Corning Convertible Preferred Stock

Gabriel Gao

SUMMARY OF CORNING ORGANIZATION

Display Technologies

Environmental Technologies

Telecommunications

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)
Tech Bubble 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

15%
Telecommunications

22%

Specialty Materials

63%

Display Technologies

Market Crash 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
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SECURITY DESIGN Funding Requirements 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 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

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
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The Proposed Convertible Preferred Stock

Term Sheet
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

Conversion Value vs. Stock Price

160 140 120 100 80 60 40 20 0 0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5 5.25 5.5 5.75

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
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Valuation Value of Convertible Preferred Stock Dividends

Dividend Stream
Date Nov-02 Feb-03 May-03 Aug-03 Nov-03 Feb-04 May-04 Aug-04 Nov-04 Feb-05 May-05 Aug-05 Total Annual Rate Quarterly Rate Dividend 1.75 1.75 1.75 1.75 1.75 1.75 1.75 1.75 1.75 1.75 1.75 1.75 20.419 1.75% 0.43%

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A B

Convertible Piece Immediate Conversion

TV = 20.419 + 3.15 * 26.021 = 102.39 TV = 20.419 + 86.369 = 106.788

Mandatory Conversion After 3 years

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
Implied Volatilities
Type CALL CALL CALL Average Excer Date Current Date Stock Price Excer Price Aver Bid-Ask Risk-Free 1/22/05 7/29/02 3.150 5.00 1.275 1.75% 1/22/05 7/29/02 3.150 7.50 0.900 1.75% 1/22/05 7/29/02 3.150 10.00 0.600 1.75% Volatility 0.871 0.834 0.780 0.828

Convertible Value
Type Amount Excer Date Current Date Stock Price Excer Price Volatility Risk-Free Option Value Total Value 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 CALL 26.021 8/16/05 7/29/02 3.150 3.843 0.828 1.75% 1.563 40.674 Convertible Value 86.369 Dividend Value 20.419 Total Value 106.788 T d1 d2 N(d1) N(d2) 3.052 0.760 -0.687 0.776 0.246 3.052 0.623 -0.824 0.733 0.205

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Deal Closure Analysis Impact Profit

Securities are attractively priced for investors, at $100 Sweeter for investors, achieving Cornings 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

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 Cornings 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

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