Capital Markets

The Emperor’s New Shares

Tracking stocks are all the rage these days. One management consultant wonders why.
Al EhrbarApril 15, 2000

As financial innovations go, tracking stocks have been a bust for a decade and a half. Consider this: From 1984 to 1999, underwriters brought an average of more than 50 equity carve-outs to the Street each year. During that same time period, investment bankers launched a grand total of 23 trackers. That’s it.

In a perfect world, things would have stayed that way. In our world, tracking stocks are suddenly popular. This is particularly true at old-economy companies, where managers now seem intent on setting up their new-economy operations as separately valued — but not truly separate — businesses. Credit Suisse First Boston, for one, has CSFBdirect for its online brokerage. Sprint has Sprint PCS, which is tied to its wireless business. And in January, officials at AT&T announced plans to issue tracking stock for the company’s Wireless Group.

For the uninitiated, tracking stocks are a special class of common shares whose value is tied to the performance of a particular segment of a company’s business. Hence the name. They “track” the performance of one operating unit, not the entire corporation. The segment in question remains a wholly owned part of the parent, with the same board of directors, the same top management, and with no legal separation of operating assets. Trackers were invented in 1984 to facilitate the purchase of Electronic Data Systems by General Motors. At the time, Ross Perot wanted a tax-free exchange for his EDS stock, but he didn’t want to tie a Nova to his tail. Thus, GM created its E class of common.

So why does a creature crafted for the convenience of Ross Perot suddenly hold such allure for potential issuers? The standard answer is that tracking stocks offer four big advantages. First, they supposedly unlock hidden value in new-economy or other high-growth businesses. Once the earnings of the tracked segment are decoupled from those of the parent, the thinking goes, they command the much higher P/E multiples normally accorded to pure plays in the tracking unit’s industry. In other words, the unlocked whole is worth more than the locked whole, even though nothing really has changed.

Second, backers say tracking stocks provide a powerful, equity-linked incentive for managers of the new units, enabling the parent to compete effectively for dotcom-savvy managers. Beyond that, trackers are thought to be an attractive acquisition currency for buying other new-economy businesses. Like Perot, those owners don’t want the doggy old-economy paper, either. Finally, and most important (to the issuers, anyway), tracking stock does all this while keeping the new unit under the control of the parent company management.

Turkeys and Carve-Outs

By my lights, the last advantage is the only one that’s real. Issuing a tracking stock instead of doing an equity carve-out or a complete spin-off does insure that the CEO of the parent doesn’t end up doing a Robert Allen. A Robert Allen, in case you don’t know, is an unfortunate maneuver named after the former chief of AT&T, who spun off Lucent Technologies but stayed with the parent. Since that spin-off, Lucent stock has simply skyrocketed. Interestingly, Lucent would not have gotten nearly the same boost had it merely become a tracked unit. Part of its surge has come from selling to network operators — operators who, in the past, shied away from buying equipment from rival AT&T.

The other supposed advantages to tracking stocks are mostly imagined. Consider hidden values. If this rationale is true, Wall Street must be peopled with incredibly inept gold-diggers — every one of whom would have starved to death in the Yukon. Even if the analysts covering, say, Sprint, are some of the duller tools in the box — and that’s not likely — the parent company ought to be able to wake up the rest of the investment community simply by disclosing more details about their new-economy operation.

As far as incentives are concerned, it’s quite possible to craft cash bonus plans for managers, which are just as effective as tracking stocks. A company should not have to issue a separate, nonvoting class of common stock just to pay a subset of its management team.

The fact is, managers who look closely at the history of tracking stocks would probably balk at them anyway. The lion’s share of those first 23 tracking issues have been genuine turkeys, underperforming both the market as a whole and the stocks of their parent companies. Finally, if tracking stocks are such a nifty acquisition currency, why were so few of them created for the more than 9,000 M&A deals completed in both 1998 and 1999?

In reality, the disadvantages of tracking stocks more than outweigh the alleged benefits. The biggest drawback seems obvious: What happens when the interests of the tracked operation come into conflict with other parts of the corporation, as they inevitably must. What, for example, is the basis for transfer prices between the tracked division and its siblings? Without a tracker, such conflicts are run-of-the-boardroom, business-judgment matters. With tracking stocks, you’re heading into class-action territory.

Indeed, that’s precisely where GM wound up with its E shares. Owners of E shares sued GM because they were unhappy with the terms dictating the exchange of their stock for shares of EDS following the spin-off. GM has prevailed in court for now, which should provide some comfort to other issuers of tracking stock. But think of the message the lawsuit sends to prospective buyers of tracking stocks.

When the idea of issuing tracking stock does come up at a company, it’s typically fueled by the question of how to best organize the pieces of the corporation. Do they really belong together? Or should one segment be spun off — gradually or all at once — to fend on its own?

The right answer never is a tracking stock. If the businesses genuinely belong together, anything else, including tracking stocks, will reduce the intrinsic value of the whole. If the activities should be separate, then an equity carve-out or spin-off — with the sharper focus and accountability they bring — are superior. Tracking stocks, on the other hand, are halfway measures that are all-the-way wrong.

Al Ehrbar is a partner and chairman of BrandEconomics LLC, a subsidiary of Stern Stewart & Co. that advises companies on brand valuation, management, and strategy. He is also the author of EVA: The Real Key to Creating Wealth.