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Bull's-eye market: will large companies in the UK soon embrace the American fashion of issuing targeted stock? Samuel Idowu, Anthony Brabazon and Kojo Menyah explain what targeted stock is--and what it can offer as a financial management tool. (Finance Targeted Stock).

Targeted stock is a relatively new class of equity that several large US companies have issued in recent years. Although no British group has yet followed suit, the London Stock Exchange has indicated that it would have no objection to this in principle.

Targeted stock (also known as tracking, letter or alphabet stock) is a special class of ordinary shares in a group designed to track the financial performance of a specific subsidiary or unit. It is an alternative to a spin-off or carve-out. Targeted stocks can be issued through an initial public offering, by way of scrip dividends, in a fights issue or by a combination of these methods.

Unlike typical ordinary shareholders, investors in tracking stock don't have a direct ownership stake in the assets of the specific business unit. The parent company keeps possession of the underlying assets. In essence, investors in the tracking stock are entitled to a dividend from the tracked unit, if one is declared, but they have no right to share the dividends of the parent company. The voting rights of targeted stockholders are normally restricted to the basic protection of their financial interests (see panel, right). They may have little, if any, say in determining the operational practices or long-term strategy of the unit.

When a company issues targeted stock, it generally produces detailed financial statements for the tracked unit as well as for the rest of the group. This transparency gives investors a clearer picture of the trading position and future prospects for the various parts of the business, in turn facilitating the valuation of each unit.

General Motors issued the first targeted stock in 1984 when it was bidding to acquire Electronic Data Services (EDS). Ross Perot, then the owner of EDS, was concerned that the efforts of his company's managers would have little impact on GM's overall performance on the stock market, so the use of GM stock options to reward them was unlikely to be effective. The proposal to introduce targeted stock for EDS's operations, which could then be used to motivate its managers, helped to convince Perot to approve the takeover.

More than 20 US companies--including AT&T, Sprint and Georgia Pacific--have since taken the plunge. One common feature of this trend is that the firms have generally used their targeted stock issues to raise the profile of a "star" subsidiary.

There are several arguments for the use of targeted stock, but it offers four main benefits at group level. The most widely cited reason for using this corporate restructuring tool is to obtain higher market valuations for divisions of a group that are undervalued because they are trading at a discount to the sum of their parts. It was for this reason that Granada considered issuing targeted stock for its media division in a bid to highlight the value this unit might attract if it were a stand-alone operation. A tracking stock may unlock hidden value in the parent's business that consequently increases the combined value of both without causing any of the problems associated with a spin-off or carve-out.

Another motivation for issuing targeted stock is risk management. A company might want to venture into an unfamiliar market but be reluctant to expose its existing operations to higher levels of risk. Issuing targeted stock for the new venture may reduce this problem, because the earnings stream of the rest of the group is ring-fenced from that of the tracked unit to some degree.

A third possible reason for adopting a tracking stock structure is to maintain tax and cash-flow benefits, which accrue to the group from the tracked unit. The parent company will be able to use any tax benefits resulting from previous tax losses--perhaps from past research and development investments in the tracked unit.

The fourth reason for issuing targeted stock is that firms keen to grow in a specific market segment can use it as an acquisition currency. The key question here is whether the valuations of targeted stocks are influenced more by the performance of parent company than that of their industry. Although research suggests that targeted stocks track the performance of their industry more closely than stand-alone firms in the same industry, it also indicates that both the stock returns and cash flows from operations of targeted stock segments track the performance of their parent firm more closely than the performance of their industry. This suggests that the use of targeted stock as an acquisition currency may not always be as valuable as companies might think.

A number of managerial benefits may also accrue to the tracked unit. These include:

* The chance to focus on a distinct market. Each tracked unit can concentrate on a specific segment of the market, which means that resources can be focused to take advantage of the opportunities that exist in the chosen area.

* The ability to issue share options whose values are linked to the performance of the tracked unit. This may help to promote an entrepreneurial environment in the subsidiary. Employees can be motivated by incentives such as share options and performance-related pay. A related argument concerns the retention of key managers if the tracked unit is a newly acquired one. To ensure the unit's continued success, the parent company may wish to retain key managers of the subsidiary by offering them share options in it.

* Synergy. A tracked unit may benefit from access to the group's production resources, customers, capital and technology. This may increase the profitability of the tracked unit via a stand-alone company.

* Separate accounting. Tracking can help to provide clarity about the objectives and financial performance of the tracked businesses. This may help to reduce the risk of (unintentional) cross-subsidisation between individual divisions.

The use of targeted stock as a method of equity restructuring has attracted interest in both the US and Japan, where Sony has issued this type of equity. A conglomerate would have many good reasons for wanting to use this for one of its subsidiaries instead of methods such as a carve-out or a spin-off. First, the parent can keep management control over the subsidiary, which a spin-off would not provide. Second, it might be able to reduce its cost of capital, because the consolidated entity is maintained and so retains debt capacity. Third, there are potential tax savings, because loss offsets in the group are retained. Lastly, if the value of the targeted stock increases significantly, the parent can acquire other companies with paper rather than cash.

Targeted stock does have some potential drawbacks, of course. One of the most significant is the potential for conflicts of interest between the shareholders of the parent group and those of the targeted unit. Because the parent can influence the strategy of the subsidiary, there is a risk that the latter will be pressured to make decisions that may be in the interests of the parent, but not in the interests of its own stockholders. This danger can be reduced by carefully drafting the relevant sections in the articles of association governing stockholders' rights.

While some British listed companies--notably, Pearson and Misys--have expressed an interest in the idea of issuing targeted stock, none has yet done so. Pearson initially considered issuing tracking stock for its e-business activities, but later decided that these were fundamental to its core business and would not be separated. Misys, on the other hand, simply felt that the financial climate was not yet conducive for a targeted stock issue.

The jury is still out on the concept of targeted stock in the UK. In the current climate of uncertainty in equities, it is doubtful that we will see an issue in the near future. In the longer term, it will be interesting to see whether UK companies use this vehicle when the economic outlook improves.


* Voting. Holders of targeted stock normally have limited voting rights.

* Dividends. The dividend rights of targeted stock are based on the earnings of the tracked unit. When, and how much of, the tracked unit's profits will be distributed is entirely a decision for the board of directors of the parent company. They can decide to pay dividends to shareholders of one targeted stock and not to others.

* Liquidation. Because holders of stocks in a tracked unit do not own the underlying assets, in the event of liquidation they don't have a special right to those assets. Liquidation rights are often defined in the shareholders' agreement relating to the targeted stock. The parent company may retain conversion rights, subject to agreed restrictions, whereby the targeted stock is converted into another class of share when specified events occur.

* Conversion. The issuer of targeted stock may be able to change it into another class of share, subject to certain conditions. In some transactions, the targeted stock automatically converts to another class of share if the issuer sells the tracked assets.

Samuel Idowu and Kojo Menyah are lecturers in the department of accounting, banking and information systems at London Metropolitan University.

Anthony Brabazon is a lecturer in the department of accountancy at University College, Dublin
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Author:Idowu, Samuel; Brabazon, Anthony; Menyah, Kojo
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:Feb 1, 2003
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