Aside from a brief upswing following yesterday's 4th quarter 2012 results, the stock price of Corning (GLW), the self-described "world leader in specialty glass and ceramics," has been dropping recently on the back of multiple downgrades and lowered estimates, with most analyst downgrades largely citing continued depression of pricing for Corning's LCD glass business segment. Corning is one of very few companies in the S&P 500 index trading below Net Tangible Assets (or book value) currently.
I am a cautious investor who has spent many hours with my nose in the time-honored book The Intelligent Investor by Ben Graham, and the letters to shareholders of his disciple Warren Buffett, and strive to follow their example by avoiding buying companies above book value (alas with little hope of following their success, but we may forever try). While investors have rarely been burned by the cautious investing style they promote (at least beyond repair) I have found myself overly cautious in recent months, and have kept too much cash on the sideline as this index has powered over 1500. As I would like to have some portion of this cash working for me, I decided it was worth doing a bit of digging to determine if Corning is undervalued at current levels. I had not followed this company in much detail before, so I will outline the thesis from beginning to end, with apologies to those who are more familiar than I was upon beginning my homework. I read through many 10-K's and conference calls, with emphasis on the recent 3rd and 4th quarters to come to my conclusion.
Corning operates in five business segments as briefly outlined for the new GLW follower here:
1. Display Technologies: Manufactures glass primarily for LCD TVs, notebook computers, and flat panel desktop computer monitors. This is a highly competitive and capital intensive field which brings about a great need for efficient business structure. 40% of GLW sales in 2011 (now we understand how depressed pricing has pummeled the stock price).
2. Telecommunications: Produces optical fiber and cable, and hardware and equipment products for the worldwide telecommunications industry. 26% of GLW sales in 2011.
3. Environmental Technologies: Manufactures ceramic substrates and filter products for emissions control, primarily for gasoline and diesel applications. 13% of GLW sales in 2011.
4. Specialty Materials: Services a wide variety of markets including display optics and components, semiconductor optics components, aerospace and defense, astronomy, and protective display glass for portable devices (namely Gorilla Glass). This Gorilla Glass is specifically designed for tablets, smartphones, etc and is built to be thin, lightweight, yet strong and damage/scratch resistant. Specialty materials as a whole was 14% of GLW sales in 2011.
5. Life Sciences: Products useful in drug discovery process. I am not the most up-to-speed in these processes or equipment needed. Suffice it to say this goes well beyond your typical glass beaker in a cartoon laboratory. Allow me to refer you to the 10-K for better description. 8% of GLW sales in 2011.
So, let us take two important segments in the media's spotlight in turn to some extent. The display technologies segment obviously accounts for the lion's share of revenues. Management gave pretty tepid guidance in Q3 2012 regarding pricing of this segment's products on the Q3 earnings conference call, including a fairly substantial drop into Q4 of 2012. Then upon reviewing the Q4 call, we see just that; a more significant decline in LCD glass in Q4 2012 from the prior two quarters. While they acknowledge these facts in a candid fashion, they also unveiled a plan in Q3 to accommodate for this decline (and contribute to it in the very near term) in pricing via new pricing agreements with major customers going into 2013. The following is my best attempt to understand and explain these new agreements.
Management describes these new agreements as "mechanisms that establish a relationship between Corning's price and the market price (for LCD glass products)" that "will assist us in maintaining share" (paraphrasing from the 3rd quarter conference call).
So what are we average investors to read into this statement? After reading the call a few times carefully, including the Q and A section, it is apparent that GLW has contracts in place to provide a certain percentage of these large customer's glass needs regardless of price, and that the price GLW will receive will be at a fixed percentage of current market price for the glass. In other words, Corning's market share is fixed in exchange for likely giving large customers a discount of some size unknown to these customers.
At first glance this seems a tough trade-off for GLW, one that could compress margins, etc. However, I will give management the benefit of the doubt that the subsequent explanation will come to fruition as to my mind it seems logical.
Essentially Corning has engineered these pricing agreements to maintain steady market share by providing the discount to customers to market price, with the thought that they can manage more efficiently and maintain the margins via improved efficiencies. Their belief is that these agreements will provide better visibility and allow them to match supply to demand more accurately, which in turn will allow them to manage capacity more appropriately (as well as assist in the overall pricing of LCD glass). This will allow them to improve cost structuring and maintain high levels of utilization at wholly owned manufacturing sites offsetting margin dings that the provided discount to customers may have caused.
This should allow GLW to grow revenues in a less capital intensive manner, which management says will allow them to increase cash returned to shareholders in the form of dividends and buybacks going forward.
In a nutshell, the company was attempting to stabilize market share and pricing to make for a more predictable business, and then manage cost tightly to improve earnings while they wait for a demand driven improvement in the segment's pricing. Reading through the 4th quarter results, it seems that this plan is shaping up as envisioned, as market share remains stable and pricing declines are projected to moderate and potentially stabilize.
An additional benefit is the intention to free up capacity in various facilities for the high growth, and better margin, Gorilla Glass business, which we will now dive into briefly.
Remember that Gorilla Glass falls under the Special Materials segment umbrella. This segment as a whole enjoyed 25% revenue growth for the year over year comparison of 2012 to 2011, with improving gross margins, largely thanks to Mr. Gorilla. Gorilla Glass reportedly was in 1 billion devices worldwide and enjoyed 33 brands as customers at the Q3 end, and for the fiscal year 2012 produced sales of over $1 billion, up 44% over 2011. One is left to wonder if the growth will continue at a nice pace, eventually becoming much more of a needle mover for the company? Management projects double digit growth of Gorilla Glass sales for the fiscal year 2013, though they admit the first quarter may be down sequentially.
Positive commentary from Corning management suggests there is still much untapped room for growth for Gorilla Glass. For starters, Gorilla Glass 3 is now available to provide better value to customers. This will likely create increased utilization for the product group as a whole via more placement wins. It is exciting to note that management expects, in fact is "confident," that Gorilla Glass will be put on an automobile in 2013, noting that the first contract is the most important. Imagine the possibilities here as far as glass needs. The possibilities do not end there, as apparent designs for notebooks with touch screens create additional market segment potential for gorilla grass, and could be a sizable incremental sales addition. In my opinion, for what it is worth, tablets will dominate the computing industry in due time, but there will be a solid niche for enterprise use of touch-screen notebook computers for many years to come.
There are some interesting trends playing out that would suggest LCD as a business can reach stabilization, and that Gorilla Glass can continue to grow with the mobile device market, and that one doesn't have to interfere with the other. It is true that in recent months/years, the overall TV LCD market, and pricing for the glass for these TV's has been under pressure. However, TV's greater than 30 inches have declined much less so, and TV's greater than 50 inches have been a relatively fast grower (which is a better margin business for GLW). In fact the Q4 call tells us that this 50 plus inch TV segment is a 50% grower and that the average TV size for 2012 is up 2 inches over 2011. It seems that people increasingly desire a large screen home TV for the living room, and a tablet or mobile device for the bedroom (hypothetically as it were). Each could continue to be good for Corning products over time. I do not see one precluding the other from succeeding, and I foresee each picking up steam in the future, though I will not proclaim myself capable of predicting when. On that note, there are interesting thoughts about the product refresh cycle in LCD display in the Q3 2012 conference call, regarding the 7 year refresh periods and many markets already eclipsing the 5 year average product life period. Food for thought.
In summary of the business segments, I see potential immediate pressures along the lines of what analyst downgrades and company outlook have described, but I do not see drastic declines for many years to come. Rather it seems that the LCD products are in the process of making a bottom, and though this pricing trough may go somewhat deeper, I believe that generally speaking earnings from this segment have more upside in the long-term than down. So if this is the case, what can we say to the numbers of the business as a whole?
As of the close of trading on 1/28/13 (Monday), GLW was valued at a Market Cap of very near $18 billion, though it has Net Tangible Assets approaching $21 billion. In other words the company is being priced at about a 14% discount to book value currently. Already I was intrigued.
Then we take a look at the balance sheet and find a company with nearly twice as much cash ($6.1 billion) as debt ($3.4 billion). A strong balance sheet, and I'm still intrigued.
I then review the cash returned to shareholder policy and find a company that is yielding very nearly 3% with the dividend after increasing the payout 80% over the last year. However, with an annual dividend of $0.36, fiscal year 2012 earnings of $1.15, we see that the payout ratio is a mere 31%, giving both cushion for declining earnings to maintain the dividend, or (as I believe more likely by far) room to grow the dividend cautiously yet substantially in the years to come giving a much better yield on cost. For example, say the dividend were grown 50% (which would still fall well within recent earnings and normalized earnings, which I will discuss momentarily) one would have locked in a nearly 4.5% yield on cost at current prices, which I do not feel to be an unlikely scenario given the strong balance sheet. Additionally the company has been buying back stock to the tune of $1.5 billion worth throughout 2012, and at pretty attractive prices to book value, adding to shareholder value.
I appreciate this quote from management in the Q4 2012 conference call in response to a question regarding potential refresh of the share purchase program in 2013:
"I think that you have seen over the past 15 months the board being very active in trying to return money to shareholders through dividend increases and a large (share) repurchase, so I think they will remain focused on that."
This appears to be a shareholder friendly and shareholder rewarding company at this time, trading below 10x earnings, and below book value. I'm still intrigued.
However, I never evaluate a company based on the past year or the next year alone. Rather I like to see companies valued attractively compared to "normalized earnings," which I have assigned a 10 year average to as definition for my purposes. The following list demonstrates net income attributable to common shares from fiscal year 2012 going back to fiscal year 2003.
|Year||Net Income available to Common|
|2004||-$2.251 billion (loss)|
|2003||-$0.223 billion (loss)|
10 year average net income is approximately $1.75 billion (about $1.18 per share with current shares outstanding). With this normalized number, the stock is still trading at approximately 10.28 times average earnings and yielding 3%, with a payout ratio of average earnings still around 31% (far from over-stretched)
Omitting the 2 years with a loss** (i.e. averaging the last 8 years) average net income is $2.49 billion (about $1.68 per share). This would yield a P/E multiple of slightly above 7, yielding 3% with a payout ratio of approximately 21% (lots of room to grow).
While I don't typically like to normalize earnings for less than a decade, one can reasonably assume average earnings for the next decade to be somewhere between these two net income normalized figures. Additionally, it is reasonable to assume moderate buybacks and dividend increases, with growing yield and a rebound in the LCD business and growth in Specialty Materials' Gorilla Glass.
** (The two years at a loss involved substantial goodwill write-downs related to an over aggressive expansion of the telecom business in the late 1990s and early 2000s. One can make reasonable assumptions that this extent of over-aggressive expansion won't plague a company that has learned its lesson, at least in theory.)
In summary, I believe GLW offers one of the more compelling buys in the S&P 500 index at this time, and is the one stock I have found with the index at current highs in which I am willing to put cash to work immediately at current levels, though I will continue to be on the lookout for opportunities to add to other current positions.
Potential hurdles to this investment thesis aside from traditional business fluctuations include fluctuations of the Yen, as these fluctuations have significant impact on income figures. Management notes on the recent call that they will be considering actions to mitigate these influences, including considering hedging activities or transitioning sales of LCD glass into U.S. dollars instead.
Conclusion: I feel GLW is approaching a bottom in the LCD segment in the not so distant future, and other segments show promise of growth for the foreseeable future. The company is trading at attractive valuations to book value and normalized earnings, with a likelihood for increased return to shareholders upcoming. I would initiate a long position at current levels, and add to it with further weakness.
The savvy reader of this article will conclude that this is foundational research that should no way be the sole source used in making an investment decision. I should take this opportunity to stress two thoughts: 1. This is not intended to be a quick money idea article, but rather is a thesis to initiating a LONG-term long position if you will, and 2. Each reader should perform their own homework and come to their own educated conclusions before putting their own money to work. I simply hope to have provided an interest in what I feel to be a good opportunity.
I welcome all comments to the bull or bear side of this argument with the hopes of bringing to light every aspect of an investment decision.