It seems like the longer the saber-rattling between China, the U.S. and its other trade partners continues, the more the market is going to get used to it and just start treating trade tension as part of the “new normal.” That may be true for the time being, especially since the latest list of about $200 billion proposed tariffs from the Trump administration is still about two months away from actually being implemented. There remains a risk, however that this is really just a long, slow-burning fuse. The longer tariffs last, or continue to escalate, the more likely it becomes to bleed into consumer prices and corporate profits. The effect so far has been mostly muted, but by the beginning of the third quarter of this year I think we could start seeing corporate earnings reports include tariffs and their effect more and more into the conversation.
There are companies out there that are doing whatever they can to mute the effect, or to adjust the business plans accordingly of course; Harley Davidson (HOG), for example is planning to move production for international sales offshore, and I expect to see others following suit the longer tension lingers. All the same, the market is an emotional animal, and sometimes that means that it will react negatively to the perception of a problem more than the reality that effect could be muted. The two stocks I’m highlighting today fall into that category. These are companies that derive major portions of their annual income from Chinese sales, and that association alone is likely to be enough for the market to put pressure on their stock prices. From a fundamental and value-based standpoint, they are also both quite overvalued, which should naturally call into question how much exposure you’d be taking on with these stocks if the economy begins to shift to the downside.
Both stocks are large-cap companies that operate in the Electronic Equipment, Instruments & Components industry. That might sound a little confusing, but both of these companies focus on the infrastructure that makes up modern, globally connected technology. That includes electrical, electronic and fiber optic connectors and systems for broadband communications. This is considered to be an area of growth in China, especially as it relates to data centers, which are expected to grow at an annual growth rate of 12% through 2022. While it isn’t a given this a business segment that will be immune to a trade war, for now China seems to be trying to encourage U.S. companies with a presence in-country to build further broadband capacity by excluding multi-mode fiber from their retaliatory tariffs. Stay tuned, though; China has yet to let the world know how it intends to respond to President Trump’s latest, $200 billion tariff salvo. That uncertainty alone could keep the pressure on these stocks for the foreseeable future.
Corning Inc. (GLW)
Current Price: $28.80
Corning Incorporated is engaged in manufacturing specialty glass and ceramics. Its segments include Display Technologies, Optical Communications, Environmental Technologies, Specialty Materials, Life Sciences and All Other. The Display Technologies segment manufactures glass substrates for flat panel liquid crystal displays (LCDs). The Optical Communications segment manufactures carrier and enterprise network components for the telecommunications industry. The Environmental Technologies segment manufactures ceramic substrates and filters for automotive and diesel emission control applications. As of December 31, 2016, the Specialty Materials segment manufactured products, which provided more than 150 material formulations for glass, glass ceramics and fluoride crystals. The Life Sciences segment manufactures glass and plastic labware, equipment, media and reagents. The All Other segment consists of its Pharmaceutical Technologies business and non-LCD glass business, and among others. GLW has a market cap of $23.9 billion.
In 2017, Corning derived 22% of its sales from China, and the company operates a number of production centers in China. That includes segments like the windows and lens business, which sources its products in China and then assembles them in the West. That puts this part of their business on the wrong side of Trump’s tariffs. It also isn’t inconceivable that they could draw ire from the Trump administration a la HOG; the President has publicly threatened to tax U.S. companies that move their operations offshore to avoid retaliatory tariffs with even more severe taxation treatment.
From a fundamental standpoint, GLW has a few red flags. The company has posted negative net income in each of the past two quarters, which naturally erodes their profit margins. As of the last quarter they carried more than $4.8 billion in debt, and are currently relying on a strong cash position of almost $3.1 billion to service that debt. Cash and liquid assets have deteriorated from more than $7 billion in mid-2016 to its current level while debt has risen. You can infer that the company is sacrificing their bottom line for the time being by investing for the long-term in other areas like fiber optic upscaling, which should be a growth area not only in China but worldwide as existing wireless infrastructure is upgraded from legacy platforms to 5G and data centers are upgraded to hyperscale configurations to keep up. Whether or not that translates to a big area of earnings growth for GLW is another question.
Don’t ignore the fact that while the stock is down about 18% from its high in January of this year, the stock is still trading more than 50% above its historical, average Price/Book ratio. That implies the stock remains significantly overvalued, and the downward trend that began in February is likely to keep the bearish pressure turned up for the foreseeable future.
Amphenol Corp (APH)
Current Price: $88.70
Amphenol Corporation (Amphenol) is a designer, manufacturer and marketer of electrical, electronic and fiber optic connectors, interconnect systems, antennas, sensors and sensor- based products, and coaxial and specialty cable. The Company operates through two segments, which include Interconnect Products and Assemblies, and Cable Products and Solutions. Its Interconnect Product and Assemblies segment primarily is engaged in designing, manufacturing and marketing a range of connector and connector systems, value-add products, and other products, including antennas and sensors, used in a range of applications in various set of end markets. Its Cable Products and Solutions segment primarily engages in designing, manufacturing and marketing cables, value-added products and components for use primarily in the broadband communications and information technology markets. It designs, manufactures and assembles its products at facilities in the Americas, Europe, Asia, Australia and Africa. APH has a current market cap of about $26.7 billion.
APH generated nearly 30% of its 2017 sales in China, which means that they have even more exposure to the kind of risk I outlined earlier than GLW does. Like GLW, they have numerous operational centers in China, which puts them in good position to benefit from the expected buildout of broadband infrastructure in that part of the world, but still begs the question of whether that is a business segment that will remain shielded from trade tensions.
APH’s fundamental profile is stronger than GLW, with healthy operating margins to service the almost $2.5 billion of long-term debt they carry, along with good cash and liquid assets. In the last quarter, their available cash declined by about 58% from about $1.75 billion to a little over $1 billion, but since their debt also declined by about the same percentage, it can be attributed mostly to paying down outstanding debt issues.
The stock’s price performance has been far more impressive than GLW’s, having followed the market’s strong upward trend since 2009 from around $8 per share to its current levels. The stock is only about $6 per share below its all-time highs, reached in January of this year. Not surprisingly, the stock is trading at very high valuation multiples; it carries a current Price/Earnings ratio of almost 41 against a historical average of only 24.4, and a Price/Book ratio of 6.82 versus its historical average of 5.5. A move to par with its average would put the stock around $71 per share, or nearly 20% below its current price.
GLW and APH are stocks that both could see major benefits from their fiber optic and other operations throughout the world. The current geopolitical climate, however makes them a risky bet for the time being. They could be interesting long-term plays if trade tensions ease or their effect is proven to be more muted than most expect; the smart move for now, however is to wait the market out and see what develops down the road.