Ignore The P/E: Corning Is Still A Value Trap

| About: Corning Inc. (GLW)

Corning (NYSE:GLW) has long been a favorite stock of retail investors. It has long held a five-star rating on Motley Fool, and the coverage -- and commentary -- here on Seeking Alpha has been consistently bullish.

At first glance, it's easy to see why. After Wednesday's fourth-quarter earnings report, the company has $2.24 per share in net cash and trailing earnings of $1.77 per share; and yet the stock closed Friday at just $12.62. The P/E is just 7.13, and backing out the net cash, even lower at 5.85. And, while the most recent quarterly results were disappointing, the company still achieved record net revenue and forecasted first-quarter sales growth in four of its five business segments.

But digging into the stock -- and the recent disastrous earnings report -- reveals the reasons for Wall Street's relatively neutral stance toward the stock and GLW's 45% drop from the 52-week high reached in early 2011. Corning faces a wealth of issues that should make investors question the sustainability of its current earnings, and provide the logic behind the company's continued low valuation. One of the key valuation metrics that stands out in GLW's case is its price-to-sales ratio. Even after a record 2011, with $7.9 billion in revenue, and a two-day, 13.4% drop following Wednesday's year-end report, Corning still trades at 2.5x trailing twelve-month revenue. Earlier this year, the company had publicly -- and confidently -- predicted a goal of $10 billion in revenue in 2014. Even at that level -- which the company has not mentioned since that second quarter conference call -- the company would still be trading at twice its annual revenue two years from now, should the stock stay flat.

Corning has managed to justify its high sales multiple through a combination of high margins and earnings from its equity affiliates (whose sales are not counted in the company's total revenue). But the company is under attack in both areas. Margins dropped 340 basis points sequentially in the fourth quarter, according to the company's conference call. Further compression is on the way, as Corning's Display Technologies segment -- which includes the company's LCD glass operations, but not its vaunted Gorilla Glass product -- is expected to see hard times in 2012. From the most recent conference call:

We have proposed advancing our normal 2012 glass price declines versus more normal moderate price declines each quarter throughout the year. This will provide our customers more immediate financial relief. However, this cumulative 2 quarter of higher price declines will cause a reset of the profitability in our display business. We're hopeful that our pricing actions combined with capacity decisions will lead us to get back to more stable price declines after quarter 1.

Yes, the company predicts that the retail glass market will grow by 10%. But Corning also expects yield (the amount of Corning glass sold that actually winds up in smartphones and tablets) to increase, and inventory in the supply chain to contract by one-half of a week. As such, the company is looking at relatively flat demand. Meanwhile, it expects its wholly owned glass business to be "in line" with the glass market -- ie, flat -- while volume at affiliate Samsung Corning Precision Materials will be "flat to down double digits," pending negotiations with major customers. With revenue flat and pricing down substantially, margins will no doubt fall considerably. This is not a short-term problem, as even the company notes; as quoted above, it is seeking "more stable price declines" that mean the company is "approaching a new floor in profitability."

The pressure on the Display Technologies segment will reverberate across the company, as that unit provides nearly all of the company's profit. According to the company's fourth-quarter financial statements (pdf), the Display Technologies segment (which includes Samsung Corning) accounted for 90% of Corning's company-wide net income. Given the pressure on margins in that segment, the fact that analysts still expect an earnings decrease of less than 20% for 2012 seems optimistic, at best. (It simply may be that it has not yet updated the numbers after the aforementioned fourth quarter earnings, which knocked the stock down 12.5% for the week.)

Corning's earnings from its equity affiliates -- including joint ventures Samsung Corning Precision Materials, Dow Corning, Hemlock Semiconductor (a maker of polysilicon majority owned by Dow Corning), and Pittsburgh Corning -- were off sharply in 2011 as well. Equity earnings were down 25% year-over-year, despite a one-time gain at Dow Corning, and are guided to fall 5%-20% in the first quarter, including a 35% decrease at Dow Corning. The culprits again are lower volumes (at SCP) and lower margins (at Dow Corning). To top it all off, the company expects its tax rate to rise to 20% in 2012, adding further pressure to the bottom line.

The issues facing Corning -- and its equity affiliates -- are structural, long-term problems that cannot simply be blamed on a weak economy or near-term difficulties. The LCD market is simply not growing as planned, which will impact profitability in the Display Technologies segment, the stock's key earnings driver. The company's joint ventures are seeing lower profitability as well, beset by increased competition and lower margins. Yes, the P/E just above 7 -- and below 6 on an enterprise basis -- looks tempting. But the company's earnings potential for the near term looks dismal. As earnings fall, the P/E will rise, justifying the stock's current valuation. This is a key point that GLW bulls often miss while pointing out the company's low trailing earnings multiple.

Those same bulls are also fond of pointing out the strength of the company's balance sheet. Yes, the company offers over $3/share in cash. But back out long-term debt and other non-pension long-term liabilities (which appear, from the most recent 10-Q, to include the company's potential asbestos liability through Pittsburgh Corning), and net cash drops to just $1.10 per share. About half of that cash will be required to complete the company's $1.5 billion stock repurchase authorization announced back in October. Over half -- some $780 million -- of the authorization has already been spent, at an average cost of $14.18 per share, a 12% premium to Friday's close of $12.62. The company also hiked its dividend by 50% in conjunction with the buyback, but even at the current depressed price offers just a 2.38% yield. The lower share count provided by the buyback seems unlikely to overcome the potential earnings loss from lower revenue and compressed margins. It's also uncertain that the company's free cash flow will cover the aggressive plans the company has to return capital to shareholders. FCF for 2011 was just $544 million -- about 5.5% of the company's current market capitalization -- and levered cash flow, which includes net interest costs on debt, was $474 million. Given Corning's market capitalization near $20 billion, those numbers are not particularly impressive.

None of this is to say that Corning is necessarily headed for bankruptcy, or a slam-dunk short at its current depressed levels. But the common bull case pitched by the stock's backers -- single digit P/E, raised dividend, strong balance sheet -- overlooks the key issues facing the stock. Yes, four of the company's five business segments are guided for growth in 2012. But while those segments account for 60% of the company's sales, they generate just 10% of Corning's earnings, due to substantially lower margins than the Display Technologies business. Specialty Materials, which includes the company's vaunted Gorilla Glass product, posted a loss in 2011, despite Gorilla Glass sales tripling. Should that segment swing to a profit in 2012, it will simply not be enough to overcome double-digit top-line -- and significant bottom-line -- decreases in the company's legacy glass operations. Corning's key business lines are under serious pressure, and the seemingly sterling fundamental numbers underlying the stock simply cannot be expected to hold up going forward. The market, when efficient, is a forward-looking mechanism, and in Corning's case, it is clearly seeing hard times ahead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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