I have noticed that public companies issue tracking stocks without fully understanding what that means. Many investors, including those participating in employee stock purchase plans and dividend reinvestment plans, may suddenly find themselves with shares in companies they do not fully comprehend. Are these shares in the same company that has been traded on Wall Street for decades, or are they something entirely new?
The Concept of Tracking Stock
Simply put, a tracking stock is a special type of stock issued by a company to represent a specific segment or division of the business. A tracking stock allows investors to evaluate specific aspects of the company under different terms and at a higher price-to-earnings ratio. While investors can speculate on the specific divisions or segments within the company, management can retain control over those divisions without the need to sell ownership or create a separate legal entity to be distributed to shareholders (which in turn requires a board of directors and its own management team).
Examples of Tracking Stock
In the 1990s, Sprint was one of the most attractive telecommunications companies in the United States. Its traditional landline business was very profitable and paid rich dividends, and it had a new and exciting division specializing in mobile phones.
With the internet explosion and stock prices rising to a level that even dividend returns were unsatisfactory, Sprint realized that cellular telecommunications companies were valued at double the rate. The company decided to split its common stock into two classes of tracking stocks, trading under different symbols, FON and PCS. This resembles a dual-class stock setup, but it differs from the classic version of this capital structure. The company’s traditional business, which generates revenue from local and long-distance calling plans, was assigned to FON. At the same time, the cellular business was assigned to PCS. Shareholders received one share of PCS for every two shares of FON they owned.
Once launched in the market, demand for PCS stock was incredible, turning many employees in the once-sleepy telephone world into millionaires as speculators drove the price of the cellular division stock higher. As the stock price soared, people paid less attention to budgets, financial statements, and other fundamentals.
When the stocks collapsed, and growth could not match the adjusted profit ratio with distribution, Sprint’s shares began to plummet alongside the rest of the overvalued securities on the New York Stock Exchange and Nasdaq. (It took the latter 15 years to reach its previous peak). The company’s board decided to exercise its authority and consolidate the tracking stocks back into a single share, FON, by exchanging PCS shares for it.
Although it is much less common, we still see some examples of tracking stocks. One such example is Liberty Media, which owned over 76% of Sirius XM Holdings as of December 2020. Liberty Media separated its ownership of Sirius into three tracking stocks – LSXMA, LSXMB, and LSXMK.
Understanding the Advantages and Disadvantages of Tracking Stocks
There are many benefits to tracking stocks. For example, a tracking stock can allow management to unlock value by increasing the company’s overall market capitalization through expansion of the overall price-to-earnings ratio. This makes existing shareholders richer as they can sell their appreciated shares to buy other investments, pay off debts, send their children to college, or meet other goals. It also gives the board a valuable currency in the form of two different stocks that it can use when making acquisitions. The company can expand its operations while retaining lower intrinsic value. Other significant benefits for management include retaining control over the tracking division or company.
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On the other hand, there are several downsides to tracking stocks. Tracking stocks often have significantly reduced or even completely absent voting rights. The owner of a tracking stock may not even own the specific part of the operating segment that is being tracked.
Investors will feel the impact of this in the event of corporate bankruptcy. The assets of the specific segment that the tracking stock was supposed to represent will be available to creditors, even if the segment associated with the tracking stock is extremely profitable and growing rapidly. This is not the case with traditional spin-offs. For example, Eastman Kodak’s bankruptcy in 2012 did not affect its former subsidiary Eastman Chemical.
If the market declines, the tracking stock can be absorbed back into the main stock at a price that may seem unattractive to the tracking stockholders, the original corporate stockholders, or both. This is what ultimately happened with Sprint, leaving some investors feeling resentful over wealth destruction.
Source: https://www.thebalancemoney.com/what-is-a-tracking-stock-357649
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