Flip through recent issues of any major financial publication and you’re bound to stumble across a story on ‘tracking stocks’. The security, which tracks the performance of a specific business embedded within a corporate parent – though it does not confer control of that asset to shareholders – has been showered with attention over the last year. In a market hungry for trends and fads, the rash of headlines has many investment professionals scrambling to learn more.
The premise behind a tracking stock is that it provides advantages to both investors and management: investors can purchase what they consider an attractive portion of a company, rather than the entire company; and corporations can reap some of the benefits of a spin-off by allowing the market to value the sum of the parts separately – presumably at a higher valuation than otherwise.
Due to the media spotlight, many have mistaken tracking stocks for a recent phenomenon, a new darling of the executive suite. The truth, however, is that the security, which is also known as ‘letter’ or ‘targeted’ stock, has been around since the mid-1980s. General Motors was the first to issue letter stock in 1985 with its EDS unit, and soon after with Hughes Electronics. USX was another pioneer, issuing letter stock in Marathon Oil in 1991. Others include Georgia Pacific’s Timber Group.
In the mid-1990s, media tracking stocks emerged, including those issued by US West and TCI. A dull trickle turned to a steady stream, as companies ranging from Genzyme to Sprint let loose with their own tracking stocks in the last few years. But it has been in the last twelve months that numbers have reached such historically high levels.
Most recently, Ziff-Davis threw its hat into the ring, issuing tracking shares for its online business, ZDNet, on March 31. DLJ, Quantum, Perkin Elmer, and DuPont are just a few of the other companies that have recently announced plans for tracking stocks. According to Lehman Brothers, the aggregate market value of tracking stocks is currently in the neighborhood of $400 bn.
Why now?
Current market conditions have helped drive the unprecedented interest. The sky-high valuations present in today’s equity markets, and the increasing capital demands of new businesses have combined to make tracking stocks an attractive re-capitalization tool.
‘The benefit of a tracking stock is that it allows a company bifurcated access to the capital markets,’ explains Barbara Byrne, a managing director at Lehman Brothers and an expert on tracking stocks. ‘For example, USX has two groups: steel, and oil and gas. The company borrows as USX but when it raises equity, it does so as either US Steel or Marathon Oil. They have the benefit of supporting a combined balance sheet on a credit basis, so they might get a better credit rating and lower cost of funds. When they raise equity they have the benefit of tapping into the core focus of the equity markets, which are highly focused on easily understood, single equity stories – pure plays.’
Byrne describes tracking stocks as a ‘security for the new economy.’ That’s because they are particularly well-suited for companies in the technology sector, as well as pharmaceutical, life sciences, and communications and media companies. ‘These are businesses where there is a tremendous need for capital,’ explains Byrne. ‘They are also cases where the market is rewarding the dynamics of these businesses, many of which are running on a revenue model as they scale up or are spending large amounts of capital to build.’
Byrne’s comments are borne out by the list of companies soon to issue. DuPont plans a tracking stock for its life-sciences biotech business, while DLJ has proposed one for its online-trading subsidiary, DLJdirect. Quantum hopes to issue a tracking stock for its computer network storage unit, and there are whispers that Disney may bundle its internet businesses into a separate tracking stock.
The nay sayers
There are, of course, detractors of the security, who point out that tracking shares limit the value of a shareholder’s vote, and deny them legal ownership of corporate assets of the business. In the event of a sale or merger of a tracking stock business, shareholders receive either net proceeds of a sale, or the stock of the parent company, though not the stock of the acquiring company. As a consequence, the security is more cumbersome to use in a corporate reorganization.
On the issue of valuation, some analysts believe that a tracking stock trades at a discount to what would otherwise be a separate, spun-off company. And because the number of tracking stocks being issued has begun to climb only recently, many investors who are unfamiliar with the security are put off by the corporate structure, which may seem highly complex. However, as tracking stocks such as Liberty Media and Sprint PCS provide spectacular returns, a re-education process has begun to get under way.
When Quantum announced plans to issue tracking stock, it received overwhelming support from its largest investors. ‘We met with our top twelve to 15 shareholders within the first few days of announcing the plan, and they were positive across the board,’ says Richard Clemmer, CFO of Quantum.
While Clemmer concedes that there were numerous questions due to many of the participants’ unfamiliarity with the security, investors quickly grasped the benefits of the plan. ‘As we described it to our shareholders, the reason we chose a tracking stock is because of the operational and technology synergies, as well as the strategic synergies. We had the ability to capture those synergies, and yet have an equity that is segmented on the different requirements and needs of various investors. A lot of investors like what we’re doing on the storage system side of the business, but they don’t want to be involved in the cyclicality inherent in the disk drive business. We’re trying to address that.’
As for the value of a tracking stock versus a spin-off, Lehman’s Byrne remains ambivalent. ‘Is the business when valued outside of a conglomerate valued differently? Yes it is. Are there cases where a tracking stock valuation can be lower or higher than if it were in subsidiary form? Again, the answer is yes,’ Byrne says. However, she points out that in the end securities have to trade based upon their fundamentals.
But does it fit?
The bottom line, according to Byrne, is that tracking stock is not for everyone. ‘But certain companies will use it because it fits their unique profile and circumstances,’ she says.
There are certainly examples of companies who have found the security a poor fit. When AT&T was walking through its recent merger with TCI, executives made it known that tracking stock was on the table for more than one business unit, in addition to TCI’s previously issued tracking shares for Liberty Media Group. But in January, AT&T abruptly announced that it was scrapping plans to split two new tracking stocks off its current stock structure. Executives cited the difficulty of managing multiple stocks while overseeing the merger as the reason for the proposal being scuttled.
Another large corporation that flirted with the idea of tracking stock is RJR Nabisco. In this case, the problem was one of liability: ultimately, by creating a tracking stock for Nabisco, the business unit would have been exposed to the huge liabilities of the tobacco company. In a reverse scenario, Williams Companies recently considered creating a tracking stock for its communications group. But management concluded that the demands of building a fiber-optic network will be so great that the increased debt load would have weakened the energy part of Williams.
Just as some companies nix tracking stock plans, not all companies that decide to issue the security stick with the structure. GM’s letter stock, EDS, became independent when the company felt the relationship was hindering growth prospects – as part of GM, EDS was unable to bid for the business of rivals such as Ford or Chrysler.
When USX brought Delhi public via a public offering of tracking stock in 1994, it was thought the move would allow faster growth in Delhi’s pipeline business. However, when the large electric companies moved in, Delhi found itself disadvantaged by its size. As a tracking stock, a merger was almost impossible. Although Delhi was a small percent of the total equity market value of USX, had a larger company tried to acquire Delhi, in reality it would have found itself swallowed up by USX. Ultimately, the underlying assets of the tracking stock were sold to Koch Industries, and Delhi shareholders received the net cash proceeds of the sale (at roughly a 30 percent premium over the trading price).
US West’s tracking stock, MediaOne Group and US West Communications, became separate public companies in June of 1998, four years after issuing tracking stock. While the company believed the security was the right structure at the time, the circumstances of the businesses ultimately changed. ‘When we established a tracking stock, we thought that was the correct structure, rather than a complete separation,’ says Larry Thede, VP of investor relations for the new US West Communications group, US West. ‘The company, at the time of the decision, thought the industries would converge so that a cable company and a telephone business would co-exist well in one company, as they might have the same technology. Over time, we saw that the technology was going in two separate directions, and public policy was going in two separate directions.’
Thede also notes that there was some pressure from institutional investors who wanted a board of directors completely devoted to one business. While he believes it can be more difficult for a board to balance the needs of different groups of shareholders, he says the regulatory issues that arose from being involved in both cable and phones was a more serious motivating factor in the decision.
IR and tracking stock
For companies that do utilize a tracking stock, there is the question of its implications for IR strategy. Some have kept one investor relations structure for both stocks, while others have split the responsibility between IROs. The decision seems to be influenced by the unique demands of the business from one company to the next.
In the case of US West, Thede says the company went to two IR structures immediately. ‘We stayed in the same building, on the same floor, which worked well, but eventually we separated into two locations so that they could be near the different management teams. Additionally, the investor base was significantly different between the two stocks – one of them paid a dividend, one didn’t; one had high single digit expected growth, the other had growth in the teens or higher. So it made sense to have focused IR groups for each one.’
Sprint, on the other hand, maintains one investor relations office for both Sprint and its tracking stock, Sprint PCS. Kurt Fawkes, assistant vice president for investor relations, says having a single IR unit removes the danger of conflicting messages being communicated to investors. While he thinks separate IR departments are suitable for very divergent companies, he says this is not the case with Sprint. ‘If you look at where telecommunications is headed – things becoming bundled with wireless and long-distance packages, for example – there’s a great deal of overlap and it’s moving more in that direction, so I think it makes sense for us to have one investor relations function,’ says Fawkes.
While investors were initially concerned that one set of investors might not get the same level of responsiveness, Fawkes says Sprint has been able to allay those fears. ‘I think if you surveyed our base today on both the wireless and wireline sides, you’d find that fear has subsided.’
Martin Sheehan, senior manager of investor relations for Hughes Electronics, thinks it makes more sense to keep separate IR functions for different tracking stocks, though he says the choice is more obvious for a company as diverse as GM. ‘Because GM is so completely different from Hughes, it makes a lot of sense. We’re a communications company, GM’s an automotive company. We’re also relatively small in size next to GM, so you wouldn’t get the same focus on an IR basis for Hughes. From my perspective, it needs to be separate.’
Sheehan says that most investors understand the concept of tracking stocks, though he finds himself walking some of the smaller investors through the security, or pointing them in the direction of the proxy statement which details what it means. He says that, overall, investors are focusing on the key elements of the business, rather than worrying about investing in a non-asset based stock. ‘People used to say there’s a 10 percent or a 15 percent discount to your stock price if you’re a tracking stock, but investors are getting a lot more comfortable with tracking stocks now.’
Understanding the security
While the pros and cons and the most suitable manner of conducting investor relations for tracking stock can be debated, one thing is not in dispute: companies must understand what a tracking stock is meant to accomplish. For companies seeking a near-term disposition, the security is an ill-advised answer.
Lehman’s Barbara Byrne, who has worked with numerous companies on a tracking stock decision, has given this message to many of the boards she’s advised over the years. ‘Tracking stock is not the world’s most efficient structure for selling a company,’ she notes. ‘It’s difficult because the reason you do a tracking stock is to keep the companies together. The best way to think about it is this way: an IPO spin-off, carve-out, or split-off is the first step in an ultimate disposition. Tracking stock is a family of companies.’
Byrne points out that tracking stock is particularly useful for companies ‘who want to stay competitive and creative on the edge in an entrepreneurial way.’ And in today’s new economy, there are plenty of companies who see themselves as fitting that bill.
