The Inside Track on Tracking Stocks
by Yi-Hsin Chang (TMF Puck)

September 7, 1999

It seems like everyone's doing it. Walt Disney Co. (NYSE: DIS) is planning to launch a tracking stock for its Internet assets, and Microsoft (Nasdaq: MSFT) is considering a similar move for its properties. But what exactly is a tracking stock, and what does it mean for investors?

A tracking stock is a separate class of stock designed to "track" the performance of a specific business within a larger company. The stock can be issued to existing shareholders, or the company may opt to sell a portion of the shares to the public through an initial public offering (IPO).

Take AT&T (NYSE: T), for example. With the company's acquisition of cable TV operator TCI, the telecom giant ended up with two tracking or letter stocks: New Liberty Media Group Class A (NYSE: LMG.A) and New Liberty Media Group Class B (NYSE: LMG.B). The two track what were formerly TCI and Liberty Media's programming, non-cable, and international assets.

AT&T explains rather eloquently the difference between asset ownership and having economic interest in those assets: "Consider this illustration. You and your brother own a house together and rent out the top floor, sharing the rent equally. After a time, your brother thinks you could charge more rent by redecorating the apartment. You're not interested, though, because your money is tied up in pork bellies. So you reach an agreement. Your brother pays you to give up part of your claim to income from the apartment. He, in turn, is free to spend on new wallpaper, carpeting, and anything else, knowing that a bigger chunk of income from renting the top floor is his to keep. So while you still both own the underlying asset -- the house -- more of the apartment's economic risk and reward belong to your brother."

So a company that sets up a tracking stock still owns all the assets associated with the businesses being tracked, but some of its economic interests -- both the risks and benefits -- in that unit will be sold to investors interested in the "pure play" of the tracking stock. Some investors like tracking stocks for such characteristics as high revenue growth and being part of an emerging industry. Other investors prefer sticking to reliable performers that pay a regular dividend and deliver steady earnings growth. For companies that opt to do so, setting up tracking stocks is a way to appeal to different investors.

In the case of Disney and its proposed tracking stock, the idea is to give those working on the Internet businesses a stock around which to rally. This way, the stock will measure the performance of the Internet businesses as well as give them a market valuation separate from the rest of the Wonderful World of Disney. Of course, the powers that be at Disney and fully expect to get a much higher valuation on a multiple-to-earnings and multiple-to-revenues basis than the regular Disney stock. Disney can then use the hot stock to attract and retain top executive talent through generous options and to make acquisitions of other Internet plays.

Tracking stocks are like internal spin-offs. So why don't companies just go ahead and spin off or spin out (a partial spin-off) a business unit? That's what Barnes & Noble (NYSE: BKS) did when it took (Nasdaq: BNBN) public. Well, tracking stocks allow companies to keep certain tax advantages, and it can help the tracked businesses to remain grounded to less risky corporate entities with solid credit ratings. In other words, the tracked businesses are given some room to maneuver but can also lean on their parent for support.

While there are plenty of advantages to creating tracking stocks, there are disadvantages, too -- mostly at shareowners' expense. In the case of DLJdirect (NYSE: DIR), the Internet tracking stock of brokerage firm Donaldson, Lufkin & Jenrette (NYSE: DLJ), DLJdirect shareholders have no voting rights. Plus, there's often a conflict of interest as a company's board is faced with trying to balance the interests of one set of shareholders versus another. For instance, how does the board and management decide how much should be invested where? And how do they decide which businesses to grow and when?

As DLJ warned investors in the DLJdirect prospectus, "An investment in DLJdirect common stock [is] riskier than an investment in ordinary common stock." In a sense, shareowners of tracking stocks sometimes assume the role of second-class shareholders. And, of course, there's no guarantee that a tracking stock will perform as the company intended or that it will even outperform its parent.

With such risks involved in owning tracking stocks, investors should tread forth with caution when evaluating the merits of such an investment.

Related Fool Articles on Tracking Stocks and Public Offerings:
  -- US WEST Goes Global by Yi-Hsin Chang -- 5/17/99
  -- DuPont's Tracking Stock by Warren Gump -- 3/16/99
  -- The ABCs of IPOs by Yi-Hsin Chang -- 3/16/99