How can Steven Fox, a director at Merrill Lynch, have both a neutral

and

a buy rating on

Corning

(GLW) - Get Corning Inc Report

, which is set to announce its second-quarter earnings after the close of the market today?


Steven Fox
Director,
Merrill Lynch

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In the near term, Fox rates GLW a neutral because, he notes, Corning's clients have been canceling orders in droves and the company has slashed prices by 20% or more. Fox also anticipates that overall fiber-optics and photonics sales will remain sluggish for another 12 to 18 months.

But Fox doesn't expect the downturn to last forever. For investors with a one- to two-year time horizon, he has a buy rating on the stock. Reminding investors that Corning is likely to rise ahead of the market upturn, he advises investors who like GLW, now trading at 88% below its 52-week high of $113.33, to buy the stock on its current weakness.

Here Fox tells Daily Interview why investors should pay close attention to what Corning has to say about its high-end fiber-optics pricing during its earnings call, and how he believes the company is likely to meet or beat consensus earnings estimates of 18 cents a share.

TSC: What do you expect Corning to announce today, and what will you be focusing on during the call?

Fox:

They came out and preannounced a couple of weeks ago that the quarter that closed June 30 would be slightly ahead of consensus estimates, so there's not going to be much surprise in the earnings number for the quarter. But at the same time, the company withdrew its outlook for the rest of the year, given the tough prospects in the fiber and the photonics business.

So, what we will focus on in the conference call, first and foremost, is what they say about the fiber business from a pricing, a sales mix and a unit demand perspective. Our view is that pricing is going to be under more pressure later in the year and that the mix is going to be under more pressure. By mix, I mean the mix between how much high-end premium fiber they sell vs. their standard single-node fibers. Their high-end fibers, which carry more data, sell for two to three times more in price, and those products have been under particular pressure. So the particulars around some of those issues are going to be important.

TSC: What's your outlook for the company over the next 12 months?

Fox:

When it comes to our earnings estimates, we are still concerned that there could still be risk there, even though we have been one of the more conservative analysts on the Street for some time and we've also been bringing our numbers down for some time. Our biggest concern is the fiber market, although we have factored in some pretty aggressive price degradation into our model.

The best case is where our numbers start to make sense, but I would say that the earnings outlook is still going to be hazy for a couple of quarters. We have a neutral on the stock for the immediate term and a buy long term. The intermediate-term rating reflects our belief that the stock trades in a narrow range for the next six to 12 months because of the fundamental issues that I mentioned.

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TSC: In June, you said that your research team went on some field checks and found that the high-margin fiber-optics business is worse than even a worst-case scenario. Where did your team go in the field and what did they hear, exactly?

Fox:

We also follow the specialty cable and wire industry, and so we follow Corning's smaller customers, or potential smaller customers, so we talked to a lot of those companies. In January, we heard that pricing was pretty stable on the contracts they were selling. And a lot of smaller users couldn't get fiber from Corning because the industry was still basically sold out.

In June, we heard that Corning was going after the smaller customers that they didn't have the time of day for just six months before. That was pretty surprising to us. It reflected the weakening demand for some of their fiber products, especially among their larger customers. Now they were going to smaller customers with contracts that were even more favorable than the best contracts they would offer their best customers.

Not only that, but a huge amount of orders have been canceled. I would say across the electronics and fiber-optics industry a huge amount of orders have been canceled, especially in the March-to-May period.

TSC: How much has Corning cut prices, and who are these new types of clients?

Fox:

At this point, it's hard to say. From conversations we have had, we expect pricing to come down roughly 20% or so. It could even come down more. Pricing could stabilize down 20% or we could even see more downward pressure, depending on what the take-up rate is. These new clients are some of the smaller cable makers that also do fiber cable.

TSC: When do you expect the telecom sector to improve, and what could possibly be a catalyst to make that happen?

Fox:

That's the question. I would say that Corning's view on their preannouncement call was that from June it could take another 12 to 18 months before the market starts to grow again. We would argue that it would be tough to see the market start to improve before the second half of next year. That's a long time off, but the market obviously will anticipate improvement ahead of time.

TSC: How effective do you think the company's cost-cutting measures will be in the interim to improve the bottom line? Corning has said it will close three plants and has postponed the construction of a new $400 million fiber-optics plant until 2005, and it recently announced it would lay off another 1,000 people. This would bring its total layoffs this year to 5,900, or 15% of its workforce.

Fox:

I think these are moves that everybody in the industry is taking, whether you are talking fiber optics or electronics. One of the problems you face when you are a supplier of components and modules like Corning is that you have to listen to your customers. And until even as late as March, the customers were still telling them that they were going to need product this year. Buildings were still going up, and a lot of people thought it was going to be a near-term issue. As their customers started to have problems, it back-flowed through the supply chain and affected Corning.

TSC: In terms of the future, do you expect that fiber optics will eventually be the enabling technology of the broadband industry, as Corning has said? Are you bullish on your outlook for the company over the next 10 years?

Fox:

I would argue that Corning is extremely well-positioned with the technologies that they have. We have just been talking about optics, and I think they have done a tremendous job of extending their breadth of offerings and also continuing to invest in R&D. We really like this company for their R&D focus, the complementary acquisitions that they have done and the conservative management team. So I would say from a technology standpoint, there are still going to be tremendous opportunities in fiber optics for Corning, but near term there are going to be some issues.

I think this is one of the higher-quality companies we follow from a management standpoint, as well as from a technology standpoint. And if you are an investor with a two-year time horizon or longer, you should look for opportunities to buy the stock on its current weakness. Unfortunately, I think it's going to be tough sledding in the near term, but this is a company that we have a long-term buy on because we really like the management team and strategy. Corning is just going through a difficult period right now, but they will come out of it. But again, the market is going to anticipate that, so you want to be positioned for when it does.