From briefing.com -
Understanding ZDNet and Ziff-Davis
Ziff-Davis (ZD) "spun-off" its ZDNet division as a tracking stock (ZDZ) last week. This event has caused more confusion among readers than almost any other event we can think of. Today, we offer some explanations.
First of all, a tracking stock is not a separate company. ZDNet is still controlled by ZD management. There is no "CEO of ZDNet". If ZD goes bankrupt for nonpayment of debt (not an impossible event given ZD's debt load exceeds shareholder equity), then ZDNet assets would be sold to pay ZD's creditors. This is the first important distinction to understand. ZDNet is not a separate company.
A tracking stock is issued to track the performance of a division of a company. The financials of ZDNet will be separately reported from the financials of ZD. Tracking stocks are designed to allow the market to clearly see and place a separate value upon a division of a larger company.
For more on tracking stocks, see our Stock Brief of March 8, 1999.
Creating Value Using the Market
Theoretically, the value of ZD before the tracking stock was issued should equal the value of ZD after the tracking stock issue plus the value of the tracking stock. Here's a table of it. All numbers in millions except share price.
DateZD Market CapitalizationZDZ Market CapitalizationTotal3/312,150
(100 million shares * 21.5)02,1504/012,400
(100 million shares * 24) 552
(11.5 million shares * 48.5)2,952
But, the value of ZDNet and ZD combined is higher than the value of ZD previously. In addition, it is higher than the $220 million that was taken in as assets.
Theoretically, the value of ZDNet should be recognized by the market whether it is reported within ZD or not. But just as splits should not increase the value of a stock, but do, the tracking stock has increased shareholder value by almost $600 million more than was brought in as cash.
This is what we meant when we said that ZD management has created value out of thin air. All of the assets represented by both stocks existed prior to the creation of the tracking stock. But the market simply didn't value it until the ZDZ stock became available.
Of course, we realize that behind this line of thinking is the idea that ZDZ investors are accurately making an assessment of ZDNet's potential and financial position, an idea which may not be well founded.
The Conversion Rights
Ziff-Davis was originally viewed as a publishing company with an internet site. We can imagine management saying to themselves "if only we can get the company to be viewed as an internet company that also prints magazines." The conversion rights give the Ziff-Davis shareholders the right to accomplish this, if the market eventually permits it.
The most important conversion right is converting existing ZD stock to ZDNet stock. This can happen under the following condition.
(ZDZ Price * Shares on Market) > [(ZDZ Price * Shares) + (ZD Shares * Price) * (0.65)]
Note that only the number of shares of ZDZ owned outside of ZD are used for this calculation.
If ZDNet becomes more than 65% of the total company, the company can actually achieve the idea of being an internet company that also prints magazines. ZD shares will be converted to ZDZ shares at a 10% premium, based on price. This means $110 of ZD stock can be converted into $100 of ZDZ stock.
The current valuation formula is about 19%. (ZD closed at $20 1/16 and ZDZ at $39 9/16 yesterday. - We used 20 and 39.5 for simplicity.)
(ZDZ Price * Shares on Market) / (ZDZ Price * Shares) + (ZD Shares * Price) = 0.185
39.5 * 11.5 / [(39.5*11.5) + (100 *20)] = 0.185
Note, however, that this formula applies at any time going into the future. As ZD sells more and more ZDNet stock from its retained interest, the formula will come closer to being a reality.
There are other conversion rights as well, including the right to bring ZDZ stock back into ZD stock, and there are conditions for a share-for-share exchange. However, neither of these conditions seem likely to us, unless the market collapses, for the first, or Ziff-Davis collapses, for the second.
Far more likely is the possibility that ZDZ shareholders will be diluted when ZD sells more of its retained interest in ZDZ.
Why Does ZD Retained Interest Represent Dilution?
Dilution means that the current ownership percentages get smaller as new investors are brought in.
Dilution for existing ZDNet investors will happen in the following way.
Currently, ZDZ shareholders have a claim upon the total assets of Ziff-Davis, Inc., using the following formula:
ZDZ Interest = ZDZ Shares Market Value / (ZDZ Market Value + ZD Market Value)
ZDZ Single Share Interest = 1 / Number of ZDZ Shares
This represents the formula used for bringing ZDZ shares back into ZD, should that ever occur, but leaving out the premium, which declines from 25% to 15% over three years. The premium would increase the percentage claim by whatever premium was in effect at the time, but does not change the illustration of the interest.
For example, what is the claim of one million ZDZ shares on the combined Ziff-Davis asset base today?
ZDZ Total Interest = (11.5 * 39.5) / [(100*20) + (11.5*39.5)]
ZDZ Total Interest = 18.5%
Since there are 11.5 million ZDZ shares, one million ZDZ shares represents a claim on 1.65% of the total Ziff-Davis assets. (19% / 11.5)
But what if eight and half million new ZDZ shares are issued at the current market price? To follow this argument, assume first that current prices do not change. The new ZDZ interest would be:
ZDZ Total Internets = (20 * 39.5)/ [(100*20) + (20*39.5)]
ZDZ Total Interest = 28.3%
The total ZDZ interest increases. But the value of one million shares of ZDZ stock decreases to 1.415% (28.3 / 20).
When the claim of each share on assets decreases, that's called dilution.
But would share prices stay the same when ZD sells part of its ZDZ shares? Not likely. But unfortunately the likely scenario would be a decrease in ZDZ share prices, due to increased supply, and an increase in ZD prices, due to the debt reduction that would undoubtedly come from the proceeds. Both trends only increase the dilution of current ZDZ shareholders.
And that's only the dilution if ZD sells their retained interest shares. If the conversion of ZD shares into ZDZ shares ever happens, it is clear that ZDZ shareholders get diluted even more, as the non-internet assets would then come under the ZDNet umbrella.
And we haven't even mentioned the 10 million ZDZ shares in unexercised options that were created for ZDNet employees.
Ziff-Davis Management Applauded
We expect Ziff-Davis management to sell their retained interest over time, if the market permits. It is the fastest way to generate cash to pay off their debt
And Ziff-Davis's debt is enormous. The prospectus lists total debt as $1.5 billion, with shareholder equity as only $1.4 billion. This is equivalent to mortgaging more than the total value of your house.
But at current prices, ZD needs only sell about half of its retained interest in ZDZ to retire their debt completely.
For ZDZ holders, dilution by itself is not bad, when the lower percentage represents a higher absolute value. But since, ZD will likely keep the lion's share of any sale of the retained interest, unlike a secondary offering by a new company, dilution will come without much additional resources. ZD shares and ZDZ shares will be closely linked .
Ziff-Davis management has to be congratulated for this deal. They are truly playing the market like a fiddle. Why investors place so much value on ZDNet when it is a tracking stock and so little on it when it was part of the ZD conglomerate is a mystery. The only real conclusion we can draw is that there are many ZDNet shareholders who do not fully understand what they have bought. |
