FOOL ON THE HILL
DuPont's Tracking Stock
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By Warren Gump (TMF Gump)
March 16, 1999

Last week, Dow Jones Industrial Average member DuPont (NYSE: DD) announced plans to issue a "tracking stock" for its life sciences business. Fools who haven't spent a lot of time around the stock market (and many of those who have) may wonder what exactly a tracking stock is. This type of security is a new class of common stock issued by a company to represent the financial performance of a specific division. Most often, tracking stocks are issued by companies that have sexy divisions expected to achieve high valuations in the market.

To gain some insight, let's look at what DuPont plans to do. Assuming its plan comes to fruition, sometime next year the company will issue a dividend of tracking stock to its current shareholders. DuPont owners will continue to hold their original DuPont shares, but they will also own newly issued "tracking" shares of DuPont Life Sciences (DLS). This stock will represent the earnings of the DLS businesses, such as the company's pharmaceutical, crop protection, and nutrition and health divisions.

Despite having separately traded stock, DLS is not a separate company from DuPont. From a legal standpoint, DuPont will still be one company with one board of directors. It will, however, report three income statements and balance sheets in its government filings. The first set of financial statements will reflect all of DuPont, including DLS and all of DuPont's other businesses. The second and third sets of financial statements will reflect DuPont's operations excluding DLS and those of just DLS, respectively.

Although this setup may sound confusing, in reality the situation is not terribly complicated. Think of Mary Jane, a woman with $15,000 in savings. She wants to enjoy life and take advantage of her savings, yet she also is trying to buy a house. She decides to allocate two-thirds of her savings to her house savings account. The remainder is free and available for her to spend on vacations and other big-ticket items. At the time she makes this decision, she creates two accounts to track her savings. The first account, her house savings account, has $10,000. The other account, her discretionary savings account, has $5,000.

Mary Jane has basically segregated her assets into two accounts the same way that DuPont will segregate itself into two different segments. If Mary Jane calculates her liquid net worth, it's $15,000. Internally, however, she has allocated $10,000 of that to her house savings account and $5,000 to discretionary savings. Likewise, DuPont will still be the same huge company, but its assets will be allocated between DuPont (original stock) and the DLS tracking stock. The income, expenses, and cash flow of those two entities will also be segregated.

Several advantages were cited by DuPont for its decision to issue a tracking stock, most of which could be also be accomplished by spinning off the life sciences business entirely. The company expects that the tracking stock for its fast-growing life sciences group will trade at a higher multiple than its slower-growing chemicals business. Assuming this occurs (which is likely), the company can use the higher-valued tracking stock as currency in acquisitions and strategic alliances. The importance of having this currency as the company expands was demonstrated by the potential dilution from DuPont's proposed merger with Pioneer Hi-Bred (NYSE: PHB). Using DuPont stock and cash, DuPont faces earnings dilution of up to $0.25 per share next year. If DuPont had a more highly valued stock, this dilution could have been reduced substantially.

Other advantages noted by DuPont are the ability to allow shareholders to invest separately in its divisions and better alignment of the company's incentive stock options for employees. Many life sciences investors may shy away from investing in the company because right now they have to buy all of DuPont's other businesses along with life sciences. When the tracking stock is issued, those investors are much more likely to evaluate DLS as an investment option.

Employees of DLS will be able to participate more directly in the success (and failures) of that business. You may not think that is terribly important, but in reality it is. For example, if you were a scientist working at DuPont and were being wooed by a competitor like Monsanto (NYSE: MTC) or Amgen (Nasdaq: AMGN), those competitors could throw out stock options that reflect the high growth of their businesses. With DuPont, however, the value of your stock options would be hampered by the slower growing and cyclical chemicals business. Having a tracking stock will give DuPont the ability to better compete for top-notch employees.

Of course, all of the advantages just listed could be achieved if DuPont were to spin-off its life sciences 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 life sciences segment of DuPont is investing lots of cash to grow its business. At the same time, the other businesses of DuPont generate significant cash flow. By maintaining one corporate structure for both businesses, life sciences 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 DLS.

The biggest drawbacks of a tracking stock are the lack of a separate board of directors to oversee life sciences and the limited voice that tracking stock shareholders have over the business. DuPont will continue to have only one board of directors responsible for both the core business and DLS. Based on the history of other tracking stocks, DLS shareholders will not have a significant voice in their selection (since the old DuPont 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. Nonetheless, since DuPont has indicated that life sciences will be its primary focus for growth, my guess is that directors will be cognizant of the needs of DLS.

Historically speaking, tracking stocks tend to perform just about as well as the company's underlying business. Many tracking stocks, such as GM Hughes (NYSE: GMH), Circuit City-Carmax (NYSE: KMX), and USX-Marathon (NYSE: MRO), have been pretty lousy investments since their issuance. This poor performance is more related to turbulent business situations for each company rather than the issuance of tracking stocks. I'm not sure any of these businesses would have fared better as independent entities. Demonstrating that tracking stocks can work (at least for a while) is U.S. West Media Group. This tracking stock was issued in late 1995 and performed well before a recent decision to completely spin off the company into MediaOne Group (NYSE: UMG).

My take on tracking stocks is they will perform just about as well as the division they're tracking. 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. Will the DLS tracking stock be a success? That answer depends on how well Dupont Life Sciences executes its strategy.