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A tracking stock is a type of issue used by larger companies as a type of “spin-off”. A company issues a tracking stock for one of its business divisions, but the division is not formally separated from the company. Most often, tracking stocks are issued by companies that have sexy divisions expected to achieve high valuations in the market.
A company will issue a dividend of tracking stock to its current shareholders. The investors will continue to hold their original company shares, but they will also own newly issued tracking shares. This stock will represent the earnings of the tracking divisions.
Despite having separately traded stock, the tracking business is not a separate company. From a legal standpoint, there will still be one company with one board of directors. When a company issues a tracking stock, it has to prepare three sets of financial statements (such as balance sheets and income statements) instead of one. One set will reflect the company as a whole, as before. A second set will reflect the business line being tracked. A third will reflect the company’s operations excluding those belonging to the tracking stock. The company has not really split up, but for reporting purposes, its assets, expenses, income, and cash flow are allocated between the company and its tracking stock.
The company has basically segregated its assets into two different segments. The company will still be the same large entity, but its assets will be allocated between original stock and the tracking stock. The income, expenses, and cash flow of those two entities will also be segregated.
There are several advantages in the decision to issue a tracking stock. The appeal of tracking stocks is that they can help investors see a company’s full value. Consider a telecommunications company, which issued a tracking stock for its wireless operations. Perhaps this company thought that investors were just thinking of it as an old-fashioned giant company. By issuing a tracking stock, it draws attention to its dynamic wireless operations, and these operations might be accorded a higher value than if they remained imbedded in regular company stock. Assuming this comes to pass, then the higher-valued shares can be used as currency when the company wants to buy another firm or forge an alliance.
Other advantages realized by the company are the ability to allow shareholders to invest separately in its divisions and better alignment of the company’s incentive stock options for employees. Employees of the tracking division will be able to participate more directly in the success (and failures) of that business. Having a tracking stock will give the company the ability to better compete for top-notch employees.
Finally, many tracking division investors may shy away from investing in the company because right now they have to buy all of the company’s other businesses along with the tracking division. When the tracking stock is issued, those investors are much more likely to evaluate the tracking division as an investment option.
Of course, all of the advantages just listed could be achieved if the company were to spin-off its tracking business into a separately traded company. So what is the advantage of having a tracking stock over a spin-off? In a word, cash. The tracking segment of the company is investing lots of cash to grow its business. At the same time, the other businesses of the company generate significant cash flow. By maintaining one corporate structure for both businesses, the tracking division has a ready provider of debt and equity capital when needed.
The added financial flexibility of a strong capital partner could become a crucial competitive advantage for the tracking division.
The biggest drawbacks of a tracking stock are the lack of a separate board of directors to oversee the tracking business and the limited voice that tracking stock shareholders have over the business. The company will continue to have only one board of directors responsible for both the core business and tracking business. Based on the history of other tracking stocks, the tracking division shareholders will not have a significant voice in their selection (since the core business will be much larger, it’s shareholders will have a larger voice in the election). Any situation where directors are not held directly responsible for their actions via shareholder votes is a reason for concern.
Historically speaking, tracking stocks tend to perform just about as well as the company’s underlying business. A complete spin-off of non-core operations is often preferable to the issuance of a tracking stock because it allows for a clean break and extremely focused management. However, a tracking stock can be a more appealing option under certain circumstances, such as when a strong balance sheet provides a competitive advantage.
