R&D Helps Corning Dig Its Moat

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Superior products and efficient manufacturing have allowed Corning to control nearly half of the glass panel market while generating some of the highest margins in the industry. Corning invests in research and development at slightly more than 3 times the rate of its peers, on average. This investment supports greater profitability and allows Corning to set the pace for innovation in the display glass space. Corning's ability to continuously innovate has enabled the company to achieve the lowest-cost manufacturing position and earn a higher share of the industry's profits. Specifically, the company's proprietary fusion manufacturing process allows Corning to produce glass that is larger, thinner, and lighter with superior surface quality over competing products. In our view, these dynamics give Corning a sustainable cost advantage and a narrow economic moat.

We think the company is well-positioned for growth in the optical fiber business, as carriers and data center operators seek to improve network capacity. However, heavy customer concentration along with stiff competition in the optical communications space has resulted in weaker profitability than in the display glass business. Beyond optical, we think Corning’s environmental technologies business stands to benefit from increasingly stringent emissions regulations in the U.S. and European markets, resulting in renewed demand for its filter products. Further, we are optimistic of the growth in Corning's specialty materials segment as the company expands its leadership position in protective coverings via Gorilla Glass for smartphones and PCs while extending its presence into adjacent markets such as wearables.

The display glass industry is controlled by three firms that collectively own more than 90% of the market--Corning (about 40% market share), Nippon Electric Glass (about 25%), and Asahi Glass (about 25%). Since Corning entered the LCD market, it has continually improved its proprietary technology for manufacturing, investing considerable resources to lower manufacturing costs while scaling up its production of glass substrates. In turn, improved economies of scale have allowed Corning to outmatch its competition in profitability. Further, the improved manufacturing economics have enabled Corning's major customers such as Sony, Samsung, and Philips to produce larger, thinner LCDs more cheaply. To that end, lowered prices have allowed for significant market penetration and essentially mainstreamed LCD technology.

Corning Makes Significant R&D Investment Corning leverages its manufacturing cost advantage by investing heavily in R&D, slightly more than 3 times the absolute dollar value of its peers on average. This investment creates a virtuous cycle where Corning can set the pace for innovation and extend its cost advantage even further. On average, Corning's peer group has invested 4% of sales on R&D, while Corning has invested 9% of sales. This has enabled Corning to deliver far superior gross margins than its competitors, or 40% versus the 23% average of the peer group.

In June 2016, Corning updated its capital allocation framework and announced the future investment of $10 billion in R&D, capital spending, and strategic mergers and acquisitions. Through this initiative, we expect the R&D spending gap to widen and for Corning to continue to set the pace for innovation in its core competencies.

Additionally, Corning's proprietary fusion technology is patented and is one of the most efficient ways for producing LCD glass substrate in large scale. Its fusion technology is only a reflection of its deep level of knowledge in manufacturing glass-based products. Corning's substantial intellectual capital allows it to keep up with the ever-increasing demands for LCD glass substrates while maintaining attractive pricing and relatively high margins. Plus, Corning's patented Gorilla Glass is a prime example of the company's innovation leadership. Gorilla Glass is superior to normal glass and other competing products because it is more resistant to scratches and breaks, it is flexible, and it is thinner than ordinary glass of the same strength.

We think Corning benefits from significant barriers to entry in its display business, keeping the threat of new competition relatively low. Glass substrate production is capital-intensive, requiring substantial investment in facilities and R&D. Over the past five years, Corning has invested approximately $5 billion in capital equipment supporting the display business while spending more than $750 million on R&D in this segment alone. Any new competitor would need to make substantial up-front investments and most likely operate at a loss for a significant amount of time in order to become price-competitive with Corning. Corning has reduced its manufacturing costs while delivering thinner and higher-quality glass over time, which has allowed it to maintain consistently high gross margins while reducing the price of its glass. Corning’s ancillary business segments (collectively 28% of fiscal 2015 operating profit) include glass products for life sciences, emissions filters, fiber optic cables and interconnect devices for telecommunications and data center end markets, and specialty materials, which include Corning's patented Gorilla Glass family of products. The vast majority of these other business segments are also capital-intensive and require the utmost quality given their mission-critical nature.

Our fair value estimate for Corning is $26 per share. Over our five-year forecast period, we expect consolidated sales to exhibit low-single-digit growth, driven by Corning’s display technologies and optical communications operating segments. We think display technologies stands to benefit from increases in screen sizes driving demand for larger sheets of display glass as well as overall glass price declines stabilizing. In optical communications, we believe demand will continue to remain strong from data center customers and growth in fiber-to-the-home products. We also expect Corning's specialty materials segment to contribute to top-line growth as the company extends Gorilla Glass into adjacent markets such as wearables.