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Tracking Stocks a Route to Big Profits? orporate restructuring is taking on a different profile this year, with a greater number of companies favoring tracking stocks over spin-offs. By issuing shares that track the performance of a subsidiary, a parent company can call attention to and unlock the value of a faster-growing unit. The benefits for investors are less clear. Typically, investors see only one or two tracking stocks a year. But through June 30 this year, investors had already encountered four, among them offerings from Donaldson, Lufkin & Jenrette and Ziff-Davis. Why the surge in issuance? One reason could be President Clinton's budget proposal to make these deals taxable in the year 2000. Joe Cornell, president of Spin-Off Advisors in Chicago, believes companies are scrambling to issue shares before the proposal can be approved, making the cost prohibitive. Another reason may be the superwarm reception accorded high-tech IPOs on Wall Street. Small wonder that corporations with Internet subsidiaries, like DLJ's DLJ Direct and Ziff-Davis's ZDNet, want to capitalize them. Even those with strong subsidiaries in other fields, like Dupont's life-sciences unit, think they can get a higher valuation by highlighting the growth of those units. Unlike spin-offs, which are usually divested because they are dragging down the parent's earnings or fit poorly with its overall business, tracking stocks are typically issued for highfliers the parent wants to keep. But tracking stocks differ from spin-offs in other, not-so-attractive ways. While a spin-off, for instance, creates a new company with its own management team and board of directors, a tracking stock is simply a new class of shares. Investors thus have no control over the assets in the tracking subsidiary. "There seems to be an inherent conflict of interest in that these units don't have a separate board," notes Cornell. "If these things do get in trouble, who's going to come first--the parent or the subsidiary?" Corporate governance is of less concern if potential returns are high enough. And some tracking stocks, such as Liberty Media, have made stellar gains: On a split-adjusted basis, the AT&T cable-programming unit skyrocketed about 600 percent between April 1996, when it began trading, and the end of June. Other issues, however, have reported atrocious numbers. Ziff-Davis's Internet subsidiary, ZDNet, dropped 28 percent from its March trading debut through June. The bottom line is that until this year, so few of these issues have traded that generalizations about returns aren't possible. Spin-offs, in contrast, have established fairly consistent performance patterns. Their first six months of trading tend to be rough because of structural selling: Some portfolio managers have charters allowing them to invest in the parent's business but not the subsidiary's, or they may run funds mirroring an index that does not include the subsidiary. After their rocky start, however, the stocks' prospects brighten. A sample of 161 spin-offs followed by Penn State University between 1965 and 1990 returned an average of 18 percent in their first year, and 51 percent in the first 24 months. These gains may be more than a rebound from artificial selling pressure. If a parent spins off an underperforming unit, says Cornell, a new motivated management team may run the company better. In a year, the improved operation may make it a takeover candidate. A takeover premium is accordingly factored into the share price. This never occurs with a tracking stock, Cornell notes, because it's still part of the parent company. If you nevertheless find the prospect of picking the next Liberty Media too tempting to pass up, Mark Sherman, managing director of e-business at BancBoston Robertson Stephens, has advice: "You have to judge the pluses and minuses of the relationship between the parent and the tracking subsidiary." Steven Bregman, editor of the Spin-off Report in New York, attributes the success of Liberty Media, originally part of Telecommunications Inc., partly to the leadership of TCI CEO John Malone and partly to the subsidiary's relationship with AT&T. When Malone sold TCI to AT&T, he arranged to have Liberty Media operate autonomously under his leadership. This way, Bregman points out, Malone "can get...an extraordinary amount of funding," since, in raising capital, a tracking subsidiary has access to the parent's credit rating. In contrast, Ziff-Davis's successful subsidiary ZDNet has been dragged down by its relationship with its debt-laden parent. If ZDNet trades high enough, Ziff-Davis may be able to pay down its debt through subsequent stock offerings. But, says Bregman, "one problem in getting ZDNet's stock price up is ZDNet stockholders don't necessarily like the fact that proceeds from the stock issue might go to the parent." Tracking stocks cannot be brushed aside with a wave of the hand. But it would be equally foolhardy to buy into the market hype around one, particularly in the Internet arena. Jump only when the numbers stack up and subjective factors like strength of management look right. |