Readers of Joseph Heller’s bestseller Catch 22 may remember the disappointment of US air force men when they reached for their parachutes and found instead worthless ‘shares’ in Milo Mindbender Enterprises. Investors in WorldCom’s MCI tracking stock had a similar experience recently.
MCITE was issued at over $18 a share and a year later bottom-feeders were picking it up at 18 cents. That was not quite what WorldCom CEO Bernie Ebbers promised when he launched the tracking stock. ‘The new structure is designed to create greater shareholder value by providing two distinct, clear and compelling investment opportunities, while serving customer needs with a more efficient operation,’ he asserted.
In reality MCITE and WorldCom shares were intimately tied. ‘They are like conjoined twins; if one gets sick so does the other,’ says NYU finance professor Richard Haas. ‘MCI’s assets are 100 percent owned by WorldCom so tracking owners are in the queue with other WorldCom holders now.’
Heavy downside
Tracking stocks raise issues of corporate governance, accounting transparency, market efficiency and executive motivation. Holders of tracking stocks have no voting rights. The only ‘right’ investors of tracking stocks have is the right to reap profits in the form of dividends or price improvements. Also, since one board oversees both the tracking stock and the parent company, there is potential for conflict of interest between the interests of the parent company’s shareholders and tracking stockholders.
Investment banks are really the beneficiaries of tracking stocks, according to Haas. ‘They are the ones who created this smoke and mirrors structure – and for very large fees,’ he says. Management also benefits. By tracking the strongest business segment in the market, tracking stocks attract new investors and are also able to attract talented employees by offering options on the tracking stock.
General Motors issued the first tracking stock in 1984 and since then a number of companies have followed suit. In the late 1990s, a number of companies set up tracking stocks to track their e-business units in hopes of milking the illusory gains of the internet bubble. Disney, for example, launched go.com and then folded it in January 2001 because it was losing badly. During the market of ‘irrational exuberance’, tracking stocks were tracked against the fevered expectations of investors, not against actual earnings.
In truth, tracking stocks don’t yield particularly rosy results, according to a recent study by University of Iowa researchers Anand Vijh and Matthew Billet. Their study found that the issuing parent stocks are usually performing below benchmarks and their tracking stocks significantly underperform as well. ‘Tracking stocks only separate the stocks without separating the businesses. Such restructuring seems to create many conflicts of interest that destroy stock value,’ suggests Billet.
From an IR point of view, tracking stocks can be more trouble than they are worth. While their initial IPO yields some new analyst attention, it is sometimes difficult for analysts to comprehend the subtleties of tracking stocks. ‘The market greets the introduction of these things with a very positive response,’ says Billet. ‘However, you have to question the parent company’s motivation.’
Many of the e-business tracking stocks issued at the height of the bull market have since disappeared, which leads one to wonder what their real purpose was in the first place.
If tracking stocks have such an ominous downside, where is the SEC? In fact, the securities watchdog has been snoozing in the sun for the last decade after an initial burst of interest in the 1980s when General Motors issued stocks for Hughes and EDS. The SEC’s main mandate is to enforce disclosure and transparency, so if investors fail to peruse the small print available when they buy into an alchemist’s IPO offer to transmute base manufacturing into dot-com gold, that’s their problem. And now, with a long list of governance and accounting reforms to implement – not to mention the odd vacancy to fill – new rules for tracking stocks are low on the SEC’s list of priorities.
Still, when GM floated its tracking stock for Hughes, the SEC insisted on multiple sets of financials, one for each business and another for the whole conglomerate. So it’s actually quite a cumbersome investor relations and accounting operation to run a tracking stock.
Stroking investors
John Rubin is IRO for Hughes, the tracking stock for General Motors’ satellite and TV division (GMH), which is the pioneer tracking stock. When he took up the position in 1994 he says, ‘There was very little liquidity, so they didn’t really need the separate investor relations function.’ Secondary offerings added liquidity to the stock and soon the Street started showing more interest.
The reasons for a tracking stock were various, says Rubin, ranging from management wanting to keep control to certain tax advantages. ‘But the main reason to do it was to get the PE multiple,’ says Rubin. ‘If we were buried in GM you would not get the multiple and this gives an increased value currency for acquisitions.’
Rubin suggests that his position is no different from any other IRO’s. ‘Investors expect a return just like they would from any other stock,’ he says. ‘We file all the usual stuff; the only thing we don’t have is the annual shareholders’ meeting. We usually end up having something like an annual meeting for IR purposes but we don’t have the formality of a shareholder vote.’
The other difference is that investors want assurance that GM will not be unfair to them at the expense of parent GM holders. ‘They want stroking from us that everything’s going to be on the up and up.’
Hughes and EchoStar recently merged and will spin-off from GM, which will mark the end of the tracking stock. ‘Technically, upstream all assets belong to GM but they set up a capital stock committee to ensure that both sets of shareholders are being treated fairly,’ says Rubin. ‘The last thing GM wants is lawsuits.’
Telling forests from trees
Georgia Pacific, which tried a tracking stock in 1997 for its timber supply, followed a similar pattern to GM’s. The company eventually spun off the tracking stock business and is now about to split into two separate companies.
IRO Richard Good explains the rationale behind the Timber Company tracking stock. As a timber and paper products business, the company owned its own supply chain – from forest to paper towels, he says. However, in the late 1990s, government policy on public forest conservation led to a huge shortage in timber supply. This move boosted the value of private forest holdings, especially in the south where Georgia Pacific was a major holder.
Understandably, ‘The timber side was something of a sacred cow with the board and some of the senior managers, hence this tracking stock for the Timber Company with which we wanted to capture some of that value. The original concept was to spin the company off but because of the timber supply’s ties to the business, the tracking stock was a compromise.’
Analysts and the financial markets also seemed to prefer the smoke and mirrors of a tracking stock. However, as Good says, the real value for the tracking stock came when it was sold to the Plum Creek Timber company, a West Coast-based Reit in 2000, at a 50 percent premium.
Once Georgia Pacific took out the timber, it was apparent that the raw material had been the glue that tied all the other businesses together. ‘Now we have paper products, solid wood and constructions materials which are entirely different businesses,’ notes Good. ‘This time a tracking stock was not even considered, since we realized there was a discount with them.’
Georgia Pacific is now spinning off its consumer products and packaging company (CP&P). With an IPO planned for later this year, the new company will have separate management and a separate stock. Existing shareholders will get a share in the new CP&P company. Each company already has an IR department up and running and Good is staying with the timber and building products company.
Good says the split-up is more desirable than a tracking stock for shareholders. ‘There are some asbestos issues for Georgia Pacific, while the new company should be insulated from that and it will trade at much higher valuations than basic forest products.’
In the current climate, with options under scrutiny, accounts under suspicion and stock markets going under, it is a fair prediction that there will be many fewer tracking stocks on offer – and perhaps more spin-offs. But there are always investors looking for gold at the end of the rainbow – and there will always be merchant banks and CEOs quite prepared to sell them tracking stocks for it.
According to Vijh and Billet, managers who want to separate unrelated businesses should use spin-offs or carve-outs for a clean separation. In other words, if you are really interested in good relations with investors, don’t issue tracking stocks.
