are denominated in Japanese yen. Growth of end user demand, as far as they’re concerned, is better measured in sq. ft. than in units. People have been buying bigger screens and the amount of glass sold has therefore grown faster than the amount of screens.
While end demand grew in 2011, it didn’t grow at expected rates and prices declined due to excess capacity in the supply chain. The top line (measured in yen) declined and of course this led to a significant decrease at the bottom line.
At SCP, where the company engages in a similar business 50/50 with Samsung, the bottom line was impacted even more, for many reasons: (i) partial expiry of a Korean tax holiday and recalculation of another holiday (ii) not just lower prices but lower volume too (iii) the impact of the supply chain contraction and excess capacity has been more severe in Korea (iv) SCP did not recover some of the market share that was lost in the third quarter.
A number of GLW patents are licensed to SCP and others, which generates royalty income. This declined too and SCP and GLW agreed that for the next 5 years the royalty rate will be halved.
Over the course of 2012 so far, the segment has been stabilized in the following ways:
- GLW and SCP reduced capacity
- Price declines have moderated substantially
- GLW now has new agreements that will stabilize price and allow capacity to be managed more efficiently. Before, they would set a price and competition would under-price and get share. Over time this state of affairs led to price volatility. In the new agreements, GLW sets a level of market share and a fixed relationship between their price and the market price. Since volatility lessens, capacity utilization can be higher. Among other things, this frees up capacity for Gorilla Glass, the glass used in the iPhone, which is produced with the same machines (but is reported in another segment).
Based on the company’s guidance and trends disclosed about price and volume expectations relative to the past, I estimate that in Q4 volumes will be about up 10% YoY and prices will decline about 10% YoY, so the top line should be about equal to that of Q4 2011. Because the company has a future of growth and has a lot of cap-ex behind it (though tax breaks that will eventually disappear), I extrapolate from there and use 2011 as a baseline - the trough year in earnings - and assume FCF equals adjusted net income (Adjusted here means removing special items including currency fluctuations and adding back taxes, which we will later deduct at a full 35% rate).
Adjusted pre-tax net income assuming currency hedge in place = $2.85B
Call options: in this segment there are two important call options:Willowand Windows 8.Willowis a bendable glass, like a sheet of plastic. WithWillow, you can cover non-flat surfaces with glass.Willowis basically ready. Windows 8 supports touch-screens and is now waiting to be used by the right hardware. GLW wants to be part of manufacturing that hardware and if this takes off, it could be a winner.
As you may imagine GLW is very competitive in the fiber area. Fiber-to-the-home, enterprise networks and wireless products are the growth sub-sectors here. Growth of adoption may be offset by a recession. The segment already disappointed in the most recent Q. Either way, it is assumed you’re shorting the consumer discretionary sector (or something else) dollar-for-dollar. Again I add back taxes. I take the midpoint between earnings in 2010 and 2011, adjusting for special items.
Adjusted pre-tax net income = $0.20B
This segment is benefiting from growth is Diesel use and implementation of new regulations in theU.S.andEurope. GLW has a very strong position in this market as well. Results can fluctuate with vehicle production, so again the recession risk applies. I go back to 2010, before Diesel truck production surged, and assume the same earnings.
Adjusted pre-tax net income = $0.06B
The specialty segment has one product that is outstanding: Gorilla Glass, a chemically-altered glass that breaks less easily. The main use is smart phones. This product is another call option, in case we all end up carrying tablets or other devices needing glass that resists. It’s tough to call based on what one thinks of how smart devices will perform in a recession. But it’s a small segment either way. 50mm should be doable.
Adjusted pre-tax net income = $0.05B
Up until now this segment was not particularly strong. Now they want to be leader in innovation and a brand leader. They have a long geographic reach both through academia and the private sector and they want to use that. Their goal is to grow to $1B in sales and to do so via acquisitions if need be - a bit aggressive forCorningbut they have the cash and they want to diversify. They’ve earned 90mm pre-tax in each of the past two years so I leave this number.
Adjusted pre-tax net income = $0.09B
Corning and Dow Chemical each own half of Dow Corning, a definite low-cost leader. Dow Corning makes silicone products and also owns 63% of a company called Hemlock that makes polycrystalline silicon for the semiconductor and solar energy industries. Here’s the 2011 story from the 10-K:
“In the second half of 2011, Dow Corning began experiencing unfavorable industry conditions at Hemlock. Declines in governmental subsidies in the solar panel industry, especially inEurope, and over-capacity at all levels of the solar supply chain led to significant declines in polycrystalline spot prices. The decline in spot prices was large enough to potentially induce Hemlock customers to default on their long term contracts. In response, Hemlock modified a number of sales agreements to provide temporary pricing relief while preserving the long-term favorable relationships with its customers. In addition, Hemlock decided to delay certain plant expansion activities until market conditions for polycrystalline silicon have improved.”
Through 2012 this segment has turned around and is set to earn about 270mm for GLW this year, pre-tax. Of course, the solar industry is also still a call option for the future.
Adjusted pre-tax net income = $0.27B
---- Sum-Of-Parts ----
Adding all of the above and taxing @ 35% + taking into account losses from the “all other” segments, corporate contributions and exploratory research (all of these were pretty high in 2011), one gets about $2.1B in net income.
In late 2011 GLW started a $1.5 billion share buyback. As of Q3 there was $125mm left to go. Assuming they did that an average price of $12.50, we deduct 10 million shares from the count. Then there are 65 million options outstanding. The adjusted share count is therefore 1.53 billion.
Adjusted EPS = $1.57/share
Stock Price = $11.12
P/E = 7
And you get another call option:Corningis working on antibacterial glass to be used in the medical context. Early results are amazing – kills 99% of bacteria and does so for a number of years before effectiveness is reduced.
And GLW trades @ about 0.85x tangible book.
---- Risks ----
- Global recession or other macro risks (but I am suggesting a hedge)
- None of the new segments grow much in the near future, combined with an eventual maturation of existing segments where price declines make up for any volume growth, all of which would result in sales going down. (note that the company’s goal is to have $10B in sales by 2014).
- Eventual stabilization of all segments
- Continuation of top-line growth
- New technology call options materialize
- Valuation itself
- More potential share buybacks
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