Are Two Stocks Better Than One?

Tracking stocks mix blue-chip securities with sky-high value--but there is a

downside
By Marcia Vickers, June 28, 1999 at 8:00 AM GMT+4
They're called "tracking stocks." And at first blush, Corporate America's passion for them may
seem like another indication of a bull market gone mad. But on closer look, tracking stocks can
make economic sense both for companies and investors.
Tracking stocks are equities issued by companies that want to separate out their sexier, high-
growth divisions. The idea is that in this nosebleed market the tracking stock and the parent
company's stock, which are traded separately, will be worth more than the single stock of the
company.
Companies are feverishly issuing tracking stocks. There are 36 on the market. Four companies--
AT&T, Perkin-Elmer, Ziff-Davis, and Donaldson, Lufkin & Jenrette--have issued tracking stocks
this year. Tracking stocks from DuPont, J.C. Penney, Snyder Communications, and Quantum
are coming down the pike. Other companies, such as Walt Disney Co. and Microsoft Corp., are
considering issuing tracking stock for their Internet subsidiaries. And numerous brick-and-
mortar retailers that have launched online divisions, such as Federated Dept. Stores Inc. and
Wal-Mart Stores Inc., are said to be considering them, too.
THE WINNERS. Jeffrey Haas, a New York Law School professor who has studied tracking
stocks, says that in theory a parent company's stock price should already fully reflect the value of
the tracking stock subsidiary. But that's only in theory; in fact, in this heady market, pure stock
plays are the winners. "Companies are shrewdly timing the debut of tracking stocks while the
market will reward them with sky-high valuations," says Haas.
Analysts note that the only way to get top value for a small but high-growth division of a large
corporation is either to spin off the division, sell the company, or issue a tracking stock.
"Tracking stocks enable big companies that have phenomenal businesses encased within them
to capture value as opposed to selling those businesses," says Barbara Byrne, a Lehman Brothers
Inc. investment banker. It's easier to tell a company's investing story with a tracking stock than
to describe a conglomerate with disparate divisions.
Tracking stocks offer up other benefits to the parent. They enable companies to offer high-
growth stock incentives to reward and retain top employees who work at slower-growing or even
out-of-favor flagship companies.
Tracking stocks are aptly named--their purpose is to track a subsidiary's financial progress. They
debuted in the mid-1980s, when General Motors Corp. created separate shares for two of its
more glamorous subsidiaries--Electronic Data Systems Corp. (EDS) and Hughes Electronics
Corp.
In order for a tracking stock to be created, it first requires a vote from shareholders of the
issuing company. If approved, the tracking stocks are then usually issued through initial public
offerings, though sometimes shares of the new stock are distributed as a dividend to
shareholders of the parent company.
Spin-offs must meet requirements in order to be exempt from capital gains taxes. For example,
the Internal Revenue Service requires that the business be at least five years old and that the
parent retains no controlling interest. There are currently no such requirements for tracking
stocks. In fact, a proposal from the Clinton Administration calling for a corporate tax to be
levied on future tracking stocks was recently shot down by Congress.

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RICH PARENTS. Tracking stocks offer one big advantage to investors: The stocks are a
convenient way for investors to own a high-flying growth company but with less risk. Because
the underlying assets are retained by the parent company, the tracked subsidiary can draw on
the parent company's credit standing to borrow money. And if the tracked company is a
fledgling operation--an Internet startup, for instance--it has the backing of a deep-pocketed
corporation. Donaldson, Lufkin & Jenrette, for instance, has retained an approximate 85%
interest in DLJdirect Inc., its online brokerage, for which it recently issued a tracking stock.
Tracking stocks, especially those of Internet subsidiaries, can sometimes be a hedge against a
market or sector downdraft. "Stand-alone Internet companies will have a hard time financing
negative cash flow and growth in tough times, so a mother-ship company provides a more stable
platform," says James Andrew, vice-president at Renaissance Worldwide Inc., a Boston
consulting firm.
But while investors may not be taking on as much risk with a tracking stock, they're giving up
some worthy features of common stock. Stocks of spin-offs may be better for investors than
tracking stocks because with a spin-off there is a separate board of directors. For that reason,
Paul T. Cook, manager of the Munder NetNet Fund, a mutual fund that invests in Internet
companies, isn't completely sold on tracking stocks. "There's a concern that the old-school
management style of the parent company won't share resources with the new company. They
may not even understand the new business."
And shareholders of the tracking stock, such as in the DLJdirect deal, may have no voting rights
or ownership in the specific corporate assets whose performance the stocks reflect. Sometimes
however, tracking stocks have market cap-based voting-rights systems. Ziff-Davis Inc.
shareholders, for instance, always get one vote per share, whereas shareholders of the ZDNet
tracking stock are awarded votes according to its market cap. ZDNet's market cap is now almost
the same as the parent, so shareholders are on equal footing in voting.
Since a tracked company is controlled by the parent, the chances of a hostile takeover are
virtually nil. For that reason, there's no takeover premium attached to the stock. If the parent
decides to sell the tracked company, however, shareholders would most likely receive some sort
of premium when they redeem their stock.
Once a company issues a tracking stock, the parent company's stock can suffer a blow, even if it
owns a big chunk of the new company. Just look at DLJ's stock, which is currently trading at
some 50% off its 52-week high of 100 3/4. Analysts say that the stock hit its peak because of the
Internet frenzy coupled with the news that DLJdirect was starting up operations in Japan. Since
the DLJdirect tracking stock debuted on May 26, however, the parent company's stock has lost
steam. True, stocks of online brokerages have dampened across the board. "In theory, the value
shouldn't be sucked out of DLJ since it owns the bulk of DLJdirect, but the market doesn't
perceive it this way--it looks at it as if they were two separate companies," says Haas
When E-brokerage stocks bounce back, the tracking stock will be the main beneficiary, not the
parent, says Haas. And the same thing should happen with the tracking stock of any fast-
growing division. That's no surprise, as perception continues to trump reality in this roaring
market.