Are These Stocks on the Right Track?

When Viacom Inc. said earlier this year that it wanted to issue a new stock tied to the performance of its Blockbuster Entertainment unit, the reaction from Wall Street was swift and to the point. Investors hated the idea.

The opposition was so loud, in fact, that Viacom, after initially trying to defend its plan, decided to shelve it.

“The market in general does not like tracking stocks and has never liked tracking stocks,� one stock analyst said at the time.

Individual investors would be wise to pay attention.

Tracking stocks have come into vogue in recent years at companies ranging from General Motors Corp. to Circuit City Stores Inc. As the name implies, companies create these stocks to track the performance of key subsidiaries. Electronics retailer Circuit City, for example, launched a tracking stock for its CarMax Group used-car superstore business.

At first blush, these securities, also known as “targeted� or “letter� stocks, may seem appealing. Companies pitch them to investors as a way to tap directly into the potential of fast-growing subsidiaries without being weighed down by stodgier parent companies.

Indeed, some tracking stocks, such as GM’s Electronic Data Systems, have proven to be good bets. But many others have flopped, in part, critics say, because the units remain tied to their parents despite appearances. What’s more, investors need to do more homework with these hybrid securities than with traditional common stocks.

“It’s hard to see where shareholders get a benefit from this,� said Joseph Cornell, equity research director at High Yield Analytics Inc., an institutional research firm in Chicago. “I’d much rather see companies go the whole way and do a spinoff.�

The rationale companies normally offer for tracking stocks is this: Because the unit is part of an older company that often has less robust prospects, investors are hesitant to buy the stock. But by separating the unit, analysts and investors can focus squarely on the subsidiary, thus rewarding it with a higher price.

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For example, an investor drawn to the burgeoning telecommunications business but uninterested in a phone stock could buy U.S. West Media Group while shying away from U.S. West Communications Group.

Sounds like a good idea. But beware the problems.

The biggest is that the new entity isn’t really separate. Its finances are broken out independently. But holders of the tracking stock don’t actually own the subsidiary. Legally, they have a piece of the overall company, just like holders of parent company shares.

That raises a conflict of interest, said Jeffrey Hass, a New York Law School professor who has studied the issue.

Rather than having its own board of directors and senior management that watch out for its interests, the subsidiary is still governed by the parent. Say the older company gets into financial trouble. There’s nothing to stop it from draining resources from the subsidiary to prop itself up.

The parent and its subsidiary are like “financial Siamese twins,� Hass said.

And if insiders hold a bigger equity stake in the parent than in the tracking stock--as is the case at some companies--they have at least a perceived inclination to favor one over the other. What happens, for example, when it’s time to allocate dividends to two sets of shareholders?

Instead of creating tracking stocks, many investors prefer that management cleave a subsidiary into an entirely separate company. That’s known as a spinoff.

One advantage to spinoffs is they sometimes carry takeover premiums. That means investors value their shares more highly than they ordinarily would because there’s the chance of an outsider buying it for a sweetened price. Tracking stocks, by contrast, don’t enjoy takeover premiums because the parent companies have the power to squelch any sale.

To be sure, tracking stocks do have some advantages.

A subsidiary can borrow money more cheaply because it’s under the wing of the larger company’s credit rating. Overhead costs are lower as well.

Shareholders are never taxed when a tracking stock is created, something that doesn’t always hold true with spinoffs. Finally, proponents argue, separations can boost the prices of both stocks because the process draws new investors who would buy neither business while it was linked to the other.

“Investors get to pick and choose which businesses they want to be in,� said Peter Fowler, head of the tracking stock group at Credit Suisse First Boston Corp.

EDS was the granddaddy of all tracking stocks--and is still the most successful. The stock surged sevenfold from the time GM bought the company (from Ross Perot) in 1984 until it spun it off last year.

But not every company has been so lucky.

CarMax has lost 55% of its value since the tracking stock began trading in February while Circuit City has eked out a 9.3% rise year-to-date. The story is similar at Genzyme Tissue Repair, the tracking stock of biotech company Genzyme Corp. The tracking stock is up 12.3% this year while the parent has surged 29.1%, just off the 32.6% showing of the S&P; 500.

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Many tracking stocks, in fact, have had trouble keeping pace with the S&P.; Investment banker Fowler defends tracking stocks by saying they shouldn’t be compared with the S&P;, which he says is too broad. Rather, they should be held up to other companies in their industries. By that measure, Fowler said, tracking stocks carry similar valuations, he said.

“When we look at how successful or not tracking stocks are, we look to see if the division trades like other companies in that industry, not whether it beats the S&P; 500,� he said.

Viacom’s proposal illustrates why investors have to pay such close attention to tracking stocks. In most cases, these deals are done to unleash the potential of a subsidiary that’s being smothered by a parent.

But Viacom wanted to do the opposite. The new stock would have tracked its troubled Blockbuster unit, which has been ravaged by the advent of pay-per-view channels. The tracking stock wouldn’t have touched Viacom’s prized assets--MTV, Nickelodeon and Paramount Pictures.

A Viacom spokeswoman said the separation makes sense because investors interested in the retail sector could focus on Blockbuster. Viacom may still pursue its plan after improving the chain’s financial position.

“Tracking stocks have been used very successfully by other businesses and we think it’s worth considering,� she said.

Further complicating matters is the fact that Viacom already had two classes of stock. Some investors could have wrongly believed the company was just adding another class.

Viacom isn’t alone in getting opposition to a tracking stock proposal from its shareholders. Shareholders of RJR Nabisco Inc. and Kmart Corp. both rejected tracking-stock plans.

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Street Strategies explores investment tactics. Times staff writer Walter Hamilton can be reached at [email protected]

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Track Record

A number of large companies have issued tracking stocks geared to the performance of individual subsidiaries. Some have done well for their investors, beating the 32.3% year-to-date return of the Standard & Poor’s 500. But others have lagged--not just the S&P; but their parent companies as well.

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Parents Ticker Monday Change since and subsidiaries (indented) symbol close April 1 Circuit City CC $32.94 +9.3% CarMax* KMX 9.50 -55.0 General Motors GM 63.81 14.5 Hughes Elec. GMH 65.63 16.7 USX-U.S. Steel X 31.81 1.4 Marathon MRO 35.38 48.2 TCI TCOMA 24.38 86.6 Liberty Media LBTYA 36.00 89.0 Liberty Ventures** TCIVA 24.94 24.3 Pittston Minerals PZM 8.19 -46.7 Brinks PZB 39.44 46.1 Burlington PZX 27.25 36.3 Genzyme GENZ 27.75 29.1 Tissue Repair GENZL 8.00 12.3 Molecular Oncology*** GZMO -- -- U.S. West Communications USW 44.31 37.4 U.S. West Media UMG 26.44 43.9 Georgia Pacific GP 85.19 18.3 Timber*** TGP -- -- Inco N 18.94 -40.6 Voisey’s Bay NVB 13.50 -44.0 CMS Energy CMS 39.06 16.2 CMS Class G CPG 23.38 27.2

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* Began trading February 1997

** Began trading August 1997

*** Not trading yet

Source: Credit Suisse First Boston