Corning: Burning Bright
We contend that Corning (GLW; recent price, $24.71) is well-positioned to benefit from growing demand for liquid-crystal-display panels and fiber-optic telecommunications equipment. By our analysis, Corning's markets for LCD glass panels will remain strong, while the company's investments in facilities and its relationships with leading market-share TV manufacturers should yield higher sales.
We also forecast that fiber-optic sales to the telecommunications sector will strengthen over the next two years. We expect strong revenue and earnings-per-share (EPS) gains in 2007 and 2008.
In our view, the shares are undervalued vs. those of peers and warrant a 5-STARS (strong buy) recommendation.
Once an old-line, slow-growing housewares company, Corning has been transformed into a leading maker of high-tech fiber-optics and high-performance glass components for the global telecommunications and personal computer industries. Results are reported in the following primary business segments: display technologies (41% of 2007 first-half sales), telecommunications (32%), environmental technologies (14%), life sciences (6%), and other (7%). In 2006, Corning's 10 largest customers accounted for about 50% of sales, but no individual customer brought in more than 10% of its consolidated sales in 2006.
Display Technologies: This segment manufactures glass substrates for active matrix LCDs, used primarily in notebook computers, flat-panel desktop monitors, and TVs.
In July, Corning said it expects the LCD glass market, measured in square feet of glass, to increase 35% to 40% in 2007. The company's LCD glass volume is expected to expand at a faster pace than the market in 2007, given the higher growth rates of larger glass substrates. Whereas desktop monitors and notebooks represented the majority of demand in 2006, in our opinion LCD TVs should account for almost one-half of all LCD glass produced in 2007 and have the greatest growth prospects.
Glass substrates, currently available in sizes up to Generation 8, were introduced by Samsung Corning (50% owned) in January, 2005. As of June, 2007, approximately 88% of Corning's LCD glass volume was Generation 5 and higher. We believe the company's proprietary fusion and environment-friendly manufacturing processes are competitive advantages in the LCD sector.
In 2006, Corning was a supplier to three of the top four LCD-TV makers: Samsung (SSGFY), Sharp (6753.T), and Sony (SNE) have a combined market share of approximately 41%, according to IDC.
Telecommunications: The telecommunications segment produces optical fiber and cable and hardware and equipment products for the worldwide telecom industry. Corning sells a significant portion of optical fiber to its own subsidiaries. The company's hardware and equipment products include cable assemblies, fiber-optic hardware, fiber-optic connectors, and optical components and couplers.
Volume growth in the optical-fiber market over the past two years has exceeded 15%. As a result, Corning announced plans in April to reopen a portion of its Concord (N.C.) optical-fiber manufacturing facility. In July, the company announced plans to expand an optical-fiber manufacturing facility in China based on continued growth in that country's optical-fiber market. The expansion is expected to be completed in 2009.
Environmental Technologies: This segment includes ceramic technologies and emissions- and pollution-control products. Although sales are to emissions-control systems manufacturers, automotive and diesel engine manufacturers also must use substrates and filters. We expect new diesel products to be a larger contributor to revenues beginning in the second half of 2007.
Other: Corning's conventional glass TV business includes a 50% interest in Samsung Corning, a producer of components for cathode ray tubes used in TVs and monitors. In November, 2006, Corning announced plans to build a new LCD glass substrate finishing facility in China.
We believe Corning's markets for LCD glass panels will remain robust, due to continued investment in facilities and customer relationships with the market leaders—Samsung, Sharp, and Sony—in flat-panel TVs. We expect demand to be stronger in the U.S. during the second half of 2007, with the start of the football season and back-to-school sales by retailers, despite the risk that mortgage delinquencies could cool consumer spending. We think prices for LCD TVs have fallen to appealing levels for U.S. consumers.
We believe fiber-to-the-premises (FTTP) products will likely benefit from increased demand and more stable pricing from large carriers such as Verizon Communications (VZ: hold; $41) in their fiber deployment spending. Also, Corning recently added a new European FTTP customer, which should create additional revenue opportunities. We forecast that telecom fiber-optic sales (32% of revenues) will strengthen in the second half of 2007 and in 2008.
Overall, we see sales advancing 15% in 2007 and 20% in 2008, due to higher demand for LCD glass substrates, a gradual recovery in the telecom unit due to new fiber business, and emerging sales in the diesel engine business. Our sales forecast for the LCD market assumes more stable pricing and demand exceeding industry glass supply in the second half of 2007. We expect gross margins to widen from 44% in 2006 to 47% in 2007 and 48% in 2008, and we expect operating margin expansion from well-controlled selling, general, and administrative expenses. We believe the second-quarter shortfall in telecom was the result of unusual items, and we expect gains in 2007-08 to support 18% EPS growth. Our operating EPS estimates: $1.32 for 2007 and $1.56 for 2008.
In early September, Corning confirmed its third-quarter revenue and earnings guidance, but noted that a favorable exchange rate in Asia could boost results. Corning also said product shipments and LCD manufacturers' inventory levels remain in line with expectations.
Ahead of Corning's second-quarter 2007 results, the company reinstated a quarterly dividend of 5¢ a share, after having canceled its dividend policy in 2001. Together with a new $500 million share repurchase program (1% of shares outstanding), this modest cash usage indicates that its fundamentals remain strong.
As for the third quarter of 2007, following commentary from Corning indicating that the LCD business remains strong, we are maintaining our projection for revenues of $1.57 billion and EPS of 35¢, even with a potentially positive impact from currency.
We believe the company has sufficient cash, cash equivalents, and investments to meet its working capital, capital expenditure, and debt obligations. In June, Corning had $3.2 billion in cash and cash equivalents and about $1.5 billion in debt. We expect 2007 capital spending of $1.2 billion, with about $700 million of that in the display segment.
We believe Corning shares are undervalued, trading below peers on a price-to-earnings basis. Our 12-month target price of $33 is largely based on a p-e of 21 times our 2008 EPS estimate—slightly above the peer average, but supported by its superior EPS growth rate. Our target price also reflects a price-to-sales ratio of 5.5 times, above the peer average. With the strong demand we see, we find the stock's valuation compelling. Our peer group comprises a blend of large-cap communications equipment companies and companies that support the LCD market.
Overall, we view Corning's corporate governance policies favorably relative to its communications equipment peers. Among the positives: The board of directors is controlled by a supermajority of independent outsiders, an approved CEO succession plan is in place, and the company has not restated financial results for a prior period or been the subject of an enforcement action due to backdating of options during the last 24 months.
Among our concerns: The chairman and CEO roles are combined, and a supermajority vote of shareholders is required to amend certain provisions of Corning's bylaws.
Risks to our recommendation and target price include soft demand for flat-panel displays, unstable pricing on display technologies products, and weaker demand with narrower margins in the telecom unit. Also, capital investments by flat-panel display competitors may increase, which could put pressure on Corning's sales.