Corning: Priced as a Commodity, But It Is Really a Tech Company

Jun. 8.10 | About: Corning Inc. (GLW)

Corning Inc. (NYSE:GLW) share prices do not reflect either the potential growth of existing product lines or the future value of R&D investments and capabilities. At a recent share price of 16, the company trades at a TTM P/E of 8.9, and a forward P/E of 8. This pricing reflects a conservative view of the future market for FPD (Flat Panel Display) Glass. However, Corning operates in multiple segments and has the ability to extend its capabilities into adjacent areas due to the strength of its R&D.

Overview - The company describes itself as follows: (Click to enlarge)

Corning Incorporated is the world leader in specialty glass and ceramics. Drawing on more than 150 years of materials science and process engineering knowledge, Corning creates and makes keystone components that enable high-technology systems for consumer electronics, mobile emissions control, telecommunications and life sciences. Our products include glass substrates for LCD televisions, computer monitors and laptops; ceramic substrates and filters for mobile emission control systems; optical fiber, cable, hardware & equipment for telecommunications networks; optical biosensors for drug discovery; and other advanced optics and specialty glass solutions for a number of industries including semiconductor, aerospace, defense, astronomy and metrology.

Segmentsas of 12/31/2009:

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The Display Technologies Segment accounts for the bulk of revenues and virtually all of the profit. However, the other segments are starting to show signs of life. The following excerpts from the1Q 2010 earnings conference call transcript shed light on developments at the segment level:

The most significant growth regions were Japan and China. In Japan LCD TV unit sales were up 79% in January, 65% in February and 167% in March. These growth rates were higher than our internal expectations.

The 40 inch and larger category has been consistently outperforming total LCD television growth during this Echo Point program. As a reminder, LCD TV penetration is already over 90% in Japan. Consumers have been purchasing LCD televisions there longer than in any other country. That is why we are focusing on consumer based studies there to understand if there has been an acceleration in LCD TV replacement rates versus traditional CRTs. This is important to know as Japan could be a precursor to what occurs in other regions.

Now I will turn to the Environmental segment where sales in the first quarter were $192 million, an increase of 6% over the fourth quarter. As a reminder we were guiding a sales decline of about 10%. We were also surprised by the strength of auto demand in the quarter. Auto product sales were $117 million, up $9 million versus Q4. Demand continued to be strong throughout the quarter. According to Global Insight, the industry source for auto data, worldwide auto production is now estimated to be 67 million in 2010. This estimate is up from 64 million just a few months ago. As a reminder last year the auto market was 59 million.

...As a result we have had to restart production that has been idle and call back workers. In addition demand has been so tight and inventory levels so low for the first time in our history we have had to air freight almost all of our production.

Sales in our Specialty Material segment were $96 million in Q1, down 13% versus Q4 and in line with our guidance. The decline was due to lower advanced optics sales. We were very pleased with the sales of Gorilla glass consistent between the fourth and first quarters. We had expected Gorilla sales in Q1 to be slightly lower given the seasonal demand in Q4. We exited Q1 with a sales rate for Gorilla of almost 170 million in the month of March. We continue to receive requests from many consumer electronics companies as well as others outside of the industry about Gorilla. Gorilla glass is now in 80 different models of handheld and notebook products and we are also very confident we will have our cover TV glass agreement soon.

We are taking steps this quarter to prepare for Gorilla glass manufacturing at our Shizuoka facility. Our Gorilla glass operations in Harrisburg, Kentucky are currently running close to full capacity.

Balance Sheet – Corning's long term debt is 12% of Shareholder's equity and is well spaced out by expirations. The company was able to borrow at acceptable terms in 2Q 2009 and enjoys excellent access to capital markets. Comparing current assets to current liabilities, and interpreting anything over 2X as excess, the company has 2.8 billion or 1.80 per share of excess cash.

Plans are underway to repatriate 1 billion of earnings from overseas, for tax reasons. As of the most recent conference call, the board had not determined what use to make of the funds. They would be available to increase the dividend, buy back shares, or deploy in the business. The FPD business is capital intensive.

Free Cash Flow – for the first quarter, free cash flow was 472 million. Corning normally has negative cash flow in the first quarter, and this year was the first exception in the past ten. Increasing free cash flow is frequently an indicator of increasing share prices to come.

Research and Development - as a percentage of revenue, R&D comes in at 10.4%, a figure that is lower if the revenues of jointly owned businesses reported on an equity basis are considered. At 563 million for 2009, the investment in research is substantial by any measure, and amounts to .36 per share.

From the 10-K:

Inventions by members of Corning’s research and engineering staff have been, and continue to be, important to the Company’s growth. Patents have been granted on many of these inventions in the United States and other countries. Some of these patents have been licensed to other manufacturers, including companies in which Corning has equity investments. Many of the earlier patents have now expired, but Corning continues to seek and obtain patents protecting its newer innovations. In 2009, Corning was granted over 180 patents in the U.S. and over 300 patents in countries outside the U.S.

Each business segment possesses its own patent portfolio that provides certain competitive advantages in protecting Corning’s innovations. Corning has historically enforced, and will continue to enforce, its intellectual property rights. At the end of 2009, Corning and its wholly-owned subsidiaries owned over 4,350 unexpired patents in various countries of which about 2,450 were U.S. patents. Between 2010 and 2012, approximately 11% of these patents will expire, while at the same time Corning intends to seek patents protecting its newer innovations. Worldwide, Corning has over 5,700 patent applications in process, with about 1,760 in process in the U.S. Corning believes that its patent portfolio will continue to provide a competitive advantage in protecting Corning’s innovation, although Corning’s competitors in each of its businesses are actively seeking patent protection as well.

While the statistics on patents in force and in process are impressive, a better feel for the effectiveness of the R&D effort is available from the R&D Presentation made at the most recent shareholder meeting. The approach to R&D is aggressive and competitive – the company utilizes its accumulated expertise to compete for and develop business opportunities in adjacent areas.

As an illustration of the resources Corning can bring to bear, here is a discussion on solar, again from the latest transcript:

I think overall the good news is we continue to believe that we can generate significant increases in conversion efficiency using a specialty glass. There was widespread disbelief in the industry. Now I would say there is widespread belief of that in the industry. Now we have to turn to the next challenge to actually turn this idea into revenue. We need to have exactly the right product for each of these areas, exactly the right manufacturing process to deliver on the appropriate economics and then we need to catch the customer build cycle exactly right.

All of that is ahead of us but I think the good news is there is nothing about our original product content, the thin specialty glass that is proving to be not a good idea.

This demonstrates a patient and thorough approach to a complex problem.

Valuation – on a historical basis, complexities are introduced by a large restoration of deferred tax assets booked in 2Q 2008, which places the company in the enviable position of having a reduced tax rate for several years going forward. Going back further, management miscalculated the future of the fiber-optic business during the tech bubble and stepped in front of serious losses. After adjusting for the tax angle, and looking past the bubble mistakes, Corning is at an acceptable buy point with respect to its demonstrated past earnings performance.

Looking forward, I project that GLW can earn 2.00 per share and grow at 7 – 10% annually for a number of years. It is no big stretch to apply a multiple of 12, yielding a target of 24 per share, within two years. That would return 22% annualized, not too shabby. For a company with strong R&D/technology growing at 7% or better, a P/E of 17 is appropriate, suggesting a high end target of 34 per share, when confidence in the global economic recovery is restored, and Corning has again demonstrated its ability to participate.

Summary – Corning derives almost all of its current earnings from the Display business, and is priced as if that were merely a cyclical/commodity business. That business may be poised for a longer period of growth than many anticipate. Also, Corning has accumulated an advantage in terms of of manufacturing skills, process improvements and patents that make it the dominant player in FPD, the low cost producer and difficult to displace. A single digit P/E understates this value.

You get the rest of the company free – the excess cash, the other segments and the R&D. Bear in mind, Corning created the fiber-optic business, and applied its strength and expertise to win the business in FPD and pollution substrates, against heavy competition. This demonstrates a long term potential that is difficult to quantify but certainly worthy of careful consideration. As new opportunities arise in areas where Corning has expertise, they are an extremely capable competitor.

Strategy – today's prices are attractive for investors with a mid-term time frame. Picking an entry point is a matter for the individual investor's sense of short-term market trajectory.

The stock is optionable, to include LEAPS. The Jan 2012 10 calls make sense to me as a substitute for share ownership, and that is how I am playing it.

Disclosure: Long GLW