Financial Derivatives & Risk Management: A Research Project

Cytec Industries' Convertible Preferred Stock (1995)


Gary Cao
April 1996

I. Executive Summary:

On December 17, 1993, American Cyanamid Company (ACY) span off its chemical 
operations unit Cytec Industries Inc. (CYT), but kept the preferred stocks 
of Cytec. In August 1995, Cytec signed an agreement with American Cyanamid 
(now a wholly owned subsidiary of American Home Products Corp.[AHP]) to 
provide for the early redemption of its "Series A Cumulative Adjustable 
Preferred Stock" and "Series B Cumulative Convertible Preferred Stock" by 
the end of 1995.  

The objective of Cytec's move was to increase its fully diluted earnings 
per common share by eliminating the dilutive impact of the Series B 
Preferred and by minimizing the number of common shares issued by Cytec to 
fund the repurchase.

This step was an important part of Cytec's strategic plan to increase its 
earnings per share (EPS) and increase its market value.  Cytec changed
its stock market image from a stagnant company to a growth company in
two years.

II.  Background:

Cytec Industries Inc. is a vertically integrated industrial chemical company
which focuses on value-added specialty products.  The company develops, 
manufactures and markets specialty chemicals, specialty materials and 
building block chemicals serving a broad group of end-users, including the 
water treatment, paper, mining, coating, plastics, aerospace, textile and 
automotive industries.  

Cytec operates over 30 manufacturing, research and development, and 
distribution facilities primarily in the United States, Canada, Mexico, 
the United Kingdom and the Netherlands.  It employs 4,000 people in 
the U.S. and 1,000 people in other countries. 

In addition, Cytec has a 50% interest in five unconsolidated associated 
companies.  In 1994, its sales revenue was $1,101.3 million, with a net 
income of $41.5 million.  Exhibits 1, 2 and 3 show the basic financial 
information.  

American Cyanamid derives about two-third of its sales from its Medical 
Group which includes pharmaceuticals, biologicals, and medical devices and 
supplies.  Its Agricultural Group produces herbicides, animal vaccines and 
feed supplements, and plant growth regulators.  Cyanamid also has a large 
R&D unit.  In 1992, it placed its chemical operations into an autonomous 
unit with a new name Cytec Industries.  It also merged its onocology 
business with cancer drug maker Immunex.  In 1993, it acquired Shell's 
international crop protection business.  That same year, it span off 70% 
of Cytec and distributed shares in Cytec to shareholders.

On December 17, 1993, Cytec issued to Cyanamid 8 million shares of preferred
stock, which included Series A Cumulative Adjustable Preferred Stock, 
Series B Cumulative Convertible Preferred Stock, and Series C Cumulative 
Preferred Stock.  Par value was $0.01 per share.  The preferred stock has 
an aggregate liquidation and redemption value of $200 million ($25 per 
share) plus accrue and unpaid dividends and ranks senior to the common
stock upon liquidation and in the payment of dividends.  Series A and B 
have a term of and are redeemable in 15 years.  Series C is perpetual.

Preferred Stock	  # of shares	Redemption Value	Annual Dividend	
Series A	3.821 mil	$ 95.522 mil		$  8.370 mil
Series B	4.175 mil	$104.378 mil		$  6.263 mil			
Series C	0.001 mil	$  0.100 mil		$  0.007 mil
Total		8.000 mil	$200.000 mil		$ 14.640 mil

Series B can be convertible to 5,553,537 shares of common stock at an 
initial conversion rate of $18.94 per share.

III. The Agreement:

Cytec believed that the dividend requirement of $14.64 million by the 
preferred stock owned by Cyanamid was one major source of cash drains 
that hurt the Cytec's common stock price.  Furthermore,  when the Series B 
converts to common stock, it would dilute the market and thus further 
depress the price.  Therefore, along with other management restructure 
and cost-cutting measures aiming to increase its efficiency and net 
earnings, Cytec decided to redeem as early as possible the series B 
cumulative convertible preferred stock held by American Cyanamid.  In 
March 1995, Cytec proposed an early redemption plan to Cyanamid.  In August 
1995, the two company signed the following agreement (revised in October): 

1. By the end of August, Cytec would redeem all of its Series A Cumulative 
Adjustable Preferred Stock for $94.3 million plus accrued dividends of 
$1.2 million.

2.  By the end of 1995, Cytec would redeem its Series B Cumulative Convertible 
Preferred Stock for (1) cash equal to the underlying value of 2.35 million 
shares of common stocks at $50.81 per share;  (2) 3.2 million shares of 
common stock valued at the public offering price less American Home's share 
of selling expenses; (3) $12 million representing the value of Series B 
over the value of the underlying common stock, plus  (4) accrued dividends.

On October 31, Cytec's public offering of 3.2 million shares was priced at 
$54.75 for sale by an underwriting group led by Goldman Sachs.  The gross
spread, or the difference between the price paid to the issuer and the 
price at which the shares are sold, was $2.17.

IV.  Analysis:

1. Benefits from Series B Cumulative Convertible Preferred Stock:

For Cytec, the major benefits were:  

(a)  In 1993, Cytec had a net loss of $286 million when it was separated 
from Cyanamid.  Its common stock price was around $17 per share.  It was 
very difficult to fund its operations by borrowing from the financial 
market (banks or bond investors).  By issuing the preferred stocks to its 
previous parent company, it received the capital for the future turnaround. 
    
(b) The preferred stock required dividend rates of 8.76% (Series A), 
6% (Series B), and 7.32% (Series C).  If it would issue bonds, the actual 
interest rate would have been more than 10%.  The relatively low level of 
interest rates reduced Cytec's burden.   

(c) Cytec wanted to be an independent company and would not issue common 
stock to Cyanamid.  Preferred stock was a feasible and acceptable 
alternative.

For Cyanamid, the major benefits were:  

(a)  As a part of Cyanamid's strategic reorganization in 1992 and 1993, 
the spinoff of Cytec was in the interests of its long-term growth.  
Cyanamid would not accept the minority ownership in the form of common 
stock, while preferred stock was a natural choice.    

(b) By holding the preferred stock, Cyanamid would avoid the down side of 
Cytec's operations, and receive the specified dividend requirements.  The 
conversion rate was $18.79 per share while the common stock price was 
about $17 per share at the time of spin-off.   

(c) By holding the preferred stock, Cyanamid would choose to convert the 
Series B into common stock if Cytec had a successful restructuring and 
Cytec's stock price increase in the future.  The series B convertible 
provided the flexibility that Cyanamid wanted.    

(d) The Series B convertible is similar to a call option.  If Cytec fails, it would have a downside cushion of the dividend payment as protection; if Cytec succeeds, it would receive the benefits of the stock's upside gain.

2. Risks associated with Series B Convertible Preferred Stock:

For Cytec, the risks were:  

(a)  If Cytec's restructuring was not successful and the net income stays 
at low level, the dividend requirements by the preferred stock would be a 
heavy burden and further hurt its chance to recover.   

(b) If Cyanamid lost its confidence in Cytec and chose to convert the 
Series B into common stock at the time when the market price was at a low 
level, the stock would be further diluted and the price would decrease more,
making the stock very unattractive to investors. 

(c) Issuing a convertible preferred stock is similar to writing a call 
option.  If the price of Cytec's common stock (the underlying asset) 
increased a very large percentage, Cytec as the writer (seller) of the call 
option would lose more, while Cyanamid as the holder (buyer) of the call 
option would gain more.

For Cyanamid, the risks was:  If Cytec did not increase its efficiency and 
the net income level, or to be worse, the company declared bankruptcy, 
Cyanamid would lose the investment.  However, this was an extreme scenario 
not likely to happen.

3. Pricing:

(1) Series B:

(a) Theoretical calculation:

The value of convertible preferred stock is the sum of pure preferred 
stock's value and the call option's value.  The value of a pure preferred 
stock can be calculated as the present value of the cash flows.

The stock price was $50.50 at the time of redemption.  The volatility level 
of its stock return was not available, but the current volatility 
(annualized) for the past six months is 22%, therefore I assume the 
historical volatility was 70% to 90%.  By using the Black-Schole Model 
of Option Pricing, and assuming the risk-free interest rate of 5.5%,  
I calculated the price of the Call Option: $34.12.  Adding the present 
values of the redemption value of Series B preferred stock and of the 
dividend payments if Cyanamid holds Series B for 15 years, the total value 
would be $277 million.

(b) Actual price: 

The cash payment for 2.35 million shares of series B was $119.4 million (at 
$50.81 per share); the proceeds from public offering (3.2 million shares of 
common stock) was $168.3 million (at $52.58 net per share); the excess value
above common stock stated in the agreement was $12 million, and the accrued 
interest was $0.9 million.  The total actual payment was $300 million.

(2) Series A:

(a)  Theoretical calculation:  

The value should be two parts: the present values of redemption value and 
of the dividend payment.  Assuming a discount rate of 8%, I calculated the 
total value is $101.36 million. 

(b)  Actual price:    

Cytec actually paid Cyanamid $94.3 million plus accrued interest of $1.2 
million, with the total of $95.5 million.  

(3) The package including both Series A and B:

The actual total package value of Series A and B was $396 million, while 
the calculated value according to the pricing model and assumptions was 
$378.5 million, a difference of $17 million.  I attribute this difference 
to the premium (excess) price that Cytec was willing to pay Cyanamid for 
the long-term positive effect on its net income and stock price.

V.  Conclusion:

From the above analysis, we may realize the flexibility of a financial 
derivative in the field of corporate finance.   Different risks and 
obligations are associated with common stock, bond and preferred stock, 
while financial instruments like Convertible Bond and Convertible Preferred 
Stock act as if they are some financial derivatives like call or put options.
Financial engineering can make various instruments with numerous patterns 
to fit the investor's needs in returns and risk tolerance level.