Tracking Stock

Discussion

Tracking stock, also known as alphabet, targeted, shadow, designer, or letter stock, is a separate class of common stock that tracks the performance of an individual business of a company. Often these are high growth, low profit units whose intrinsic value may not be accurately reflected in the market price of a conglomerate parent company. By creating a "pure play" security, companies believe they can unlock this value and take advantage of the tracker's higher market multiple for raising funds.

As in other repackaging schemes, tracking stock results in a more focused business unit with greater financial disclosure. However, in a spinoff or carve out, a new corporate entity is formed through the distribution of a subsidiary's stock, which begins to trade publicly. Shareholders of that entity have conventional shareholder rights: they have a claim on the entity's assets and are entitled to vote on matters pertaining to the entity, including electing its board.

In contrast, a tracked business has no separate legal identity. It remains under the control of the parent company, allowing it to retain operating synergies, credit quality benefits, and economies of scale. Tracking shares are created through a charter amendment, subject to shareholder approval, providing for different classes of common stock of the parent company, each reflecting designated business lines. Hence, tracking stock does not represent legal ownership of the tracked unit's assets, but rather an equity interest in the parent company. Although the company must publish separate financial data for the tracked and parent businesses, a single board oversees both entities. (See "Repackaging Corporate Assets"). Once established, tracking securities are typically issued as a share dividend to existing shareholders, in an initial public offering (IPO) to new investors, or as "currency" to pay for an acquisition.

Early trackers

General Motors Corp. (GM) pioneered the first U.S. tracking stock in 1984 to pay for its acquisition of Electronic Data Systems Co. (EDS) from Ross Perot, who insisted on receiving consideration in a stock that would track the success of his former business. EDS, which has since been spun off, was followed by a second letter stock in 1985 for GM's purchase of Hughes Aircraft Co. (now Hughes Electronics Co.).

No other tracking stocks were adopted again until the early 1990s, when USX Corp. mimicked the structure to fend off demands by investor Carl Icahn to separate its steel and energy operations. Since then, the pace of tracking stock proposals has accelerated with four in each of 1993 and 1994, five in 1995, and six in 1996.[1] By the end of the decade, the lofty valuations of Internet and "new economy" stocks spawned a deluge of trackers. According to Spin-Off Advisors L.L.C., a total of 33 tracking stocks were issued between 1984 and 2000, with 15 created between 1998 and 2000 alone.[2]

Overseas interest has grown as well. Although trackers were first tested briefly in Belgium and the Netherlands some 40 years ago, they have only recently made a comeback. New Zealand's Fletcher Challenge Ltd. and Canada's Inco Ltd. experimented with tracking stocks in the mid-1990s, though both have since detracked. In July 2000, French broadband networker Alcatel SA launched the first European tracking stock to mirror the performance of its optical components division. And several Japanese companies have their own tracker plans in the works.

Tracking Stock Pros and Cons: Advantages to Companies

Tracking stocks are appealing to their corporate sponsors for one cardinal reason: control. Diversified firms want to get credit in the market for fast growing divisions without having to relinquish their ownership, particularly if the parent is in a more mature industry. Some of the benefits to issuers include:

Economies of scale: By remaining a part of an established, existing company, a tracked division can retain the economies of scale of a large conglomerate. Administrative duties such as payroll and purchasing remain under the umbrella of the parent company. Name or brand recognition may continue without interruption.

Preserve credit quality and financial resources: Establishing financial resources and a credit rating can be a time-consuming and expensive process for a spinoff or new issue. Having an established parent with solid cash flows to pay creditors while a new business becomes profitable can bestow a significant competitive advantage over highly leveraged competitors.

Financing currency: A company with tracking stock has "bifurcated access" to capital markets: it can borrow as a single entity but enter the equity market as separate ones, thereby taking advantage of the tracked business's higher market multiple. According to underwriter Lehman Brothers Inc., this can be particularly beneficial for companies in the technology, pharmaceutical, life sciences, and media and communications sectors that have sizable capital requirements and a huge growth trajectory. AT&T Corp., for example, raised an impressive $10.6 billion through its issuance of AT&T Wireless Group in 1999, making it the biggest domestic IPO in history.

Acquisition currency: Tracking stock can serve as an effective acquisition currency. This is particularly true when target firm shareholders do not want to own stock in a large, diversified buyer or prefer a security closely aligned to the performance of their old business. A high tracker stock price can also facilitate big-ticket purchases. Liberty Media Group, for example, forged over $6 billion in deals during 1999.[3] About a dozen tracking stocks have been created through acquisitions.

Segmenting dividends: Tracking stock gives a company the ability to vary its dividend policy by business line, so investors may choose between income-producing and growth-oriented stocks. Fletcher Challenge Ltd., for example, assigned dividend payouts of 35 percent, 60 percent, and ten percent, respectively, to its pulp and paper, building activities, and energy divisions.

Retained interest: Companies issuing tracking stock through an IPO typically retain a significant interest (at least 80 percent) in the tracked business. Retained interests are useful in that they give parent companies the choice of issuing additional tracking shares either from authorized share capital (authorized but unissued shares) or from the shares retained by the parent company. The retained interest also entitles the parent company to a pro rata portion of any dividends paid by the tracked unit. Retained interest shares have no voting rights until they are sold publicly.

Tax benefits: The move to a tracking stock structure creates both a one-time tax benefit as well as ongoing tax breaks. First, tracking stock can be established without causing a taxable event to either the company or shareholders. This is because it represents shares in the parent firm rather than shares in an actual or constructive subsidiary. Other repackaging schemes, such as selling the assets of a specific division, can cause the parent to realize a taxable gain if it shows a profit in the sale. A tracking stock IPO, on the other hand, is not taxable to the company so long as the parent's retained interest is 80 percent or more. And unlike a spinoff, shareholders are generally not taxed when tracking stock is distributed to them as a stock dividend (though the IRS will not give advanced rulings on the tax treatment of tracking stock issuances). Spinoffs must meet certain conditions- such as the business being five years old-in order to qualify as a tax-free distribution under Section 355 of the Internal Revenue Code.

Second, by filing on a consolidated basis, the parent can reduce corporate income taxes. The parent can use its own net operating losses (NOLs) to offset earnings from the tracked unit or, alternatively, losses from the tracked business can be applied against the parent's profits. According to McKinsey & Co., over half of the companies issuing tracking stock have taken advantage of NOLs.[4]

Employee incentives: For conglomerates, tracking stock may serve as a more effective motivational and retention tool than conventional shares since the efforts of any individual manager may have little impact on the parent company's stock price. Awards denominated in tracking stock can link managers' performance directly to their specific business units.

Issues Facing Tracking Stockholders

Tracking stock, by its very nature, can intensify "sibling" rivalries within a conglomerate by virtue of creating an additional class of stock with its own financial interests and its own set of shareholders. And because they are hybrid securities, tracking shares do not accord their holders with the traditional rights associated with share ownership. The following are some of the risks investors should consider:

Board conflicts arising from disparate interests: With rare exceptions (such as Liberty Media), the tracked unit is not governed by a separate, independent board but by the board of the parent company. While this can provide flexibility and unified decision making, the directors are effectively serving two masters. The existence of multiple series of common stock may give rise to occasions in which the interests of one group of shareholders diverges from the other's.

Directors' own shareholdings in the various classes of stock can also create biases in how they choose to allocate resources, debt, taxes, and dividends among the divisions.[5] To avoid clashes, some boards, such as Sprint Corp.'s, have created a special committee to oversee the tracked unit's operations and establish arm's-length agreements with the parent over intercompany transfer pricing, resource policies, and capital expenditures.

Discordant interests have in some instances led to shareholder lawsuits. In 1996, GM pulled $500 million from EDS before it was spun-off as a separate company, prompting EDS's Class E shareholders to sue the board for unilaterally favoring GM. The Hughes Class H shareholders raised a similar charge when GM restructured Hughes in late 1997. In both cases, the Delaware Chancery Court ruled against the shareholders, arguing that the board had no special responsibilities to the holders of the tracking stocks, but was governed by the "business judgment rule."

Genzyme Corp. likewise came under harsh scrutiny in late 2000 when it borrowed $200 million to acquire Biomatrix, Inc., to combine with its surgical products and tissue repair divisions. Critics charged that the Genzyme General shareholders were footing the bill for a purchase that would primarily benefit the two tracking units.

Voting limitations: Tracking stock results in a dual-class capital structure that may embody uneven voting rights. While some tracking issuances have been nonvoting or subvoting, most carry formulaic voting rights based on the tracked business's share price or market capitalization relative to that of the parent company. For tracking shareholders, this may be a boon or bane depending on the performance of the stock. Generally, the tracking stock and parent stock vote together as a single class, though class voting may be permitted on matters that affect the tracked business.

Takeover deterrent: Tracking stock can serve as a formidable takeover defense. With such a structure, it is not enough for an unsolicited buyer to acquire 51 percent of any of the separate businesses; it would have to gain voting control over the entire corporate entity or control of the board. And even in a friendly deal, selling the tracked business alone would be taxable to the parent company. It would only be tax-free if the acquirer purchased all of the shares of the parent company. Because of these obstacles, tracking share prices do not reflect the takeover premiums enjoyed by independent companies.

Asset ownership and liability: Because the separate divisions are in legal terms the same company, problems of the parent will affect the tracker and vice versa. Tracking shareholders thus face all the risks of an investment in the parent company as well as in the tracked business. And in case of liquidation or bankruptcy, all assets could be used to satisfy debtors' claims.

This "Siamese twin" syndrome has prompted several companies to actually "detrack." In December 1999, Pittston Co. opted to fold its trio of trackers into a single corporate issue due to investor concerns that the pension and health care liabilities of the coal business would drag down the prices of the air cargo and armored truck units. Media firm Ziff-Davis Inc. similarly nixed its tracking stock structure after only one year when its ZDNet shares failed to take off. Although not cited as a handicap to ZDNet's performance, the parent company had used 85 percent of ZDNet's $200 million IPO to pay down its own sizable debt which, along with Ziff-Davis's losses, may have rattled investors.

Potential for investor confusion: Although transparency is touted as a benefit of tracking stock, greater analyst coverage and more accurate market valuations have not been true across the board. Some analysts have in fact dropped stocks they covered, not wanting to follow both the parent and the tracker. In addition, the sheer complexity of a tracking stock structure can lead to investor and analyst confusion, which is often blamed for tracking stocks not performing as well as expected. According to a study by two University of Iowa professors, analysts were no better at accurately projecting earnings for companies after they issued tracking stock than before.[6]

Liquidation and disposition rights: In a liquidation, the tracking shares are entitled to their pro rata share of the parent's assets, but have no special rights to the assets of the tracked business. Liquidation rights are generally based on the relative market capitalization of each business unit.

If the tracked business is sold or dissolved, the board will generally either pay a dividend or repurchase the tracking stock in an amount equal to the sale proceeds (USX's 1997 sale of Delhi Group to Koch Industries Inc.) or will convert the tracking shares into parent shares based on their relative market values (Ralston Purina Co.'s 1995 sale of Continental Baking to Interstate Bakeries Corp.). In this sense, holders of tracking stock have greater protection than owners of a fully spun-off subsidiary.

Unequal treatment in mergers: No longer just a theoretical risk, several deals have demonstrated that tracking shareholders may not receive equal treatment in mergers-or any consideration for that matter.

Both DLJdirect and Circle.com were orphaned when Donaldson, Lufkin & Jenrette Inc. (DLJ) and Snyder Communications, Inc., were acquired in 2000 through the purchase of only the parent shares, leaving the tracking stock outstanding as share capital of the merged company. Thus, the tracking shareholders were excluded from the premium-priced offers received by the parent company shareholders. DLJdirect shareholders, lacking any voting or appraisal rights, filed suit against DLJ. Snyder's buyer, Havas Advertising SA, agreed in early 2001 to acquire the Circle.com shares at a premium after deciding not to operate the Internet unit as a separate division.

Performance: 2 + 2 = 5?

Although the intent of tracking stock is to unlock value- i.e., the sum of the parts is worth more than the whole- the performance of most tracking stocks has, in fact, been less than sterling.

Initial share price reactions to the announcement of tracking stock have been positive for parent companies, in the same vein as announcements of spinoffs and carve-outs. For 35 parent companies, John Elder and Peter Westra of Middlebury College found a mean abnormal return of over three percent in the two days following a tracking stock announcement.[7] Studies by Salomon Smith Barney and Logue, Seward and Walsh also found an average increase in parent company share prices of 5.4 percent and 2.9 percent, respectively, around the announcement date of the transaction.[8] Lehman Brothers similarly examined 35 parent and tracking securities and found that from announcement date to issue date, the market reacted favorably (parents outperformed their peers) 63 percent of the time. After six months, 80 percent of the trackers outperformed their peers.[9]

However, once the short-term euphoria has abated, most trackers fail to sustain their performance, lagging not only their nontracking peers, but also their parent companies. According to a study by Matthew Billett and Anand Vijh of the University of Iowa, the three-year returns of 19 tracking stocks issued between 1984 and 1998 were below those of market benchmarks, while another four trackers had mixed returns. Only five tracking stocks, including standouts Sprint PCS Group and Liberty Media, outperformed the market the three years after issuance.[10] Parent companies, on the other hand, showed neutral performance vis a vis the market after unleashing their tracking shares.[11]

McKinsey & Co. uncovered similar results from 23 trackers floated between 1988 and 1999. Two years after issuance, the average total return of the tracking stocks was 19 percent, versus a 21-percent gain for the S&P 500 Index. Parent company stocks, on the other hand, generally kept pace with the index while spinoffs and carve-outs during the same period delivered 27-percent and 24-percent annualized returns, respectively.[12]

Although the "offtrack" performance can be partly blamed on the collapse of Internet stocks at the end of the 1990s, J.P. Morgan cites other factors. In a 1995 study, Morgan analyzed the trading multiples of eight tracking stocks and found that they typically trade at a five- to ten-percent discount to their peers due to the lack of a takeover premium (since the parent still exerts control), and because of inferior shareholder rights, the potential for internal friction, and exit difficulties.[13]

Billet's and Vijh's May 2000 study was the first to implicate performance issues on a number of levels, yielding one overriding conclusion: the poor long-term returns of tracking stocks did not justify their issuance. Examining subsets of 28 tracking stocks, the two academics found:

• Tracking stocks linked to small corporate divisions showed worse returns than large trackers (measured either by market capitalization or by ratio of tracker-to-parent market value).

• Tracking stocks are not a panacea for poor performing parents. Tracking stocks whose parents had negative industry-adjusted preannouncement returns continued to be poor performers after issuance.

• Tracking stocks that partitioned a firm into growth and value plays performed better than those without this distinction (the "broader investor clientele" effect).

• Tracking stocks issued as merger consideration earned significantly negative returns. Target shareholders will get better value by receiving parent company shares rather than tracking shares.

Given these longer term results, Billett and Vijh could not explain the market's preference for tracking stocks. If they make no economic sense, are they simply a new feat of financial engineering? Financial author Burton Malkiel points to historic waves of conglomeration and deconglomeration where valuation dynamics were often driven more by the fads and fancies of Wall Street than by real economic performance. In a two-tier market where hot sectors command lofty valuations, or high "price-to-hype" ratios, segmenting out tracking stocks may indeed lead to value creation at least temporarily. "History suggests," however, "that popular financial techniques to enhance market values tend to get undone in saner times."[14]

Detracking

So when has a tracking stock outlived its usefulness? Interestingly, Billett and Vijh found that the reasons given by managers for dismembering tracking stocks are remarkably similar to those given to justify their existence: the complexity of the structure, the inability to value the businesses, and a discounted market price.

About a dozen companies have unwound their tracking shares or spun off or sold the assets underlying the tracked business. Some trackers, as acknowledged by Billett and Vijh, proved to be abysmal failures in the marketplace or simply a poor fit for their companies. Other firms (GM, USX, and US West Co.) found that keeping the tracked units within the parent organization was hindering growth and competitive prospects or creating regulatory problems.

Issues Facing Existing Shareholders

The creation of tracking stock can pose a number of risks to a company's existing shareholders, stemming, in part, on the degree to which they can participate in the initial issuance. Concerns of conflicting interests, board partiality, and voting power are largely mitigated when the owners of the parent shares and tracking shares are one and the same.

In evaluating tracking stock proposals, current shareholders should take into account the following factors which could negatively impact their rights:

• Adverse governance changes: Tracking stock proposals are occasionally bundled with gratuitous corporate governance changes that are adverse to current shareholders, such as unfavorable charter or bylaw amendments or reincorporations. Some tracking stock designs may perpetuate an existing dual-class capital structure (Cablevision Systems Corp.) or otherwise empower supervoting shareowners to the detriment of the single voting shares (The New York Times Co.).

• Excessive increase in authorized capital stock: Companies often seek to increase their authorized common shares in order to conduct the tracking stock issuance. ISS uses its capital structure model to determine if such increases are reasonable or excessive.

• Unfair method of distribution: Tracking shares are generally issued as a stock dividend to existing shareholders or sold to new investors in an IPO. In a share distribution, current shareholders receive the tracking stock in addition to their stock in the parent company. Because they can monetize the tracking shares, they can directly benefit from the "unlocking" of the tracked subsidiary's value.

  An IPO benefits the company by raising capital. However, current shareholders receive no direct benefits from the tracking shares unless they purchase them in the open market. Their only benefit is indirect, through the parent's retained interest in the tracked business and its use of the IPO proceeds. Hence, from a shareholder standpoint, an IPO is less desirable. It also creates an immediate bifurcation of the shareholder base by introducing an additional class of investors.

• Diminution of voting rights: Tracking securities can be highly dilutive to existing shareholders when issued in an IPO. While nonvoting or limited voting tracking shares have a minimal impact, most carry variable voting rights that are periodically adjusted in accordance with the tracker's share price or market value relative to that of the parent. This fosters a better equilibrium between equity interest and voting power- an advantage to the tracking shareholders-but can result in substantial dilution to current shareholders if the tracking securities soar in value. Some firms, such as BellSouth Corp. and The Walt Disney Co., have mitigated the potential dilution by capping the tracking shares' aggregate voting power (typically between 25 percent and 40 percent of the total voting power).

• Adverse conversion terms: Tracking shares are usually convertible into parent company shares (and sometimes vice versa) at ten- to 25-percent premiums. Generally, the board may effect a conversion for a certain number of years after issuance or if the tracked business reaches a specified market capitalization level (typically 40- to 60-percent of the consolidated company's market capitalization). Tracking shares may also be convertible to parent company stock upon the sale of substantially all of the tracked division's assets or if the company decides to adopt a different capital structure. Shareholders should consider the degree of dilution they may face if a conversion were to take place.

• Negative impact on stock option plans: Tracking shares can be a desirable form of stock-based incentive for executives and employees of the tracked business by aligning their interests directly with the performance of the tracker. However, such awards should ideally be limited to those employees through separate stock option plans. This is particularly true if the tracked shares were issued through an IPO to the exclusion of current shareholders. Extending participation throughout the parent company would give insiders the benefit of owning the tracking stock while shareholders are shut out. As a case in point, Staples, Inc., which has yet to publicly float its tracking stock, issued 4.9 percent of the Staples.com shares to corporate officers and directors as stock options, valued at $2.8 million.

  In practice, most companies simply amend their existing stock option plans to permit the issuance of either parent or tracking shares, at the board's discretion. And even when separate tracker plans are created, there is often a confluence of participation among parent and tracker employees. In evaluating individual plans, ISS applies its stock-based compensation model.

• Other alternatives: The most critical question facing shareholders is whether the company should remain a combined entity or restructured as separate entities, and whether tracking stock is the most appropriate way of differentiating a piece of the business as opposed to carving out or spinning off a subsidiary. (See "When to Restructure")

  All repackaging strategies attempt to reduce or eliminate the so-called "conglomerate discount" and unlock the value of a unit of a larger company. Grouping different assets with different growth rates in a single company can bury a business that might command larger multiples as a freestanding entity or as a separate class of stock. However, one easy alternative to restructuring- tried by MCI Communications Corp.-is to simply provide greater disclosure by separating the financial results of the company's different businesses. Such additional information would aid investors in determining what any individual unit is really worth.

  To be suitable for tracking stock, the business unit should be easily isolated and well-defined from the rest of the company. It should also be in an industry that is valued differently by the market than the rest of the company's businesses. This may be evident when valuations of pure play competitors are driven up by investors or if the business operates off a revenue model rather than an earnings model.

  There should additionally be compelling synergistic benefits to remaining under the umbrella of the parent company. Tracking stock is a "fiction" in that it apportions the company into different stocks without separating the businesses. Nor does it produce the kind of long term value seen with spinoffs and carve-outs. But tracking stock may be more appropriate than a full or partial divestiture if legal separation from the parent might result in negative regulatory or tax implications or impair the financial flexibility of either the parent or tracked business.