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Tracking Stock for Utilities: Highway to Higher Valuations?

Fortnightly Magazine - April 1 2000

utility's generation business is being opened up to competition while its transmission and distribution (T&D) operations remain regulated. Investors' aversion to regulatory uncertainty and their preference for pure play investments mean that an integrated utility's deregulated generation business is unlikely to command the same earnings multiples that capital markets use to value merchant power businesses. Consequently, a utility may be unable to deliver to its shareholders the potential worth of its generation operations. A separate class of common stock linked to a utility's generation business might help unlock its true value.[Fn.2]

Different Strokes for Different Folks. In a restructured market, an integrated utility's deregulated generation and regulated T&D businesses will be characterized by marked differences in their risk-return profiles. Recognizing that, capital markets will quickly develop independent valuation parameters for each. While unified managerial control over both generation and T&D may continue to yield operational efficiencies even after restructuring, a common shareholder base for the two sets of businesses probably will be a handicap. Shareholders who originally would have found the utility's stock attractive because of its steady earnings and predictable dividend payouts, during recessions and expansions would have little appetite for a generation business that will be exposed to the discipline of the market. Investor discomfort with combining deregulated and regulated businesses will increase the cost of capital, not just for the utility's generation business, but also for its T&D operations. Separate stocks that track the utility's generation and T&D businesses would offer an ideal way of separating their shareholdings without disrupting existing lines of managerial control.

The Telecoms' Winning Track . Utilities might take a hard look at the telecommunications industry, where companies increasingly employ tracking stock capital structures to raise the combined capitalization of their regulated and deregulated businesses. Several telecommunications companies have issued tracking stocks in a bid to develop separate investor bases for their regulated local phone operations and other so-called "old-economy" businesses, on the one hand, and their much-faster-growing deregulated ventures such as wireless telephony and Internet operations, on the other hand. US West, for example, characterized its Communications Stock, representing an interest in its local exchange operations, as an income-oriented stock, while marketing its Media Stock, which tracked its phone directory, direct marketing, cable TV, cellular, entertainment, and international divisions, as a "growth-oriented" vehicle.[Fn.3] US West's tracking stock structure, implemented in September 1995, was a huge success, with its Media Stock more than doubling in value in less than three years.

Along with US West, Tele-Communications Inc. (TCI) embraced the concept of tracking stocks early on when it created a separate security for its Liberty Media Group in July 1995. AT&T decided to retain the separate listing for Liberty Media's stock, which has increased in value almost 10 times since it was originally issued, after it completed its acquisition of TCI last year.[Fn.4] AT&T took a leaf from TCI's book when it recently announced that it will issue its own tracking stock for its wireless business. (See sidebar, "A Hesitant Start.") Sprint adopted a tracking stock capital structure in November 1998 and has two classes