Question: What is a Tracking Stock?
You may have heard of a special kind of investment called a tracking stock. Just what is tracking stock and what are the benefits and drawbacks?
Answer: A tracking stock is a special type of stock issued by a company to represent a particular division of segment of the business. It allows management to retain control of the operation without having to sell it or spin it off to shareholders as a legally separate entity while providing investors the opportunity to value various aspects of an enterprise on different terms and price to earnings multiples.
Example of Tracking Stock
Several years ago, Sprint had a cell-phone division called Sprint PCS. The company announced that it was going to create a tracking stock so the market could value that particular division as opposed to having it absorbed in the company. Because PCS was growing faster than the traditional phone business (affectionally known as Sprint FON to stockholders), it was considered more valuable. With only one, single stock in existence at the time, however, this shining star of Wall Street was dragged down and sold for less than if the two operating segments were separate businesses.To solve this problem, each Sprint shareholder was given 1 share of PCS for every 2 shares of Sprint FON they owned. Thus, they traded as two different stocks on the New York Stock Exchange, but PCS was owned by Sprint and only represented a division of its business.
Pros and Cons of Tracking Stocks
There are several pros to tracking stocks:
- They can allow management to "unlock value" by increasing the total market captialization of the business. This increases the actual paper wealth of the shareholders, who can sell fewer shares of stock to buy a new car, house, or fund their retirement. It also allows management to pay for acquisitions using stock, as opposed to cash; the higher valuation makes the ultimate economic cost to shareholders lower than it otherwise would be.
- Management retains control over the "tracked" operating segment or business.
There are several drawbacks to tracking stocks, however:
- Tracking stocks often have greatly reduced (or non-existant) voting rights.
- An owner of a tracking stock might not actually own the specific aspect of the operating segment tthat is being tracked. In the event of a corporate bankruptcy, for example, their assets would be fair game for the credits even if the division associated with the tracking stock was extremely profitable and growing rapidly.
- If the market goes south, the tracking stock can be absorbed back into the main stock at a price that may appear unattractive to either (or both) the owners of the tracking stock and the original corporate stock. This is eventually what happened to Sprint.
