Understanding A Tracking Stock

Tracking Stock Definition for New Investors

What Is a Tracking Stock?
A tracking stock arises when a company divides its common equity into multiple divisions with their own respective ticker symbol to reflect the division without actually legally separating the company itself, as is done in a traditional spin-off. It is mostly used during stock market bubbles to raise the valuation of a firm for long-term owners. Take a Pix Media / Getty Images

When I first began running Investing for Beginners back in 2001, a popular question I received was, "What is a tracking stock?".  In the years prior, companies had begun spinning off tracking stocks left and right so many investors, including those participating in employee stock purchase plans and dividend reinvestment plans, suddenly found themselves with shares of businesses they didn't quite understand.

 Though they are now largely an anachronism, financial history has a tendency of repeating itself so I'm not only going to keep this old article around for posterity, but clarify and expand on it so the next time this particular fashion comes back into vogue on Wall Street, it will be here waiting for you.

The basic definition of a tracking stock is simple enough.  A tracking stock is a special type of stock issued by a company to represent a particular division or segment of the business.  Tracking stocks allow management to retain control of the operation without having to sell ownership or create a separate legal entity that is spun off to shareholders, with its own board of directors and management team, while allowing investors the opportunity to value various aspects of an enterprise on different terms and price-to-earnings multiples.  At the time they were used, they were effectively the result of ambitious management teams trying to cash in on the obscene (and stupid) once-in-several-generations valuation levels that seemed to be hitting new highs on an almost daily basis back during the dot-com bubble.

 Even stable, old-fashion blue chip stocks got in on the madness.

An Example of One Particularly Popular Tracking Stock 

In what now seems like a lifetime ago and long before its meltdown, Sprint was one of the most attractive telecommunication companies in the United States.  Its traditional landline businesses were highly profitable and paid a rich dividend and it had a new, exciting division that specialized in cell phones, which management was convinced would replace landlines someday; a notion that seemed strange to the typical citizen at the time but one that was often discussed with increasing frequency in the Form 10-K filings.

As the Internet boom got out of control, pushing the stock price ever-higher to the point even the dividend yield became non-enticing, Sprint saw that cellular companies were being valued at crazy multiples. The already-richly valued telecommunication utility decided to divide its common stock into two classes of tracking stock trading under two ticker symbols, FON and PCS, somewhat resembling a dual class stock setup but very different from what the classical version of such a capital structure actually represents.  Its classic landline business, the cash cow gushing money from local and long distance plans, was assigned to FON.  Meanwhile, the cellular business was assigned to PCS.  Shareholders were given 1 share of PCS for every 2 shares of FON they held.

After hitting the market, the demand for PCS was incredible and a lot of employees in the formerly sleepy world of switchboards and telephone poles became millionaires as speculators drove the price of the cellular division's tracking stock higher.  Things like fundamentals - paying attention to balance sheets and income statements - no longer mattered to people.

When the bottom fell out and the growth couldn't match a reasonable dividend adjusted PEG, Sprint's stock began to collapse along with the rest of the overvalued equities on the New York Stock Exchange and Nasdaq (in fact, it took fifteen years for the latter to reach its former high).

 The company's board decided to exercise its authority and reassemble the tracking stocks into a single ticker, FON, by exchanging shares of PCS for it, hunkering down to try and make it through the storm.  In 2005, Sprint merged with Nextel.  It didn't do much good for Sprint's long-term equity holders who have suffered a catastrophic loss of purchasing power over the past twenty years.

Understanding the Pros and Cons of Tracking Stocks

There are several benefits to tracking stocks.

  • A tracking stock can allow management to unlock value by increasing the total stock market capitalization and enterprise value of the business through expansion in the overall p/e ratio.  This makes existing shareholders wealthier as they can sell their appreciated shares to buy other investments, pay down debt, send their children or grandchildren to college, donate to charity, build a new home, take a vacation, or any number of other things.  It also gives the board of directors an appreciated currency in the form of two different shares it can use when making acquisitions, letting it to expand while giving up less intrinsic value.
  • Management retains control over the tracked operating segment or business.

On the flip side, there are several drawbacks to tracking stocks.

  • Tracking stocks often have greatly reduced or non-existent voting rights.
  • An owner of a tracking stock might not actually own the specific aspect of the operating segment that is being tracked. In the event of a corporate bankruptcy, the assets of the particular division their tracking stock was supposed to represent would be fair game for the creditors even if the division associated with the tracking stock was extremely profitable and growing rapidly.  This is not the case with traditional spin-offs.  For example, look at the bankruptcy of Eastman Kodak and how it had no effect on its former subsidiary Eastman Chemical.
  • 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.  There can be resentment and wealth destruction depending upon where you sit.