Thursday, October 6, 2011

Valuing Corning in an Extended Period of Lower Revenue Growth

Corning (NYSE: GLW), founded in 1851, has historically been at the forefront of glass production technology. Corning invented the glass process to produce light bulbs in the late 19th century, fiber optic cable in the 1970's, and liquid crystal displays (LCD's) in the 1990's to early 2000's.

Glass, which is produced from silicon (which in turn is made from sand) will likely be utilized in society far into the future, in so far that glass has certain suprior optic characteristics vis-a-vis plastics, a chief competitor material. Further, plastics are produced from more expensive hydrocarbons.

Corning, along with many downtrodden stocks in the current environment, is currently selling at a multi-year lows, at approximately $13, down from $22 in July and only moderately above the depths of the near $8 valuation at the bottom of the financial crisis. Corning's valuation represents 1x book value and approximately 6x historical earnings, with a net cash position of over $4.1Bn on Corning's balance sheet.

The question most relevant for investors is: at this current valuation is Corning significantly undervalued?

The answer to this question mainly lies with the direction of the High Definition television market. Corning's current profitability is highly dependent on its patented Fusion Process for liquid crystal display (LCD), which are used for high definition televisions and displays for computers and hand held devices. Corning, along with its 50% owned equity company Samsung Corning, has an estimated 83% market share in the manufacture of LCDs.

In the last quarter ended 6/30/11, Corning's LCD segment, along with equity earnings from Samsung Corning, comprised 90+% of operating income.

Corning's Profitability is Likely Significantly Higher in LCD's Produced for HD Televisions Verses for Computers and Hand Held Devices:

Corning in its 2010 Investor's Day estimated that approximately 60% of the volume (square feet) of this LCD glass was produced for HD televisions, and 40% by sq footage was produced for computers and hand held devices. Corning does not split out the relative profitability for computer and hand held display glass, however it is likely that Corning derives a higher percentage of its display earnings from HD Television glass, in so far that this glass is significantly thicker and represents a higher valued added product, in which screen resolution is significant competitive differentiator.

The Fusion Process Invention for LCD Marked an Incredible Turnaround for Corning in 2004:

Corning in the 1990's derived the majority of its income from the production of Fiber Optic fiber, where GLW had a market leading market share. In 1998, Corning derived 65% of its operating income from its telecommunications division, which mainly sold fiber optics. Interestingly, in 1998, Corning derived only 11.5% of its operating income from its information display segment, which at that time produced glass mainly for cathode ray tube televisions and computer monitors (this segment would by 2005 comprise the vast majority of Corning's profits through LCD technology).

Optic fiber sales collapsed in 2000 following the popping of the Internet bubble. Corning reported losses of $5.2Bn, $1.2Bn and a slight gain of approximately $200M in 2002, 2001 and 2000 respectively. In retrospect, it could be said that fiber optics worked TOO well, in so far that, according the publication The City of Light: The History of Fiber Optics by a medium sized, single fiber optic cable had enough capacity to carry ALL the phone calls in the United States simultaneously. One could say, Fiber Optics would be built once, then would not need to be rebuilt for 10 years or more -- a difficult market to build a sustainable business.

Are there Parallels Between Fiber Optics and LCD Technology in terms of the technology "working too well?" LCD's interestingly do not wear out at any sort of moderate pace -- most technological publications estimate that LCD screens will last decades -- 30,000 to 60,000 hours for the LCD screen to lose 50% of its display brightness, which, at a rate of 8 hours of use a day means a minimum of 10.6 years before the LCD needs to be replaced.

One could envision a scenario in which consumers buy one LCD television and do not replace this television for 15 or more years. Corning, in its 2010 annual investor meeting, estimated that 50% consumers would replaced their HD televisions every 6 years on average, but this data is speculative in so far that HD televisions have been introduced only since 2006 and therefore not many consumers have replaced their televisions for functional deterioration or any other reason.

HD televisions were introduced in 2006, and experienced rapid growth as consumers replaced their traditional cathode ray tube (CRT) sets with LCD and plasma televisions. In North America, Europe and Australia and New Zealand, initially the sales of HD televisions was likely buoyed by a strong housing market -- as one buys a new house, part of the improvements process likely involved buying a HD television for the living room (which could be viewed as an "investment" along with new floors, landscaping, furniture etc). All in all, HD televisions increased at an annual rate of over 30% from 2006 to 2008, driving HD televisions to a respectable 44% of all televisions in the United States (or slightly more than 1 HD television set per household in the US) by 2010. HD televisions represent 37% of all televisions in the EU-27 and 45% of all televisions in Japan. Even China reports HD television market share of total television units of 21% across all approximately 400 million households, even as according to the China's People Daily, the Chinese middle class (defined as households with income of at least 60,000 rmb or approximately $10,000 per annum) comprises 23% of the total population -- in other words nearly all of China's middle class as of the end of 2010 already owns an HD television set.

Will HD Televisions Units Sales Grow Significantly Going Forward?

At first glace, this question would be ridiculed by Corning and industry consultancies, which would reply of course! Corning has estimated that the total sq footage of HD televisions will increase at an annual rate of 21% in China and other emerging markets, with a total increase in HD television sales to 2014 across all areas of 12% (with only 4% growth in North America and Europe on an annual basis).

It is argued here that 1) HD television penetration in China likely will only grow at the rate of the overall Chinese middle class growth and 2) economic weakness in the US and Europe will mean flat to declining HD television unit sales in the near term.

The Chinese publication estimated at in July 2010 that the middle class would reach 48% of the total population from the current 23% by 2020, or a near doubling in 10 years. However, this implies that HD television sales will increase at only an approximate 7.2% per year -- and this under more optimistic economic growth forecasts for China of last year (in which growth rates of 8-10% were considered attainable for the next 10 years, currently China is more likely to achieve lower economic growth).

HD televisions do not appear to be any cheaper within China than in the US or Europe, with starting costs at around $US300 -- a newly minted middle class member of China with approximately $10,000 of annual income can afford this purchase but those with lower incomes likely will keep their old CRT televisions (currently China already has on average 1.1 televisions per household).

In the 4th quarter of 2008 and the first quarter of 2009, Corning's display segment reported significantly lower sales, total year on year sales declines of 50-58%, as North American and European consumers cut back on discretionary purchases. As Goldman Sachs has recently updated the forecast for a recession in the US to a 40% probability in 2012, and likely the odds of a recession in Europe are significantly higher (given the banking crises there) unit sales growth of HD televisions appears to be on a declining trend in the US and Europe for 2012 and the intermediate term.

Overall, Corning's 2010 investor day forecasts of 12% industry growth in HD television sales growth should be averaged to a rate that is significantly slower, and potentially (probably) slightly negative (mid single digit sales growth in China, declining sales growth in North America and Europe). The question is, can Corning remain profitable in these conditions?

Estimating Cornings' Display Segment Profitability with Mid-Single Digit HD Television Sales Declines:

In the 1st quarter of 2009, Corning's display segment actually reported a small profit (excluding Samsung Corning) of $38M despite 57% lower sales year on year -- however $37 of this profit was due to favorable exchange rates. Some of this moderate result was due to Corning idling LCD plants. Impressively, Samsung Corning only reported 13% lower year on year profit declines to $180M in the 1Q 09 -- mainly (appears, as Samsung Corning does not publish separate financial figures) due to continued growth in HD sales in China during 2008 and 2009 as the Chinese middle class bought new HD televisions.

With lower than expected growth over the near to intermediate term, it can be inferred (very roughly, based on Corning's historical ability to idle plant capacity) that Corning will eek out approximately low profits, in the $100M range per quarter. It does not appear that Samsung Corning will get the same boost from Chinese demand going forward into 2012 as it did in 2008 and 2009, but on the flip side, other region's declines of 50-58% in revenues is quite severe and not likely to be repeated. Total yearly profits therefore appear around $400M to $800M in the LCD division for intermediate term.

What Annual Earnings in a Slow Growth Environment would Corning's Other Division's Yield?

Corning's fiber optics group has reported relatively break even profits (with growth mainly dependent on infrastructure spending in China) and three interesting, but smaller groups -- specialty materials which includes Corning's Gorilla Glass and Biologic Glass, which includes high-tech glass for biotech laboratories (cells, test tubes, etc -- glass is non-reactive so has an advantage in these applications verses plastic). Corning's environmental technol0gies group produces glass for catalytic converters, and reported profits of $42 in 2010. Earnings were $60M for life sciences in 2010, and Gorilla Glass reported impressive sales growth but no profits in 2010. All in all, in appears Corning's other divisions can be counted on for around $100M in annual earnings in a slow economic growth environment in 2012.

Dow Corning Earnings:

Corning owns 50% of Dow Corning, which is a major producer of silicon and silicon based materials. Dow Corning is a large company in a period of world economic growth, with earnings approaching $800M for 2010. In a recessionary environment, Dow Corning broke even in 2008. With recessions more likely than not in 2012, Dow Corning appears to be set for low profits in 2012, barring significant governmental action.

Likely Earnings for Corning in a low Growth Environment:

Corning appears to be set for $600M in annual earnings without significant new product introductions ($400M approximately in their Display Segment and $100M per year in their other segments combined, and $100M for the 50% stake in Owens Corning). With a 14x multiple, $600M would command a market cap of $8400M (plus $4.1Bn of net cash) would be valued at $12.5Bn -- current entreprise value is $15.71Bn.

Corning would likely significantly disagree with this analysis, but such an analysis assumes significantly lower HD television sales growth and significantly lower replacement rates for HD televisions, based on a more challenged global economic enviornment. To the extent that Corning is accurate in forecasting close to double digit HD television sales growth going forward, Corning's long term value would be significantly higher.

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