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|RUSS BANHAM is a Pulitzer Prize-nominated business journalist and author of several books, including his most recent, Rocky Mountain Legend, a biography of the Coors brewing dynasty. He lives in Seattle and Missoula, Montana.|
fter startling the business world with the largest IPO in history last year, the DuPont Corp. made another bold pronouncement in March: The giant chemical company would issue a tracking stock for its fast-growing life sciences division, in effect creating a separate, stand-alone company.
The decision by the staid, two-century-old DuPont to issue a stock to track the performance of its life sciences assets underscores just how popular in the marketplace this unconventional corporate restructuring strategy has become. Fifteen companies have issued 37 tracking stocks since General Motors created the first one (to buy Electronic Data Services in 1984). Most of these deals were transacted in the past three years. With tracking stocks’ popularity on the upswing, it’s a good idea for CPAs to know what they’re about in case they show up in their companies’ or clients’ plans.
HOW THEY WORK
A tracking stock—also called a lettered stock or targeted stock—is a special class of a corporation’s voting common stock that is tied to the earnings performance of a distinct business unit. Investors buying shares in the tracking stock do not own the underlying assets (which they do with common stock transactions); these are owned by the parent company. Instead, they are investing in the earnings performance and growth characteristics of the targeted stock “company.”
A tracking stock can be issued for a business division, geographic segment, product line or any other separable business, such as DuPont’s life sciences group, which includes its biotechnology, pharmaceutical and agricultural chemicals enterprises. In effect, DuPont is creating a company with one consolidated balance sheet and one board of directors, but two income statements—one for its common stock and the other for its tracking stock.
If the tracking stock is issued as planned this fall, DuPont would continue to own all the assets and debt of the life sciences division, but the tracking stock would trade separately from DuPont’s common shares. Given that life sciences companies are trading at a rate of 30 to 50 times earnings, vs. DuPont’s customary 18-times-earnings ratio, the tracking stock could have significant investor appeal. The tracking stock’s equity also would be a higher-valued currency that DuPont could use to acquire other life sciences companies.
Tracking stocks have captured the imaginations—and dollars—of a veritable Who’s Who of corporations, including GM, USX, U.S. West, Pittston, Georgia-Pacific and Ralston-Purina. Within days of DuPont’s announcement, Donaldson, Lufkin & Jenrette said it would issue a tracking stock for its online brokerage unit, DLJdirect.
Each of the companies that have issued tracking stocks has done it for specific and somewhat dissimilar reasons. GM, for example, issued a tracking stock to generate currency to buy companies outside its core area and to provide higher-valued stock options to key executives. Others, such as Georgia-Pacific and USX, issued tracking stocks to encourage a wider group of financial analysts to value their disparate businesses according to fundamentals that are more relevant to each particular unit.
DuPont is keen on all three reasons for issuing its tracking stock, none more so than as a way to create a separate, pure-play currency to make acquisitions. Recently, the Wilmington, Delaware–based company announced its intention to acquire Pioneer Hi-Bred International Co. in Des Moines, Iowa, an agricultural biotech firm, for $7.7 billion. The company will become part of DuPont’s life sciences assets if the deal goes through. In October 1998, DuPont said it would focus on biotech.
With all the hoopla, one would think tracking stocks are the IPOs of tomorrow. Don’t bet on it. The structuring strategy has significant disadvantages, notwithstanding the fact that they’re extraordinarily complex and costly undertakings. Tracking stocks impose additional fiduciary responsibilities on corporate officers and boards of directors, incite internal turf battles, create cost allocation issues and, worst of all, are under federal scrutiny as a tax avoidance scheme. Yet tracking stock adherents are unswayed by the criticism, arguing the strategy is no less viable than other ways of restructuring a corporation.
AN OPEN FIELD
GM devised the first tracking stock, primarily as a way to acquire EDS, a high-flying technology company it has since spun off into a separate unit. “We found there was an advantage to having the market value a piece of your parent company independently,” says William Kager, director of corporate financial reporting at the Detroit-based automaker.
GM was faced with the option of using its own stock, which historically had had a relatively low price-to-earnings ratio, to buy EDS and Hughes, or issuing tracking stocks that would garner higher P/E ratios to make the acquisitions. “From the buyer standpoint, shareholders would not really be investing in GM, but in the underlying business of EDS or Hughes,” Kager explains. “And in both cases, we’re talking companies with higher P/E ratios. The beauty is that the letter stocks still are a part of GM’s market capitalization. They provide a means for us to obtain independent valuations of higher-growth businesses, and to translate that to the implicit value of GM’s common stock.”
That’s not all. The tracking stocks also helped GM hold on to top executives, engineers and scientists at EDS and Hughes Aerospace. The fear was that professionals accustomed to fast-growing stock options at EDS and Hughes would be less than eager to see them converted into GM’s slower-moving shares. “GM wanted EDS but didn’t want to lose its key employees after the acquisition to another high-tech company with a better compensation arrangement,” says Alain Lebec, vice-chairman of investment banking at Merrill Lynch, New York. By issuing a tracking stock for EDS and promising those stock options to key EDS employees, GM overcame internal EDS resistance to the acquisition. “EDS had an entrepreneurial spirit and sense of excitement that GM, for the most part, lacked,” Lebec says. “They needed to keep these employees motivated, as well as attract the best college graduates. The tracking stock helped create this security.” It also continued to trade in line with the more dynamic EDS performance.
USX, an amalgamation of the old U.S. Steel and Marathon Oil companies, had a more pressing reason to issue tracking stocks for each company: investor Carl Icahn. Icahn had taken a fairly sizable position in the Pittsburgh-based company stock and was agitating to separate its two internal businesses. He mounted an unsuccessful proxy fight and was determined to wage another. “It was getting to be an acrimonious situation,” recalls Robert Willens, a managing director at Lehman Brothers. “Icahn did not think the value of Marathon Oil was properly represented in the marketplace and believed it would be better valued if spun off. He saw a business that, if focused on separately, would command much higher multiples in earnings.”
Although the USX board disagreed with Icahn’s solution, it affirmed his argument. “He was right,” says Edward Guna, USX vice-president and treasurer. “At the time, we had a confusing mix of businesses. Steel analysts had trouble with us because we weren’t comparable to other steel companies. And energy analysts didn’t want to follow us because of our steel business. As a result, we didn’t get nearly the number of analysts covering us, or the prospective investors, we felt we deserved.”
The USX board believed, however, that a spin-off of Marathon Oil or U.S. Steel would weaken the remaining company. “It was questionable whether or not steel could have been structured as a stand-alone, viable business with investment-grade credit—given the capital challenges facing it,” Guna says.
So USX accepted Icahn’s analysis but devised a different kind of fix. The company issued two tracking stocks, one for steel and the other for oil and gas. The decision marked the first time a corporation was completely retooled, from the top down, into a tracking stock structure. “Each company trades on the basis of the performance of its respective business but retains the overall benefits of a consolidated corporation from a credit standpoint,” says Kenneth Matheny, USX vice president and controller.
Under terms of the transaction, each USX shareholder received one common share of Marathon Group and a one-fifth share of U.S. Steel Group for each USX share. In essence, the USX share became a Marathon Group share and the holder received a new share certificate of U.S. Steel Group. Wall Street applauded the deal. The day after the company issued tracking stocks in 1991, the market value of USX common stock shot up 7%, or $600 million. Moreover, within a few weeks, the company had attracted an additional 29 equity analysts to follow it, most of them in the oil sector. Since issuing the separate tracking stocks, both the steel and oil and gas businesses have traded in line with their peers. Previously, USX traded like its slower-growing steel counterparts, despite the fact that 75% of its total value was derived from Marathon Oil.
DuPont is hoping its tracking stock, which is slated to be issued by the end of the year, will achieve similar results. “DuPont was receiving complaints from shareholders about its underperforming stock and the fact that it had this great business—life sciences—trapped inside this heavy chemical company,” says chemical industry analyst Leslie Ravitz, a managing director at Morgan Stanley Dean Witter in New York. “The company had to figure out a way to unlock this business to create shareholder value.” DuPont declined comment.
HIGH JUMPS AND HURDLES
While the reasons for issuing a tracking stock are elementary, the process is more intricate. Says Guna from USX, “We had to put together separate and complete financial statements covering each tracking stock and the parent company. Internally, that required a great deal of effort. The corporate-governance provisions also had to be looked at carefully, since we would have a single board responsible for two very different companies.”
The fiduciary responsibilities in a tracking stock structure loom large for corporate officers and directors. “It is crucial for the board to make sure that one group is not advantaged to the detriment of the other,” Matheny says. Such extended duties curbed some companies’ plans to issue a tracking stock. AT&T, for example, said it was gung ho in 1998 on a tracking stock for its wireless and cable businesses, then suddenly did an about-face in January. “The fiduciary responsibilities for the board and management—to make sure we had a good segregation of economics cut out for each class of shareholders—ultimately gave us pause,” says Nick Cyprus, AT&T vice-president and controller in the company’s Basking Ridge, New Jersey, offices.
AT&T originally was captivated by the promise of a more-appropriate market valuation for its wireless and cable units. Ultimately, it was dissuaded by the additional fiduciary responsibilities, as well as internal management and cost allocation issues. “We would have had to set up policies around intergroup transactions,” Cyprus says. “We didn’t want to create internal barriers, such as in the area of corporation allocation processes. Once you erect boundaries, you slow the speed to market to get something done.”
Lebec agrees a tracking stock structure can create turf divisions. “You essentially have two companies competing for capital from the parent,” he says. “You’re setting yourself up for potential conflict.”
AT&T’s tracking stock plans, though shelved for now, still had an impact on Wall Street. “It got analysts to look at the different pieces of our business, causing our stock price to climb,” Cyprus says. “Management thought, ‘Hey, a lot of what we wanted has been accomplished, so why incur the negatives of a tracking stock?’”
Such negatives include administrative nuisances and steep costs. USX, for example, paid Lehman Brothers more than $4 million for help with its tracking stock restructuring. What did Lehman do to justify the expense? The 200-page proxy to shareholders may be an indication. “When you do a tracking stock, instead of having one balance sheet, you have to create three—for the consolidated balance sheet and the two separate stocks,” says Barbara Byrne, Lehman managing director.
Yet the three balance sheets don’t represent three separate companies in the traditional sense. Although debt is consolidated on the consolidated balance sheet, it must be divided and allocated to each of the tracking stocks, which requires mathematical gymnastics and a dose of common sense. “When you set it up, you allocate debt logically, based on cash flows and coverage ratios,” Byrne explains. “You also allocate it with respect to the marketplace and the valuations of other companies in the peer group.” Byrne says it’s critical also to consider the leveraging of the tracked entity, “because you don’t want to overleverage it and affect the valuation. At USX, for example, we didn’t want to overallocate debt to steel because it was struggling. We wanted each entity to have its own resources to serve its own debt prudently.”
Once the balance sheets are put in place, companies must devise formulas for shared cost allocations. At USX, the tracked companies share a CEO, CFO, general counsel, accounting systems and so on, on an ongoing basis. “We helped them develop the formulas to allocate the costs between both entities,” Byrne says. “As for intercompany charges, when one entity is selling to the other, there’s a great deal of financial analysis involved; it takes between four to six months to execute a tracking stock restructuring.”
Aside from the fees that are associated with hiring an investment bank to advise on and underwrite the securities, there are substantial legal bills. “There’s a lot of lawyering, because you’re essentially amending the charter of the corporation,” Byrne explains. USX, for example, hired outside legal counsel to advise it on SEC and stock exchange ramifications.
“With an IPO of a subsidiary, you just write a registration statement, then file and issue it,” Byrne says. “But with a tracking stock, you must go to the shareholders of the company for a proxy to amend the corporate charter and change the nature of the company common stock into two classes. Anytime you increase the number of shares, you have to file another proxy. These are full recapitalizations of a company so they’re pretty complex transactions.” There are also fees for a CPA firm to register the tracking stock with the SEC and for the SEC registration.
So far, the IRS apparently has chosen not to rule on the proper classification of tracking stocks. “They’ve always washed their hands of it,” says Willens. Yet the specter of future IRS scrutiny hangs over these deals. “Unlike an IPO or most spin-offs, a tracking stock is not taxable after implementation,” Willens says. “Existing shareholders simply receive the new stock tax-free. On the other hand, it is arguable, but not likely, that a tracking stock could be construed as something other than the stock of the issuing company, making what is currently a tax-free stock dividend a taxable distribution of property instead.”
A more ominous threat comes from the U.S. Treasury Department. The Clinton administration’s proposed budget for 2000 includes a provision to tax the issuance of a tracking stock as though it was a sale of assets. The tax would be based on a hypothetical “gain,” determined by “an amount equal to the excess of the fair market value of the tracked asset over its adjusted basis,” according to the Treasury proposal.
Why is Treasury eyeballing tracking stocks? “They were told to find areas in the corporate arena in which they could effectively increase taxes,” Byrne says. “Their apparent argument is that tracking stocks are, in substance, spin-offs and thus deserve the same tax treatment.”
Byrne insists that tracking stocks are created for purely legitimate business reasons and not tax purposes. “A tracking stock is not a sale of business,” she argues. “Although it creates a separate entity and currency, this entity is governed by the same board of directors. The tracked stocks are exposed to each other’s liabilities and are subject to the same shareholder votes.”
In short, no company issues a tracking stock because it wants to sell off a business. “Actually, a tracking stock is a very positive statement that a company wants to keep a business and create a currency that enhances its valuation,” Byrne says.
USX CFO Robert M. Hernandez agrees. “We never considered tax avoidance as a reason to establish our tracking stock structure,” Hernandez says. “From the start, we viewed this structure solely on sound business considerations.”
If the Treasury proposal is adopted, companies with tracking stock structures will suffer. The potential for expansion through acquisition and recruitment of key executives will erode sharply. Worse, the proposal would force 15 companies with roughly $395 billion of equity securities outstanding to recapitalize at considerable cost to them and their shareholders.