40% Upside on Corning (GLW) – Part 2
Guest post by
Joakim Aske
This is part two of an investment thesis on Corning (GLW).
Every Company has Risks
Lawsuits
GLW and its subsidiary Dow-Corning are involved in several lawsuits regarding different health issues. Corning through another subsidiary is exposed to an asbestos lawsuit and Dow-Corning is exposed to a lawsuit from former creditors before they went in chapter 11 in the 1990’s.
The potential losses they could incur if they were to lose these lawsuits are not material in the way that they will not interfere with GLW’s business operations. It could be a non-recurring loss in the magnitude of 200-800 million depending on the result of the lawsuits.
LCD Slowdown affecting Profitability
The setback in LCD business that started in 4th quarter 2011 could change the profitability level in the business.
There is likely to be a reduced level of profitability and I have considered this in the analysis. Assuming a 30% decline EBIT across the whole business to be on the conservative side. Management has estimated that net income could be reduced by 30% from the SCP subsidiary due to this slowdown.
A positive note is that supply chain inventory levels have been reduced to 2008-2009 levels, 12-13 weeks of inventory, a level where the LCD industry experienced stock outs due to lack of glass when demand picked up again.
Currency Risk
A plus or minus 10% movement in the USD – JPY exchange rate would result in a change to net income of 146 million and a plus or minus 10% movement in the USD – EUR exchange rate would result in a change to net income of 34 million for 2011.
The effect of currency movements can have adverse effects on GLW`s bottom line, however it is not enough to make it incur losses or decrease its FCF to an unattractive level based on the current price.
At the end of 2011, they had 309 million in foreign exchange gains due to favorable rates. Therefore, this buffer would first have to be eliminated before it would have a negative effect on the business. I have excluded the exchange gain from my valuation of GLW to be conservative.
(there is a table displaying the different scenarios based on changes in currency value. The pdf link is provided at the end of this analysis.)
Underfunded Pension Fund
Currently the combined pension plans are underfunded by 1650 million. The obligations are spread out over time so this is not a lump sum that needs to be paid in the short term. Majority of their plan assets are in US corporate bonds or investment funds. Due to this, there is a small likelihood that the plan will have large increases in plan assets due to a recovery in the stock market. The investment funds performance depends on their degree of fixed income to equity.
I expect GLW will need to contribute to the plans to fund them going forward. However, the contributions will not be beyond 100 million, per annum, and will not affect the underlying business strength.
Financial Risk
There is a low risk of default for Corning as they have been at an average Altman Z score of double the safe ratio for the last 6 years.
Their statements also carry a low likelihood of earnings manipulation according to the Beneish M score as well as I found no indication of it reading through the last 10 years of financial reports.
They are capable of paying off their total debt in less than 1.5 years using their free cash flow of 2284.49M, assuming the do not use cash, as cash to debt is: 3.77. Therefore, there is little risk from a financial leverage standpoint.
Valuation
In valuing GLW, I have used three methods: Asset Replacement Value, Earnings Power Value (EPV) and Value of Growth.
These methods are ideal as forecasting is kept to a bare minimum.
Replacement Value: This is what it would cost to create a clone of GLW. What an entrant would have to spend to create an equal to GLW. Below is the book values found for GLW on a consolidated basis. I have included my assumptions for each adjustment I
have made. The replacement value of GLW is 30 Billion, or $19.80 per share. This is an upside of 48.83% from the current price of $13.30.
The second valuation method was calculating the earnings power value for GLW assuming 0% growth.
The numbers for EPV and assumptions are in the table below. I use a required return of 10%, which yields, after adding cash and subtracting debt, a value of $18.65 per share for GLW, an upside of 40.23%.
- *Assumes a 30% reduction in overall EBIT going forward due to a tougher environment for display, SCP, Dow-Corning and Hemlock and subtracts 309 million of currency exchange gains
- **Assumes a 35% tax charge going forward, however management estimates taxes around 20% for 2012
- *** Maintenance capex for Corning is 600M, I assume the ratio holds for GLW`s subsidiaries.
The final valuation method assumes profitable growth from the base scenario created for the EPV method.
I assume that GLW will be able to grow at a rate equal to the 20-year US GDP moving average growth rate of 2.5%. ROC is derived from the base scenario laid out for the EPV method above. This method gives GLW a value of $19.44 per share, an upside of 46%.
Risk Reward Ratio
Even with a downside of 32.8% that requires a 10-year negative growth of 2.80% in FCF replacement value reward/risk is 1, EPV is 0.942 and PV is 0.982 – Assuming required return of 12% for the investor.
In the range of 15% downside to current price as max downside the potential return ranges from: 26.5%-46.2%
- These returns are based on very conservative assumptions regarding GLW`s ability to grow profitable and the effect of the current slowdown in the LCD segment and Dow-Corning subsidiary.
- This conservative assumption is 30% decline in consolidated EBIT across all segments.
- 35% tax rate is assumed while GLW is expecting 20% for 2012
Relaxing the assumptions to 15% decline in EBIT across all segments and 25% tax rate with a profitable growth rate of 3.5% gives this range:
- 26.5% – 102.3% for 15% downside to current price
Corning will have to experience an extreme decline in its business fundamentals for intrinsic value to decline to or below its current market price.
Catalysts
The effect of the decline in the LCD segment materializes – Uncertainty of its effect is removed
The uncertainty that is depressing the price currently will be retreating as the next quarterly reports are released. They will shed light on the results of the decline in LCD profitability and show unencumbered earnings due to restructuring charges.
Free cash flow is utilized to increase dividends or buy back shares
GLW’s free cash flow is strong, even during a ramp up in capital expenditures to finish several new plants to meet demand. As time progresses this will enable GLW to increase its dividend and maintain a healthy balance sheet. If the price stays at where it is the board has signaled that it is willing to commit funds to buy back shares as the share price is significantly below intrinsic value.
Pay off Target Price: $18.65. Upside 40%
At the time of this writing the stock price was $13.30.
- Corning is a 71-cent dollar assuming zero growth in its free cash flows.
- It has compelling fundamental factors such as a 7 year average profit margin of 22% and 3 year average ROE of 21.67%.
- It has little debt with total debt to capital at 10%, market cap of 19.5B and a quick ratio of 3.32.
- Conservative assumptions for the valuation methods yield values significantly above market price.
- It is currently trading at 0.93 P/B and 7.48 P/E.
- GLW has initiated a 1.5billion share repurchase and has spent half of that so far.
- Its current dividend yield is 2.30%.
