Understanding a Tracking Stock
Tracking stock definition for new investors
You may have noticed a public company spinning off tracking stocks without fully understanding what that entailed. Many investors, including those participating in employee stock purchase plans and dividend reinvestment plans, may suddenly find themselves with shares of businesses they didn't quite understand. Are these shares in the same company that has traded on Wall Street for decades, or is this something completely new?
The answer is a little of both, but it's less complicated than it may seem at first. A few basic facts will help you understand tracking stocks, and how they could fit into your portfolio. They may be less common in 2019 than they were in 1999, but it's still worth learning about these securities.
Defining Tracking Stocks
Simply defined, 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 give investors the opportunity to value specific aspects of a larger enterprise on different terms and with different price-to-earnings (P/E) multiples. While investors can speculate on specific departments or segments of a company, management can retain control of the segments without having to sell ownership or create a separate legal entity that is spun off to shareholders (which would then require its own board of directors and management team).
Tracking stocks experienced perhaps their biggest heyday in the 1990s. They were effectively the result of ambitious management teams trying to cash in on valuation levels that seemed to be hitting new highs on an almost daily basis during the dot-com bubble. Even stable, old-fashioned blue-chip stocks got in on the craze.
Tracking Stock Examples
In the '90s, Sprint was one of the most attractive telecommunication companies in the United States. Its traditional landline businesses were highly profitable, paid a rich dividend, and it had a new, exciting division that specialized in cell phones. Management was convinced cell phones would replace landlines someday, as was often discussed in their Form 10-K filings.
As the internet boom got out of control, pushing the stock price ever-higher to the point that even the dividend yield became non-enticing, Sprint saw that cellular companies were being valued at crazy multiples. The telecommunication utility decided to divide its common stock into two classes of tracking stock, trading under two ticker symbols, FON and PCS. This resembles a dual-class stock setup, but it's different from what the classic version of such a capital structure 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 one share of PCS for every two 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. As the stock price soared, people paid less attention to balance sheets, income statements, and other fundamentals.
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 (it took 15 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.
While far less common, we can still see some examples of tracking stocks in 2019. One such example is Liberty Media, which owns more than 71% of Sirius XM Holdings as of October 2019. Liberty Media has spun off its Sirius ownership into three tracking stocks—LSXMA, LSXMB, and LSXMK.
Understanding the Pros and Cons of Tracking Stocks
There are several benefits to tracking stocks. For example, 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 to college, etc. It also gives the board of directors an appreciated currency in the form of two different shares it can use when making acquisitions. The business can expand while giving up less intrinsic value. Another big benefit for management is that they retain 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 even own the specific aspect of the operating segment that is being tracked.
Investors would feel the effect of this in the event of 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, the bankruptcy of Eastman Kodak in 2012 did not affect 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 owners of the tracking stock, or owners of the original corporate stock, or both. This is eventually what happened to Sprint, and some investors were left experiencing resentment and wealth destruction.