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Are Tracking Stocks on Track?

Amid claims of greater corporate performance and higher market value, these controversial securities raise an awful lot of ethical questions.

A relatively recent innovation in raising equity capital is a security often referred to as a "tracking stock." Many corporations and investors consider tracking stocks an important vehicle not only for raising capital but also for increasing a company's value. Proponents claim that these securities are a way to attract and retain excellent managers and unlock hidden assets.

The record of tracking stocks, however is mixed. Many of the issues they raise are still too new to know whether the stocks will help increase shareholder value. Furthermore, they create a number of ethical concerns for corporations and their managers and investors. [1]

Also referred to as "letter stocks" or "targeted stocks," tracking stocks had their beginnings when General Motors acquired EDS and issued the GM Class E share. Other companies that have issued them include Ralston Purina, Georgia-Pacific, Sprint, USX, and Pittston. An investor who purchases a tracking stock receives a security with a dividend tied to the cash flow of a specified unit. As Sprint wrote about the tracking stock for its PCS division (Form S-3 filed with the SEC in 1998):

The Sprint Board will periodically consider appropriate dividend policies and practices relating to future dividends on the PCS Stock. The Sprint Board does not expect to declare any dividends on the PCS Stock in the foreseeable future. Pursuant to the Tracking Stock Policies, dividends on the PCS Stock may be declared and paid only out of the lesser of (i) the funds of Sprint legally available therefor and (ii) the PCS Group Available Dividend Amount. The PCS Group Available Dividend Amount is similar to the amount of assets that would be available for payment of dividends on the PCS Stock under the Kansas General Corporation Code if the PCS Group were a separate company.

However, the investor does not receive an actual ownership interest in the division or company. The assets in the tracking stock belong to the parent corporation and are controlled by the parent's board of directors. When AT&T announced the creation of a tracking stock for its wireless unit, Blumenstein (1999c) reported that the company planned to sell about 20 percent of the stock to the public (which would be the largest initial public offering to date) and distribute the rest of the unit's shares to its existing shareholders. Though it would not hold an economic interest in the unit, it would still own the unit's assets.

Voting rights are usually attached to tracking stocks. However, owners of the stocks usually have fewer votes per share than the owners of the parent company's common stock. For example, in the prospectus for its PCS offering, the Sprint Corporation explains voting rights:

Each outstanding share of Series 1 PCS Stock and Series 3 PCS Stock is entitled to a number of votes (the "PCS Per Share Vote") equal to: (1) if the record date for determining the stockholders entitled to vote is on or before December 31, 1998, the PCS Ratio, and (2) if the record date for determining the stockholders entitled to vote is after December 31, 1998, the ratio of the Average Trading Price of one share of Series 1 PCS Stock to the Average Trading Price of one share of FON Stock computed as of the tenth trading day before the record date for determining the stockholders entitled to vote, expressed as a decimal fraction rounded to the nearest three decimal places. Each outstanding share of Series 2 PCS Stock is entitled to a number of votes equal to 1/10 of the PCS Per Share Vote. In matters on which the holders of PCS Stock vote as a separate class, each share of PCS Stock, including each share of Series 2 PCS Stock, will receive one vote per share. Except as otherwise provided under the Amended Ar ticles or required by the Kansas General Corporation Code, the holders of the FON Stock and the PGS Stock will vote together as a single class.

Because the PCS Per Share Vote will vary from time to time, the relative voting power per share of PCS Stock and FON Stock will fluctuate. It is expected that initially the FON Stock will have a substantial majority of the voting power of Sprint.

Tracking stocks differ from dual class stocks. With the latter, a company sells two or more classes of stock for the parent company. Although both classes usually have the same cash flow per share, they differ in their voting rights. The purpose of dual class stocks is to allow the company s founder or managers to diversify their holdings, or raise additional equity capital, without the risk of losing control of the company. The GM Class E stock is referred to as both a tracking stock and a dual class stock. In fact, it is credited with being the first tracking stock, and represents the first time the New York Stock Exchange allowed a listed corporation to issue dual classes of common stock.

The Proponents' View of Tracking Stocks

Four reasons are often cited as the advantages of owning tracking stock:

1. It offers more attractive stock options.

2. It allows undervalued units to increase their market value (as well as the parent's).

3. It provides a "currency" to use to acquire other companies or raise additional capital.

4. It avoids a drag on the parent company's stock price.

When GM acquired EDS, it was concerned with keeping the managers there. As members of a growth company, the managers were used to options that would obtain a higher value quicker than those from a stodgier GM. The solution was to create the Class E stock. Because the dividend on the stock was tied to the EDS unit, the security should be able to reach higher values. Thus the executives, receiving stock options on the Class E shares, should receive higher compensation. GM would then be able to attract and keep more talented executives for the EDS unit.

Proponents of tracking stocks maintain that markets are not efficient and investors do not understand all aspects of a company's business. If a company has a small unit in a dotcom or some other technology-based business, they argue, that unit might not be valued properly. By issuing a tracking stock for it, reports Caddell (1998), the unit can be treated as a "pure play"--a company in only one industry. As such, it can be valued according to the price-earnings multipliers for that type of industry, which could be higher than the multiplier for the parent company. In January 2000, the value of the GM Class H tracking stock (Hughes Electronics) had a market value twice as high as the parent's market value. The combined value of the two units (parent company's common stock and the tracking stock) would be higher than if the cash flow of the unit represented by the tracking stock was kept as part of the cash flow for the parent's common stock.

Because the tracking stock has higher values, it can be used to pay for future acquisitions. The reasoning is that because the stock is expected to increase in value at higher rates than the parent company's common stock, the owners of companies the firm seeks to acquire might be willing to accept tracking stock shares instead of cash. Or, if the unit needs to raise cash, the parent can sell the tracking stock to provide the capital it needs. AT&T intends to use the tracking stock in its wireless unit as an investment currency for its capital-hungry unit, thereby avoiding a drag on its stock. "Most Internet companies are losing money," says Goldberg (1999). "But by separating [them] from the parent, the parent's stock wouldn't suffer. And if the industry is a high flyer, the higher prices would allow the parent to attract high-quality people with stock options, or acquire other companies."

Instead of creating a tracking stock, the parent could spin off the unit. But tracking stocks have tax or legal advantages over spin-offs. A spin-off would not be tax-free unless the parent owned it for at least five years. Tracking stock, states Caddell, is "more flexible than a spin-off, yet still gives all the advantages of a separately traded company."

The Problems with Tracking Stocks

Several problems exist with tracking stocks. First, they may be hard to explain. Investors may not always understand that, although the unit's value is based on its cash flow, they do not control the underlying assets. Coy (1999) reports that GM Glass E and Glass H shareholders sued GM because they felt the company had duped them.

Tracking stocks also create higher costs because separate statements must be produced for each unit as well as for the parent company In its 1995 S-4 filing with the SEC, the Pittston Company stated:

The Company will prepare Pittston Brink's Group's, Pittston Burlington Group's, and Pittston Minerals Group's respective financial statements in accordance with generally accepted accounting principles, and these financial statements, when taken together, will comprise all the accounts included in the corresponding consolidated financial statements of Pittston. The financial statements of Pittston Brink's Group, Pittston Burlington Group, and Pittston Minerals Group principally reflect the financial position and results of operations for the businesses included therein. Consistent with the Articles of Amendment and related policies, such financial statements also include portions of certain corporate assets and liabilities (including contingent liabilities).

The company goes on to say that certain corporate activities, such as the allocation of corporate overhead, income taxes, and interest, will be divided among the three units based on their percentage of use.

Each of these sets of financial statements must be audited. One determinant of audit prices is the natural logarithm of asset size. So unless the tracking unit is very small, the cost of the audit will rise. For example, the natural logarithm for a company with $100 million in assets is 18.42. If the company splits into two units of equal size, each of these $50-million-in-asset units has a natural logarithm of 17.72.

Another complaint about tracking stocks is that they tend to create conflict of interest issues. One board of directors controls both the parent company and the tracking stock. But will it always act in the best interest of the tracking stock? Consider the prospectus for DLJdirect, as reported by Coy: The board of directors may make decisions that favor DLJ at the expense of DLJdirect. Due to the extensive relationships between DLJ and DLJdirect, there will be inherent conflicts of interest.... There can be no assurance that DLJ will not expand its operations to compete with DLJdirect.

Other conflicts of interest may occur as well. Georgia-Pacific created a tracking for its timber division. As reported by Caddell, "The timber tracking stock used to sell most of its output to the paper division. But now it can sell to another company at higher prices. At what point do such sales hurt the competitiveness of the paper division?"

Allocation of capital is yet another conflict. The high-growth unit with the tracking stock may need a lot of capital, but because of monetary losses it may not be able to raise it on its own. Should its capital come from the slower-growing but cash-rich, more mature company? Investors value securities issued for a cash cow division on the basis of its cash flows. If these flows were diverted to the other division, investors would be justifiably upset.

Some of the advantages of tracking stocks have sometimes turned out to be disadvantages. For example, the tracking stock form may hinder a firm's efforts to acquire other companies or to be acquired itself. Consider USX-Marathon. When Carl Icahn pressed USX to spin off Marathon Oil, USX created the tracking stock instead. Management argued that losses at USX would shelter the profits from Marathon Oil. However, those losses are now reduced and although the oil industry is consolidating, Marathon, for the most part, is left out of the picture. As McGough and Matthews (1999) explain:

Marathon sells at a discount from other oil companies because the form prevents other companies from acquiring Marathon. The shareholders of the other tracking stock--USX-U.S. Steel--would also have to approve the deal and it would be taxable to USX unless the oil company bought the parent as well. And the relatively low stock price hurts Marathon when attempting to acquire other companies.

In general, tracking stocks are a hindrance in a takeover. The units tend to lose any takeover premium because the parent's board of directors must review and approve any such deal. The acquisition of the parent is another interesting issue. When MCI WorldCom acquired Sprint, investors wondered what would happen to the Sprint PCS tracking stock. Asked Harris (1999), "Will WorldCom issue a new security? If so, will the tracking stock owners receive a takeover premium? WorldCom could acquire control with out doing anything."

After the takeover, MCI announced that it would keep the tracking stock and that losses in the unit would continue for at least two years. According to Blumenstein (1999b):

When a company creates a tracking stock to increase the value of undervalued units, the move may backfire. Pittston created three tracking stocks: Brink's, its home security and armored car unit; BAX Global, its freight and transport business; and Pittston Minerals, its coal and mineral business. However, even though the units have combined revenues of $4 billion, the total market value for the units is only about $1 billion. The liabilities of the coal business affect the values of the other units. Since all the units are part of one company, investors fear that the cash flows from the other units will be used to pay the coal unit's liabilities. Or, as Pittston wrote in its 1995 registration statement:

Since the company retains the assets, the losses could affect the company as a whole. The tracking stock allows the company to isolate the losses but the capital needs of the tracking stock unit "would likely affect how the company allocates capital." The company also said that they reserve the right to fold the unit back into the parent company when the losses subside.

Proposal will not affect legal title to such assets or responsibility for such liabilities for the Company or any of its subsidiaries. Holders of Brink's Stock will be common shareholders of the Company, which will continue to be responsible for all of its liabilities. Financial impacts arising from one group that affect the Company's financial condition could affect the results of operations and financial condition of each of the groups. Since financial developments within one group could affect other groups, all shareholders of the Company could be adversely affected by an event directly impacting only one group.

Most financial activities are managed by the Company on a centralized consolidated basis. Changes in the Company's total debt that are caused by the cash flows of one Group could affect the weighted average interest rate, which will be used to charge interest expense to all Groups having attributed debt, and to that extent could affect the interest expense charged to the other Groups.... In obtaining financing through increases of its attributed debt, one Group could receive a "benefit" or "detriment" to the extent that such weighted average rate is lower or higher, respectively, than the "market" rate for a hypothetical borrowing by such Group if such Group were a separate corporation....

The separation of the ownership of the assets and the cash flows deriving from those assets also creates tension between the classes of stockholders. Prior to the December 1999 board meeting of General Motors, reports Yost (1999), GM stock rose in anticipation that the board would spin off its Hughes unit. Many hoped the unit would be spun off. The tracking stock had done well and holders of the GM common stock wished they could share in its success.

The law of conservation of value states that the value of the whole is equal to the value of its parts. The late Merton Miller was once asked to explain his Nobel Prize-winning theories in a way readers would understand, even if they had no knowledge of economics.

Miller recalled a story about baseball star Yogi Berra, who was once asked if he wanted his pizza cut into quarters or eighths. Berra said he wanted it cut into eight pieces because he was feeling hungry. "If you know why this is a joke," said Mr. Miller, "you understand the M&M theorem." ("Merton Miller" 2000)

So even if the company decides to divide its cash flows differently, the total value is going to be the same. The value of any security is derived from the future cash flows associated with the assets, given the timing of those flows and their risks. These cases show one of the problems with tracking stocks: the separation of the ownership of the assets and their cash flows. If a tracking stock is created, the parent company's common stock no longer participates in the unit's cash flow, yet it still bears the risk. The investors in the parent's common stock can expect smaller dividends in the future (no longer receiving benefits from the unit). They can also expect their risks to increase because they still own the assets of the tracking stock. Given the increase in risk, investors will require higher rates of return on their investment. Thus the value of the common stock would decline, offsetting any increase in value from the tracking stock.

The companies issuing tracking stocks are among the largest and best-known companies in the world. They also have more security analysts following them. Research has shown that larger companies are more fairly priced than smaller ones. Groth and Martin (1981) studied the buy recommendations from 1964 through 1970 and found that the largest firms receive the closest attention from security analysts. Although they discovered a difference in the speed with which information is identified, distributed, and included in security prices, there is an inverse relationship between firm size and the frequency, magnitude, and duration of the abnormal returns. Therefore these companies have nothing to gain by issuing tracking stocks. Because more people follow them and understand their operations, few of them will have undervalued units.

Companies have issued tracking stocks to provide attractive stock options to executives, achieve higher valuation for undervalued units, provide a method of acquiring other companies, or avoid a drag on the parent stock. Given these reasons, people contend that the issuance of these securities will create better performance and higher stock market valuations for the issuing company. However, potential conflicts of interest are inherent in the tracking stock form. Investors in both the tracking stock and the parent company's common stock need to be very careful of ethical concerns.

Daniel L. Tompkins is an assistant professor of finance at Niagara University in New York.

Notes

1. This article does not argue whether or not shareholder wealth maximization is the proper goal of the firm. It is the author's belief that shareholder wealth maximization is consistent with ethics.

References

Russ Banham, "Track Stars," Journal of Accountancy, July 1999, pp. 45-48.

Rebecca Blumenstein, "AT&T Weighs Stocks to Track Different Units," Wall Street Journal, October 4, 1999(a), p. A3.

Rebecca Blumenstein, "MCI Says Sprint Unit's Losses May Weigh on Firm," Wall Street Journal, November 9, 1999(b), p. B9.

Rebecca Blumenstein, "AT&T to Offer Wireless Tracking Stock," Wall Street Journal, December 6,1999(c), p. A3.

Richard E. Caddell, "Divide and Conquer," Institutional Investor, March 1998, p. 33.

Sean Callahan, "IPO Brings Mixed News for Ziff-Davis," Advertising Age's Business Marketing, April 1999, p. 2.

Peter Coy, "Tracking Stocks Are Accidents Waiting to Happen," Business Week, August 2, 1999, p. 33.

Lisa Reilly Cullen, "Tracking Stocks: No Free Ride," Money, October 1999, pp. 52A-B.

Nikhil Deogun, "Pittston Plans to Sell Coal Unit and Scuttle Its Tracking Stock Effort," Wall Street Journal, December 6, 1999, p. B16.

Steven Goldberg, "The Hot New Stocks Aren't Exactly Stocks," Kiplinger's Personal Finance Magazine, September 1999, p. 34.

John C. Groth and John D. Martin, "The Impact of Firm Size on Capital Market Efficiency," Journal of Economics and Business, Winter 1981, pp. 166, 168.

Ferdinand A. Gul, "Audit Prices, Product Differentiation, and Economic Equilibrium," Auditing: A Journal of Practice & Theory, Spring 1999, pp. 90-100.

Nicole Harris, "Structure of Sprint's Wireless Unit May Play a Key Role in MCI Talks," Wall Street Journal, October 1, 1999, p. B6.

"IRS Ruling Permits Cablevision to Realign Rainbow Media Assets," Wall Street Journal; November 30, 1999, p. C24.

Tim Kendall, "Show Me the Money," Forbes, February 21, 2000 (Supplement ASAP), p. 30.

Robert McGough and Robert Guy Matthews, "Tracking Stock Fans, Consider Marathon Oil," Wall Street Journal; November 10, 1999, p. C1.

"Merton Miller," Economist, June 10, 2000, p. 94.

Seth Schiesel, "Tracking Stocks Show Signs of Respectability at Age 15," New York Times November 24, 1999, p. C10.

"Wireless Tracking Stock Is Put Under Consideration," Wall Street Journal, December 1,1999, p. B14.

Mark Yost, "GM Shares Rise Ahead of Board Meeting That Will Include a Review of Hughes," Wall Street Journal, December 6, 1999, p. B19.
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Author:Tompkins, Daniel L.
Publication:Business Horizons
Geographic Code:1USA
Date:Nov 1, 2000
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