Those who are familiar with my work know that I like it when investment ideas remind me of prior decisions that have worked out well. Corning (GLW) reminds me of other cyclical stocks that have done well once earnings estimates first start to get revised upwards. A year ago, the Street was expecting Corning to earn $2.00 per share in 2013. Today, the consensus expectation for 2013 EPS is $1.43. In early 2011, Corning was trading above $22. It is now below $13, which puts it at 9x 2013 EPS and below book value. The company recently increased its dividend (yield of close to 3%).
Corning is involved in several businesses, but most of its earnings currently come from LCD glass. The LCD glass industry went into oversupply, because of two simultaneous events. First, the weak economy caused demand to be weaker than expected for LCD TVs, computer monitors and laptops. Second, the industry started a transition to using thinner glass, which effectively increased supply. The industry is currently half-way through this transition. The oversupply caused pricing pressure and market share loss for Corning and was the primary reason for the dramatic cut in earnings expectations for the company.
Corning responded by taking close to a quarter of its own capacity offline. Since Corning has about half of the industry's supply, this move resulted in a moderation of pricing pressure. On the company's Q2 earnings call, CFO Jim Flaws stated, "Our quarter two price declines for LCD glass were indeed much more moderate than the previous two quarters." During the question and answer session of the call, Flaws also stated, "I'm delighted by the Q3 pricing that we basically have reached agreement with almost all of our customers already." With pricing more of a known variable, the company appears to be set to beat earnings expectations in the short term for several reasons:
- Demand has turned out to be better than expected. Since Corning's last earnings call, there have been many industry data-points that imply strengthening business conditions. AU Optronics (AUO), one of Corning's largest customers, reported September quarter revenue that was better than expected. When AUO initially gave Q3 guidance at the end of July, it expected large panel shipments to be flat sequentially from Q2. Actual shipments wound up being up close to 5% sequentially. A couple of weeks ago, Nippon Electric Glass (NEG), the number 3 manufacturer of LCD glass, also revised upward its expectations for the September quarter. Retail TV Demand from China during its Golden Week Holiday appears to have been better than expected. This is important since Corning's CFO specifically highlighted Chinese demand as the biggest risk-factor during the Q2 earnings call. He stated, "I feel our biggest risk is our television forecast is China." Despite all these positive industry data points, consensus estimates for Corning's Q3 have barely changed.
- Currency has gone in Corning's favor. Something many people usually miss is that the company prices much of its LCD glass in Japanese yen. The yen has strengthened versus Q2. The stronger yen will not only help the company beat short-term expectations, but it will also give even more confidence to bulls who are looking for continued moderation in pricing pressure.
- The company has become more aggressive with returning capital to shareholders. It recently increased its dividend by 20%. Corning also bought back close to 2% of its total shares outstanding in Q2. This was at a faster pace than Q1. The Street does not appear to be accurately modeling Corning's share buyback going forward. Most expect the company's share count to increase going forward when it should be decreasing.
People who are bearish on Corning will point out how the stock has recently risen from slightly below $11 to about $13 per share in a couple of months. They will affirm that recent data points are already "priced in." The problem with this point of view is that it fails to take into account the larger context. While the stock has done well recently, it has still underperformed massively over the last couple of years. A large portion of industry supply has been taken off-line and the most painful part of the transition to thin glass is in the rear-view mirror. At the current valuation, the stock is not priced like a company that is expected to beat earnings expectations. The price-to-earnings multiple at 9x can only go up from here and it should go up given the improved certainty around industry pricing and the return to growth. Q4 should be the first quarter in a long time when revenue and EPS inflect back to positive year-over-year growth. This is usually a positive for the multiples of cyclical companies.
Longer term, there are several potential positive scenarios for the company. I do not necessarily have a strong view about any of these, but at the current valuation, I think of the stock as a cheap call option (Actually, it's better than a call option, because instead of paying premium, I get paid close to a 3% dividend to wait). The positive scenarios:
- Large new business opportunities and diversification should help the stock's price-to-earnings multiple. Corning is an R&D company that has regularly reinvented itself over its long history. During the dot-com bubble, it was primarily known as a supplier of fiber optics and it is currently viewed as a manufacturer of LCD glass. The company's labs are constantly churning out new technologies. It is only a matter of time until one or more of these new products become another big business for the company. Furthermore, because some of the technologies Corning is working on leverage its existing manufacturing facilities, there is the potential that its success leads to better industry supply conditions and pricing for LCD glass. The company's effort in glass for solar panels is one example. Corning is working on lightweight glass that would protect solar panels but also would make them much more efficient at generating electricity. Since the Street is not modeling anything from this new business, any success in this area would be a source of earnings upside. Moreover, since solar glass would be made with LCD glass factories, success in solar glass could also lead to upside in pricing for LCD glass. Even without a large new explosive business, Corning's earnings should become more diversified over time as other businesses are expected to grow faster than LCD. In an upgrade note published in mid-September, Goldman Sachs noted that it expects Corning's LCD business to account for 74% of earnings in 2013 down from 96% in 2009. The diversification should lead to less cyclicality and increased predictability over time. This, in turn, should improve the stock's multiple.
- Replacement demand and a housing recovery could drive an upturn in LCD TVs. According to the company, the average LCD TV is replaced about every 6.5 years. This replacement rate implies that a very small amount of current TV demand is for replacement. However, that will change in a couple of years. In 2008, there were about 118 million LCD TV units sold. Replacement demand for these units could drive an upturn in overall TV demand in 2014. Furthermore, while many expect housing to recover, current TV demand expectations assume little to no correlation to housing. Therefore, any positive correlation could lead to upside. I hypothesize that the correlation is higher than people think. I personally bought a new TV when I recently moved into a new apartment and I know several other people where this was also the case. Since industry supply has been taken off-line, any significant upside surprise in demand could cause pricing to actually go up for a short period of time. This has happened in the past and there is no reason why it can't happen one day again if demand improves.
- Windows 8 could drive an improvement in PC demand. While most believe that the PC market is secularly challenged, there is an argument that PC demand is also cyclically depressed ahead of the launch of Windows 8. Any significant cyclical improvement could lead to upside to industry demand projections.
Of course, there is also the risk that Christmas demand for TVs and PCs is very weak. Retail demand will be the main variable to monitor. The Japanese yen is another variable to keep an eye on. As of now, channel inventories appear to be in good shape and I feel relatively confident with the stock's risk / reward. A stock's price is a function of earnings and the multiple applied to its earnings. Both the earnings and the multiple are more likely to be revised upward than downward after Corning's Q3 results are reported. I am apparently not alone in thinking this. Several corporate insiders have bought stock at around this same price over the last several months.
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Disclosure: I am long GLW.