Shareholders cheered when Corning Inc (GLW 0.46%) reported its second-quarter earnings last month. After the share price declined by double-digit percentage points earlier this year when the company posted what was perceived to be a disappointing first quarter, the stock price has rebounded sharply and is now up more than 10% since its second-quarter results were released.
In the second quarter, the company's core sales rose to $2.76 billion, a 9% increase year over year, while core earnings per share (EPS) decreased 3% to $0.38. The company also said it expected to expand its margins and raised its revenue guidance to $11.3 billion, a $300 million increase, which would represent a 10% year-over-year gain. While the numbers seem to paint a mostly positive picture, they don't tell the full story.
Corning's heavy capital expenditure spending is beginning to show some handsome returns. Image source: Corning Inc.
A glass half full
The primary reason why shares jumped is that Corning is finally beginning to realize gains from its numerous investments in manufacturing expansion projects. In 2017's fourth-quarter conference call, CEO Wendell Weeks said the company had 23 ongoing projects in the works, including the construction of 11 new plants. These heavy investments weighed on the company's cash flow statements, as capital expenditure spending in 2017 shot up to $1.8 billion, a 60% increase year over year. The market never likes the "uncertainty" of heavy investments in the present for future gains, and Corning's shares predictably tumbled.
The expectation, however, was that as these capacity expansion projects began to come online, the company's sales and margins would improve, which is exactly what appears to be happening now. In the company's second-quarter conference call, transcribed by S&P Global Market Intelligence, Weeks said:
As planned, we undertook a phase of intense operating and capital investments to help us meet committed demand and capture new opportunities. We have now reached an inflection point where those investments are yielding clear benefits, including increased sales and greater profitability. Several of our largest projects have exited the start-up phase and production and efficiency rates are climbing. So we are on track to meet increased demand, grow sales and significantly improve profitability in quarter 3 and beyond ... So we feel great about both the back half of 2018 and our long-term opportunities...
Let's take a brief look at a couple of specific areas where these investments are already beginning to pay off.
A prettier display
Corning's Display Technologies division manufactures glass substrates used to make liquid crystal displays (LCDs) for screens on televisions, monitors, and an array of other gadgets. Due to increased global competition, this product is becoming commoditized, and margins and profits in this segment have plummeted for years. For a single data point to illustrate this point, in 2014's second quarter, core earnings in this segment were $300 million. This quarter, earnings were $192 million, representing a 36% decline from the segment's results four years ago.
The weakening in this segment's profitability is expected to continue, though it does seem to be slowing. So, what's the good news amid this secular decline? Corning just finished significant improvements to its LCD manufacturing capabilities, concluding a huge project in Hefei, China. This new plant works more closely with Corning's largest display customer, allowing the company to ramp up or down its production in tandem with the industry. The increased capacity and flexibility is expected to improve margins.
The best part is that these improvements may have finally let Corning achieve a significant lead on the competition. In the conference call, CFO Tony Tripeny said: "[O]ur competitors continue to face profitability challenges at current pricing levels. Therefore, we expect their price declines will slow further as they try to remain profitable."
Corning's moat in optical fiber widens
Corning's largest division by sales is its Optical Communications department. Last year Corning announced it had passed the milestone of producing more than 1 billion kilometers of optical fiber, or about one-third of the optical fiber ever produced in the history of the world. In Q2, net sales in this division rose to $1.2 billion, a 16% increase year over year, while earnings grew to $150 million, a 17% increase year over year. This increase was helped by its acquisition of 3M's Communication Markets Division and the new projects coming online. Or, as Tripeny put it, "As expected, capacity utilization and profitability increased due to volume growth and progress in our capital expansion initiatives."
The best part about the investments in its optical fiber solutions business is that capacity expansion is based on existing demand from customers. Last year, for instance, Corning scored major commitments from Verizon and Saudi Telecom for the purchase of significant amounts of optical fiber from Corning as the companies begin to lay the infrastructure for 5G wireless communications and the Internet of Things.
Harvest time
Wall Street can sometimes miss the forest for the trees, getting far too caught up looking at a company's next quarterly release or two rather than the years ahead. As individual investors, buying and holding great stocks over a long time horizon remains our biggest advantage.
Corning had to significantly increase its spending to invest in its future. While it can be frustrating to look at a field of dirt in early spring, it is important to have the vision and patience to realize a bountiful harvest in the fall. Corning shareholders are now beginning to see the first green shoots pop up in a previously bare field.
In the conference call, Corning's management fielded a question from an analyst about when the company would begin to see real results from this heavy phase of investments. Weeks answered:
[W]e are in this pretty intense operating and capital investment cycle. Here is the good news: I think you're going to start to see the harvest begin now. We expect that we're in an inflection point in this quarter, and that you're going to see growing sales from those capacity investments and expanding profitability from them. So I do not think we need to wait long.
Predictably, Wall Street loved the news from this quarter, but investors wise enough to have the patience to see this investment phase through are sitting on handsome gains. As more of these investments come online, I believe Corning's margins and sales will continue to improve, driving more market-beating returns well into the future.
