Tracking Stocks and Tracking Stocks

First up is Mike Gillen, who writes in with the most elaborate of several questions this week on tracking stocks: "Can you tell me what a 'tracking' stock is? How is issuing a 'tracking' stock on a particular segment or division of a company different from a 'spinoff' of the division? Doesn't the parent still have to float an IPO of the tracking stock and then report on it as if it were a separate company? What are the advantages of issuing a tracking stock for the company? What are the advantages of a tracking stock for the investor? How do tracking stocks perform with regard to the parent corporation?"

Let's start with the motivation behind this type of securitization. Imagine a company focused primarily on one type of manufacturing -- say, automobiles. This company is huge. So massive, in fact, that you can lose track of entire businesses within it, businesses that don't have a whole lot in common with the firm's main focus. The tragedy of it all, from the company's perspective, is that these businesses have actual book value and earnings that investors haven't priced into the parent company's stock.

What to do? The parent company -- call it General Motors (GMH) -- spins off the unappreciated unit -- call it Electronic Data Systems or Hughes Electronics -- as a tracking stock, and the companies start reporting their earnings separately (though they continue to be taxed as a single entity).

That's the general logic behind both spinoffs and the creation of tracking stocks. In the language of public relations, the process is about "unlocking hidden value," and companies can do it with both real, neglected subsidiaries and with Web sites whose value couldn't be hidden any better by the Easter Bunny himself.

In plainer language, "unlocking hidden value" means hundreds of millions of dollars. As TSC editor-at-large Cory Johnson reminded readers this week, the purpose of an IPO is to raise cash for the issuer, and tracking stocks do this as well as spinoffs. But tracking stocks have an immeasurably important benefit for the issuer that true spinoffs don't: They leave control of subsidiary in the parent company's hands. It's free money.

That's right. Holders of tracking stocks typically don't have any voting rights in the company whose performance those shares track. Nor are they considered equity holders in that company. Their equity stake is in the parent corporation, which can do things like reorganize or even liquidate the assets of the subsidiary without any consent from that subsidiary.

Retaining this kind of control is very attractive for the issuer of a tracking stock. Lacking it is the major drawback of owning a tracking stock. In fact, dissatisfaction with its lack of control over its own operations eventually led EDS to break off from GM.

So why would anyone want to own tracking stock?

To begin with, being a subsidiary isn't all bad. For one thing, subsidiaries have access to the parent's war chest, nothing to sneeze at in the case of a company like GM. Also, regardless of how well hidden a subsidiary's value may be, it can rely on Daddy's good credit rating when it comes to raising cash.

Oh yeah -- there's also the possibility of making money. It's hard to say how tracking stocks perform via their parents, because there isn't much long-term data. But some tracking stocks have done very well. For example, GM's Hughes Electronics (GMH) has gained about 367% over its 14-year tracking-stock existence, and more than 570% since its nadir in the early 1990s. During both periods, GM has risen a more modest 161% and 181%, respectively.

In the short term, be wary. In one sense, the recent vicissitudes of Ziff Davis' (ZD) tracking stock, ZDNet (ZDZ) -- after rising as high as 48 11/16, it has recently dropped below its IPO price of 19 -- are a factor of Internet volatility in general. But remember that if ZDNet one day finds itself in an environment that demands it produce significant earnings not later, but now, it'll be Papa Ziff, not ZDNet shareholders, who'll determine the fate of your "stock."

Message Center

From tracking stocks to, well, tracking stocks, here's a memo to Steve Hamilton, who wonders if there's a good site where he can log his stock transactions: There are a plethora (a slight exaggeration) of Web sites that allow you to do this, Steve. We've got a good tracking tool here at TSC in our Portfolio section.

Memo to C. Prattico, who wonders if there's a such a thing as a "financial interactive encyclopedia" that will let him look up key terms and concepts: As with portfolio trackers, there are a ton of glossaries out there on the Web, though the term "financial interactive encyclopedia" is a bit too high concept to describe what they do. We have one here in TSC's Basics section. Invest-faq is also excellent, in my opinion. But if you're not wedded to hypertext, you can't beat Barron's Business Guides glossaries.

To be honest, though, Q&A columns like this one are as interactive as it gets.

Memo: Have a dumb question relating to finance? Have a problem with something I've written? Send it to [e-mail], and I'll do my best to answer. Include your full name, and please, no questions seeking personal financial advice or regarding personal brokerage disputes. And this reminder: Because of the volume of mail, personal replies can't be guaranteed.

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