On Track?

Dec. 21, 2004
Interest in tracking stocks is growing. However, skeptics say they're not all they're tracked up to be.

During the last year, tracking stocks have taken off. Computer-component manufacturer Quantum, Sprint, investment firm Donaldson, Lufkin & Jenrette, and technology publisher Ziff-Davis have issued them. Others, such as Du Pont and AT&T, have announced that they're considering the use of tracking stock. These firms join a list -- including General Motors, USX, Genzyme, and Georgia-Pacific -- that have used tracking stocks for a number of years. Robert Hernandez, chief financial officer with USX Corp., estimates that about $400 billion in tracking stock is currently trading, versus about $35 billion in 1991. Tracking stocks follow or "track" the performance of a particular unit of the parent company. However, the company remains a single entity for legal and financial-reporting purposes, and the executive team and board of directors continue to oversee one organization. The company files one tax return and one set of 10Ks and 10Qs with the SEC, although it must disclose the financial performance of each operation that a tracking stock follows. Why all the interest? One reason is the proposal -- later dropped -- by President Clinton to tax tracking stock, says Robert Willens, tax and accounting analyst with Lehman Brothers Holdings Inc., New York. "It focused a lot of attention on tracking stock," he says. Currently, issuing tracking stocks isn't a taxable event. The increasing role in the economy of e-commerce is another catalyst. Even as pure-play Web companies attract tremendous investor interest, brick-and-mortar companies that start e-commerce operations often find them overlooked by the capital markets. Tracking stocks can unlock the value of such operations, say proponents. Managers can use the higher-valued stock to make acquisitions and reward employees. Instead of issuing tracking stock, a company could just spin off a line of business. However, by keeping them together management can take advantage of any synergies and efficiencies, say proponents. All units of the company can benefit from the credit rating of the corporate entity, which generally is higher than the divisions would achieve on their own. If one side of the company is losing money, it can help lower the tax bill of the company overall. And a spinoff can mean additional taxes. In 1991 USX became one of the first companies to issue tracking stock. By separating its energy (MRO, NYSE) and steel (X, NYSE) operations, the firm doubled the number of analysts covering the company to about 50, says Hernandez. "Energy analysts don't know that much about the steel business and vice versa." Increasing the number of analysts who cover a company generally means greater attention for the firm, which can help boost the liquidity and price of its stock. The day after USX announced its intention to issue tracking stock, the stock jumped about 8%, says Hernandez. Since then, USX has raised more than $2.5 billion in equity -- more than one-third of the $6.5 billion in equity on the balance sheet. "I don't think we could have done that with the old USX stock," Hernandez says. While the USX steel and energy businesses are fairly distinct, $700 million Genzyme Corp., Cambridge, Mass., has issued four tracking stocks -- all for businesses that compete in the biotech arena, but at different stages of development. Genzyme General (GENZ, Nasdaq) develops and markets pharmaceuticals and is the largest part of the company. Genzyme's other tracking stocks, all traded on the Nasdaq compete in the surgical products (GZSP), molecular oncology (GZMO), and tissue repair (GZTR) markets. "Each stock represents the economic activity of a specified business. It's like owning stock in a division of a company," says David McLachlan, former chief financial officer and now a consultant to the firm. Total capitalization of the four stocks is about $3.9 billion. McLachlan contends that the attributes of the different divisions are distinct enough that they appeal to different types of investors. While Genzyme General is an established business and turning a profit, the others are in development stage and losing money. On the other hand, the divisions benefit from their common ownership, says McLachlan. "All can avail themselves of the underlying core technology of the corporation on a cost basis." Quantum Corp., Milpitas, Calif., had similar reasons for issuing tracking stock in August. The $5 billion company competes in two areas: hard disk drives and storage systems. The disk-drive business is cyclical, and the product has become a commodity, says Richard Clemmer, chief financial officer. Still, he expects reasonable returns over the long run. Quantum's storage-systems group, in contrast, generates operating margins of 20% to 30%, and it should grow by 40% to 50% for the next five to six years. Prior to issuing the tracking stock, Quantum was valued at the lower multiples of the bruising disk-drive market, says Clemmer. Although management considered breaking up the company, it also wanted to take advantage of the technology and customers shared by the two lines of business. "We felt that the synergies of the business were worth tracking stock," Clemmer says. It's a bit early to draw any conclusions about the performance of Quantum's tracking stock, although it probably hasn't gotten off to the start that management had hoped for. Clemmer says it takes most tracking stocks about six months to achieve the same valuations as their peers. As of mid-October, the stock following the hard-disk-drive group (HDD, NYSE) was trading at $6, down from its opening price on Aug. 4 of $7.125. The storage-systems stock (DSS, NYSE) was trading at $14, also down from its opening price of about $19. In that period, the Dow Jones Industrial average dropped about 3%. Even proponents of tracking stocks acknowledge that they aren't a panacea and can create problems of their own. USX CIO Hernandez says tracking stocks are like "shining a spotlight on pieces of the company." When the going gets rough, that may be just what management doesn't want. If management wants to keep attention away from a particular part of the business for competitive reasons, tracking stocks -- with the increased scrutiny that they bring -- aren't a good idea, says J.B. Haller, a vice president with Current Analysis Inc., a Sterling, Va.-based firm. Issuing tracking stock won't automatically attract investors. Genzyme's McLachlan notes that the stocks following the three smaller divisions of the company have the same trouble raising capital that plagues most small biotech companies -- namely, they struggle for attention. There also is a potential for conflicts of interest. Should one side of the business do better than the other, management and the board might be tempted to favor it when doling out funds for acquisitions or capital investments, say critics. Others counter that the conflict-of-interest argument is largely theoretical and often overblown. Most companies that issue tracking stocks also implement policies to guard against any bias. For example, the USX corporate charter prohibits the board from taking money from one group and giving it to the other, says Hernandez. The most important question about tracking stocks is: Do they work, or are they simply smoke and mirrors? After all, they won't correct shortcomings in performance. "You're not creating value, you're not creating synergy, you're not creating cash flow," points out Neal Cannon, vice president with the Financial Relations Board, Chicago. Some say tracking stocks actually can constrain the stock price of the other lines of business. Fadel Gheit, an oil and energy analyst with Fahnestock & Co. Inc., New York, follows USX's energy side, Marathon Group. He says that the U.S. Steel Group side of USX "is a dead weight that keeps the oil stock down," noting that it trades at a 20% to 30% discount to its peers. Marathon's three-year total return for the period ending this Sept. 30 was about 47%, reports Bridge Information Services. During that period, the Dow Jones Industrial average increased about 75%. On the other hand, some tracking stocks turn in tremendous results. Last fall Sprint Corp. issued tracking stock (PCS, NYSE) for its wireless business. Total return so far exceeds 300%. Clearly, tracking stocks can't compensate for poor strategy or operations. However, tracking can bring to light a line of business that otherwise is overlooked. "It's a very valid restructuring tool," says Barbara Byrne, managing director with Lehman Brothers. "But it's just one tool."

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