Corning Convertible Preferred Stock

Gabriel Gao
 SUMMARY OF CORNING ORGANIZATION

Display Environmental Specialty Life

Telecommunications
Technologies Technologies Materials Sciences

• Founded in 1851 as a manufacturer of

glass products 15%
• By the late 1990s, transformed into a Telecommunications
high-tech company 22% Specialty Materials
63% Display Technologies
• By 2000s, Corning has only three
segments (shaded in blue)

Tech Bubble Market Crash

• Soaring fiber optic sales in late 1990s • When high-tech firms crashed in
• Market price increased by factor of 12 2000/01, demand fell sharply, causing
between late 1998 and Fall 2000 Corning stock price to plummet
• Corning (and other telecom stock) • Financial distress and negative cash flow
continue to rise in 2000 even after the 2000 • In danger of violating D/E covenants for
dot.com and Nasdaq crash large outstanding loans; needed new equity
• Expansion using massive equity raising infusion to satisfy these covenants
Prepared for Finance 335 1
 SECURITY DESIGN

Funding Requirements Drawbacks of Equity Financing

• Corning needs new equity to make its 60% • Signaling:

D/A requirement
• Violating covenants will lead to bankruptcy
• Cash flow from operating activities were
deteriorating
- Strong cash flow through 2001
- Turned negative in first half in 2002
• Earning are also negative in 2002
• Still holds $1.3B in cash and equivalents
• Even though cutting costs such as overhead
significantly, sales are falling even quicker
- For a distressed high-tech firm, there
may be a lot of asymmetric information
possessed by management
- Issuing equity may strongly signal that
managers think share price still too high
• Severe dilution effect:
- Market is likely to react negatively to
share issue
• Time-consuming for issuing equity

Why Mandatory Convertible Preferred Stock?

• Speed: can issue this security quicker than equity

• Guarantee: offer “free candy” (discount) to investors in order to obtain the capital
• Disguise: Do not want to make the issuing at discount too obvious
• Why issue such a security now: Appeal to hedge funds because ONLY they have money
Prepared for Finance 335 3
 The Proposed Convertible Preferred Stock

Term Sheet Conversion Value vs. Stock Price

• Offer size: 500 Million US$ 160
• Par Value: US$100 140
• Dividend: 7% annual dividend 120
• Payment frequency: Quarterly, guaranteed by 100
$102 Million in Treasuries Bonds 80
• Conversion ratio: Variable, based on 22% 60
conversion premium 40
- Set to ensure $100 in shares on conversion date 20
for any share appreciation between 0 and 22% 0

0.5

1.5

2.5

3.5

4.5

5.5
0.25
0.75
1.25
1.75
2.25
2.75
3.25
3.75
4.25
4.75
5.25
5.75
0

- Get less than $100 in shares if negative
appreciation, and get more with more than 22%
appreciation
• Maturity: 3 years, mandatory conversion from
preferred stock into Corning common shares with
the conversion ratio determined by the closing
price at maturity
• Redemption feature: Nil
• Pre-conversion: Allow immediate conversion at
lowest conversion ratio; pay all dividends in arrear
Prepared for Finance 335
5
Market Reaction
• It is still an equity offering
• Investors might do dynamic hedge
• Effect from equity offering signal and
hedge fund shorting could combine to
have a significant negative price impact
on common stock price
4
 Valuation

Value of Convertible Preferred Stock

Dividends + Convertible Piece

Dividend Stream TV = 20.419 + 3.15 * 26.021 = 102.39
A Immediate Conversion
Date Dividend
B Mandatory Conversion After 3 years TV = 20.419 + 86.369 = 106.788
Nov-02 1.75
Feb-03 1.75
May-03 1.75 • A long position in 31.746 shares of Corning common share
Aug-03 1.75 - A short position in 31.746 call options with a strike price of $3.15
Nov-03 1.75
Feb-04 1.75 - A long position in 26.021 call options with a strike price of $3.843
May-04 1.75 -Use Black-Scholes formula to price the value of the options
Aug-04 1.75
Nov-04 1.75 Implied Volatilities
Feb-05 1.75 Type Excer Date Current Date Stock Price Excer Price Aver Bid-Ask Risk-Free Volatility
May-05 1.75 CALL 1/22/05 7/29/02 3.150 5.00 1.275 1.75% 0.871
Aug-05 1.75 CALL 1/22/05 7/29/02 3.150 7.50 0.900 1.75% 0.834
CALL 1/22/05 7/29/02 3.150 10.00 0.600 1.75% 0.780
Total 20.419 Average 0.828
Convertible Value
Annual Rate 1.75% Type Amount Excer Date Current Date Stock Price Excer Price Volatility Risk-Free Option Value Total Value T d1 d2 N(d1) N(d2)
Quarterly Rate 0.43% SHARES 31.746 - 7/29/02 3.150 - - - - 100.000 - - - - -
CALL -31.746 8/16/05 7/29/02 3.150 3.150 0.828 1.75% 1.711 -54.305 3.052 0.760 -0.687 0.776 0.246
CALL 26.021 8/16/05 7/29/02 3.150 3.843 0.828 1.75% 1.563 40.674 3.052 0.623 -0.824 0.733 0.205
Convertible Value 86.369
Dividend Value 20.419
Total Value 106.788

Prepared for Finance 335 5


Analysis
• Securities are attractively
priced for investors, at
$100
• “Sweeter” for investors,
achieving Corning’s goal
for raising capital
• Could convert
immediately and capture
the $2.39 premium
• Or could hedge
dynamically to capture the
$6.80 premium
• Hedge fund probably
would not want Corning
stock exposure
Deal Closure
Impact
• The negative market
reaction was very huge
• The prospectus was
released on July 29, after
the stock closed at $3.15
• The stock fell to $2.47
the next day and to $1.60
two days later when the
deal closed
• Under the new terms,
upon conversion Corning
would have to issue double
the number of shares it
had planned, total of an
20% extra dilution of
existing shareholders
Prepared for Finance 335
Profit
• Most shares bought by
hedge funds
• Many were immediately
converted
• High costs of dynamic
hedging is the reason why
they chose immediate
conversion
• Corning’s shares
rebounded over the next
several years, selling for
$7.18 a year later, and
$19.05 3 years later
• This offering is indeed
very cheap for investors
6