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Msg  643 of 654  at  3/25/2021 5:30:08 AM  by


Corning's Centralized R&D Allows It to Gain a Cost Advantage in Its Core Markets

 Corning's Centralized R&D Allows It to Gain a Cost Advantage in Its Core Markets
William Kerwin
Business Strategy and Outlook | by William Kerwin Updated Mar 24, 2021

Corning is a global leader in materials science, specializing in the manufacture of glass substrates for televisions, notebooks, mobile devices, and wearables, optical fiber for broadband networks and data centers, ceramics substrates and filters for catalytic converters, and pharmaceutical glass. In the firm’s 170 years of operation, it has constantly innovated (including inventing glass optical fiber and ceramic substrates for catalytic converters) and oriented itself toward evolving demand trends it can serve through its core competency of materials science. Most recently, we’d point to Corning’s domination of the smartphone cover glass market and deals with U.S. network carriers to supply fiber for 5G buildouts as evidence of the firm pivoting toward growth.

We think that Corning is able to use its scale to invest heavily in research and development—over $1 billion per year—and spread these expenses across its five segments. We think that centralizing research and development allows the firm to manufacture products for a materially lower cost than its competitors, all while using this hefty investment to maintain an innovation lead that results in leading share positions in its end markets. Corning’s cost advantage and intangible assets give it a narrow economic moat, in our view.

We expect Corning to continue focusing resources on opportunities that align with secular trends toward connectivity and efficiency. The firm will be a key enabler to 5G networks, providing the fiber backbone to network operators as well as selling Gorilla Glass into phone back panels to enable millimeter wave reception. Corning’s ceramic substrates and gasoline particulate filters will enable automotive OEMs to achieve rising efficiency standards around the world. The firm is also poised to continue dominating the market for thin display glass as it operates three of the four new Gen 10.5 plants in the world—the cutting edge for 65-inch and 75-inch screen sizes. Finally, we think the firm’s Valor Glass will continue to disrupt the market for pharmaceutical glass, specifically in genomics.

Economic Moat | by William Kerwin Updated Mar 24, 2021

We award Corning a narrow economic moat rating, based on a firmwide cost advantage and intangible assets in certain segments. The combination of Corning’s competitive advantages across its business gives us confidence that it will earn returns on invested capital in excess of its cost of capital for the better part of the next decade.

Corning has five segments: optical communications, display technologies, environmental technologies, specialty materials, and life sciences. While all Corning’s segments sell into very different applications, Corning is a leader in each one because of its proficiency in materials science, gained through 170 years of operation and innovation. These markets are typically characterized by specialized competition, and Corning is the only company that plays in all five—boasting a leading market share in all but life sciences.

As a result of diversified end markets with a common theme of materials science, Corning benefits from a cost advantage through massive and centralized annual research and development expenses ($1.15 billion in 2020) that benefit and are spread across all of its segments. Corning operates by a so-called 3-4-5 framework, with three core technologies (glass science, ceramic science, optical physics), four manufacturing and engineering platforms, and five market-access platforms. Management focuses 80% of its resources on opportunities that leverage at least two of these technologies and platforms. The firm credits this strategy for numerous product innovations, including iterations of its marquee Gorilla Glass and advances in optical fiber. Overall, we think this strategy means that Corning can consistently outspend its competitors on research and development to maintain its leading share in most markets while still producing its products at a lower cost. We point to Corning’s gross margins and operating margins leading every single one of its competitors—across end markets—as evidence.

Corning’s largest segment is optical communications, which made up 32% of 2020 sales and revolves around the manufacture of optical fiber. Optical fiber is a broadband solution made out of strands of glass or plastic thinner than a human hair, which offers superior performance to incumbent copper cabling in broadband networks. Corning’s fiber transmits data by coding it into pulses of light that are sent through pure glass, compared with copper which transmits electrons. This allows data transmission at the speed of light, with high bandwidth and low loss. While optical fiber was initially used in niche applications (after Corning invented it in 1970) due to costing more than copper, bandwidth needs of the 21st century and reductions in cost are making it the new standard in broadband access. Corning is working with cellular networks like Verizon and AT&T to provide a fiber backbone to their 5G network buildouts as well as providing fiber to the home to cities and communities to improve their home broadband. The firm also works with hyperscalers to input optical fiber into data centers.

Corning is a vertically integrated optical fiber manufacturer, controlling every part of the process from taking raw materials and producing a final optical fiber cable, even manufacturing its own furnaces and machines for production. Corning invented and uses to this day a process to create its fiber called outside vapor deposition, or OVD, to produce its fiber. This is a lengthy process that involves coating a “bait rod” evenly with a vapor solution that gets heated layer by layer to create a “preform”--essentially a thick tube of glass—that then gets heated and purified into a “blank,” where impurities are measured in parts per billion. Finally, the blank is suspended several stories in the air and the tip is heated to the point where a gob of pure liquid glass drips down, thinning and solidifying as it does. This becomes a hair-thin strand of optical fiber. According to Corning, a single blank (the size of a tube of salami) can produce a few thousand kilometers of optical fiber. While many firms produce their own optical fiber cabling (by outsourcing for the fibers themselves), there are only about 15 firms globally that manufacture fiber from scratch, with vertically integrated leaders Corning, Prysmian, and Yangtze Optical Fiber taking up about 40% of the market, according to Network Telecom and Thomas Publishing. Corning sells optical fiber at every stage in the process. It sells preforms and finished spools of optical fiber to third-party cable manufacturers, and manufactures its own fiber cables as finished products, along with cable assemblies and accessories.

Corning is constantly refining its OVD process to produce more fiber from a single blank, and we think it is able to leverage its centralized R&D spending to do so. Management has credited investments in the 3-4-5 framework for doubling the length of fiber produced from the same diameter blank. We think this continued innovation results in a persistent cost advantage for Corning’s optical business, with gross margins consistently more than 1,000 basis points above those of YOFC, its closest peer in global market share. Although Corning has decades of research and development that have gone into perfecting its proprietary OVD process, we would not assign an intangible asset moat source to the company’s optical segment, as competitors like YOFC have also developed optical fiber that meets the needs of many customers in the marketplace—just at a higher cost.

Corning’s second-largest segment is display technologies, with 28% of 2020 sales. Within display technologies, Corning supplies flat-panel glass into liquid crystal display and organic light-emitting diode televisions, as well as into notebooks and other displays.

To produce flat-panel glass to be used in televisions, Corning uses its proprietary “fusion draw” process. The fusion draw entails pouring molten glass into a pentagonal trough until it spills over the edges and drips down a height of six stories slowly through open air, thinning and solidifying as it descends. The ingenuity of this process is that the glass never touches another surface during its formation, greatly reducing surface imperfections, and the need for additional polishing. This is in contrast to the traditional “float method” used by competitors Asahi Glass and Nippon Electric Glass, where glass sheets form over a bed of molten tin before getting polished and finished.

We think Corning can produce these high-quality glass substrates at a lower cost than its competitors as a result of its centralized R&D. Corning uses the same fusion draw process to make glass substrates for both its display technologies and specialty materials segments, which it credits for saving upwards of $1 billion in investment, on top of the money it saves per substrate on refining and polishing. We think these dynamics exhibit themselves in industry-leading margins far and away above Corning’s nearest competitors. Corning’s gross margins come in consistently in the upper-30s (barring an exceptional 2020), while AGC and NEG are stuck in the mid-20s. Corning’s operating margins are stable in the low to midteens compared with AGC and NEG, which are stagnant in the high single digits. This is all while Corning more than doubles the R&D spending of these competitors, both on an absolute basis and as a percentage of sales.

We also think that Corning enjoys a virtuous cycle in its glass production between its cost-advantaged position and intangible assets in the production of thin glass substrates. Corning invents and manufactures all of its own equipment and machinery for its fusion draw, which produces best-of-breed display glass, which we think has resulted in its leading market share. Glassmaking is a high fixed-cost business, with more than half of Corning’s manufacturing costs being fixed. The display glass market is an oligopoly, with Corning, AGC, and NEG taking up an estimated 95% share, of which Corning accounts for half. Because Corning’s sales double that of its closest competitor, AGC, it can spread its fixed costs over a larger volume, resulting in an enduring lower average cost per glass substrate. Corning can then use the money it saves to reinvest in innovating its production processes even more and continue to sustainably outprofit its competition.

Finally, Corning’s display business also presents meaningful switching costs to its customers as a result of co-location and co-investment, although we can’t say that all of Corning’s businesses benefit from similar switching costs. Due to the inherently fragile nature of sheets of glass as large as 100 square feet in area and as thin as 0.5 millimeters, the firm’s display plants are located next to customer facilities to reduce the risk of lost inventory and to save on travel time and expense. Additionally, when Corning builds a display glass plant, it secures over 75% of the initial investment outlay from customers and partners. These plants can cost up to $7 billion to build (and often a 10-year supply agreement), creating a strong incentive for customers to maintain their relationship and earn a return on their large investment. We think panel manufacturers that partner with Corning would be hard-pressed to lose the sunk cost of a billion-dollar investment and reduce their own production for multiple years to arrange for a new source for glass.

Corning’s specialty materials segment made up 17% of 2020 sales, with the lion’s share of this revenue coming from sales of its marquee Gorilla Glass. Gorilla Glass is the protective cover glass designed into nearly three fourths of the global smartphone market (including every Apple iPhone ever made), as well as into wearables, tablets, and notebooks.

Corning invented Gorilla Glass in 2006, when Steve Jobs gave the firm six months to design a cover glass for the first iPhone. The latest iteration is Gorilla Glass Victus, which can withstand drops of up to 2 meters and boasts twice the scratch resistance of its predecessor, Gorilla Glass 6, Corning says. Gorilla Glass is known in the industry as best-of-breed, and we think this is exemplified by its stranglehold on the global smartphone market, with a 73% share in 2016, according to EMR--the latest share data we can find. Gorilla Glass is found in every premium smartphone on the market (iPhone, Samsung Galaxy, Huawei Mate, to name a few) while its chief competition, AGC’s Dragontrail and NEG’s Dinorex, are largely featured within economy phones.

We think the firm’s specialty materials segment enjoys the same cost advantage in the production of glass as it does in its display technologies segment. Corning’s Gorilla Glass is produced using the same proprietary fusion draw process as it does for display glass, which again has helped save $1 billion in investment and allows the firm to save money on refining and polishing versus the competition. We credit these dynamics for resulting in industry-leading gross margins well above those of AGC and NEG. Corning’s synergies between display and specialty materials, along with its unparalleled scale in the cover glass market, allow it to consistently achieve operating margins 500-plus basis points above its chief competitors.

We also think Corning’s 15 years of dominance in the premium smartphone market reflect the same virtuous cycle of intangible assets and a cost advantage in durable cover glass production. Corning claims its sales of Gorilla Glass are 10 times that of the nearest cover glass competitor, meaning it can spread its fixed costs over a large production volume even more so than it does in display glass, reducing its average cost per substrate and allowing the firm to reinvest money saved to maintain its innovation lead over the industry.

Corning’s environmental technologies segment (12% of 2020 sales) sells ceramic substrates and particulate filters into the catalytic converters for gasoline- and diesel-powered cars and trucks. Corning invented ceramic substrates for emissions control in 1970 following the U.S. Clean Air Act. Gas and diesel engines produce toxic pollutants that can render air harmful to breathe, and the Clean Air Act was the first legislation to target a reduction in those emissions. Substrates and filters are a one-two punch to accomplish this, with substrates removing gaseous pollutants and filters taking out toxic particulates.

Substrates are a solid ceramic in a honeycomb shape coated in catalytic materials that turn harmful gases like carbon monoxide and nitrogen oxide into gaseous nitrogen, water, and carbon dioxide. For color, Corning can pack a surface area the size of a football field into a product roughly the size of a can of soda. Currently, while most diesel engines use a substrate and filter, most cars only use a substrate. However, the demand for gasoline particulate filters, or GPFs, is greatly expanding as a result of global emissions regulation. The typical internal combustion engine emits trillions of particulates every mile, and regulations like Euro 6 and China 6 require a 99% reduction, which only an advanced GPF can accomplish.

We think Corning benefits from a cost advantage in substrates and filters, again stemming from its centralized R&D spending, as well as a virtuous cycle with intangible assets in ceramic substrate production. Corning occupies a plurality of the GPF market, with 27% share, and the top three firms combined made up 60% of the total market in 2019, according to 360 Research. Corning invented this industry, and after five decades of innovation, we think Corning possesses intangible assets in ceramic substrate and filter production that have resulted in its leading share. Similar to the dynamics in its glass businesses, Corning can divide hefty fixed costs across a greater volume than its competition, resulting in materially lower average costs and industry-leading margins. Among its competition, it is rivaled only by NGK Insulators in margin performance, and we think the two hold a cost advantage over the rest of the field. Both Corning’s and NGK’s operating margins have trended around 15% of revenue since 2015—more than double that of the next largest firms by market share, Ibiden, and Faurecia—all while they dwarf their competitors’ R&D expenditures.

Corning’s final segment is life sciences, making up 9% of 2020 revenue, where the firm produces glass equipment for pharmaceutical research, development, and production. The firm’s marquee product in this segment is Valor Glass, which reduces particle contamination in pharmaceutical packaging and elevates production throughput via reduced breaking or cracking compared with incumbent pharmaceutical glass.

While we think Corning’s life sciences segment benefits from its centralized R&D spending (which we think led to the invention of Valor Glass), we don’t consider this segment moatworthy in isolation. It is already a $1 billion business for Corning but goes up against massive incumbents like Thermo Fisher and Danaher, which generate several billion dollars in revenue from pharmaceutical packaging alone, on top of massive R&D budgets and lasting customer relationships. Still, we think Valor Glass could be an industry disruptor, and as Corning continues to take market share, we may deem its life sciences segment as moatworthy in the future.

Fair Value and Profit Drivers | by William Kerwin Updated Jan 27, 2021

Our fair value estimate for Corning is $35 per share. This valuation implies fiscal 2021 price/adjusted earnings of 17 times, an enterprise value/sales multiple of 3 times, and a free cash flow yield of 5%.

Through 2025, we expect Corning to grow revenue at a compound annual rate of 8%. We expect Corning to feel its strongest growth in its specialty materials segment, where content growth for Gorilla Glass and Ceramic Shield in smartphones will drive 8% compound annual growth over our explicit forecast. We also forecast 10% growth for the firm’s optical communications segment, where 5G network buildouts will elevate demand for fiber. In life sciences, we expect Valor Glass to continue outpacing the pharmaceutical glass market as it takes share and will drive 7% growth for the segment. The environmental technologies segment will ride the wave of gasoline particulate filter adoption caused by rising global emissions standards, resulting in 12% growth through 2025. Finally, we expect the firm’s mature display technologies segment to grow at a rate of 1% over our forecast, as increases in average screen size offset mid-single-digit pricing declines.

Corning has high operating leverage, with over half of its costs across the business being fixed in the short term. Following plant shutdowns and reduced demand in the last quarter of 2019 and throughout 2020 as a result of COVID-19, we expect margins to expand back to midcycle levels as Corning ramps back to full production. We forecast a gross margin of 42% and an operating margin of 18% in 2025, the final year of our forecast, compared with 31% and 5% earned in a COVID-affected 2020, respectively.

Risk and Uncertainty | by William Kerwin Updated Mar 24, 2021

We assign Corning a Medium uncertainty rating. The firm must continuously innovate to stave off competition in each of its end markets, which are constantly evolving. We think that any stagnation in Corning’s ability to innovate, or renewed vigor or capital intensity from a competitor, could eat into Corning’s leading market share. Still, we don’t think Corning’s end markets are at great risk of disruptive new entrants, given the massive capital intensity and research and development required.

Corning also faces risk from its global business model. Corning earns two thirds of its revenue outside the U.S. and has to carefully manage fluctuations in exchange rates with large currency hedges. If Corning were to fail to implement the proper hedges, it could face volatility in its results from changes in exchange rates. Additionally, Corning earns $3 billion from China, and any trade tensions between China and its domicile of the U.S. could affect its ability to do business.

Corning has a concentrated customer base, specifically in its display business. Display technologies accounts for a bulk of Corning’s profits, and the four largest customers account for more than 70% of segment revenue. If Corning were to lose one of these customer relationships, it would materially impact the firm’s top line. Nevertheless, Corning operates numerous plants with each of its large customers, typically with multiyear supply agreements, which we think insulate it against the risk of losing an entire customer relationship.

Finally, we don’t foresee major ESG (environmental, social, governance) risk for Corning over our explicit forecast. The company has a substantial carbon footprint from its manufacturing, but it has been implementing solar energy at facilities and is committed to increasing its use of renewables by 400% in 2030.

Stewardship | by William Kerwin Updated Jan 27, 2021

We rate Corning’s capital allocation as Exemplary based on a sound balance sheet, exceptional investments, and appropriate shareholder distributions. The firm has consistently balanced investments in its own innovation with dividends and share repurchases, and we expect this to continue.

We rate Corning’s balance sheet as sound, due to low net debt relative to EBITDA and our assessment of enterprise value. Corning uses its extremely long debt maturity profile to invest in growth and reinforce its firmwide cost advantage and intangible assets, which gives rise to exceptional investments, in our view. Corning operates via what it calls a 3-4-5 framework. The firm has broken out its core competencies into three technologies, four engineering platforms, and five market access platforms. The framework calls for management to devote at least 80% of its investments toward opportunities that benefit two or more of these core competencies. We think this is a core tenet of Corning’s cost advantage through centralized research and development and has been responsible for innovations like Gorilla Glass that propel Corning’s cash generation.

When Corning invests capital in a project, we think it has a good track record of reducing its risk via purchase agreements and co-investment. In its display business, it builds plants adjacent to customer facilities, and secures 75% of the capital investment from customers and downstream partners. This co-located and co-invested dynamic both reduces Corning’s initial outlay and ensures every member of the production relationship is motivated to produce an attractive return. Additionally, Corning has secured $450 million in investment from Apple to continue developing new iterations of Gorilla Glass, which is deemed crucial to future iPhone innovation.

Finally, Corning focuses its M&A on opportunities to expand the reach of its existing businesses, shown most recently through its bolt-on of 3M’s communication markets division in 2018 that broadened the geographic reach of its optical segment into Europe and Asia.

Finally, we think Corning appropriately returns its ample leftover cash to investors. Under Corning’s 2016-19 capital allocation plan, the firm sought to generate more than $20 billion in cash over four years, supplementing strong operating cash generation with new long-term debt. Management planned to allocate $10 billion of its cash to research and development, capital expenditures and acquisitions, while returning $10 billion more to shareholders via dividends and opportunistic share repurchases. Corning exceeded these lofty targets, generating $26 billion in cash and investing $12 billion in capital expenditures, research and development and acquisitions, all while returning $12.5 billion to shareholders.

Corning’s capital allocation plan for 2020-2023 involves generating $16 billion-$18 billion in operating cash flow alone, up from the $13 billion generated under the prior framework. Management plans to invest $10 billion-$12 billion in the business, with approximately $3 billion going to research and development, $1 billion going to bolt-on M&A, and the rest going toward capital investments. The firm plans to return $8 billion-$10 billion to shareholders, via $5 billion-$7 billion in repurchases and 10% annual growth in its dividend. The firm also expects compound annual revenue growth of 6%-8% in this period, with earnings growth of 12%-15%.


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