Proponents call tracking-stocks a tool for unlocking shareholder value. Skeptics deem them an instrument for unleashing shareholder lawsuits. Either way, interest has never been higher in the issuance of separate securities to “track” the performance of different parts of a company’s operations.
In the past year, six companies have created such securities–Genzyme Corp. did it twice for two different biotech research efforts– and at least 10 other such stock issues are pending. Sprint Corp. kicked off the latest wave last November, offering a separate security for its PCS Group wireless subsidiary. (MCI WorldCom Inc. has said it expects to retain PCS as a tracking-stock when its merger with Sprint is completed.) The strongest endorsement yet for these issues could come from AT&T Corp.’s recent expression of interest in establishing trading-stocks for three of its “new economy” units.
Indeed, most deals have been designed to highlight high-growth divisions. Among them: Donaldson, Lufkin & Jenrette Inc.’s online brokerage firm DLJdirect; DuPont Co.’s life- sciences business; Web-related assets of Ziff- Davis Inc.; and pending stock issuances from General Electric Co., The Walt Disney Co., and Staples Inc.
“To get big fast and compete, you have to be able to acquire customers at the rate the Internet start-ups can,” says Staples CFO John Mahoney. “You have to be willing to spend a lot of money on marketing, and to lose money in the early stages. Given our record of consistent performance in Staples’s main company, we thought that would be hard to do” for its three electronic businesses, which will rack up close to $200 million in sales this year. And at both Staples and Disney, which have seen recent deterioration in their stock prices, separate securities offer a currency for rewarding high-tech employees with stock options, and for making acquisitions.
“Disney’s Inter-net business, like the Internet itself, is only beginning to realize its potential,” Disney CFO Thomas O. Staggs declared when the company announced plans in July to combine Web businesses under the go.com brand, and to issue stock in the merged entity.
In addition to the value-enhancing benefits for the parent, there can be a boon for Wall Street. “This strategy gives investors more- direct access to specific businesses run by a conglomerate,” says New York Law School professor Jeffrey Haas. In Staples’s case, says CFO Mahoney, shareholders “need to be able to see the results independently between the core business and the Internet business, or they won’t get as complete an understanding of how we’re doing.”
For Those Special Core Assets
The total market value of shares in tracking- stock form, including the securities of the parents, is expected to top $400 billion by early next year, estimates Barbara Byrne, a managing director at Lehman Brothers Inc. And though she concedes that some interest would dry up if the recent slide in Web-related valuations continues, she expects traditional companies to keep the tracking trend alive as they cultivate embryonic businesses, as well as businesses that trade on very different metrics from those of the parent company.
“Tracking-stock is not a fad where everybody will be doing it,” Byrne says, “but it is a security structure for certain large companies that have new-economy identities for a core group of assets. If they’re looking to facilitate their growth strategies, which will require acquisitions and rewarding their employees with growth securities, they’ll look to this.”
In contrast to spinning off, carving out, or divesting an operation, issuing a tracking- stock allows a company to maintain control of the business in a tax-free transaction, and to retain any operating synergies, credit-quality benefits, and economies of scale in administrative costs. Furthermore, the tracked business need not be five years old, as would be the case with a spin-off. Adopting this subsidiary-creating form requires a shareholder vote. Because of the large amount of work required in unwinding what can be a complex corporate structure, “this is not a good stalking horse for a third-party sale,” Byrne advises.
Although the promise of higher valuations drove its deal, Quantum Corp. sought the full range of tracking-stock benefits when it created two separate securities in July to replace its existing stock. Investors had been ignoring the progress that the $4.9 billion Milpitas, California, company had made with its newer digital tape storage division, even though a yearlong communications program was stressing Quantum’s tenfold revenue increase in the area over just five years. “We were continuing to be seen as a disk-drive company,” says Quantum CFO Richard Clemmer. “We were convinced that with two stocks, they’d be valued independently based on the prospects of our two businesses.”
Like about 80 percent of tracking-stock issuers, Quantum distributed the new stock through a dividend process. For each share of Quantum stock, shareholders got one share of the storage-system stock and half a share of the disk-drive stock. “This distribution was faster,” says Clemmer, “and we didn’t have a compelling need for the cash.”
In a second variation of the tracking-stock approach, companies looking for cash can distribute new shares through an initial public offering. DLJ raised about $138 million from the sale of the tracking-stock for DLJdirect, with the proceeds going to the subsidiary. The IPO for ZDNet, the Internet business unit of Ziff-Davis, raised more than $200 million, though 85 percent of the total was used to pay down some of the $1.2 billion in debt on the parent’s balance sheet.
“This was not a handicap in any way to ZDNet in terms of its marketing the offering,” says Ziff-Davis CFO Timothy O’Brien. “We gave ZDNet a promise that we would provide any capital that it would require for future growth.”
Joined At The Hip
Nevertheless, the Ziff-Davis situation highlights the major concerns that some corporate-governance experts have about tracking- stocks: that the stockholders have limited class-voting rights, if any; lack rights to the assets of the subsidiary; and can’t elect their own boards. The fate of their holdings, in other words, is inextricably linked to the parent. And that could create conflict in times of financial hardship.
“The different business groups are still joined at the hip, and if either side performs poorly, that can drag down the other side,” cautions law professor Haas. “The other big concern is that a single board serves disparate groups of shareholders, and the sibling rivalries for capital that would play out at a senior-management level could have an impact at the shareholder level.”
The prospectus for DLJdirect explicitly warns that the online firm may find itself competing with its investment-banking parent for customers and resources. “The board of directors may make decisions that favor DLJ at the expense of DLJdirect,” it states. “There will be inherent conflicts of interest…[and] there can be no assurance that DLJ will not expand its operations to compete with DLJdirect.”
Institutional Shareholder Services, a proxy- advisory service, actually recommended that Quantum shareholders reject the stock restructuring because of concern about such conflicts, although the plan was easily approved. “Investors will have to find a way to live with them and make decisions about good and bad tracking-stocks,” says Patrick McGurn, director of corporate programs at ISS.
“As some people say, it creates a wonderful opportunity for lawyers and accountants,” jokes Staples’s Mahoney. Still, any negatives will be far outweighed by the “bounce-back value” from the new companies helping “our retail business as it adapts to the Internet world.”
A New Valuation Dynamic
The first tracking stocks were issued by General Motors Corp. in the mid-1980s, as the automaker sought to set up arrangements for post-acquisition control of EDS Corp. and Hughes Aircraft Co., now known as Hughes Electronics Corp. (EDS was split off again in 1996.) In 1991, USX Corp. became the first company to use a tracking-stock as a vehicle for separating businesses, creating different classes of stock for its steel and energy operations.
After a flurry of issues, interest waned in the mid-1990s, when proposed deals by Kmart and RJR Nabisco were greeted with negative market reaction, and were pulled. Over the next four years, there were only 12 tracking- stock deals. Although many were successful, the recent rash of interest seems triggered by the market’s interest in pure-play opportunities, and by the lofty valuations of Internet and other new-economy company stocks. “Companies are struggling to deal with this new valuation dynamic,” says Lehman’s Byrne.
Typically, the boards of companies planning a tracking-stock create a special committee to oversee the tracked unit’s operations and establish arm’s-length agreements between the parent and its subsidiary regarding transfer pricing, capital expenditures, and other resource policies.
“We have some shared services where we leverage off [our parent’s] operations,” says William Gunter, CFO of Sprint’s PCS subsidiary, “and we have some [product] bundling initiatives.” In light of intercompany pricing for services and revenue- sharing, he explains, a newly formed capital stock committee of outside directors was created to “make sure that no one set of shareholders is disadvantaged.”
Lehman’s Byrne suggests that the tracking- stock structure has the “perverse effect of creating a lot of discipline around how decisions are made” in companies that may have been less deliberate in the past. While she considers any true dangers of the approach “overblown,” she allows that “the potential for conflict is there, as with any company.”
Such assurances, coming at a time when the economy is strong, hardly sway those who predict that internal competition for corporate resources will intensify in a recession, or who suggest that tracking-stock shareholders could be sucked in when an unrelated part of the business collapses. Either way, lawsuits would surely ensue.
“The day may come when one part of a diversified company takes a nosedive, and shareholders of tracking-stocks will realize they don’t own a stand-alone business,” Haas counsels. “In a bankruptcy context,” he notes, “all the company’s assets are available to satisfy claims, not just those of the business that goes belly-up.”
Courts have been less than friendly to arguments that tracking-stock-holders have the same rights as investors. In two recent cases, the Delaware Chancery Court ruled against holders of GM’s Hughes, and of the former EDS tracking-stock. The holders claimed they did not receive fair distributions of proceeds when assets in the businesses were sold, but since the shareholders had voted for the transactions, the court said they didn’t have a case. The plaintiff lawyers have appealed.
Delivering On Their Promises
While a few tracking-stocks, such as Circuit City Stores Inc.’s CarMax Group, are dogs because of poor business fundamentals, for the most part, the technique has delivered on its promise. US West and Tele-Communication Inc.’s Liberty Media, to name two, have been spectacular winners. And Sprint’s PCS Group has surged about 250 percent, to $70, in less than a year. More important, PCS’s shares have outpaced those of its peers in an industry that is far outstripping forecast growth rates. “We’re growing faster than any other carrier in the market,” says CFO Gunter, “and that performance is reflected in the value of the tracking-stock.”
Both DLJdirect and ZDNet are trading significantly below their offering prices, a drop many attribute to dampened enthusiasm these days for Internet holdings in general. Still, Ziff-Davis CFO O’Brien is disappointed that ZDNet’s market cap is a third the size of that of CNet Inc., its most direct competitor, and in part blames the tracking-stock dynamics. “We have approximately the same revenues, and our metrics, in many cases, are better,” O’Brien gripes. “I think there tends to be a larger discount because it’s a tracking-stock. CNet may have a takeover premium embedded in its valuation, but it’s harder to think of ZDNet as a takeover target, because it would require the consent of Ziff- Davis.” Asked if the parent company’s recent losses and the debt on its balance sheet might also make Web investors leery, he concedes that those could be factors, too.
In 1995, J.P. Morgan analyzed the trading multiples of eight tracking- stocks, and concluded that the security typically traded at a 5 percent to 10 percent discount to its peers. Director of M&A research Rick Escherich believes this still holds true, and attributes the phenomenon to the tracking-stock structure, with its inferior shareholder rights, investor concerns about internal friction and possible exit difficulties, and the fact that a raider cannot gain control of the subsidiary by accumulating the tracking- stock alone.
In an analysis compiled this past summer, Lehman Brothers compared the performance of 35 parent-stock and tracking-stock securities with that of their peer groups. The research found that between the announcement of plans to issue a tracking-stock and the issuance date, companies outperformed their peers 63 percent of the time. “In the majority of cases, the market reacts favorably,” says Barbara Byrne. Short-term, more than half the issues underperform, the study shows, but after six months, the percentage of tracking- stocks outperforming their peers has grown to 80 percent.
“Once it becomes clear to the market that there are two separate securities with two separate fundamental drivers to achieve valuation,” Byrne says, tracking-stocks “tend to come out ahead of the game.”
Rick Clemmer is certainly hoping that holds true for Quantum’s new tracking-stock. After two months of trading, the tape-storage subsidiary carries a price/earnings-to- expected-growth ratio of about 0.5, less than half that for its peers. “It could take six months to see the enhanced value,” Clemmer says, “but we feel we’ll be part of the 80 percent.”
———————————————– ——————————— Keeping Track: The Pros and Cons of Tracking Stock
Parent retains control of the subsidiary and related synergies
Better financial information and analyst coverage for subsidiary
Autonomy and stock options for subsidiary management
Tracked stock available as acquisition currency
Likely support of bondholders
Limited rights of tracked-stock shareholders
“Pseudo” independence could stymie tracked subsidiary
Market could penalize potential internal friction
Can be difficult to unwind
Less takeover interest, because subsidiary’s assets linked to parent’s
Source: J.P. Morgan