Headlines around Corning (NYSE:GLW) simmered down a few years ago, but the specialty materials manufacturer hasn't stopped chugging along since then.
In this week's episode of Industry Focus: Energy and Industrials, host Sarah Priestley and Motley Fool contributor Matt Cochrane take a deep dive into the company that produces our smartphone glass -- how it makes money, how it's turning around a bit of a rough patch, and what long-term investors should know about the company's future. Tune in and learn about some of the other products that Corning makes, why they still expect growth in Gorilla Glass sales when the smartphone market is pretty saturated, and more.
A full transcript follows the video.
This video was recorded on July 19, 2018.
Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking about Energy and Industrials. It's Thursday, July 19, and we're going to be talking about Corning's stock. I'm your host, Sarah Priestley, and joining me on Skype from sunny Florida is Motley Fool contributor, Matt Cochrane. How are you doing today, Matt?
Matt Cochrane: I'm doing fine, Sarah, how are you?
Priestley: I'm good. It's going to be very hot this weekend, and I'm actually moving, so I'm not looking forward to that.
Cochrane: Moving is never a fun process.
Priestley: It's not. You always end up looking at all of this stuff thinking, "I didn't even know that I had 50% of this." [laughs] I wanted to talk about Corning. The ticker for this stock is GLW, for anybody listening. I came across this company after -- I'm very accident prone, and I think I hit the screen full-on of my iPhone into the corner of a wall. It didn't scratch, and I was amazed, so I started to do some research on who made glass for the screen. I came across an article that you had written on Corning. I have subsequently been so impressed by your amazing write-up and done a lot of research that I bought the stock.
It's been an interesting story over the last 12 months since I've owned the company. I thought it would be really interesting to introduce the listeners to a company that definitely had its heyday, in the coverage sense, around 2012 or 2013. It was a big stock then. Coverage has died down, so I wanted to reintroduce listeners to it. Matt, can you give listeners a brief background on Corning and what they do?
Cochrane: Sure. They primarily manufacture specialty materials, basically glass and ceramics, for a variety of industrial and scientific applications. The company itself has a very rich history. They were founded in 1851, almost 170 years ago, as the Bay State Glass Company. They moved around a lot. They finally settled in a small town in upper state New York which was named Corning. For the next 120 years, it would be known as Corning Glass Works. The Glass Works is actually where their stock ticker symbol, GLW, comes from. In the late 80s, they dropped the Glass Works and just adopted Corning Incorporated as their company name.
Way back, they were the company that made the glass encasement for Thomas Edison's first light bulb. They really made their name when, the American railroads would have their signal lamps, and they kept breaking. In the summertime it would get hot, and then it would rain. That temperature change would shatter all the glass globes. Corning developed a low-expanding, heat-resistant glass to fix that problem.
Basically, since that time, they were known as the premier glass manufacturing company in America. Since then, they basically invented optical fiber for use in the real world, they made the glass used on the Hubble telescope, and, as you discovered when you almost broke your iPhone, they introduced the world to Gorilla Glass, which is the top resistant glass used on our mobile devices.
Priestley: Incredibly rich history. I really enjoy reading about companies that have these storied histories. I love learning about how GE got established, from very disparate beginnings, very engineering-focused background, and they carry that legacy through.
Corning obviously services a variety of industries, from consumer goods and tech companies to industrial companies. How do they categorize their income streams from all of these endeavors?
Cochrane: They actually have five business divisions. I would say what investors really need to know is, they have three primary revenue streams, the first of which is Display Technologies. The Display Technologies division is responsible for making the specialized glass substrate, which is the key component used in LCD screens. As most people know, that's used on large screen televisions, computer monitors, tablets, and even some smartphones.
The top line growth has been hard to find in this market as of late. Glass prices keep coming down, they keep declining. But this is still their No. 1 revenue stream. In income, this division represented about 44% of the company's overall bottom line last quarter. While that's a lot, that's come down significantly from a few years ago, when it was well over 50%. That's because, while revenue from this division has been coming down, revenue from other divisions have been ramping up nicely.
Another one of their revenue streams is Optical Communications. This company makes optical fiber. In fact, Corning has now produced 1 billion kilometers of optical fiber, which is about a third of the optical fiber ever manufactured in the history of the world. Its primary buyers are major telecom companies and internet service providers. As these companies are getting ready for 5G, and as the Internet of Things keeps expanding, they've gotten a lot of new deals recently. For example, last year, Verizon announced it was going to buy more than $1 billion of optical fiber over the next three years. They scored a major deal with Saudi Telecom last year.
Optical fiber is literally the infrastructure backbone to 5G and Internet of Things. As the demand for data and bandwidth grows, this segment should continue to grow. Corning is now the world's lowest-cost producer of optical fiber. It recently acquired 3M's optical fiber division for about $900 million. This division, they see a lot of demand for this growing, and they think it's going to continue to grow. It's becoming one of their largest divisions.
Finally, Gorilla Glass, as we already talked about, is the popular covering for mobile consumer electronics these days. They're on their fifth generation of Gorilla Glass. Later this year, they're going to come out with the sixth generation. With every successive generation, Corning's profits continue to go up. They can demand more money. Later this year, they will unveil the sixth generation of Gorilla Glass.
Priestley: They seem like they're very dominant in the arenas that they are based in, but it's a mixed bag with these results. The notes you sent over before we recorded the show, the last quarter saw sales declines of 7% for their Specialty Materials Division, which is where Gorilla Glass is located in. Obviously, anything that you do with consumer electronics is going to have these ebbs and flows. We see that a lot with component suppliers for the iPhone in particular. Is this decline just as the basis of the cycles that the phones are going through?
Cochrane: CEO Wendell Weeks said they still expect overall sales to increase for the year, but they do say it is driven a lot by other manufacturers' product cycles. Like you said, that will ebb and flow from time to time. They still expect, though, sales in this division to double over the next several years. While that is vague, they aren't more specific than that, it's still impressive, because the smartphone market is maturing. But, yes, a lot of it does depend on product cycles.
Priestley: And expanding to new products and revenue sources for that product, too. One thing I really liked about your write-up is, you go back three years ago to look at some of the growth initiatives and the origins of the company's strategy today. I'd love for you to introduce the listeners to what that is.
Cochrane: This is probably the key to understanding the company today -- in 2015, Corning released its Strategy and Capital Allocation Framework, which they will continually reference in conference calls and analyst calls and things like that. They always go back to this. This was essentially Corning's plan to define its priorities from 2016 to 2019, it was a four-year plan. They were going to refocus on the company's core competencies. It would basically define how they would allocate their capital. Namely, they would do this by returning money to shareholders via dividends and buybacks, and spending a large amount on expansion projects and R&D.
Since announcing this framework almost three years ago, Corning has returned to $10 billion to shareholders through dividends and buybacks. Earlier this year, they authorized a 16% increase in the dividend. Since the beginning of the plan, the company's dividend has increased 50%. And they've reduced the share count by about 30%. So, they've definitely held up their end of the bargain when it comes to returning money to shareholders.
The rest of the Strategy and Capital Allocation Framework was basically how they were going to devote money to their core competencies. For instance, they sold Dow Corning, which was a joint venture with them and what is now Dow DuPont. They sold that to Dow DuPont and used that money for additional money back to the shareholders. They just wanted to refocus on what they thought they did best.
Priestley: It's interesting because I wouldn't class this as a dividend yield stock, but it's always nice to see a company that's focused on shareholder returns. The yield isn't bad at all, it's about 2.5%, which is better than the S&P average. Un-diluting the share pool is something that's really nice to see as a shareholder.
But, as a shareholder, I'm a little perturbed, because shares are down about 15% year to date. Short-term, some investors might be nervous about what's going on here. I know that there's been a couple of disappointing quarters. Can you give us a bit more detail on those?
Cochrane: There's no doubt, if you take a quick look at the numbers, the last two quarters, the numbers have not been impressive. For two consecutive quarters now, Corning has presented disappointing GAAP earnings. But neither of those numbers reflect the true state of the business in my opinion.
For instance, in 2017's fourth quarter, the new tax legislation led the company to report an EPS loss of $1.66. However, when the new tax legislation was taken into account, their core EPS, which is essentially their version of adjusted earnings, came in at a much better $0.49 per share. Corning reports core revenue and earnings to take into account things like tax laws and foreign currency fluctuations. In this year's first quarter, Corning once again, however, reported a GAAP loss. This quarter, the loss could not be blamed on the new tax law.
That being said, it was more of, for lack of a better term, an accounting fluke, than a change in the company's underlying health. Corning produces a lot of their glass in foreign countries. This quarter, their currency hedges, which GAAP requires to be marked-to-market, were to blame as Corning reported an EPS loss of $0.72. I don't want to get too lost in the weeds there, but when the CFO explained this in the conference call, this does not affect Corning's cash flows in any way. The mark-to-market accounting rules basically have no effect on the cash flow. Their currency hedges, it does protect them from foreign exchange rate fluctuations in the future. But, they have to mark them on mark-to-market, which means, what's the current value of them now at the end of each quarter. So, the quarter looked a lot worse than it was.
Priestley: OK, so, it's essentially a writedown on the currency that they hold.
Priestley: OK. To me, the story very much -- and, this is the way that you've explained it to me -- is that the free cash flow has been depressed because of a lot of capex and investment the company is making in its future. It seems like they're, I wouldn't say struggling, but they're investing to keep up with demand. Demand doesn't seem to be the issue, if you prescribe to what Wendell Weeks, the CEO, is saying. You were saying free cash flow was negative, but a lot of that is just increased spending.
Cochrane: Yes. In 2016, for instance, Corning's capital expenditures was about $1.1 billion. This year, it's expected to be over $2 billion. Capex has essentially doubled in the last couple years. In a recent analyst conference call, Jeffrey Evenson, Corning's chief strategy officer, said that investors should expect baseline capex, just for maintenance of their factories and everything like that, to be about $1 billion. So, a lot of this money is going toward increasing capacity.
The market never likes that aura of uncertainty which surrounds increased spending. But it's these investments in its future that should propel it in the years ahead. They're growing at a near-dizzying pace. It's almost hard to keep up with everything they're doing. They currently have 23 capital expansion projects under way, which includes the opening of 11 new plants. Their CEO, Wendell Weeks, ended their first quarter conference call, as you were saying, by saying, "While these are a drag on gross margins now, they're necessary to capture opportunities in the market."
Starting in the second half of this year, management believes these expenses will begin to decrease, and margins should start to rise. For instance, earlier this year, Corning opened a new plant in China, which enabled them to manufacture a greater grade of LCD glass than anywhere else in the world. This should be a big boost to their Display Technologies division, which is its most profitable. A quote, Wendell Weeks said, "This sets the stage for higher profitability in Display as our new plant and process technology come online in the second half."
While this is just one of Corning's many new projects coming online, it illustrates how these projects can produce profitable growth. And management states that all of their current projects are just to meet existing customer demand and should drive efficiency and earnings.
Priestley: It's encouraging to me to see management making that trade-off of being unpopular in the short-term to invest in good foundations for growth. So often, you see management avoiding that, the next fiscal year, the next fiscal year. This seems to me like they're really focusing on the long-term and investing in their growth. They've had a couple of one-time accounting fluke hits. I'm not saying that that's something people should ignore, but it's certainly something that people should discount somewhat. It seems like it's temporarily causing them to not look as attractive of a stock for short-term thinkers. But, long-term, they seem to have a lot of future growth catalysts.
Cochrane: Yeah, absolutely. Beyond the 23 capital expansion projects and how they're placed to capture a lot of the growth in 5G and Internet of Things, there are other reasons to believe that Corning is on the right side of several long-term trends.
One of those is Gorilla Glass. While the smartphone market is maturing, and the number of smartphones isn't expected to increase much in the coming years, because everyone basically has them already, there are a lot of reasons to believe that Gorilla Glass will be used more on these phones. For instance, CEO Wendell Weeks believes Gorilla Glass sales could double in the next several years because, they believe, smartphones in the future will be double-sided with Gorilla Glass. For instance, the latest Samsung Galaxy S9 and S9 Plus use Gorilla Glass on the front and back of each phone.
The benefits for device makers in going this route are enormous. It betters their radio frequency transparency. And, for wireless charging, it's better to do this with glass. As these needs increase, Weeks said, it will be easy to see phones going to all-glass enclosures in the future.
Another thing is, Gorilla Glass is expected to be used more in automobiles. In the first quarter conference call, Weeks said the company was currently working with 20 different car manufacturers to help equip automobiles with Gorilla Glass, on both the inside and outside. On the interior, that can include integrated and interactive displays, like head-up displays on the windshields. On the outside, Gorilla Glass laminates are tougher and lighter than conventional auto glass. It gives the driver superior optical quality, and it's lighter, which helps fuel mileage.
Priestley: We know that interactive or digital content, the tech content of cars, is just exploding, especially in the monetary terms. A lot of automakers, their standard vehicle comes with these standard interactive displays. It's a huge boon for them, especially working with 20 car manufacturers. That must be a lot of big hitters there. I know they didn't go into detail about that.
Priestley: The last growth initiative is hugely interesting to me. It was in the article of yours that I read, and that is, am I saying this correctly, Valor Glass?
Cochrane: Valor Glass. It's Corning's new pharmaceutical packaging, which is supposed to dramatically decrease lamella, which is tiny flakes of glass that can contaminate pharmaceutical products. One of Corning's plans under construction, one of the many capital expansion projects we were talking about, is in North Carolina. It's just for this manufacturing of this new product. Valor Glass should help eliminate cracks and breaks in medical packaging and translates into less waste for pharmaceutical companies.
Already, two industry giants, Pfizer and Merck, have given the project their blessing. They sent representatives to join Corning at the event in North Carolina when the project's construction was first announced. The CEO, Weeks, said that Corning was working closely with the FDA to ensure that Valor glass gets a speedy approval. He said, "We continue to believe Valor has the potential to power Corning's growth through the next decade and beyond."
While this isn't approved by the FDA yet, they're not expecting any serious pushback. This isn't like when a drug needs to be approved and it has to go through lots of trials. They expect this to be fairly easy and straightforward, and they believe it represents about a $4 billion opportunity, which is absolutely huge for a company the size of Corning.
Priestley: Yeah, the pharmaceutical market could be an incredible boon for them. It's always encouraging to see Pfizer and Merck being interested at this early stage. I know I was encouraged about a year ago when Apple invested about $100 million, which I'm sure is chump change for Apple, to help Corning get online with Gorilla Glass and invest in R&D for Gorilla Glass. It's nice to see those partnerships from who would essentially be their customers. It's a good initial footing for those relationships.
Cochrane: Correct. And it was part of Apple's big new project to invest in American companies. It was the very first reward they gave to a company. It shows you how important Apple considers Gorilla Glass to the future of the iPhone, that of all the American companies to invest in, Corning was the first one to receive anything.
Priestley: In summary, this seems like they have a few short-term headwinds, but a lot of long-term growth opportunities. I'm particularly very bullish about this stock. Is there anything that we've missed during the discussion that you would like to touch on before we go?
Cochrane: No, not really. Look, it can be frustrating for investors to watch a company's stock price get hit while the company is investing in future growth. As a shareholder, I feel the frustration as much as anyone. But, I think their numbers look worse because of a couple of one-time accounting flukes that hit the company's GAAP numbers, and all the investments temporarily depress the company's cash flow.
But, that being said, if you believe the management that strong demand is present for the company's products, this should probably be viewed more as a temporary decline than a sign the company's business is on a permanent slide. In my opinion, it's probably a nice buying opportunity if you have the proper long-term mindset.
Priestley: Absolutely, I couldn't have said it better myself.
That's it from us today. If you would like to get in touch, please feel free to email us at firstname.lastname@example.org, or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you, as always, to Austin Morgan for producing the show. For Matt, I'm Sarah Priestley. Thanks for listening and Fool on!