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Executives

Ken Sofio – Division VP, IR

Jim Flaws – Vice Chairman & CFO

Wendell Weeks – Chairman & CEO

Analysts

Mark Sue - RBC Capital Markets

Christopher Muse - Barclays Capital

Jeff Evanson - Sanford Bernstein

Jim Suva - Citigroup

Steven Fox - CLSA

John Roberts - Buckingham Research

Carter Shoop - Deutsche Bank Securities

Yair Reiner - Oppenheimer & Co.

Brendan Furlong - Miller Tabak & Co., LLC

Paul Bonenfant - Morgan, Keegan & Company, Inc.

Corning Incorporated (GLW) Q2 2009 Earnings Call July 27, 2009 8:30 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Corning Incorporated second quarter results conference call. (Operator Instructions)

Now with that being said, I'll turn the conference over to the Division Vice President of Investor Relations, Ken Sofio. Please go ahead, sir.

Ken Sofio

Thank you. Good morning and welcome to our second quarter conference call, also being audiocast today on our website.

Jim Flaws, our Vice Chairman and CFO will lead the discussion. Wendell Weeks, Chairman and CEO will join the Q&A.

Today's remarks contain forward-looking statements under the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially. These risks are detailed in the company's SEC reports.

Jim?

Jim Flaws

Thanks, Ken. Good morning, everyone.

This morning we released our results for the second quarter, which can be found on our Investor Relations website. We have also posted the company's slides on our website.

We were extremely pleased with our results and hope that you are as well. Before I get into the details I want to walk you through the key points we'll be covering this morning.

First, second quarter sales, gross margin and profitability grew significantly, driven primarily by strong Display volume.

Two, we believe supply chain inventories at the end of the second quarter have rebuilt to levels similar to where we entered 2008 as the industry prepares for a stronger seasonal second half of the year. We estimate that the current inventory supplies are 16% less than quarter two last year compared to retail demand that's been actually running 15% ahead of a year ago. Retail demand for LCD products is forecasted to continue growing at double-digit rates in the back half of the year. This comparison gives us comfort about the current supply chain and the outlook for the remainder of the year.

Third, retail sales of LCD televisions remained strong worldwide throughout the second quarter. This helped pull through a significant amount of product in the supply chain and kept inventory levels healthy.

Fourth, based on the robust retail data in the first half, in our expectations for the second half we've increased our forecast of the LCD market glass volume this year from roughly 2.2 billion square feet to 2.3 billion square feet.

Fifth, we met 40% of our wholly owned Display shipments in quarter two by depleting our inventory. We need to and have restarted tanks to replace this inventory drawdown to meet quarter three demand. We have some decisions to make soon about whether or not to bring back capacity for quarter four, but we are proceeding cautiously until we have more information from our customers on their quarter four plans and, of course, we'll continue to monitor end market demand.

Sixth, despite our efforts to bring required capacity online rapidly, we expect to be capacity constrained in Q3 and are prioritizing our glass allocation to customers with long-term supply agreements.

Seventh, we expect our Q3 Display volumes to be flat to up slightly compared to the stronger-than-expected Q2 performance. We also expect Display gross margins to be consistent with Q2. You should note that our Display volume estimates for Q3 are much higher today than they were just a few months ago.

Eight, we expect our Display glass prices to be flat in Q3 sequentially at both our wholly owned business and SCP. This is a dramatic improvement from the significant price declines we experienced in Q1.

Lastly, we expect consistent to modest sequential growth in our other businesses for the second quarter in a row and this could be an indication that our businesses may have hit bottom in Q1, so let me turn to the details.

Our second quarter sales were about $1.4 billion, a 41% increase versus the first quarter. Q2 sales were negatively impacted by changes in exchange rate versus Q1.

Moving down the income statement, gross margin was 41% in Q2 compared to 27% in Q1. This significant increase was primarily due to higher Display volume.

SG&A was $211 million or 15% of sales in Q2 compared to $207 million or 21% of sales in Q1. We're very pleased we were able to maintain a consistent level of SG&A given the 40% increase in sales.

R&D was $136 million in Q2 or about 10% of sales compared to $151 million or 15% of sales in Q1.

The cost savings from our restructuring actions were about $35 million in the second quarter. That breaks down to $20 million in cost of goods sold, $8 million in SG&A, and $7 million in R&D.

Other income was $41 million in Q2 versus other income of $20 million in Q1. The increase was primarily due to higher royalty income from SCP driven by their higher Q2 sales.

Equity earnings were $361 million in the second quarter compared to $195 million in the first quarter, a sequential increase of 85%. The significant increase was due to higher earnings at both Samsung Corning Precision and Dow Corning. As a reminder, quarter one equity earnings had included $29 million in restructuring charges at Dow Corning.

Net income excluding special items was $614 million in Q2. This is four times our Q1 net income excluding special items of $150 million.

You should note that EPS and net income excluding special items are non-GAAP measures. The reconciliation to GAAP can be found on our website.

Our share count for the second quarter was 1.57 billion shares and consistent with the first quarter.

Now let me turn to our segment results, starting with Display. Second quarter sales were $673 million, an 89% increase over the first quarter sales of $357 million. Volume at our wholly owned business was up 101% sequentially. Sequential price declines were much more moderate than the first quarter, as expected. Q2 sales were also negatively impacted by the change in the yen to U.S. dollar exchange rate in Q2 versus quarter one.

Equity earnings from SCP's LCD glass business were $284 million in the second quarter, an increase of 58% compared to $180 million in Q1. Volume was up 50% sequentially. Price declines at SCP were minor, as expected, and less than the wholly owned business. The impact of exchange rates overall was a slight negative at SCP.

For modeling purposes, SCP's second quarter LCD sales were $960 million compared to $659 million in the first quarter, an increase of 46%. As a reminder, this represents SCP LCD sales only. Our public filings will report SCP's total sales, which include CRT glass and other product sales.

Net income in Display segment, which includes equity earnings, was $555 million in the second quarter versus $218 million in the first quarter. As a reminder, Q1 net income had included $34 million in restructuring charges.

The improved performance on our Display segment was driven by both the higher sales volume and improved manufacturing performance. The higher volume was fueled by the replenishment and slight expansion of the supply chain during the quarter. This stronger volume resulted in a significant increase in Display gross margin, which accounted for most of the improvement in the total company gross margin performance.

We were able to meet the stronger-than-expected demand through a combination of production, from continuously operated capacity, glass shipments from inventory, and production from capacity restarted in the quarter. As a reminder, our wholly owned business ran at less than 50% capacity for most of Q2. It was not until the end of the second quarter that we began shipping glass from restarted production capacity.

Since glass demand was much stronger than we expected, we began restarting capacity earlier than planned; however, there's a lag of several weeks between restarting a tank and producing good glass. About 40% of our Q2 shipments in our wholly owned business came from inventory. We made the decision to deplete most of our glass inventory in the quarter to meet the needs of our customers.

At the end of Q2 our utilization rate, based on all of our available capacity, was around 75%. We'll continue to evaluate our production capabilities versus demand expectations. Any decisions will be made a little later this year.

I'd like to spend a few minutes discussing the current supply chain and retail environment. As I mentioned earlier, we entered the second quarter with two key assumptions - first, LCD televisions would continue to exhibit good year-over-year growth at retail, and second, the supply chain would replenish following a significant contraction in Q4 '08 and Q1 of '09. We were correct on both. Let me start, first, with retail.

LCD televisions continue to be a resilient consumer purchase in the second quarter. Worldwide, LCD television unit sales at retail were up 27% in April and 33% in May. We don't have complete data for June to provide worldwide growth data for that month. As a reminder, worldwide retail sell through is the aggregate of the data provided by different data vendors in each of the primary TV sales regions - China, Europe, Japan and the United States.

The most significant growth regions were Japan and China. In Japan, LCD television unit sales were up 18% in April, 48% in May and 42% in June. In China, unit sales were up 77% in April, 80% in May, and 68% in June. For the first six months, LCD television sales in China are up 71%. We believe the strong growth in China so far has been more the result of the attractive retail pricing rather than a stimulus pricing.

In Europe, LCD TV unit sales were also very strong. In both April and May unit sales were up 22% over last year. We do not yet have June data for Europe.

In the U.S., LCD TV sales rebounded nicely after a slightly weaker April. April was up 9%, May 13%, and June 29%. All months came in higher than we had forecasted. We believe the slightly stronger June sales may have been due in part to the second round of digital conversion which took place on June 12th.

As a reminder, the U.S. data provided by MPD in their data does not include Wal-Mart or Costco; however, Costco recently reported that June LCD TV sales grew [50%] over last year. This higher growth rate supports our belief that discount retailers have continued to gain share.

As a result of the very strong demand for LCD TVs in the first half of the year, we've increased our forecast of LC glass market volume for the year. As you may recall, our original forecast called for a flat market versus 2008 of around 2 billion square feet. This estimate was revised upward in April to a range of 2.1 to 2.2 billion square feet. We're not estimating the total market to be around 2.3 billion square feet or about 15% growth over last year.

The revision is largely the result of our revised forecast for LCD TV sales this year. We now estimate 129 million units will be sold versus our previous estimate of 121 million. This represents about a 25% increase over last year. Much of the 8 million unit increase will be in China, where we now estimate 22 million units to be sold versus our prior estimate of 18 million.

We've also slightly increased our estimates for notebooks and monitors. Our estimates for notebook sales this year increased slightly from 126 million to 129 million, which is consistent with last year's total. The estimate for monitors has moved from 143 million to 154 million. This is still lower than last year's total of 167 million monitors.

In summary, we're feeling very good about LCD sales at retail.

Now I'd like to provide an update on the Display supply chain. During the second quarter the supply chain replenished following the significant contraction which began in Q4 of last year and continued into Q1. We believe this rebuilding of inventory is appropriate given the strength of retail demand during the first half and the need to service a larger end market than was forecasted entering the year.

We believe the total inventory in the supply chain as measured in square feet of glass increased from around 500 million square feet at the end of Q1 to around 650 million square feet at the end of Q2. This level is consistent with the amount of supply chain inventory entering the year, which was around 630 million square feet.

The key question that remains is: Is the supply chain building too much inventory too fast again? Difficult to answer, as it ultimately depends on end market demand. Perhaps the best way to think about it is this: We estimate that the level of total supply chain inventories is 16% than the second quarter a year ago. This is compared to retail demand for both the total glass television IT that's been running 15% ahead of a year ago and it's forecasted to continue to grow at a double-digit rate in the back half of the year. This comparison gives us some comfort about the outlook for the remainder of the year.

Looking ahead to Q3, we expect the supply chain to expand further to meet seasonal demand in Q4. The industry simply cannot make and ship enough televisions within the fourth quarter to meet that level of demand. However, the supply chain expansion in Q3 may be slightly constrained by the availability of glass. Our models suggest inventory levels in Q3 could reach 800 million square feet. That's about 9% less than Q3 of last year, which we all know now was higher than it needed to be. Given that this year's end market in Q4 may be 10% higher than last year, this level of inventory may be appropriate. Time will tell.

The key will be how strong Q4 retail demand is and how much inventory is pulled out of the supply chain. Right now our model suggests about 100 million square feet will get pulled out in Q4, leaving the total supply chain about 700 million square feet at year end. We would view that level of inventory to be appropriate for a market of this size.

With that overview, let's start with the second quarter, beginning with glass supply and demand. Glass demand for the industry in total was higher than the industry's ability to ship in Q2. The glass industry did restart capacity to meet demand, but it generally takes more time to bring on glass capacity than it does the panel makers to ramp their utilization. In addition, glass inventories are likely depleted faster than expected. The amount of glass industry capacity currently being restarted appears to be following customer demand.

Now turning to panel makers in Taiwan, utilization rates increased during the first two months of the second quarter; however, glass shortages may have had an impact as those rates declined slightly in June. In April utilization rates at the Taiwanese averaged nearly 80% compared to about 70% in March. In May, rates increased to 85%; however, in June the average declined to 75%. Taiwanese panel inventories at the end of Q2 were around four and a half weeks, a level we would consider normal.

In Korea, utilization rates remained fairly steady in Q2, averaging between 90% to 95% each month.

In terms of the total panel maker inventory as measured in equivalent square feet, at the end of Q2 they were half of what they were in Q2 of last year.

Moving on to the set assembly level, inventory levels measured in square feet of glass have increased in comparison to the first quarter, as expected. At the end of Q2 our models suggest they were slightly higher compared to inventory levels entering the year, but 20% less than Q2 last year. We would expect set assembly level inventories to increase again in Q3 in preparation for Q4 demand.

At retail we believe inventories increased compared to Q1. Inventory levels as measured in square feet of glass were about 12% higher in Q2 than a year ago, which is in line with end market demand that's forecasted to be 15% above.

We also saw a steady increase in panel prices during the quarter for all key panel sizes. For monitors and notebooks, panel prices have had their most material increases over the last several weeks. For TVs, panel price increases have been fairly steady over the last two months. This is another indication of tightness in the supply chain.

My last comment about the supply chain is regarding the concept of double booking or double ordering. It's always difficult to tell if there's double ordering either from your direct customers or their customers further down the supply chain. We assume there is some level of double ordering, but it's impossible to quantify. If there were any double ordering within the Display supply chain we would believe it most likely would be at the set assembly level. In times of rising panel prices set assemblers may decide to purchase more panels in advance. This could explain the increase in inventory levels there. We would be more concerned about this if retail demand were not as strong and pulling inventory out of the supply chain.

I'll cover our supply chain expectations for the third quarter and our capacity decisions in the outlook section.

My last topic is our Gen 10 plan. We continue to ramp our production there in preparation for Sharp's planned start up later this year. Investors should note the impact of fixed costs associated with our ramp is material to Display's gross margin. In Q2 the impact to Display gross margin was about 400 basis points. In Q3 it may be as high at 550 basis points. There will continue to be a fixed cost overhang until production volumes at Gen 10 are high enough to offset them. We expect this to happen some time in 2010. The exact time will be dependent on how quickly Sharp ramps its own production.

Now I'll turn to the Environmental segment, where sales in the second quarter were $132 million versus first quarter sales of $110 million. The 20% increase was driven primarily by demand for our automobile products. Auto product sales were $85 million in Q2 compared to $64 million in Q1. We experienced strong demand within Germany, China and the U.S. U.S. demand was likely the result of the replenishment of supply chain during the quarter versus an increase in auto production. We believe Germany and China demand was attributable to government incentives there.

Despite the recent spike in demand driven by incentives and refill of the supply chain in Q2, longer term we now believe the worldwide auto market will remain at fairly low levels. Most industry forecasts predict auto production between 54 and 55 million cars this year, roughly a 20% drop from last year. These same industry sources estimate auto production will not return to pre-recession levels until the early part of the next decade. As a result, we're not considering further restructuring actions to resize our auto business and align our capacity with a smaller market. These actions may include further asset utilization and work force reductions, and we expect to announce any decisions and actions later this quarter.

Diesel sales in the second quarter were $47 million and flat versus the first quarter. The segment incurred a net loss of $9 million in the second quarter versus a net loss of $44 million in Q1. Q1 segment income had included $19 million in restructuring charges.

I'd like to make some additional comments on our diesel business. We're halfway through the year and clearly the heavy duty engine market continues to suffer in this economic environment. Light duty diesel is actually holding up well, but we're still disappointed with the relative amount of total diesel sales. That being said, we still believe this business will reach $500 million in sales within the next few years. Regulations also continue to tighten over the next decade, requiring even more advanced emission control products, and new standards for off-road engines will provide additional revenue opportunities.

So while it is taking longer than anticipated, this market is there, it's still large and it continues to be an attractive growth opportunity for us.

Turning to Telecom, sales in the second quarter were $437 million, an increase of 14% versus Q1 and higher than our expectations. China continues to have a strong demand for optical fiber and cable products. In North America we saw increased demand for fiber in the home, cable and hardware equipment products due to the release of carrier capital spending. On the downside, North American private network demand was weaker.

Sales of our fiber and cable products in the second quarter were $235 million, an increase of 20% sequentially. China's 3G buildout was the primary driver again this quarter. The China fiber market is now the largest in history; no small feat considering the size of the long haul buildout in North America in 2000. We expect the China fiber market to grow 40% this year, while the rest of the world declines 15%. In total we now expect the worldwide fiber market to be flat to up 5% versus last year.

Sales of hardware and equipment products were $202 million in Q2, an increase of 5% sequentially. Fiber to the home sales, which are primarily hardware and equipment related, were $94 million in the second quarter, up 15% sequentially.

Segment net income was $18 million in the second quarter compared to a net loss of $1 million in the first quarter. Q1 had included $15 million in restructuring charges.

Sales in our Specialty Materials segment were $71 million in Q2, an increase of 18% versus Q1, which is more than we had anticipated. The increase was driven primarily by higher demand for our Gorilla glass. The segment incurred a net loss of $10 million in Q2 versus a $27 million loss in Q1. Q1 had included $18 million in restructuring charges.

In the Life Sciences segment sales in the second quarter were $81 million, an increase of 7% versus Q1 and in line with our expectations. Segment net income was $9 million versus $8 million in Q1.

Turning to Dow Corning, equity earnings in Q2 were $58 million compared to $5 million in Q1. As a reminder, Q1 had included restructuring charges of $29 million. This sequential increase was driven by higher demand in both the Silicon segment as well as Hemlock. Silicon sales have grown each month over the past several months. Hemlock benefited from capacity that came online during the quarter. For modeling purposes, Dow Corning sales were $1.2 billion in Q2 compared to $1 billion in Q1.

Moving to the balance sheet, we ended the second quarter with about $3.1 billion in cash and short-term investments, up from $2.6 billion last quarter. The increase in cash was primarily due to the issuance of $350 million in senior unsecured notes during the quarter and strong free cash flow. Free cash flow was $156 million in Q2. Free cash flow is a non-GAAP measure and the GAAP reconciliation is on our website.

Inventory fell slightly from $731 million at the end of Q1 to $647 million at the end of Q2. The biggest decline came from Display inventories, but Environmental and Telecom declined also.

Now on to our outlook. We expect glass volume at our wholly owned business and SCP, both separately and in the aggregate, to be flat to up slightly compared to the very strong second quarter. As I mentioned earlier, about 40% of our Q2 shipments came from existing inventory.

As a result, we need to and have restarted tanks to replace this inventory drawdown to meet Q3 demand. We are restarting tanks earlier than expected and we are getting them back online at a record pace. We have some decisions to make about tanks that could deliver additional glass in Q4; however, we need to know more about our customers' plans for Q4 and we also want to continue to monitor retail sales and inventory levels.

Our caution for Q4 comes from the uncertainty about the economy and a desire to avoid costs from starting and stopping tanks. While we designed our LCD operations to be scalable, it's still a complex and costly process to take tanks on and offline. As a result, we expect to be capacity constrained in Q3 and we are prioritizing glass allocation to customers with long-term supply agreements. If end market demand continues to outpace our revised expectations - and we believe it will be robust - we have the flexibility to bring on additional capacity to meet that demand.

Regarding glass pricing, we expect pricing at both our wholly owned business and SCP to be sequentially flat in Q3.

With regard to Display gross margins, we expect them to be consistent with Q2. The benefit of running higher utilization rates will be offset by the higher Gen 10 fixed costs and depreciation from some of the restarted tanks. Because of this we would expect that Display gross margins will be similar to Q2 and the same is true for our corporate gross margin.

Looking ahead to Q4, we would typically expect glass shipments for the industry to be seasonally lower; however, given the continued retail strength, we believe the declines could be more muted this year. As a remainder, supply chain inventories are usually depleted in Q4 to meet this surge and retail demand.

Panel makers typically continue to run at higher utilization rates for part of Q4 to replenish the inventory levels the supply chain requires for Q1 demand. Once they reach those inventory levels and demand subsides they lower the utilization rates for the remainder of the year. If retail demand in Q4 is stronger than expected, more inventory will be pulled out of the supply chain. In that scenario the panel makers may have to run the higher utilization rates for a longer period of time. This could result in strong glass demand and Q4 being flat with Q3.

In our Telecom and Life Sciences segments we expect Q3 sales to be comparable to Q2. Environmental sales are expected to be up modestly in Q3, while sales in Specialty Materials are expected to be up 10% to 20% on stronger Gorilla glass sales. At Dow Corning we expect Q3 equity earnings to be up more than 25%.

Moving to the income statement, SG&A will be slightly higher in terms of dollars and R&D will be consistent with Q3.

For a tax rate based on the mix of income by geographic region, we expect our tax rate to be between zero and 3%, Q3 and Q4.

I have some comments about how investors should think about our tax rates going forward. At our annual investor meeting in February we told you to use a tax rate of 16% to 18% for 2010 and beyond when modeling. We now believe our 2010 tax rate could be much lower. I'd like to walk you through the details.

Like most companies, our tax rate is influenced by where our income is generated and the tax rate in those regions as well as changes in tax code and tax holidays. Looking forward, we're anticipating changes in each. Let me start with income.

In Japan, where tax rates are high, our income this year has been offset by the start up costs of the Gen 10 factory. As a result, we've been incurring a tax benefit in that region and this has helped to offset tax expense elsewhere and lower our overall tax rate.

Starting in 2010 we expect those costs to by and large be offset by income to result in either a much smaller tax benefit or a small tax expense. We estimate this change could increase our overall tax rate by approximately 4 percentage points.

Regarding the tax code, there's one item that has the most material impact to Corning's tax rate; it relates to foreign dividends. Today dividends declared by foreign subsidiaries are not taxed if the related income is not distributed back into the U.S. This tax law has been in existence now for several years, but there's currently discussion on Capitol Hill to allow this exemption to expire. If that happens, dividends from affiliates such as SCP will be taxable even if the money stays abroad. This could increase our 2010 tax rate by another 4 percentage points. Congress still has until the end of the year to extend this law for another year. Obviously, if that happens this would not be a 2010 tax event for us.

We will also begin to see the phasing out of tax holidays in both Taiwan and Korea; however, the impact to our overall tax rate is not material from these changes until 2011.

So in summary, for 2010, assuming the U.S. tax exemption on foreign dividends is allowed to expire, our tax rate could be around 10% next year. However, given the uncertainty of other proposed changes by the Obama administration to current tax law, this estimated rate could be significantly different.

That wraps up my discussion on taxes and hopefully this data will help your modeling.

One other modeling point: Investors should note that our results can be materially influenced by the yen to U.S. dollar exchange rate. For Q2 the yen averaged 97. For every 1-point move in the yen our net income moves by about $7 million, so if the yen were to average 95 in Q3, our net income benefit would be about $14 million or roughly $0.01 of EPS.

Before I head into Q&A I'd like to make some overall comments on how management views Corning and why we believe in our long-term potential.

First, we remain the market leader in all of our major businesses in terms of share, technology and cost. Even during this downturn these strengths have not been eroded.

Second, the growth trends in profitability of our largest business, Display, remain robust. Penetration of LCD televisions into the worldwide installed base remains very low. Only 13% of all televisions worldwide entering the year were LCD. In China, which is the world's largest and fastest growth market, less than 40 million have been sold there to date. The penetration trends are good and so is our ability to have robust profitability from this business.

Third, we expect to be generating significant cash flow over the next several years. We are not anticipating a significant spike in capital spending going forward. In fact, we believe our CapEx next year will be about $600 million, down from $1.1 billion this year.

Fourth, as I mentioned earlier, our diesel business continues to have the potential to be another significant business for Corning.

Lastly, we continue to innovate and have several promising technologies that have the potential of delivering significant revenues over the next decade, including solar, green laser and Gorilla glass. I'm sure Wendell will be happy to take any questions on these during the Q&A.

So in summary I can tell you senior management feels very good about long-term prospects for Corning.

Ken?

Ken Sofio

Thank you, Jim.

And, [John], I believe we're ready to take some questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Sue - RBC Capital Markets.

Mark Sue - RBC Capital Markets

On Display glass, if the inventory supplies are less than a year ago and demand is greater than a year ago, shouldn't we see magnified improvements as we move into 3Q and then an increase in 4Q since there is still some catch up going on?

Aside from the macro, is it set assembly data that's kind of giving you pause or any other thoughts aside from the macro picture for your conservatism?

Jim Flaws

Well, we feel comfortable about where inventories were at the end of Q2. We expect them to build in Q3 and to get up, as I said, to about 800 million square feet. That's down from where it was at the end of Q3 last year, which we had thought was excessive, but we think that's an appropriate level heading into what will be the Q4 demand.

I hesitate to replay to the word conservatism. In our models and our tracking of demand, we think the inventory level is appropriate - not being overbuilt and not underbuilt, either.

Wendell Weeks

And I'd add to that that there's always room for some caution here because though we feel really good about the end market, it's always possible for different players in the supply chain to make a judgment on how much inventory they want to carry and what their confidence is for the coming quarter.

So that's why before we make some decisions about restarting even more capacity we want to get a little bit better insight into those plans and a little more data [under our belt about the end market.]

Mark Sue - RBC Capital Markets

And, Jim, just as a follow up, can we assume a steady level of gross margin improvements as we see growth in Display glass for the balance of the year? I think at this revenue point and with stable pricing it was kind of near 48% in the past. Is that kind of within the ballpark that we should think about?

Jim Flaws

I'm sorry; you broke up so I couldn't hear the question.

Mark Sue - RBC Capital Markets

Sure. Can we assume a steady level of gross margin improvements as we see growth of Display glass for the balance of the year around this revenue point and with stable pricing? Can we assume right around 48% gross margins? Is that reasonable? We saw this in the past.

Jim Flaws

I'm not going to give you a forecast of corporate gross margins. You heard in my script that we're talking about gross margins for the corporation being flat in Q3 versus Q2 and the same for Display.

Operator

Your next question comes from Christopher Muse - Barclays Capital.

Christopher Muse - Barclays Capital

In terms of glass capacity constraints, can you comment on when you think that will ease up? And then as part of your glass guidance now of up roughly 15% year-on-year, is that what you think all the glass makers can provide as of today and plans today or is that number higher?

Jim Flaws

It's what we believe that the glass market is going to be based on what we are aware of, either our own plans or what we think the other glass makers are going. Clearly, we could turn on additional tanks and provide more in Q4 if we thought that was appropriate. Both of our other large competitors have additional capacity that's not lit. We're not capable of knowing how fast they can bring that on.

Wendell Weeks

So glass is tight now, C.J., and we would anticipate it would remain relatively tight.

Christopher Muse - Barclays Capital

And that is all the way through year end?

Wendell Weeks

I think as Jim comments, a lot depends on how the seasonality works its way through this quarter. And you heard in his opening remarks that we have scenarios that have a quarter four that is relatively flat demand and then scenarios that have a quarter four that drops off a little, more than normal seasonality.

And so we're not really ready to make an definitive comments about Q4 at this time, C.J.

Christopher Muse - Barclays Capital

And I guess moving on to OPEX and unallocated expenses, R&D showed a 10% sequential drop. Was that part of the initial plan or is that timing related? How should we think about OPEX going forward?

And then as part of the same question, unallocated expenses came down pretty dramatically as well. Is that something that we should change in our models as well?

Jim Flaws

R&D benefited in Q2 from restructuring and also we had some programs that didn't repeat themselves. But R&D is always somewhat subject to just program expense and we have some. Our new business has been moving ahead successfully, so we think it's flat for Q3 but it could go up a little as we evaluate those programs.

And I think unallocated I'll leave to a more detailed call with you and [Kim].

Christopher Muse - Barclays Capital

And then final question, on the Display gross margin side, you provided some good color there; I was wondering if you could dig a little bit deeper, though. I would have thought that you would have seen a slight uptick, at least, in Q3 given not selling from inventory and running full out. Why just flat? Is that a level of conservatism on your part or are there other issues going on?

Jim Flaws

The reason it's flat is that we have the Gen 10 drag increasing. We're also making some other change to our capacity that will hurt [inaudible] a little in Q3 as well as some of the depreciation from the restarted tanks.

Operator

Your next question comes from Jeff Evanson - Sanford Bernstein.

Jeff Evanson - Sanford Bernstein

First just a clarification. You're guiding for our Q3 shipments in the wholly owned business to be up slightly. Do you define up slightly as low single digits?

Jim Flaws

We guided it to be flat to up slightly so that could be zero to five.

Jeff Evanson - Sanford Bernstein

And when we look at the panel manufacturers, although we certainly haven't seen all of them, I'd say in aggregate they're guiding for up 10% to 15% in their shipments. How does the math on that work out?

Jim Flaws

We don't believe that in aggregate the entire industry, when you could all the panel makers, could achieve that.

Jeff Evanson - Sanford Bernstein

And when you talk about extra capacity that you could light, where is that capacity and what generation is it?

Jim Flaws

It's mostly in Taiwan. We do have capacity in Japan that would be Gen 6 capacity, but we're not planning right now to light that. And then we have capacity in Taiwan - that'd be Gen 5 and Gen 6 - that we could light.

Jeff Evanson - Sanford Bernstein

And lastly, it sounds like Wendell wanted to say something about solar from your last comment in the prepared remarks, Jim, and I'd love to hear it.

Jim Flaws

He does; he's been very excited about solar recently.

Wendell Weeks

I don't actually know that I wanted to make a comment on it in a conference call, however.

I would characterize our progress on solar as very encouraging right now. We feel [inaudible] showing that very thin glass we can make. Our damage resistance is enough to be able to sustain the same or even better performance as the relatively thick glasses of today, and we continue to generate some very encouraging data on improvement in conversion efficiency related to some of our exciting new composition work.

So, so far, so good on solar, Jeff.

Operator

Your next question comes from Jim Suva - Citigroup.

Jim Suva - Citigroup

Can you just help me better understand a little bit of connecting the dots where inventory went down 11% in Q2, which I would have actually thought it would have come a little bit more, but more importantly your comments about Q3, about your shipments to be flat to up 5%, rebuilding some inventory. But if there's some shortages it sounds like you're making some priority allocations as far as who gets the supply. I would have thought that a sale today versus putting something in inventory and limiting the sales is quite an interesting discussion. Why would you build inventory if you're allocating supply in Q3?

Jim Flaws

We didn't say we were building our own inventories.

Jim Suva - Citigroup

Okay, so you're not building inventory in Q3? Okay. Okay, that's very interesting to know.

And then can you also talk about the expansion of Taichung. I believe the Phase 4 expansion was shifted a little bit or delayed to 2010. Is that one of the areas of production that you could actually bring back online potentially and what's the status of that?

Jim Flaws

Taichung Phase 4 was never brought online, so it's not bringing it back. We do have some of that capacity that is a potential decision, but most of the decisions are in Taichung and [Tainam], Taichung early gen, Phase 3, and then in [Tainam].

Jim Suva - Citigroup

Right, but the expansion is continuing to plan for 2010?

Jim Flaws

I'll just say we could bring capacity online from Phase 4 in 2010 from Phase 4.

Operator

Your next question comes from Steven Fox - CLSA.

Steven Fox - CLSA

First of all, Jim, is the peak drag from the Gen 10 ramp, is it the 550 basis point drag or could it get worse from there?

And then, secondly, given how you describe potential seasonality in the fourth quarter, when will you get back to sort of a comfortable level of inventories for LCD glass on your own balance sheet?

Jim Flaws

On the latter point, we're comfortable with the inventories on our balance sheet. We don't actually like to have inventory, so we're kind of back to where we would like to run, I mean, maybe just a hair under. So we feel comfortable running with very low inventories.

I don't actually know exactly the quarter by quarter on Gen 10. We have lit our second tank now. We have plans to light additional tanks there. But I don't have a quarter by quarter ramp from Sharp, so I don't know exactly what the drag is. I have a hard time imagining it being much worse than the number I gave you, though.

Operator

Your next question comes from John Roberts - Buckingham Research.

John Roberts - Buckingham Research

Do you think the loss of the dividend tax holiday is an eventuality - if it doesn't happen this year it's most likely going to happen next year or soon after?

Jim Flaws

It's very hard for us to judge. This has been in the tax extender bill last year, just like the R&D credit, which gets renewed on an annualized basis, so I think it's difficult for us to predict. Obviously, there's a desire for more revenue in Washington, so that might go against us. But we're not the best predictors of tax policy in Washington.

John Roberts - Buckingham Research

And if you lose that tax holiday, is there no tax on dividends you would bring back, then?

Jim Flaws

I'm not sure I follow your question?

John Roberts - Buckingham Research

So if you're going to get taxed on the earnings generated abroad, if you wanted to bring that cash back as a dividend to the U.S. would there not be a double tax on that, then?

Jim Flaws

That's correct.

John Roberts - Buckingham Research

Then you're underlevered, I think, or potentially significantly underlevered in some of the foreign operations and the JVs. Could you lever up and bring back a fair amount of cash then tax free, because it's not generating earnings if you're just leveraging up to pay the dividend back to the parent.

Jim Flaws

We're not intending to lever up Samsung Corning Precision. We could bring extra dividends back. I think those extra dividends would have a tax on them.

John Roberts - Buckingham Research

Okay, if you levered up and paid dividends back there'd be a tax on that.

Jim Flaws

We're not intending to lever up, John.

Operator

Your next question comes from Carter Shoop - Deutsche Bank Securities.

Carter Shoop - Deutsche Bank Securities

I have a couple of questions on the Chinese market, [inaudible] TV side, and then one on the Telecom side.

Given the limited visibility into the Chinese TV market, particularly the opaque and distributed retail channel, how confident are you that there isn't an inventory build in China and what extra precautions are you taking, if any?

Jim Flaws

We do believe there's been some inventory build in China. We have gone around and we've had some people over there meeting with all the Chinese set manufacturers. Inventory is done a little differently there; it's more on a consignment basis and the brands actually, the television that's out at retail, is on consignment to the brands. We do think there's been some increase, but it doesn't appear to us to be inappropriate at this level. But we have met with basically all the Chinese television - set assembly television manufacturers over the past two months.

The Chinese government, I think, actually this morning announced how many televisions have been sold under the stimulus package, which looked about in line with our expectations. So we feel pretty good about China and not worried. I think if panel prices for small televisions climbed a lot more from where they are now that might be a negative for the Chinese television market.

Carter Shoop - Deutsche Bank Securities

And then the second quarter on the TV side, can you give us an update on what types of investments you made in China on the glass side since your initial foray into the market about a year ago in Beijing? And then any kind of future plans there would be helpful.

Wendell Weeks

We've had no further investments on the mainland since that initiative investment in Beijing. We continue to be engaged with the appropriate folks in China and I think a lot of where our decisions will go will depend on ultimately what happens with panel capacity there.

So that is how we're continuing to steer our way through the development of the LCD manufacturing base in China.

Carter Shoop - Deutsche Bank Securities

Last question on the 3G buildout in China as it relates to the Telecom segment. We've heard a couple of equipment manufacturers cite slowing demand there as a result of that buildout decelerating a little bit. What's your view on the current pace of the fiber buildout in China right now? Are these levels sustainable?

Wendell Weeks

Well, they're very strong. We're not seeing signs of a slowdown at the glass level. We continue to be able to sell everything we can make there, and we timed our capacity expansion in China, it looks like, perfectly. So that's all going very well.

That being said, anytime you do a build along this type of scale you're going to have a complicated set of projects that's going to have some ebbs and flows to it, so I find it very believable that we'll see some movement one direction or another as the 3G buildout continues. But overall we remain very bullish on the size and scale of the China fiber market.

Operator

Your next question comes from Yair Reiner - Oppenheimer & Co.

Yair Reiner - Oppenheimer & Co.

On SCP, it looks like gross margins in the quarter were exceptionally high. I wondered if you could tell us if you think that's sustainable at least for the near term or whether we should expect that to ease a bit?

Jim Flaws

The gross margins at SCP were fabulous. We expect that their level of volume utilization along with price declines for them to remain strong. But I will point out a lot of that has benefited what the Korean won is, so if there was a significant change in that that could drive those margins differently.

Yair Reiner - Oppenheimer & Co.

Now second question, also related to the Korean market. It appears as though capacity there for glass is particularly constrained well beyond the issue of how many tanks are lit or not re-lit. Is there any opportunity for the whole [inaudible] business to take advantage of excess capacity in other regions of the world and actually shift into Korea?

Jim Flaws

We can manage the worldwide capacity footprint in such a way to do our best to get glass to our customers that need it and we're always working our way through that and trying to find the best possible way to serve our customers in both directions.

Yair Reiner - Oppenheimer & Co.

Final question - it appears that the bottleneck right now for the LCD industry's clearly glass. That's causing ultimately or put pressure on LCD panels and perhaps down the line is going to limit the ability of the retailers to discount in the holiday season. Do you have any concern that the glass constraint is going to ultimately impact sell through and then come back and have an adverse affect on the whole industry?

Wendell Weeks

Well, I don't think we have any deep concerns about that. I think the issue has been the way the supply chain has interacted with the end market demand and what happened is that the supply chain overreacted due to concerns about the economy and that in turn pushed back to the least-flexible component. So glass, if you're going from 1,600 degrees C down to room temperature, that is not the component you want to try to build your supply chain flexibility into. It takes awhile to recover from that because you've got to get it from room temperature back to 1,600 degrees C.

So we would say most of our concern has been around - as Jim was, I think, one of the very first people in the world to point out - has been around the way in which the supply chain is understood and thought through the levels in the end market rather than any real concerns on the end market.

But, Jim, you've had the most insight on this. Do you want to add anything?

Jim Flaws

Oh, I think that we're actually pleased that panel prices came back up because if you look at the panel makers' financials they were losing money and you can't have that go on for a long period of time. So obviously we don't want the 32-inch panel price to go back to where it was at the beginning of 2008 - $300; we think that would be negative. But we're not sure that there's going to be a significant amount more increase from where we are right now.

So we still think there'll be a very healthy retail pricing environment for the fall.

Yair Reiner - Oppenheimer & Co.

I know that it's very early to look at 2011, but if you have to look at the market and glass demand, do you think we should get ready to expect a similar year to 2010 or a little bit below, a little bit above?

Jim Flaws

We expect overall glass demand to grow in 2010 and 2011.

Operator

Your next question comes from Brendan Furlong - Miller Tabak & Co., LLC.

Brendan Furlong - Miller Tabak & Co., LLC

Earlier on in the year you said that Corning standalone versus the industry will kind of [inaudible] some market share, if you will, because of the Taiwanese and the impact of the Koreans, with the major shift in dynamics in the last six months where do you see Corning standalone versus the industry now in terms of share for the year?

Jim Flaws

I think we've regained the share that we lost when the industry was barely operating at all in the January/February period of time, so we think shares are by and large back to where they've been for quite awhile.

Brendan Furlong - Miller Tabak & Co., LLC

Do you expect the full year share to be the same as 2008?

Jim Flaws

In general, yes.

Brendan Furlong - Miller Tabak & Co., LLC

And just a clarification on the R&D, flattish in the September quarter, does it stay at these low levels or does it spike up again for some reason or should we just model incremental gain from $136 million in the next few quarters?

Jim Flaws

I don’t think you should expect any unusual spike up or spike down. I mean, we're looking for our overall level of corporate R&D next year to be slightly down from this year, but you should not expect any unusual movements.

Brendan Furlong - Miller Tabak & Co., LLC

You exited Q2 with 75% utilization. Just as a matter of interest, what's the trigger point on utilization levels where you get worried and you have to add more capacity - is it 85% or what's the number?

Wendell Weeks

We don't think about it that way. We have tanks that are cold today, they're rebuilt, ready to restart. It takes us about a month to bring a tank up once we make the decision. We have to make some decisions soon in order to bring up more capacity relative to quarter four and get ready for Q1 next year, and we'll be making those decisions over the next month.

Operator

Your next question comes from Paul Bonenfant - Morgan, Keegan & Company, Inc.

Paul Bonenfant - Morgan, Keegan & Company, Inc.

Did you have any 10% customers in the quarter?

Jim Flaws

Yes, I think our same LCD customers were 10%.

Wendell Weeks

That's correct.

Jim Flaws

That would be [AUO] and [Chimi].

Paul Bonenfant - Morgan, Keegan & Company, Inc.

One of your larger customers last week suggested that a new government stimulus plan in China, this one aimed at urban areas versus the existing stimulus plan for rural areas to subsidize, I guess, TV upgrade and replacement from older CRPs to new, more energy efficient LCDs. It was expected to go into effect some time over the summer.

Do you have a sense for or have you built that into your expectations for demand in China?

Jim Flaws

Yes, that's not new news; that's been known now for almost a quarter.

Paul Bonenfant - Morgan, Keegan & Company, Inc.

Do you have a sense for what the maximum theoretical glass industry output is for 2009 and 2010 with all capacity lit? It would seem that we're bumping pretty close up against those maximum limits.

Jim Flaws

No, I wouldn't say that. I mean, you have to remember - I'll just pick for ourselves as an example  when you think about 2010, we operated most of the first half of the year in our wholly owned business with only 50% of our capacity running, so if we run that all year long next year there's quite a bit of capacity available.

I think we said that the industry had footprint under way, either lit or under construction, that they could get to 2.6 to 2.7 billion square feet, so there clearly is, if everybody lights and runs everything, there's enough glass capacity around.

Ken Sofio

John, we have time for one more question.

Operator

Your final question comes from Ajit Pai - Thomas Weisel Partners.

Ajit Pai - Thomas Weisel Partners

A quick question about your cash flows. I think you guided to next year your CapEx falling by about $500 million, from $1.1 billion to $600 million, so this year, you know, you've already said that the CapEx should be falling through the end of the year. Could you give us some color as to what kind of cash flow can we expect this year and next year?

And then also use of cash, you talked about, I think, on your last conference call that the priority for acquisitions was getting a little higher. Could you give us some color as to what you've been seeing over there, experiencing there as you look at potential business development activity?

Jim Flaws

I won't give a free cash flow forecast for next year, but it should be substantial. And we are looking at acquisitions with more urgency than we were before and actually expanding our corporate development group, so definitely that would be a potential use of the cash. But our free cash flow should be excellent next year assuming that the economy doesn't do something strange.

Paul Bonenfant - Morgan, Keegan & Company, Inc.

And any color for the free cash flow for this year?

Jim Flaws

We're delighted that it's positive in the first half of the year. We expect it to be nicely positive through the whole year. Some of our CapEx got delayed a little on finishing Gen 10 to quarter three, but we're feeling very good about the free cash flow for this year.

Ken Sofio

Okay, Jim.

Jim Flaws

Just to wrap up with a couple investor-related announcements. Wendell and I will be in Boston meeting investors on Tuesday, August 4th. There will be a luncheon. If you're interested in attending please contact Ken or [Ann].

And then looking out to September, Wendell will be one of the keynote speakers at the Citi Technology Conference in New York City on Thursday, September 10th.

And lastly, [Jim Claffin], President of Display Technologies, will be presenting at the Deutsche Bank Technology Conference in San Francisco on Tuesday, September 15th.

And we look forward to seeing you at one of these events and hope you all have a very nice finish to the summer.

Ken?

Ken Sofio

Thank you, Jim. Thank you, Wendell. Thank you all for joining us today.

A playback of this call will be available beginning at 10:30 a.m. Eastern Time today. It will run until 5:00 p.m. Eastern Time Monday, August 10th. To listen in dial 800-475-6701. The access code for that call is 106323. An audiocast will also be available on our website during that time, as will the slides from today's call.

Operator, that does conclude our call this morning. Please disconnect all lines.

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Source: Corning Incorporated Q2 2009 Earnings Call Transcript
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