Real Options and Financial Structuring - Case Study 2

Corning: Convertible Preferred Stock

Hallgerður Helga Þorsteinsdóttir, Léo Lenel, Thibaud Vincent, Tristan Buchs
19th December 2016

1 Corning’s Business
Corning was originally founded in 1851 and then was mainly in the glass business. It was one of the first
companies to establish an industrial research department dedicated to research and development, having
researchers that were granted numerous awards and distinctions. The focus of the company has evolved
through the years, and, by late 1990s, it emphasized on three operating sectors: telecommunications,
advanced materials and information display. In the last years, Corning has bet on growing demand for
fiber optics, cable systems and other high-tech equipment which proved to be a good bet, but Corning
is now in trouble after the bursting of the tech bubble. This growth strategy has been done through
strategic acquisitions and continuous commitment to internal growth through research and development.
The company has negotiated a $2 billion dollar credit line but must maintain its debt to capitalization
ratio below 60%. In 2001 Corning has a $5 charge to earnings so the company is in danger of violating
its debt-to-assets covenant and in the first half of 2002 its cash flow has turned negative. Corning now
has important decisions to make about its continuing operations.

We can look at Corning’s performance from several aspects. From Exhibit 6 we can see that there
has been a growth in sales from 1991 to 2000 (≈ 2x) and that the operating profit also grew over the
same period (≈ 3x). Those sizes drastically go down in 2001 and 2002 due to the tech bubble bursting,
with operating profits becoming negative. Corning’s cash flow from operating activities is negative today
- which means that the company could have issues meeting its short-term debt. On the other hand, from
Exhibit 5, we notice that Corning’s liabilities increase during the period. Especially the long-term debt
(≈ x6), along with the current liabilities (≈ 3x) and those debts don’t go down in the next 2 years as do
the profits. To conclude, Corning’s performance from 1991 to 2000 has been good with a lot of investing
in its growth plan, it spent huge amounts on acquisitions in 2000 along with increases in its capital
expenditures. It changed for the worse in the years 2001-2002 where it had troubling accounts, Corning
might have overreached a little. This is depicted in Exhibit 2 where we can see how Corning has been
performing better than the telecom index until 2001, before its fall.

The changes in valuation for Corning stock in Exhibit 2 are mainly due to the growth in the tech
industry, which brought many opportunities for Corning and made its stock price skyrocket. The burst
of the tech bubble is mainly responsible for the fall of the market valuation of Corning. In 1996 the
Telecommunication Deregulation Act was passed. This had the effect that in 1997 and 1998, there was an
increase in telecom players on the market, many of them being start-ups. Many players in the industry
saw many possibilities of large future revenue growths and invested billions in new projects. This had a
dramatic increase in demand for Corning’s products, which brought significant revenue growth (explain-
ing the upwards swing from 1998 to end of 2000). Corning partially spent these revenues on strategic
acquisitions and capital expenditures in research and development to encourage future growth. In 2000
and 2001 capital markets retreated, therefore many of the newly created carriers cut their spending -
which made the incumbent telecom carriers follow the reduction in their spending. As there was fewer
demand for optical systems and components, Corning’s total returns dropped dramatically from 2001 on
as can be seen in Exhibit 2.

Forecasting the tech bubble bursting would have been difficult to do. There were some indications
that suspicious things were happening in the market since some companies were having extremely high
returns, which could not be sustainable in the long run. When things are too good to be true - it’s time
to look closer and figure out the reason behind it.

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Real Options and Financial Structuring - Case Study 2 Hallgerður, Léo, Thibaud, Tristan

2 Financing Strategy
In the past Corning has raised capital with a few approaches, namely offering bonds, common stocks,
commercial papers , debentures and convertible debt. In August 2000, it negotiated a deal involving
access to $2 billion credit line with the requirement to keep its debt-to-total-capitalization ratio at 60%
or less. We have an overview of the recent financing activities in Exhibit 1. From the Cash Flow
Statement in Exhibit 7, we analyze further how Corning has raised capital through the years. The
results are depicted in Figure 1, where we can see how much money they spent/saved each year on
financing themselves. We observe that the largest raise of capital was done by issuing equity and then
by issuing debt, with a huge increase during the years 1999-2001 (see Table 1). In Table 2, we see how
Corning’s financing strategy, with respect to debt-to-asset ratio, has evolved over the last 10 years. The
debt ratio increased until 1996. It started to decrease to reach a minimum of 0.393 in end of year 2000.
This minimum reflects an issue of 250 9000 000 common stocks, which dramatically raised the equity. In
2001 and 2002, Corning carefully lowered its equity and raised more debt, keeping its debt-to-asset ratio
below the set goal of 60%.

Figure 1: Cash Flow of Financing Activities

Table 1: Capital raising in the past

Net issuance of stock Net Long-Term Debt Other Financing

Total: 4913 3252 138

Table 2: Financing strategy of Corning

De91 De92 De93 De94 De95 De96 De97 De98 De99 De00 De01 Ju02
Total D: 1805 2456 3521 3735 3860 3339 3427 3458 4050 6884 7372 6804
Total E: 2047 1831 1712 2288 2127 983 1266 1524 2476 10642 5421 5082
D/A: 0,469 0,573 0,673 0,620 0,645 0,773 0,730 0,694 0,621 0,393 0,576 0,572

3 Raising Capital
Through the last 2 years Corning has severely cut down it size to deal with the after-match of the tech
bubble bursting. It has closed 7 major plants and removed 120 000 jobs. To get through those crisis the
company has set 3 goals for the next years:

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• To preserve the financial health of the company

• Return to profitability in 2003

• Continue to invest in the future

In order to achieve those goals, the firm needs more restructuring and has to lower its costs. If all this
goes according to plan, the company should be well set to compete with other firms when the telecommu-
nication market will recover from the downturn. The only way to make this possible is through raising
more capital.

Today, Corning has a Credit rating of BBB (S&P) and Baa1 (Moody’s) which is described as a lower-
medium credit rating. The financial leverage ratio is high at 1.34 or, more precisely, the Debt-to-Capital
ratio is 0.57, which is only 3% below Corning’s limit of 0.6 to keeps the $2 billion credit line open. From
these statistics, we can see that Corning is already in trouble and has some debt-overhanging problems.
That is, its debt burden is so large that Corning can not take on additional debt to finance projects, not
even those that, in the long-run, would permit to reduce its indebtedness.

Issuing new equity when Corning already has a debt overhang problem requires careful handling. The
new equity holders would be investing in a company that is in trouble. The old equity and debt holders
own little of the company and adding more money would benefit the debt holders more than the equity
holders. That is, most of the proceeds from issuing new equity would go directly to the debt holders who
have a senior stake in the company which isn’t the case of the equity holders. As a compensation, the
new equity holders would demand a high discount on the price of the equity to substitute for the "bad"
position they’re taking in the company.
Another negative part of issuing equity is that it is a time consuming process and Corning needs
more funding as soon as possible.
In all, issuing new equity is an undesirable option. Investors buy it highly discounted because of
reasons stated above and since they’re suspicious of Corning’s stock price still being too high, even after
last two years downward fall. This new, cheap equity would dilute the old shareholders stocks and that
does not benefit today’s owners of Corning’s common stocks and therefore is an undesirable option.

4 Security
There are several reasons why J.P. Morgan is proposing this particular security. First of all, by issuing
preferred stock rather than common stock, it should be easier to attract investors to buy a share in a
company that is in a large down swing. The preferred stock owners have a higher claim on the assets &
earnings of a company than regular common stock owners. The others options of issuing either equity or
debt are not easily feasible, as aforementioned. Issuing a security like this one is a quick process, much
less time consuming than issuing equity. This is underlined by the fact that Corning is in desperate need
of getting funding in the near future.
This security has an extra incentive for investors willing to buy, namely the riskless opportunity to
make profit by immediately exercising the optional conversion feature of the security by converting it
immediately. It will be explained in more details in question 5. It follows from the optional conversion
feature that can be exercised immediately - resulting in riskless profit. It is hidden in the structuring of
the proposed terms so that not everybody would realize it, but for sure hedge funds looking at the deal
would spot it and gain interest in the transaction. Hedge funds are thus the most likely buyers of this
security.
This security has another interesting feature in its green-shoe option of 750,000 shares. If the sales of
the mandatory convertible preferred security goes better than expected, the underwriters (J.P. Morgan)
can issue more shares, which is profitable business.
The limitation clause on how Corning can use its proceeds from the issuing can be seen as a sort of
an insurance policy for the investors. By including that Corning should use $102.1 million to purchase
U.S.Treasury securities and pledging them as collateral for dividend payments, they make the deal more
secure and appealing. The proceeds are also to be used to retire long-term debt securities, which would
lower the debt-to-asset ratio, and lower interest payments. The fact that the stock has a mandatory
convertible preferred structure ensures that, at maturity date, the stock holders get equity, also leading
to lower debt-to-asset ratio.
High volatility increases the value of the convertible security, allowing Corning to obtain a higher
price on this security than if it had an historically lower volatility.

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Real Options and Financial Structuring - Case Study 2 Hallgerður, Léo, Thibaud, Tristan

5 Payoff
The payoff of the proposed portfolio is illustrated in Figure 2 and can be represented by:

 S ∗ 31.746 if S ≤ 3.15
100 if 3.15 ≤ S ≤ 3.843
S ∗ 26.021 if 3.843 ≤ S


The security has three distinct parts that add value. The value of the portfolio in Figure 2, the $7
dividends payments each year and the optional conversion option before maturity date. To be able to
price those 3 parts we need to calculate a few sizes.

Figure 2: Payoff of the Portfolio

We have a 1 year risk-free rate of 1.75% corresponding to the yield of the U.S. Treasuries that Corning
buys to insure the dividends payments. We calculate the 3 month risk free interest rate with:

(1 + i1Y ) = (1 + i3M )4 ⇒ i3M = (1 + i1Y )1/4 − 1 = 0.004347

We assume the first dividend payment will happen in ≈ 3months, on November 16th 2002 and that
each payment will be of $1.75. Discounting all the dividends with our 3-month risk-free rate, we end
up with a present value of ≈ $20.42. This amount non-surprisingly equates the $102.1 million treasury
bond insurance divided by number of shares (50 0000 000) published in this offering.
We notice that if we use the optional convention clause immediately, there is an arbitrage opportunity.
If we buy the security at $100 and convert, we have a profit of:

26.021 ∗ $3.15 + $20.42 − $100 = $2.386

Therefore yes, we would definitely buy Corning convertible preferred shares at par. With the plan of
converting it immediately. Assuming many people in the market have the same idea Corning will suffer
losses (their stock price will go down). Therefore it might be smart to buy short-term puts along with
the convertible security to maximize the gains. In Exhibit 11, there is a put option with Maturity date
17-Aug-02, a strike price of 7.5 and an ask price equal to 4.5. Looking at historical data for Corning’s
stock price on that year, we found that the price on that date had gone down to $1.6. An investor could
therefore have made a profit of 7.5 − 1.6 − 4.5 = $1.4 for each put bought
We see that our payoff diagram of the portfolio in Figure 2 can be replicated with:
• Short position in 31.746 calls, with strike price K = $3.15
• Long position in 26.021 calls, with strike price K = $3.843

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Real Options and Financial Structuring - Case Study 2 Hallgerður, Léo, Thibaud, Tristan

• Long position in 31.746 shares of Corning’s common stock

To value these options, we use the Black-Scholes formula. The historical volatility of Corning is given
at 60%, but that volatility is not good when using the Black Scholes method to price the options. Some
research have shown that the volatility smile BS delivers when using a constant volatility does not
produce realistic results. Instead, we decide to use the implied volatility from BS of the options with
similar time horizons as the security. The best we can do are the call options that mature at 22-Jan-05,
and extract their volatility. Results are depicted in Table 3. The average volatility is ≈ 0.828 and that
is used when pricing the portfolio.

Table 3: Volatility of corresponding Call options

Calls Exercise price Best Bid Best Offer Average bid/offer Risk free rate Volatility
22.jan.05 5 1,2 1,35 1,275 0,0175 0,8712
22.jan.05 7,5 0,85 0,95 0,9 0,0175 0,8343
22.jan.05 10 0,6 0,6 0,6 0,0175 0,7796
Average: 0,8284

Using the BS formula again we now calculate the values of our calls. The values are (pricing the
options from today the 29th of July 2002 until maturity):

C BS (3.15, 3.15, 0.0175, 1114/365, 0.828) = 1.7110

C BS (3.15, 3.843, 0.0175, 1114/365, 0.828) = 1.5635

At last, we can calculate the total value of the convertible security:

Table 4: Valuation of the Convertible security

Long 31.746 Shares: 100

Short 31.746 Call (K = 3.15): -54,3174
Long 26.021 Call (K = 3.843): 40,6838
Convertible value: 86,3664
Dividend Value: 20,41853322
Total Security Value: 106,7849332

6 Risks of the offering

The offering deal had multiple risks for Corning. Ultimately, the capital raised will be seen as equity but is
in fact a form of debt. This permit Corning to bring in new investors. By issuing the convertible preferred
stocks, Corning has to guarantee the paying of the dividends. It needs huge amount of collateral which
cannot be invested in more profitable projects in a period of struggle for the company that experienced
a drop of over 10% in 2001 alone. Its fragile financial situation might be put to test if it has too much
outstanding debt that cannot by met.
Moreover, an important aspect not to neglect is the public opinion of the company. By issuing
convertible preferred stocks while in a precarious position, Corning exposes itself as a desperate company,
which might push some investors to show less interest in investing in Corning. Adding the low rating on
its debt, Corning’s image will be heavily impacted.
In addition, there is a clause saying that the deal would be completed two days after the primary
prospectus was filed. This opens the door to speculator that are going to heavily short the stock, as a
lower stock price in those two days will be beneficial for the non-Corning players.
Finally, by issuing convertible preferred stock, Corning’s upper management is sending a signal that
its stock price might be too high. All these reasons will most likely bring the share price down and dilute
the current shareholders.

7 Recommendation
We have seen in the previous sections that there aren’t many possibilities for Corning’s CFO to raise
capital. He needs to be profitable again in 2003 and has to increase the sales to good levels by then.
By issuing equity, it would be extremely complicated to raise a decent amount of capital seeing the

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Real Options and Financial Structuring - Case Study 2 Hallgerður, Léo, Thibaud, Tristan

current value of Corning’s share. Moreover, by raising debt, it’s target of 60% debt-to-asset ratio would
go through the roof, killing its credit line with the banks in the process. Not doing anything wouldn’t
improve Corning’s situation as no new projects could be undertaken without capital to fund them.
All in all, issuing convertible preferred stocks is the alternative. It’s risky, but it gives the investors
multiple incentives to invest. The CFO should go with it and hope for the best. And if we try to look
what actually happened, we see that that summer, hedge funds would bet against Corning, nearly sinking
its efforts to raise the cash it needed to stay afloat. Houghton would have to gut Corning’s world-leading
optical-fiber business and entirely exit the photonics business, which had been its brightest hope during
the telecom boom. Ultimately he would have to slash the payroll in half, by some 200 000, to save $2
billion. Corning is still around meaning that all the bets paid off and managed to save the company.
We can ask ourselves if they could have done things differently, such as by removing the optional
converting feature from the terms to get rid of the arbitrage. The problem is that there would have been
no guarantees that investors would have bought the securities without this huge incentive to do so. It
worked out well in the end, Corning survived therefore the terms it used were for the best.

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