Dear Dagen: On the Trail of Tracking Stocks

A slew of new tracking stocks were issued this year. What are they and how do they work?
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A tracking stock is a bit like an adult child who never leaves home.

There are lots of issues.

And these peculiarities are more important than ever as a new wave of these securities has hit the market this year and even more are expected next year.

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For investors, tracking stocks can be a way to buy an especially fast-growing piece of a company's business. But the performance of these fairly rare securities has been mixed.

Right now, you'll find 29 tracking stocks in the market, nine of which made their debuts this year. Typical of this year's tracking-stock issues is

ZDNet

(ZDZ)

, the Web division of

Ziff-Davis

(ZD)

. The tracking stock was issued in March.

Next year,

AT&T

(T) - Get Report

will create a tracking stock for its wireless business.

SBC Communications

(SBC)

is considering the same for its own wireless units. And, proving that the move isn't just for tech companies,

J.C. Penney

(JCP) - Get Report

is planning a tracking stock for its

Eckerd

drug stores.

A tracking stock is a way for a company to create a separate security to track and, as we'll see, highlight the financial performance of a division or subsidiary while keeping 100% ownership.

If a company has developed a distinct business line that is lost among its other businesses, it might issue a tracking stock in order to receive full market valuation for it.

This year, financial markets have rewarded almost any company that can claim to be an Internet or wireless company. Tracking stocks give companies a way to draw attention to their Internet and wireless businesses and boost their value without giving up corporate control.

If the price-to-earnings multiple available for a particular business unit in the public market is so much higher than the one for the overall company, then there's the natural temptation to separate that business from the rest of the company.

Ultimately, the value of the tracking stock and the main company's stock would hopefully add up to more than the original did on its own.

Lately, that temptation has been apparent among telecom companies, such as AT&T and SBC, as they try to attract the market's attention to their high-growth wireless businesses.

Since its debut late last year,

Sprint PCS

(PCS)

, the wireless division of

Sprint

(FON)

, has soared 563%, compared with 75.2% for its parent.

Before the surge in Internet and telecom tracking stocks, this strategy was sometimes used to separate disparate businesses. In the early 1990s,

USX

split into

USX-U.S. Steel

(X) - Get Report

and

USX-Marathon Group

(MRO) - Get Report

. Any investor who wants to buy a steel company would likely want a pure steel stock, not one with heavy exposure to an oil company. This tracking-stock arrangement solved that problem.

Actually, once the tracking stock has been issued, you really have two tracking stocks. Two sets of securities exist that track different assets within the same corporation.

A tracking stock should technically trade the same as a spinoff, although investors in a tracking stock don't actually own a share of the underlying business and they can have diluted voting rights.

It's not really clear what hard assets you own with a tracking stock. "You are removed one layer away from legal ownership of the assets, relative to ownership in a typical company," says Bill Nygren, manager of the

(OAKLX) - Get Report

Oakmark Select fund.

You don't have to own the original stock of the parent to own the tracking stock. When creating a tracking stock, a company might distribute shares to the company's existing shareholders or sell them to the public in an initial public offering. The latter can be a strategic move to raise cash. AT&T could raise as much as $7 billion to $10 billion in creating a wireless tracking stock.

Though it has its own set of books and its own leadership, a tracking stock usually has the same board as its parent company. This arrangement draws the disapproval of some investors, who say tracking-stock holders might suffer from the lack of an independent board to look out for them. As a separate corporation, a spinoff, on the other hand, would have its own board.

"The larger of two stocks controls management and the board. The smaller company could have minority influence. If you think there are issues of management fairness going in, it's better to walk away," Nygren says.

One alternative to creating a tracking stock is to spin off the business entirely, creating an independent company. There are two primary reasons for opting instead for a tracking stock.

The first is that a tracking-stock structure makes it easier to borrow money. In assessing the company's creditworthiness, "the lender, if necessary, can look to the assets of the entire company, not just of the assets of the tracking stock," says Ron Gallatin, senior advisor to

Lehman Brothers

. The original company and the tracking entity keep separate books, but it's the totality of those two books that equals one company. It's like a parent guaranteeing a mortgage for an adult child.

Second, the parent company still gets to file a consolidated tax return that includes the result of the tracking stock. If this sexy division is a money-loser, and will be for some years to come, the parent still gets to reap the benefits of those losses on its tax returns.

Also, if the two entities "are in related businesses, they are not bound by rules that would otherwise prohibit competitors from discussing issues like pricing. If they are separate companies, those discussions might be viewed as collusion," Nygren notes.

For investors, any benefits would really be in the performance. Many of these securities are too young to tell how they will do in the long run.

Sprint PCS has obviously done well, but other tracking stocks haven't done as well. ZDNet is up only 2% from its offer price earlier this year.

That's behavior worth scolding.

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