Lessons From a Turnaround [Fool on the Hill] July 11, 2000

FOOL ON THE HILL: An Investment Opinion
Lessons From a Turnaround

Corning was an unloved stock in 1998 as the Asian flu and other problems caused earnings to fall. Fast forwarding two years, the stock has moved up tenfold. Focusing on growth opportunities, making significant investments in research and development, and a booming fiber optic marketplace led to this success.

By Warren Gump (TMF Gump)
July 11, 2000

A little footnote in yesterday's merger announcement between JDS Uniphase (Nasdaq: JDSU) and SDL (Nasdaq: SDLI) was that Corning (NYSE: GLW) had been in discussions to acquire SDL prior to JDS Uniphase's offer. I haven't given Corning -- which makes telecommunications equipment (fiber optics and photonics), advanced materials (it's amazing what they do with glass-based technology), and information displays (glass panels for TVs and computer monitor) -- too much thought over the past year and half since I last wrote about it in a Fool Plate Special.

But after investigating the company's recent history, I was struck by the presence of several characteristics that are common to other successful technology turnaround stories.

Back in early 1998, few people were interested in owning shares of Corning. After a fairly strong 1997, the company warned that earnings were going to fall in the first half of 1998 due to a downturn in Asian markets, increased pricing pressures in fiber optic cable, and challenges at a TV glass manufacturing facility. The stock fell 46% from its mid-1997 high to about $35 per share. Analysts were also waiting for the company to sell its more mature consumer products division (Pyrex, Corning Ware, Revere Ware), but no buyer had emerged.

The middle part of 1998 wasn't that much better for the stock. Predicated weakness in Asian markets and pricing pressure for optical fiber materialized, resulting in 25% declines year-over-year earnings for the first two quarters of they year. The company did, however, close the sale of its consumer products division during April, relieving it of a slow-growth subsidiary. Nonetheless, the weak earnings had lowered the stock to $22 7/8 by early September.

Ramped-up research and development (R&D) spending was an overlooked factor contributing to the company's weak earnings. Management often cuts back on R&D spending when earnings are being squeezed, because this line item is immediately deducted from the earnings statement. Although times were tough, Corning was dramatically increasing the amount being spent to bring new products to market. In absolute dollars, R&D spending jumped 36% during the first half of 1998. As a percentage of revenue, this line item moved up to 8.6% from 6.0%. While Wall Street was bemoaning the low earnings, Corning management focused on future opportunities.

Moving into the latter half of 1998, Corning began to show tentative signs of a turnaround. Third quarter earnings dropped only 2% (compared to 25% drops in prior quarters) as demand for optical fiber, particularly its then-new LEAF product, picked up. From that point forward, reported results picked up and have continued to improve.

In the fourth quarter of 1998, the company began to resume earnings growth, with earnings per share rising a modest 3%. This is about the point of my Fool Plate Special, where the stock had doubled and other investors were starting to get on the bandwagon. Despite signals that Corning's markets were starting to improve dramatically, many analysts were still cautious with their annual long-term growth rate estimates. Given the problems earlier in the year, the First Call estimate for this number was still 15%, despite signs of the exploding telecommunications market. The stock was around $50 a share.

Starting with the first quarter of 1999, Corning's earnings have risen more than 20% a quarter. In addition to strong growth from the fiber business, the company benefited from excellent results in its photonics (amplifiers used in fiber networks) and liquid crystal glass. As more investors became aware of this growth, the stock continued rising -- hitting $100 in November 1999.

With its stock price surging, the company took advantage of this valuable currency to acquire other companies in important markets. Corning picked up Oak Industries last November for about $2 billion to expand further into the telecom equipment components business. It spent another $3.4 billion picking up Netoptix and Siemens' Fiber Optics division to position itself even better. The company's EPS rose 89% last quarter and is projected to rise 63% this quarter. The stock is now trading around $250 per share and the long-term growth rate has jumped up to 21%.

Below are my observations about the Corning story applicable to many other technology turnarounds:

Focusing on growth opportunities. Selling its consumer business enabled Corning to escape from a business that was experiencing revenue declines and had limited obvious growth opportunities. With this operation shed, the company could devote more management and financial resources to high-growth opportunities.

Emphasizing R&D spending. R&D expenditures hurt the bottom line, since they are expensed immediately. Nonetheless, they are often a key ingredient to maintaining and gaining a foothold in rapidly changing technology marketplaces. Companies that want to thrive will not sacrifice integral R&D spending to achieve short-term earnings objectives.

Maintaining strong financial position -- particularly liquidity. Although Corning had a modestly high debt/equity ratio of 1.08 at the end of 1997, most of its debt had extended terms. A company needs to ensure it has some financial flexibility so that it can withstand unexpected challenges.

Importance of macroeconomic conditions. While a company can control a lot of things, it can't decide what happens in the overall economy or business segments (it can choose which ones to participate in, though). Corning was unduly crucified for problems in the Asian economy in 1998 and greatly benefited from the unexpectedly strong worldwide fiber optic buildout schedule. You need to step back from a company and evaluate industry prospects to consider if a turnaround is feasible.

Analyst estimates often over-extrapolate current trends. Whether a Wall Street analyst or an individual, our tendency is to extrapolate current trends well out into the future. While this is the easiest thing to do, it may not be accurate -- particularly if a trend is near an inflection point. We should always be aware of the impact a change in a trend could have. Two years ago, in the midst of an earnings decline, investors scoffed that Corning might not achieve its projected 15% growth. Now analysts are projecting 21% and some think it might be higher!

Higher stock prices open the door to more opportunities. With a rebound in its stock price and operating performance, Corning was able to embark on a multibillion dollar acquisition spree to gain more market coverage. Only time will tell whether these are fruitful transactions, but a higher stock price provides companies with many, many more opportunities.

Your Turn:
What characteristics do you look for in companies trying to turn themselves around? Share you thoughts with the Foolish community.

Suggested Links:

  • Corning's High Fiber Double, Daily Double 5/11/00
  • Corning's Profits Jump 78%, Breakfast News 4/25/00
  • SDL Joins the Optical Component Shopping Spree, Fool News 3/1/00
  • Corning Scooping up Oak Industries, Fool News 11/15/99
  • Corning Connects, Fool Plate Special 1/3/99
  • Corning Discussion Board