Responding To The Bull Case For Corning

| About: Corning Inc. (GLW)
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Corning (NYSE:GLW) has rebounded sharply as of late, up about 20% since trading around $11 per share in early August. Recent upgrades from Goldman Sachs (NYSE:GS) and Oppenheimer have both helped boost the stock from those August levels. At that point, the stock was trading at three-year lows after disappointing second quarter earnings put additional pressure on the struggling stock. Year-over-year, revenue fell 5%, and profits dropped 35%, due in large part to price declines for Corning glass. GLW was off nearly 8% on the news.

I have been bearish on the Corning stock, going so far as to call it a "value trap" and questioning the stock's jump after what appeared to be similarly disappointing first quarter earnings. And despite Corning's recent struggles, I still appear to be in the minority, at least among retail investors. Coverage here on Seeking Alpha has been consistently bullish, with the overwhelming majority of commenters supporting an investment in Corning.

And, as I've noted previously, the bull case for the stock seems relatively simple. Even with recent bottom-line weakness, the stock is trading at around 10x trailing and forward earnings, and at a discount to tangible book value. Skeptics like myself argue those seemingly low valuations are warranted; GLW bulls disagree. In articles and comments, here and elsewhere, bulls largely return to the same group of arguments. Here are the seemingly most common arguments, with my response:

Earnings will normalize, as the issues affecting earnings -- notably pricing difficulties in the Display segment -- are largely short-term.

There is a lot of talk of Corning returning to previous earnings levels -- earnings per share were 2.29 in 2010 and 1.77 in 2011, likely falling to the 1.30-1.40 per share range in 2012. But that talk seems to assume that the Display segment -- which still drives about 80% of earnings -- is poised for a rebound.

It's true that analysts are expecting reasonable earnings growth in 2013 -- about 11% based on consensus forecasts. But analysts are often wrong and are far more likely to be more optimistic than is warranted. The fact remains that the Display business normally sees yearly price declines; the issue as of late, notably in Q1, was the fact that those declines were more significant than usual.

The pricing pressure seems unlikely to change. TV manufacturers have been killed over the past two years; no less an authority than Corning CEO Wendell Weeks noted on the Q1 conference call that, "in the Display industry, our customer base, are [sic] quite challenged financially."

That hasn't changed; TV sales fell 8% percent year-over-year in the second quarter, according to DisplaySearch. With TV manufacturers such as Sony (NYSE:SNE) focusing on profitability over volume, and emphasizing yield in their bid to cut costs, retail glass demand seems likely to show little, if any, growth in the near term. With prices declining, top-line growth in Corning's Display segment will be challenged, at best. Given that Display creates the majority of Corning profits, GLW earnings cannot grow without at least maintaining revenues in Display. That may be difficult, to say the least.

The low level of growth in Display will be offset by the company's other four segments.

This is the argument made by Goldman analyst Simona Jankowski, who projected that the four non-Display segments would contribute 26% of net income in 2013, versus just 4% in 2009. Oppenheimer's Andrew Uerkwitz echoed that bull case, projecting 40 percent growth in the Telecommunications segment and improvement in Specialty Materials from tablet and smartphone adoption.

Those segments better show significant growth, because the simple fact is that none of Corning's businesses outside of glass are very profitable. Excluding a $130 million restructuring charge in the Specialty Materials segment, Corning's non-Display operations made $471 million combined in 2011, about 32 cents per share. Notably, those profits came on revenue of $4.7 billion; the profit margin of 10% in those businesses was a far cry from the 74.7% posted by Display. Even excluding earnings from affiliates, Corning's wholly-owned glass business posted an impressive 42% margin.

And yet, in the first half of 2012, earnings outside the Display segment showed literally no growth, with total net income of $209 million identical in both years. Top-line growth was just 4.4%. If growth in those segments will buoy the stock, it had better start soon.

Gorilla Glass will be the next earnings driver; if not Gorilla, the company's century-plus history of innovation means another home run is likely around the corner.

Gorilla Glass, used in smartphones and tablets, and Willow Glass, a paper-thin, flexible product, show Corning's ability to innovate in the glass business. But it's not yet clear how much money they will make the company. Corning originally forecast Gorilla Glass sales of $1 billion in 2011; the number actually came in at $710 million. After a strong Q1, Specialty disappointed again in the second quarter, and it seems likely that Gorilla Glass will miss its $1 billion target yet again this year. But after last year's miss, Corning management no longer breaks out Gorilla numbers.

Willow was only introduced in June, but its future depends on customers' ability to find a use for it, which literally needs entirely new products to be invented for any sort of major impact at Corning. With smartphones and tablets appearing to reach a divergent market model -- high-end phones for Western customers, low-end, mass-market phones for the rest of the world -- demand for these higher-cost glass products may be limited. Given the below-expected growth rate with Gorilla, it's clear that Corning investors cannot take the success of either product -- nor any other glass innovation -- for granted.

The fundamentals are outstanding.

At current earnings level, yes. But that's precisely the argument, isn't it: where are earnings headed? Low-growth tech companies are not seeing particularly great multiples. Intel Corporation (NASDAQ:INTC) is trading below 10 times trailing earnings; Dell (DELL) at just over 6x. With Corning now just above 10x consensus 2012 earnings of $1.28 per share, it's no slam dunk that the multiple will expand to 12x or 15x, giving the stock a price tag of $15-$19.

And, yes, Corning is trading below book value. But nearly half of that book value is depreciated property and equipment. Furthermore, the carried value of Corning's equity investments -- representing nearly a quarter of book value -- actually rose in the first half of 2012, despite severe earnings drops at joint ventures Dow Corning and Hemlock Semiconductor. If profits at Corning and its affiliates don't improve, those values may be written down. Either way, book value won't save the stock if projected earnings don't materialize.

Corning has a fortress balance sheet and billions in cash.

At the end of Q2, Corning had $3 billion in net cash. But another $300MM remains in the company's share repurchase and $730MM is earmarked for the company's acquisition of the BioSciences division of Becton Dickinson (NYSE:BDX). Still, the bulls are right; the $2 billion in net cash gives management flexibility for additional acquisitions, or perhaps...

Corning's policies toward dividends and buybacks prove that the company is shareholder-friendly and should improve the total rate of return for investors.

Corning's October move to raise its dividend and implement a $1.5 billion share repurchase was certainly a shareholder-friendly move. But it seems unlikely, given Corning's year-long trading range, that the company acquired the $1.2 billion in shares it purchased through Q2 at a substantial discount to the current price. The 2.26% dividend yield at Monday's close of $13.25 is nice; but the aforementioned Dell and Intel both offer yields over 3% as well.

I'm in Corning for the long term.

It's interesting how often this rationale is used, but it is only meaningful if the other bullish arguments -- notably that Display will rebound and the company's smaller segments will turn into profit drivers -- are correct.

Indeed, this is the key split between Corning bulls and bears: whether or not the multi-quarter decrease in earnings is evidence of a cyclical low or a fundamental, structural change in the company's earnings power.

If it's the former, then the GLW bulls who cite their 3-5 year timeline -- often accompanied by a $20 price target -- will be rewarded for their patience. If Corning can drive earnings back toward 2010, or even 2011, levels over the next five years, it is indeed the undervalued gem its backers claim.

But shareholders and investors should at least consider the real possibility that Corning's basic business model and earnings power have been fundamentally altered by changes in the industries its serves. There seems to be an attitude among some Corning bulls that the stock is literally unthinkably cheap; that's simply not true. There are very real pressures facing Corning, and legitimate concerns that have driven the stock down nearly 50% over a matter of months. Even CFO Flaws admitted in the Q4 conference call that Corning is, "approaching a new floor in terms of profitability." How quickly Corning can get off that floor will determine whether the stock is truly as undervalued as the bulls believe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.