Good Article from Red Herring about Tracking Stock:
The pros and cons of tracking stocks
By Sarah Lai Stirland
Redherring.com
December 1, 1999
AT&T's (NYSE: T) doing it. Walt Disney's (NYSE: DIS) doing it. Microsoft (Nasdaq: MSFT) is thinking about it, and Excite@Home (Nasdaq: ATHM) is about to do it.
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In light of the recent rise in prominence of "tracking stocks," it's not hard to imagine chorus lines of executives dancing around their boardrooms, chanting, "Let's do it, let's do a tracking stock." But investors should be warned: the virtual nature of tracking stocks gives the shareholder little control or concrete value with the security.
In case you've been on vacation for the past couple of months, tracking stocks are a type of stock that corporations issue when they want a particular division of their company to be valued independently of the company as a whole.
Excite@Home expects to issue a tracking stock in 2000.
Microsoft considers a tracking stock for its Internet properties.
Investors may not understand exactly what ZDNet is.
Here's a list of frequently cited reasons to issue tracking stocks: they can help corporations control a subsidiary while separating it enough to break out more valuation from the parent company (that is, they "unlock shareholder value"); the subsidiary's value will explode when an increased number of analysts cover it as an independent unit; the parent can use this stock as acquisition currency; the subsidiary will be able to borrow money at lower costs because it can use the credit ratings of its better-respected parent; the parent company can use the tracking stock to retain talent; and operating losses of the subsidiary can be used to offset the gains in the parent and in turn can be used to lessen the parent's tax burdens.
The increasing popularity of tracking stocks isn't likely to fall off anytime soon: financiers and consultants say they are receiving more and more calls these days from clients who are wondering whether they should issue tracking stocks, do carve-outs, or completely spin off their Internet or high-tech ventures.
TRACKING THE FLOPS
Are tracking stocks good investments? It's really hard to say, since their history is limited.
For both the investor and the corporate executive, simply looking at the performance of the various tracking stocks that have been issued over the years isn't much of a help. Although the figures vary, only around 23 tracking stocks are still outstanding, making them statistically insignificant.
Two recent tracking-stock bombs include DLJdirect (NYSE: DIR) and ZDNet (NYSE: ZDZ). DLJdirect, the online retail brokerage of parent brokerage Donaldson, Lufkin & Jenrette (DLJ) (NYSE: DLJ), priced at $20 at the end of May, spiked to around $43 shortly thereafter, and has since plummeted to end Tuesday at $16.56. ZDNet, the online division of the global tech publishing conglomerate Ziff-Davis (NYSE: ZD), priced in late March at $19, has fallen as low as $13.38, and ended Tuesday at $22.94.
In contrast, Sprint's (NYSE: FON) wireless Sprint PCS (NYSE: PCS) tracking stock has climbed steadily since its issuance in February, from around $20 a share to its Tuesday close at $91.75. Tracking stocks in similarly hot sectors -- such as PE Biosystems (NYSE: PEB) and Celera Genomics (NYSE: CRA), which are both biotechnology tracking stocks and subsidiaries of the PE Corporation (Nasdaq: PBIOW) -- have performed even more spectacularly this year.
POOR MAN'S SPINOFF?
For all the talk about "strategic flexibility" that Excite@Home executives and others mention when they've decided to issue tracking stocks, financiers say that the tracking-stock route is really the least attractive choice for companies, when compared to carve-outs or spin-offs.
" are not a vehicle of choice to me -- it's a fall-back position," says Patricia L. Anslinger, a partner in the corporate finance division of consulting firm McKinsey & Company in New York.
Companies usually choose the tracking stock option "because it's too difficult to do a carve-out or spin-off," notes Gregory J. Rossmann, a managing director at the technology, media, and communications investment banking firm Broadview International. In addition, the parent company may face some channel conflicts or other political issues that make any other path difficult to take.
Mr. Rossmann believes that the only situations in which tracking stocks can work is if the business can be isolated and well-defined from the rest of the company, with all the costs and shared resources broken out and clearly accounted for in the tracking-stock subsidiary. With this in mind, he thinks that a tracking stock for AT&T's wireless assets, for example, would be a mistake.
"Wireless [in this context] is a last-mile solution," Mr. Rossmann says. "You're looking at the mingling of technologies -- coaxial, twisted pair, and wireless -- and it's difficult to isolate the wireless."
Although the tracking stock would be an interesting exercise in valuation of AT&T's wireless assets, it wouldn't serve AT&T well because all of its divisions are going to have to work together to serve the same consumers, he points out. Referring to AT&T's desire to use fixed wireless technology to get into people's homes, Mr. Rossmann notes that consumers just want access and aren't going to care how they get it.
DOMESTIC STRIFE
In some cases, the tracking scenario can create conflict, as when the subsidiary ends up competing with the parent. In fact, that's a concern that some have cited about DLJdirect.
"I've seen them present at some conferences, and they're trying to go after the wealthy investor, but that's a niche that everyone's trying to go after, and the governance structure makes things more complicated," says Michael J. Barry, a buy-side research analyst for Boston-based Frontier Capital Management.
Like most other companies that are traded as a tracking stock, DLJdirect is governed by the same board as its parent company, DLJ, which also serves high-net-worth individuals and is engaged in investment banking. "Everyone's worried about the parent screwing them," says McKinsey's Ms. Anslinger.
Indeed. That concern was precisely what motivated General Motors/EDS tracking stock shareholders to sue General Motors (NYSE: GM) when it spun off Electronic Data Systems (NYSE: EDS) more than three years ago.
WHO BENEFITS?
General Motors was the first corporation to issue tracking stock. A judicial opinion emerging out of this lawsuit could be the first to clarify some of the problematic issues associated with tracking stocks.
In the lawsuit, tracking-stock shareholders sued because they were unhappy with the terms dictating the exchange of tracking shares for EDS. In addition, tracking-stock shareholders charged that GM's directors had breached their fiduciary duty to them by negotiating terms that favored GM. The most recognizable symbol of this was a $500 million cash payment that GM extracted from EDS prior to the spin-off.
The suit, which was brought in the Delaware court of the chancery, was decided this March in favor of General Motors. But it's on appeal in the Delaware Supreme Court; a further opinion is expected by the end of the year. Jeffrey Hass, a professor at New York Law School, says that if the Supreme Court rules that GM's board of directors have no special fiduciary duties to both classes of investors and instead should just go by the "business judgment" rule -- that is, use their best judgment on what's best for "the company" -- tracking-stock shareholders should could end up getting a raw deal.
This shows that tracking stocks create potential conflicts of interest between the shareholders of the parent company and the shareholders of the tracking stock. In the case of GM, it was obvious that the directors were making the decisions in favor of GM and to the detriment of EDS, says Mr. Hass. The EDS managers effectively had to play by the rules of the GM directors if EDS wanted to complete the spin-off transaction. "When you're negotiating with yourself [over the terms of a spin-off] a bar-room brawl is not going to break out," Mr. Hass notes.
Mr. Hass says that the latest tracking-stock issuer, Excite@Home, seems to have addressed this governance issue by appointing an independent board to govern its media subsidiary. But he points to lingering issues. It's still not clear, for example, who will appoint members of the new board.
I DON'T MIND
On top of the troubling governance issues that may lead company boards to treat their tracking stock subsidiaries unfairly, Mr. Hass calls tracking stocks "fictional stocks." That's because investors who hold tracking stocks don't actually have any legal claims to the assets of the company should it go out of business.
Meanwhile, many investors seem oblivious to tracking stocks' subpar status. When McKinsey recently took an informal survey of analysts and professional investors about the subject, for example, it found that those surveyed were ambivalent about tracking stocks.
Indeed, Bill Valentine -- an Excite@Home shareholder, a money manager for wealthy individuals, and founder of Valentine Ventures -- likes tracking stocks. He says, "From a shareholder standpoint, the tracking-stock solution is attractive." He expects it to unlock shareholder value, enabling his holdings to soar. |
