FOOL PLATE SPECIAL
By selling shares of its CarMax tracking stock to fund its own operations, electronics retailer Circuit City illustrates some of the trouble with trackers. Investors who own tracking stocks need to understand why some critics of the shares call such investors "second-class stockholders."
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This story has been updated from the originally published version to correct inaccuracies. The author and The Motley Fool regret the error. Investors interested in the workings of tracking stocks have a useful case study -- one that doesn't, thankfully, have anything to do with the labyrinthine world of telecommunications -- by examining the case of Circuit City Stores' CarMax (NYSE: KMX) no-haggle used-car sales division. A tracking stock, in short, is created when a company decides it wants to "free up the value" of a division by putting it on the market -- but also wants to avoid the tax consequences (or other government regulations) that can make outright spin-offs seem less attractive. The tracked division's revenues and costs are thus broken out of the parent company's financial statements, though the parent company retains control of the division's operations. (Its assets are also removed from the parent's balance sheet.) But owners of a tracking stock are often called second-class stockholders. They generally receive no voting rights, and are essentially still owners of the parent company despite the separate ticker symbol -- meaning the parent's common board can move assets and liabilities to and from the tracker as needed. Trackers are also known as "non-asset-backed securities": While their holders give access to the tracking firm's earnings, they have no direct claim on its assets because those are not separate from the parent company's. Since they share common directors, such conflicts frequently arise. (In the case of EDS (NYSE: EDS), a former GM (NYSE: GM) tracker, such concerns eventually led to the outright spin-off of the computing services company. Other trackers, including GM's Hughes (NYSE: GMH) division, have been more successful.) Importantly, the CarMax tracker is somewhat different than many trackers. Circuit City Stores encompasses CarMax and the Circuit City Group (NYSE: CC) consumer electronics company, and both have voting rights. While tracking stocks enjoyed a brief heyday in the Internet gold rush as old-economy companies looked to generate instant paper money by creating trackers for their high-growth Internet operations, dowdy CarMax was decidedly unsexy. Some even argued that it was a drag on the broader company's business and should have been divested entirely. But as the economy has slowed, CarMax has started performing like the Mach 5, even as the Circuit City chain has suffered because of decreased consumer spending and the after-effects of a much-needed company-wide remodeling scheme that has yet to bear fruit. CarMax this morning raised its earnings expectations for the second quarter ending August 31. Now Circuit City plans to sell approximately 8.9 million shares of additional CarMax stock to the public, plowing the proceeds -- about $137 million based on the planned offer price of $15.50 per share -- back into Circuit City's operations and remodeling. This move certainly makes sense from Circuit City's perspective. CarMax currency is strong, and by selling more of it Circuit City gets access to cash without diluting the sharecount of its core operations, perhaps hurting its ability to meet future earnings targets. While CarMax stockholders will not see their own earnings diluted because the shares being sold are not new ones but shares owned by Circuit City Group, they don't stand to see much of the cash associated with the offering. While there's nothing underhanded about this deal, it's one example of some of the limitations forced upon tracking stock owners. Remember, Dave Marino-Nachison fights the octopus. His stock holdings can be viewed online, as can The Motley Fool's disclosure policy.
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