Corning Convertible Preferred Stock

Gabriel Gao

SUMMARY OF CORNING ORGANIZATION

Telecommunications Display

Technologies

Environmental

Technologies

Specialty

Materials

Life

Sciences

• Founded in 1851 as a manufacturer of

glass products

• By the late 1990s, transformed into a

high-tech company

• By 2000s, Corning has only three

segments (shaded in blue)

• Soaring fiber optic sales in late 1990s

• Market price increased by factor of 12

between late 1998 and Fall 2000

• Corning (and other telecom stock)

continue to rise in 2000 even after the 2000

dot.com and Nasdaq crash

• Expansion using massive equity raising

Tech Bubble

• When high-tech firms crashed in

2000/01, demand fell sharply, causing

Corning stock price to plummet

• Financial distress and negative cash flow

• In danger of violating D/E covenants for

large outstanding loans; needed new equity

infusion to satisfy these covenants

Market Crash

63% 22%

15%

Telecommunications

Specialty Materials

Display Technologies

Prepared for Finance 335 1

Prepared for Finance 335 3

SECURITY DESIGN

• Corning needs new equity to make its 60%

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

Funding Requirements Drawbacks of Equity Financing

• Signaling:

- 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

• 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

Why Mandatory Convertible Preferred Stock?

Prepared for Finance 335 4

The Proposed Convertible Preferred Stock

0

20

40

60

80

100

120

140

160

0

0.2

5

0.5

0.7

5

1

1.2

5

1.5

1.7

5

2

2.2

5

2.5

2.7

5

3

3.2

5

3.5

3.7

5

4

4.2

5

4.5

4.7

5

5

5.2

5

5.5

5.7

5

• Offer size: 500 Million US$

• Par Value: US$100

• Dividend: 7% annual dividend

• Payment frequency: Quarterly, guaranteed by

$102 Million in Treasuries Bonds

• Conversion ratio: Variable, based on 22%

conversion premium

- Set to ensure $100 in shares on conversion date

for any share appreciation between 0 and 22%

- 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

Term Sheet Conversion Value vs. Stock Price

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

Prepared for Finance 335 5

Valuation

Dividend Stream

Date Dividend

Nov-02 1.75

Feb-03 1.75

May-03 1.75

Aug-03 1.75

Nov-03 1.75

Feb-04 1.75

May-04 1.75

Aug-04 1.75

Nov-04 1.75

Feb-05 1.75

May-05 1.75

Aug-05 1.75

Total 20.419

Annual Rate 1.75%

Quarterly Rate 0.43%

Value of Convertible Preferred Stock

Dividends Convertible Piece

Immediate Conversion

Mandatory Conversion After 3 years

TV = 20.419 + 3.15 * 26.021 = 102.39

+

• A long position in 31.746 shares of Corning common share

- A short position in 31.746 call options with a strike price of $3.15

- A long position in 26.021 call options with a strike price of $3.843

-Use Black-Scholes formula to price the value of the options

A

B

Implied VolatilitiesType Excer Date Current Date Stock Price Excer Price Aver Bid-Ask Risk-Free Volatility

CALL 1/22/05 7/29/02 3.150 5.00 1.275 1.75% 0.871

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

Average 0.828

Convertible ValueType Amount Excer Date Current Date Stock Price Excer Price Volatility Risk-Free Option Value Total Value T d1 d2 N(d1) N(d2)

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

TV = 20.419 + 86.369 = 106.788

Prepared for Finance 335 6

• 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

• 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

• 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

Analysis Impact Profit