Strengths and Weaknesses of the firm
Strengths:
- They own 50% of the optical fiber market, twice that of its nearest competitor
- They own 60% of the world’s market share of LCD
- Access to man power, technology and capital, which represent barrier to entry
- Corning is well diversified in several market segments
- Shock price went from a low of $10.40 to a high of $113.30 in six years
- Current Debt-to-Equity ratio is low at 26.2%
Weaknesses:
- 70% of their revenues come from one particular segment: telecommunication, where their customer base is restricted to few key players in the industry. Any adverse relation with anyone of these players, may affect the performance of Corning significantly
- Beta has increased from 0.87 to 1.53 in six years
- Stock price is overvalued “past month has been 94 times estimated 2000 earnings and 75 times estimated 2001 earnings, compared with an average of around 30 times for the S & P 500.
- Low credit rating, bonds have to be sold at a discount
Major Issues
The market for the products manufactured by Corning depends largely on the telecom service providers and their customer base seems to be highly concentrated. If Corning looses a major customer in this segment its sales will be affected badly. Moreover the telecom division is heavily dependent on the capital spending and the ability of the service providers to raise and invest capital in the infrastructure development. Any downturn in the industry will severely affect the performance of Corning.
Although Corning considered otherwise but many industry experts felt that an excess in fiber capacity was emerging in the optical fiber industry. In spite of such warnings Corning is investing heavily in developing additional capacity. If the actual downturn occurs before the gestation period of Corning’s investments the company will loose large amounts of money. Moreover, an overcapacity in the industry will lead Corning to face pricing pressure further reducing its margins.
The telecom division of Corning grew during the last couple of years on the basis of expansion by the major US carriers like MCI, Sprint, AT&T, and their customer base was largely restricted to these few key players. Now the major investment in this sector in the US was likely to slow down which would result an overcapacity of Corning in its manufacturing units. In order to overcome this Corning has to shift its focus to overseas markets. Although the overseas markets were expected to be strong, the overseas service providers were much smaller compared to their US counterparts and were considered riskier.
Finally, the market for Corning’s products was characterized by rapidly changing technologies, evolving industry standards and frequent new product introductions. Corning’s success was heavily dependent on the timely and successful introduction of new products, upgrades of current products to comply with emerging industry standards and ability to address competing technologies and products. If this is not achieved it could have a negative impact on the company’s performance.
In addition to selling debentures, Corning is going to be issuing 30 million shares, which means Corning is chasing after the same investment dollar. This is primarily done by Corning to reduce the cost of capital by providing an increased upside to debt holders.
In the past year, the volatility of Corning stock has increased which makes the call option more valuable. But Corning appears to be issuing converts at a time when both its share price and stock market valuations are at historic highs.
Valuing the Straight Bond
Looking at Exhibit 6, we see that Corning’s bonds have been rated differently by two agencies. We consider a comparable bond of the same rating and having similar maturity period from Exhibit 8 and get two comparable bonds as follows:
Walt Disney Co.: A & 2015 = YTM 7.90
American Stores: A- & 2017 = YTM 7.99
Considering the average of these to we get (7.90 +7.99)/2 = 7.945%
Considering the above YTM on a semi-annual basis the price of the equivalent straight bond becomes 1000/ (1.03972530) = $310.775. Hence, the price of the embedded option charged by Corning Inc. is $741.923 – $310.775 = $431.148.
While valuing the conversion option we consider the same as a call option and using DerivaGem software, we derive the value of the call option as follows:
(Values from Exhibit 5, 10, 12)
So = $71.25*$8.33 = $593.51
X = $1000
r1 year = 6.14%
σ1 year = 79.67%
Considering the 1 year rates of risk free and stock volatility, the value of the conversion becomes $674.43
The value of the redemption by the company at 75% volatility is $284.98 and that of the redemption option by holder is $166.25 at 75% volatility.
Hence value of the debenture = $310.775 + $674.43 - $284.98 + $166.25 = $866.475
Apparently, the option seems to be offered at a discount.
Under what condition will the company call the debenture?
The company would call the debenture after November 8, 2005, only when the call price (pre-fixed at accrued original issue discount) is lower than the conversion price. Hence, if the option is in the money on or beyond November 8, 2005, the company will call the debenture thereby preventing dilution and will also have access to capital at pre-tax cost of only 2% compared to comparable bonds which have an YTM of 7.945%. If the option is out of the money beyond November 8, 2005, the company will not call the debenture.
Hence, we conclude that the conversion will never be in the money beyond November 8, 2005, and if the option tends to be in the money the company will call the debenture (exercise the Put Option). However, within the time period November 8, 2000 until November 8, 2005, the company cannot call the debenture and the conversion option can be in the money.
While valuing the conversion option, we consider it as equivalent to an American Call option with the following:
Strike Price: X = 741.923* (1.01)10 = $819.546
So = 741.923
r1 year = 6.14%
σ1 year = 79.67%
Considering the risk free rate and stock volatility for one year, the actual value of the conversion becomes $492.28.
Hence the actual value of the debenture = $310.775 + $492.28 - $284.98 + $166.25 = $684.325
Under what condition will the investor redeem the debenture on November 8, 2005 & November 8, 2010
If the option is out of the money then the holder will have an option to redeem the debentures at pre-determined rates, which we presume is higher than 2%, in order to encourage the investor to redeem the debenture. This would prevent the dilution.
Invest or Not?
Our analysis reveals that the debenture is overvalued by $57.598. However, investing in the debenture can only be profitable if the conversion option (American Call) is substantially in the money within November 2005, to such an extent that the cost of the forgone opportunity is realized.
Let us consider the $741.923 is invested in a straight bond with YTM of 7.945%
PV of Straight Zero-Coupon Bond = $741.923
YTM: 7.945% (From above)
Term: 5 years compounded semi-annually
Thus, the future value of the bond is 741.923(1.4763) = $1095.326
At the end of 5 years, the share value required for the option to generate equivalent bond return = $1095.326/8.3304 = $131.485
However, the risk of a convertible debenture is more than that of a straight bond, hence, if we consider risk adjusted returns, the share price at the end of 5 years should be more than $ 131.485. Therefore, every year the stock price has to grow at least 13.04% continuously for the next 5 years in order to provide a yield equivalent to the straight bond value.
Do we believe that the stock price of Corning will significantly exceed $131.485 by November 8, 2005?
To determine this we re-look at the issues stated above:
- Corning believes that there is a huge potential for growth in the telecom sector but we feel that the sector has already reached its peak at least for the next 5 years. Hence, a growth from this sector is not possible. Rather we feel that Corning’s revenues are likely to be reduced significantly in this sector which would adversely affect the total revenues and profits of Corning Incorporated.
- The volatility of Corning’s stock has increased in the past year, which makes the call option more valuable. But Corning appears to be issuing converts at a time when both its share price and stock market valuations are at historic highs.
Recommendation:
In the view of all our above analysis, we recommend Coopers not to invest in the Zero Coupon Convertible Debentures offered by Corning Inc..
