Tread Carefully When You Buy Tracking Stocks
Tracking stocks are all the rage on Wall Street. AT&T, for instance, is about to roll out a tracking stock tied to the performance of its wireless unit in an initial public offering expected to raise $10 billion. A dozen other big corporations also have tracking stocks in the works, including Staples, New York Times, J.C. Penney, DuPont, and Cendant.
These oddball equities are a class of common stock whose value is tied to a particular segment of a corporation's business. They are especially popular right now because they allow diversified companies to highlight a high-growth business in a hot stock-market sector. Many of the newest tracking stocks, for instance, are tied to the performance of a corporation's Internet or telecommunications business. The more traditional way for a corporation to unlock the value of a high-octane division is to spin the unit off. With a tracking stock, however, the parent maintains complete control of the subsidiary. "The parent can have its cake and sell it, too," says Joseph W. Cornell, president of Spin-Off Advisors LLC, a Chicago research firm.
MIXED BAG. But tracking stocks can be better deals for the corporations issuing them than for investors. For one thing, their performance has been a mixed bag (table, page 184). It's true that a handful of tracking stocks have been wildly successful, such as Sprint PCS. That tracking stock, which is tied to the performance of Sprint's wireless group, gained 363% last year, while the share price of the parent rose 65%. AT&T's cable programming group, Liberty Media, and biotech darlings Celera Genomics, a tracking stock of PE Corp., and Genzyme Surgical, a tracking stock of Genzyme, have similarly seen their share prices soar. But many others have been duds. Among them: DLJ Direct, the online brokerage unit of Donaldson Lufkin & Jenrette, which is off 66% since its May debut. Meanwhile, Disney's Internet portal Go.com has dropped 28% since its November launch, and Circuit City's used-car-dealership subsidiary CarMax is down 93% since its 1997 debut.
How do tracking stocks fare overall? McKinsey & Co. examined 23 trackers between 1988 and 1999. The management consultant found that in the two years after the tracking stock was issued, its average total return was 19% versus an average 21% gain in the Standard & Poor's 500-stock index during that time. Meanwhile, the parent stocks generally outperformed the trackers, roughly keeping pace with the S&P 500, the study found.
Trackers possess many of the same features of regular common equity. For instance, companies can issue dividends for the tracking stock. Corporations also provide separate financial data for tracking-stock subsidiaries in filings with the Securities & Exchange Commission. And companies issue options on tracking stock to help attract and retain top executive talent at their subsidiaries.
EQUITY INTEREST. But trackers also have characteristics that can be drawbacks for investors. Because a tracking stock is actually an equity interest in the parent company, not the subsidiary, another company can't acquire the subsidiary by buying up the shares. That means there's no chance for tracking-stock investors to receive a takeover premium. "One of the reasons why investors like pure-play companies is because they are often ideal takeover targets," says Cornell of Spin-Off Advisors. He points to the example of Media One, the cable business of US West, which became a tracking stock in 1995. Three years later, US West spun off MediaOne as a stand-alone company. Cornell says that MediaOne's share price languished while it was a tracker. But soon after it became independent, AT&T proposed acquiring MediaOne, causing the stock price to surge. In the past year, MediaOne's share price has climbed 36%. AT&T's acquisition of MediaOne is pending.
Another problem is the potential for conflicts of interest because the parent company's board of directors also governs the tracked unit. When it comes to allocating expenses or resources, for instance, it's possible that a subsidiary may get the short end of the stick from the board. "You have to trust the board of directors to do the right thing," says Jeffrey Haas, a professor at New York Law School who studies tracking stocks. "But you could wind up getting burned if they don't."
Consider what happened when media company Ziff-Davis issued a tracking stock via a $19-a-share IPO for its dot-com unit, ZDNet, in March, 1999. The parent company used $175 million of the total $201 million it raised from the ZDNet offering to pare its own debt. The remainder went to ZDNet, which has just begun to turn a profit. Shares of ZDNet have fallen 14% since their launch, and Ziff-Davis plans to eliminate them as part of a broad reorganization that will allow the company to better focus on its Internet operations. For every 100 shares of ZDNet owned, investors will receive 180 shares in the reorganized company.
Conflicts of interest between the parent company and its tracking-stock shareholders have occasionally spawned lawsuits. The most prominent involves General Motors. In 1996, the auto maker extracted a $500 million payment from EDS, the tracking stock of its Electronic Data Systems unit, right before the unit was spun off as a separate company. EDS tracking stockholders sued the auto maker, charging it had breached its fiduciary duty to them by deciding terms arbitrarily favorable to the parent, GM. In March, 1999, a Delaware court decided in favor of GM; the Delaware Supreme Court upheld the decision in January. New York Law School's Haas says the ruling is a setback for investors in tracking stocks, because it undermines their legal protections. "It's caveat emptor," he says.
PARENTAL ISSUES. Another difficulty with tracking stocks is they can be affected by problems elsewhere in the parent company. That's what happened to Pittston, which in the mid-1990s reorganized itself as three tracking stocks for its coal, Brinks armored trucks, and air cargo units. Pittston recently opted to fold the tracking stocks back into a single corporate issue because investor fears about pension and health-care liabilities at the coal company were dragging down the prices of the other two tracking stocks.
Tracking stocks tend to cash in on investing fads. So it's easy to gloss over their extra risks when their shares are flying high. That's why it's important to look closely at the parent stock's financial stability as well as the tracker's prospects. In essence, you are really buying an interest in both.