Corning May Be Chipped And Scratched, But It Can Be Polished

Apr.27.12 | About: Corning Inc. (GLW)

It's probably cliché now to talk about how former high-flying tech stocks like Alcatel-Lucent (ALU), Ciena (NYSE:CIEN), and Corning (NYSE:GLW) now trade at fractions of their former highs. Corning has never fallen out of the groove in terms of technology or R&D, but instead found itself in situations where high capex investments, industry overcapacity, and price erosion crushed its ability to sustainably earn its cost of capital.

Although Corning is not out of the woods yet, it's more diverse now than it has been in a very long time, and the company may finally be in position to see some positive economic leverage.

"Less Bad" Is The Good In Q1

Corning did not have an especially strong quarter in absolute terms, but there were positives to take out of it. Revenue was flat with last year and up about 2% sequentially. Revenue was led by display, where revenue fell 11% yoy and 10% qoq, while telecom, environmental, special materials, and life sciences all showed growth.

Profitability continues to be a challenge, and gross margin slipped almost four points from last year and one point from the prior quarter. Operating income was down more than one quarter from last year, but down just a bit (3%) from the fourth quarter. Corning also continues to spend pretty diligently on R&D, with nearly 10% of revenue going here in the quarter.

Has Display Settled Down?

Corning management talked about mid-single-digit volume sequential volume growth in display, highlighting the extent to which price erosion has been a factor in this market. In fact, Corning and its rivals Asahi Glass and NEG have been seeing average quarterly price declines of about 3-4% for several years now. Compounding matters, volumes in this market have been pretty miserable of late (as investors in companies like AU Optronics (NYSE:AUO), DuPont (NYSE:DD) and 3M (NYSE:MMM) well know).

Have things finally bottomed out? Corning management has talked about cutting production costs about 10% a year and that could actually be enough to make some headway so long as the industry stays rational about pricing and sales of products like TVs and notebooks recovers.

R&D And Diversification Should Help Long-Term

Corning's ongoing R&D efforts have paid real dividends over the years - producing marketable products in areas like emissions control, as well as the well-known Gorilla Glass that goes into Apple's iPhones and iPads.

As time goes on, this is going to be no less important. Take the case of potential OLED competition in display. OLEDs require only one piece of glass instead of two, so it would seem that widespread adoption of OLEDs will halve Corning's market.

Maybe not. OLED panels are very hard to produce right now and the yields are very low in part because of the temperatures involved - meaning that they are quite expensive. There's an opportunity here for better substrates, and Corning is working on them. Of course there are no guarantees, but R&D in substrates could allow Corning to capture even more value-add in display in the years to come.

While it's not nearly so exciting, the company's decision to buy Becton Dickinson's (NYSE:BDX) Discovery labware could also pay off. Corning management has talked of wanting to get 10% of its revenue from life sciences, and this accelerates the process. While labware is a generally a sedate business, it can be a relatively high-margin business and I wouldn't rule out the ability of Corning R&D to add value here as well. There is a lot of research in so-called "smart materials" in diagnostics and life sciences, research that incorporates a variety of technologies, reagents, and so forth into glass or other kinds of substrate.

Leveraging Old Businesses Into New Profits?

I'm also optimistic about Corning's ability to leverage what it already has established in markets like display and telecom. As I mentioned before, Corning missed out on a lot of the benefits of the optical fiber and LCD booms because of the huge upfront capex needs and resulting oversupply. But these markets haven't gone away.

What I'm suggesting then is that Corning could benefit from the long-awaited recovery in telecom carrier spending and ongoing initiatives like fiber to the premises. Moreover, while Corning is going to continue to invest in its production assets (including a new facility in China later this year), the scale of that investment should decline and allow the company to sport better margins (from better leveraging its capacity) and better cash flow (from lower capex).

The Bottom Line

I'm well aware of the risk that I'm getting sucked into a value trap here, and that Corning may very well just continue stumbling along with inconsistent and unspectacular cash flow. But I also know that it's not everyday that companies with legitimately good R&D and relatively limited competition trade at around tangible book value.

If Corning can see that capex leverage and the display market doesn't going back to mid-to-high teens price erosion, these shares could trade into the high teens. There aren't a lot of analysts that will agree with me on this, and I admit it's an unconventional stance, but every once in a while these tech stories get a second or third act.

Disclosure: I am long MMM.