Seeing the Light on Corning
We believe Corning (GLW: $21) shares are materially undervalued, making the stock a compelling investment opportunity. We think the combination of high market growth potential in flat-panel display, fiber optics to the home, and substrates and filters for emissions-control manufacturers, along with the company's continued cost control initiatives, should lead to positive earnings growth and cash-flow generation in 2007.
Additionally, we believe Corning will gain market share over its competitors in the flat-panel display market. In our opinion, the company stands to benefit from a more favorable mix of Gen 7 and Gen 8 fabrication facilities that make larger flat-panel screen displays. Also, we see the potential for customer demand outstripping supply in the flat-panel display industry during the second half of 2007, when two-thirds of annual television sales are normally recognized.
Corning is trading at a slight discount to its peers based on p-e and other measures using our 2007 estimates. But we believe the shares should trade at a premium valuation based on our view that Corning is growing faster than peers with a strong business model. Our recommendation on the shares is 5 STARS (strong buy).
Corning has completed a transformation from an old-line, slow-growing housewares company into a leading maker of high-tech fiber optics and high-performance glass components for the global flat-panel display and telecommunications markets.
Committed to Innovation
The company's results are reported in four primary business segments: display technologies (45% of 2006 fourth-quarter sales), telecommunications (29%), environmental technologies (11%), life sciences (5%), and other (10%). Corning's 10 largest customers account for about 50% of sales, but no individual customer accounted for more than 10% of consolidated sales for 2006.
The company continues to be committed to investing in research and development and engineering to drive innovation, in our view. We're positive on Corning's further investment in a wide range of technologies with a focus on glass substrates for active-matrix liquid-crystal displays (LCDs), diesel filters, and substrates in response to tightening government emissions-control standards, and the optical fiber and cable and hardware and equipment that will enable fiber-to-the-premises.
In our opinion, the company's available funds for capital expenditures will continue to be earmarked to expanding manufacturing capacity for LCD glass substrates in the display-technologies segment and diesel products in the environmental-technologies segment. Total capital expenditures for 2005 were $1.6 billion, of which $1.2 billion was directed toward display technologies and $171 million was invested in the environmental-technologies segment, primarily in anticipation of the emerging market for diesel emission-control systems. Corning posted 2006 capital spending of $1.2 billion, and a breakout of segment data will be released with the company's 10-K report.
Flat Panel Penetration
We believe demand will remain high in 2007 for flat-panel displays for televisions, notebooks, and computer monitors. In 2006, soft demand in the June quarter led to excess inventory for the industry, which exacerbated sharp price declines heading into the second half of the year. Approximately two-thirds of total flat-panel televisions are purchased by consumers in the second half of the year.
In the year ahead, we believe Corning has taken steps with its major customers such as Samsung, Sharp Electronics, and Sony to better manage the supply chain and pricing schedule for the company's flat-panel displays.
The company forecasts that the market penetration rate for global flat-panel televisions may reach the mid-30% range in 2007 (60 million-65 million units) compared to 22%, or 43 million units produced in 2006. We estimate the average selling pricing per unit for the wholesale flat-panel television market will decline 15% to 20% in 2007, compared to declines of 25% to 30% for 2006, year over year.
The capital spending programs for new flat-panel display foundries by Corning's competitors are significantly lower for 2007 than in 2006.
In our opinion, the industry drivers for flat-panel display are favorable for Corning's business outlook. First, we believe consumers will continue to buy larger-size, flat-panel televisions that require state-of-the-art foundries, known as Gen 5 through Gen 8. The company stated that the average size worldwide for LCD televisions was around 29 in. in the 2006 fourth quarter compared to 24.7 in. in 2005.
To produce flat panels of 40 in. or greater, suppliers like Corning need Gen 6 or higher foundries to meet the increasing demand for larger television screens. Only a Gen 8 foundry is capable of producing glass large enough to result in six 46-in. LCD panels or four 52-in. panels. Samsung, a Corning partner, has plans for LCD television panels above 60 in. in 2008 and 2009.
A second factor in the company's favor is that it has the highest mix of foundries, with 87% of output at Gen 5 to Gen 8. This is in contrast with competitors such as LG Philips (LPL), AU Optronics (AUO), and other Taiwanese foundries that mostly have a higher mix of foundries below Gen 5, which are screens for notebooks, monitors, handsets, and MP3 players.
Environmental Tech Growth
And third, we agree with Corning that there may be a shortage of glass-panel capacity in the second half of 2007 for the flat-panel television market. Measured in square feet of glass panels produced, the company forecasts that the 2007 display industry will grow at least 400 million square feet compared to increases of 800 million in 2005 and 1.2 billion in 2004. We project the company's display technologies business unit to realize 20% to 22% revenue growth in 2007, comparable to 2006.
The telecom segment produces optical fiber and cable and hardware and equipment products for the worldwide telecom industry. A significant portion of Corning's optical fiber is sold to its own subsidiaries. The company's hardware and equipment products include cable assemblies, fiber-optic hardware, fiber-optic connectors, optical components and couplers, and other equipment.
We believe fiber-to-the-premise (FTTP) products may benefit from increased demand and more stable pricing from large carriers in their fiber deployment spending. In its 2006 fourth-quarter earnings report, Corning stated that its telecom business is seeing improved demand from service providers in Europe and North America. We forecast this business unit to realize revenue growth of 7% to 10% in 2007.
The environmental-technologies segment includes ceramic technologies and solutions for emissions and pollution control. Although sales are to emissions-control systems manufacturers, the use of substrates and filters is also required by automotive and diesel-engine manufacturers. We look to new diesel products as a larger contributor to revenues in the second half of 2007 and future years. Our 2007 sales projection for this business unit is for 27% growth, with most of the contribution coming in the second half.
Boost from Top TV Customers
Following a 13% increase in 2006, we see Corning's sales advancing 14% to 16% in 2007, due to higher demand for LCD glass substrates, a recovery in its telecom unit, and emerging sales for its diesel-engine unit. Our sales forecast for the LCD market assumes more stable pricing and demand exceeding industry glass supply in the second half of 2007. We believe fiber-optic demand from major telecom carriers will be positive.
We expect the company's top three customers in flat-panel television—Samsung, Sharp, and Sony—to gain market share and demand larger-size glass from vendors. Corning has invested in more plant capacity for large-size glass than any of its competitors. We project gross margins to be stable—near 45% in both 2007 and 2008. We expect 2007 operating expenses to be held to the levels seen in 2006.
Corning's conventional glass television business includes a 50% interest in Samsung Corning Co., a producer of components for cathode-ray tubes in televisions and computer monitors. In November, 2006, the company announced that it plans to build a new liquid-crystal display glass substrate finishing facility in China.
We believe Corning's markets for LCD glass panels will remain strong and forecast telecom fiber-optic sales to strengthen throughout 2007. Leading LCD peers such as AU Optronics, LG Philips LCD, and Hoya remain competitive, but the company's strong investment in facilities and its relationship with the market leaders in flat-panel televisions benefit its sales outlook, in our opinion.
With $3.2 billion of cash and cash equivalents, the company should, in our opinion, be able to meet its working capital and debt requirements and still have available funds to invest in the business and enhance shareholder value through potential share repurchases.
Based on our Standard & Poor's Core Earnings methodology, we believe the quality of Corning's earnings is in line with its peers. Employee stock option expenses are included in our 2007 and 2008 operating EPS estimates, as new accounting standards now require all employee stock options to be expensed. We're assuming $0.05 per share of stock option expense in both of these years.
Based on our 2007 estimates, Corning shares are trading at a p-e multiple of about 16.3 times and an enterprise value/EBITDA multiple of 17.0 times (15.9 times using 2008 estimates), slightly below the average for our communications-equipment peer group. In light of our positive fundamental outlook for Corning vs. its peers, we believe the stock should trade at a premium to its communications equipment peer average. Using this methodology and a multiple between 20 to 21 times our fiscal 2007 EPS estimate, we arrive at our 12-month target price of $27. Based on our discounted cash-flow model, we arrive at an intrinsic value of $28.50.
Risk of Supply and Demand
We believe Corning's corporate governance practices are in line with other communications-equipment providers we follow. Among the characteristics we view favorably are that the board of directors is made up of a supermajority of independent directors (greater than two-thirds), committees have been established to address governance issues, and the company doesn't have a poison pill in place or a dual-class capital structure.
One concern we have is with the recent election of the CEO to the additional position of chairman. In general, we believe that these positions should be separate.
Risks to our recommendation and target price include weak demand for flat-panel displays, unstable pricing on display technologies products, and weaker demand with narrower margins in the telecom unit. Capital investments by flat-panel display competitors may increase in the future, which may bring capacity levels back to supply imbalances with the market, similar to what the industry experienced during 2006.