Telecoms may offer IOUs a model for multiplying market caps by dividing their shareholdings.April 1, 2000
On Feb. 1, CMS Energy Corp. announced plans for a $600 million initial public offering (IPO) of a "tracking stock" that will represent a 20 percent interest in its electric and natural gas utility subsidiary, Consumers Energy. News of CMS Energy's proposed offering comes at a critical time for the energy industry.
Utility stocks have fallen on hard times and the reason is not hard to uncover. The inexorable march of electric industry restructuring exposes large parts of an integrated utility's operations to the forces of competition. Even as it is being forced to abide by market rules in certain sectors, the utility remains weighed down by regulatory obligations in others. That leaves the utility shareholders confused and its management frustrated.
Previous exercises in deregulation and reform in other industries, most notably telecommunications, similarly have transformed the characteristics and prospects of their incumbent monopolies' constituent businesses. Confronted with apathetic investors, many of these companies have sought to enhance their investment appeal by reengineering their balance sheets and creating "tracking stocks" - separate categories of common stock linked to the performance of their various individual lines of business. Can utilities follow this strategy and increase their market capitalizations by issuing such stocks that independently track their regulated and deregulated businesses? Or will these securities only heighten the tension between a utility's different business groups?
Splitting the Issue: When the Sum of Parts Exceeds the Whole
What are tracking stocks? And how can they "create" shareholder wealth? Also known variously as "letter," "alphabet," or "targeted" stock, a tracking stock is a class of common stock that usually represents an economic, rather than a legal, ownership interest in a discrete set of assets and operations of a diversified company. Shares of a tracking stock are designed to constitute the economic equivalent of an equity stake in a particular line of business, division, or group within the company. A tracking stock structure enables a company to repackage its existing equity securities in a manner that facilitates easier access to multiple sources of capital, each with a different investment objective. By targeting investors whose risk preferences are more closely aligned with the performance characteristics of a company's various individual business groups, a company can use tracking stocks to help lower its cost of raising capital and, as a result, achieve a higher stock market valuation.
Over the years, at least 21 different companies in various industries have issued a total of 50 tracking stock securities. As of the end of 1999, the aggregate capitalized value of outstanding tracking stock issues exceeded $400 billion. Most issuers distributed shares of their new classes of tracking stock as stock dividends to their existing shareholders. However, almost a quarter of all tracking stock issues to date have been IPOs that raised additional capital for the issuing companies.[Fn.1]
Setting the Genco Free. Why might utilities consider adopting tracking stock equity structures? Restructuring of the electricity industry is creating a schism within the integrated utility. The 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 of common stock outstanding. Sprint's Class A Common Stock tracks the company's FON Group, which consists of Sprint's long-distance and local telecommunications divisions. Sprint's PCS Common Stock is linked to the PCS Group, which includes Sprint's wireless mobile telephony services. Sprint's PCS tracking stock has performed spectacularly, with a fivefold increase in value in just over a year, and MCI WorldCom intends to adopt it as its own tracking stock after it completes its acquisition of Sprint.[Fn.5] Despite a shakeup in its executive suites, Global Crossing Ltd. is proceeding with plans to issue a tracking stock for its Internet-services business, GlobalCenter Inc.[Fn.6] SBC Communications has said it may create a tracking stock for its wireless operations. And from Atlanta comes word that BellSouth is contemplating issuing as many as three separate tracking stocks - one each for its wireless, international, and Internet divisions.[Fn.7]
Dressing Up the Divestiture
The success of telecommunications "trackers" suggests that utilities may be able to profit from instituting tracking stock capital structures that allow an investor to "cherry-pick" among regulated and deregulated businesses. But can't a company give investors the same choice by incorporating and listing separate subsidiaries? Why implement a tracking stock structure instead?
Because tracking stocks offer the benefits of segregated shareholdings without sacrificing the advantages of a combined balance sheet - greater borrowing capacity, higher credit rating, and the stability of a diverse asset base. In addition, a single corporate entity means one tax return and the continued ability to shelter income from one division against losses in another. And even for a utility considering an eventual spin-off, partial or complete, of some or all lines of its existing generation business, a tracking stock can be a useful intermediate step. With separate financial reporting already in place for a utility's generation operations, capital markets should be well prepared for receiving and pricing stock in a generation subsidiary that the utility eventually spins off.
Green Light From Wall Street. Tracking stocks often result in greater analyst coverage and better valuations for the divested subsidiary. Wall Street is familiar and comfortable with the strategy of prefacing a spin-off with a tracking stock issue. The stock market's enthusiastic reception of US West's separate tracking stock for its Media Group culminated in the Group's spin-off as an independent publicly traded company under the name MediaOne in November 1998.[Fn.8] Not long after that, in April 1999, AT&T entered into an agreement to acquire MediaOne for $85 per share, representing a return of over 500 percent since the stock was issued in September 1995 and over 200 percent in the five-month period since US West had completed the spin-off.[Fn.9]
Attracting Mr. Right. In addition to yielding a higher valuation for a spin-off, a capital structure with different classes of common stock that separately track a utility's generation and T&D operations also could serve as a prelude to a successful "exit" strategy. A utility with a tracking stock equity structure that puts itself up for sale will attract a pool of potential acquirers that includes those interested in acquiring all of its assets and operations as well as those whose exclusive interest is either the target's generation or its T&D operations. Transparent prices for tracking stocks will help establish market values for each business and ease the due diligence process. An acquirer that seeks only the target's generation business could exchange its own shares for the utility's generation tracking stock in a tax-free stock swap and "adopt" the target's T&D tracking stock by classifying it as its own tracking stock. An acquirer interested only in the T&D business would do the reverse - swap its shares for the target's T&D tracking stock and assume ownership of the target's generation tracking stock as its own after the acquisition.
Swapping Shares. The telecommunications industry again provides an example of structuring such a transaction. MCI WorldCom's recently announced bid to acquire Sprint highlights the benefits of a target's tracking stock capital structure in forging a deal. Under the terms of the acquisition, holders of Sprint's Class A Common Stock will receive $76 worth of MCI WorldCom stock for each Class A Common Stock share they own. For the separate Sprint PCS tracking stock, MCI WorldCom will issue a new tracking stock, swapping one new share for one old share. In addition, owners of the tracking stock will get a bonus of approximately $11 worth of MCI WorldCom common stock for each share they own.[Fn.10] Separate stocks linked to the FON Group and the PCS Group make it easier for MCI WorldCom to retain or divest either group after completing the acquisition.
A Hesitant Start - But now a rapidly growing list of issuers.
Tracking stocks reflect Wall Street's preference for pure play investment opportunities. A tracking stock is linked to a specific business group within a company by means of independent financial reporting. But legally, a tracking stock is little different from conventional common stock. Shares of a class of tracking stock, like those of conventional common stock, represent a residual claim on the assets of the company that remain after satisfying creditors of all business groups. A tracking stock does not confer a prior right to the assets of the specific business group that the stock tracks. However, shares of the tracking stock trade based on the earnings of this tracked business group. Separate financial statements for a company's different business groups enable investors and business analysts to independently price the specific class of tracking stock linked to each. In essence, tracking stocks work because the financial community believes in the concept.
"What's Good for GM..." General Motors was the pioneer in adopting a tracking stock capital structure. Calling it "alphabet" or "letter" stock, General Motors issued its GM Class E Common Stock to purchase Electronic Data Systems from Texas entrepreneur Ross Perot in 1984. General Motors relied on another letter of the alphabet when it acquired Hughes Aircraft in October 1985 in exchange for its newly issued Class H shares.
Main Street on Target. The term "target stock" was coined by Lehman Brothers when it advised USX Corp. in May 1991 on issuing separate tracking stocks for its US Steel Group and Marathon Oil Group. In April 1992, USX issued a third tracking stock, for its Delhi pipeline assets, the USX Delhi Group. USX Corp. has since redeemed this stock.[Fn.15]
Other Early Plays. In addition to General Motors and USX Corp., early issuers of tracking stocks included The Pittston Co., for its coal operations, Pittston Minerals Group, in July 1993; Seagull Energy Corp., for its Alaska utility operations, in May 1994; Genzyme Corp., for its Tissue Repair Division, in November 1994; Tele-Communications Inc. for its Liberty Media Group, in July 1995; and US West Inc., to separate its Media Group from its Communications Group, in September 1995.[Fn.16]
Failed Attempts. At least two prominent U.S. companies have proposed but failed to issue tracking stocks. Kmart Corp.'s proposed issue, detailed in its annual report and proxy statement dated April 28, 1994, was rejected by its stockholders on June 3, 1994.[Fn.17] RJR Nabisco Holdings Corp.'s stockholders voted on June 23, 1993, to reject a tracking stock capital structure that had been proposed and explained in the company's proxy statement dated June 4, 1993.[Fn.18]
(Ir)rational Exuberance? The stock market's current lofty valuations of Internet, wireless telephony, and other new-economy businesses have led to a rash of new tracking stock issues.
Genzyme Corp. issued a second tracking stock, for its Molecular Oncology Division in 1998, and followed it up with a third issue, for its Surgical Products Division, in 1999.[Fn.19] Sprint created a separate stock linked to its wireless telephony operations, PCS Group, in November 1998 that MCI WorldCom Inc. will retain as its tracking stock after completing its merger with Sprint. Other recent tracking stock issues have included Donaldson, Lufkin & Jenrette Inc. for its online brokerage firm, DLJdirect; DuPont Co. for its life-sciences business; and Staples Inc., The Walt Disney Co., and Ziff- Davis Inc., for their respective Web-related businesses. The Quantum Corp. became the first Silicon Valley company to adopt a tracking stock equity structure when, in July 1999, it issued separate stocks linked to its disk-drive and digital storage businesses.[Fn.20]
The strongest endorsement yet for tracking stocks came when AT&T revealed plans for a public offering of a stock that will track its wireless business. The offering, slated for the first quarter of 2000, is likely to be the largest IPO in U.S. history.[Fn.21]
Asset Deals: Incentives on the "Buy" Side
A tracking stock equity structure may offer an alternative to, or a step toward, an asset divestiture. Tracking stocks may also make a utility a more attractive merger candidate. But do tracking stocks offer any benefits to acquirers of assets?
Cheaper Financing. Consider the recent turnover in the ownership of generation assets prompted by ongoing electric restructuring. Utilities that have been actively seeking to acquire generation assets generally have refrained from tapping equity markets. Typical investors in utility stocks, who would constitute the majority of a utility's existing shareholders, are unlikely to respond favorably to management bidding aggressively in auctions for generation assets. As a result, acquirers largely have relied on bank lending and the high-yield bond market for financing. A tracking stock linked to a utility's deregulated generation business, and targeted to investors with a greater tolerance for risk, might offer a cheaper source of equity financing.
A Larger Carrot. A stock linked to its deregulated generation business may give a utility more valuable currency, not just for acquiring assets but also for compensating its employees. Utilities are discovering that managerial talent for their deregulated businesses is at a premium. Along with other "Web-less Wonders," utilities are finding it difficult to compete for a limited pool of qualified personnel with dot.com startups and the lure of instant stock market riches that they offer. Several companies that have recently issued or are preparing to issue tracking stocks, including Sprint, AT&T, and Global Crossing, have cited as a primary motivation the perceived need for a more richly valued stock that they can use in incentive-based compensation. Options on a stock that tracks its deregulated business may ease a utility's burden in attracting, retaining, and motivating employees.
Stranded Costs: A Way to "Cash Out"
While many of the gains that telecommunications and other companies have reaped from tracking stocks may be universally applicable, issuing such securities may afford unique advantages to utilities during the transition to competition. Utilities in jurisdictions that will adjust stranded-cost awards to reflect asset sale prices or allow sales only if gains are shared with ratepayers would, in effect, have all surplus from any asset divestiture expropriated. Such a utility that does wish to sell all or part of its generation asset portfolio could, instead, create a class of tracking stock that is linked to the performance of these assets. The utility could then sell shares of this tracking stock in a public offering. The stock offering would allow the utility to monetize a portion of the cash flows associated with its generation assets without affecting the size of its stranded-cost recovery or violating any divestiture restriction.
Securitization by another name. Tracking stock also may offer a way out for utilities in states that have not enacted laws that enable securitization of a competition transition charge (CTC). These utilities will actually receive their stranded-cost recoveries over transition periods that could be as long as five to 10 years. Though the CTC would be collected from a utility's distribution customers, it would constitute compensation for the loss in value of the utility's generation assets caused by deregulation. Therefore, the income stream that the CTC represents would belong to the utility's generation segment. A utility that issues a generation tracking stock would allocate to its generation group its generation assets as well as the rights to recover all stranded costs associated with them. As a result, the generation tracking stock's price would reflect the utility's entitlement to receive a stranded-cost recovery in the form of a CTC from its distribution customers. If the utility issues and sells additional shares of this generation tracking stock, it would capitalize a part of the uncollected stream of CTC payments. In effect, a generation tracking stock would allow the utility to use the equity markets to securitize a portion of its future CTC receipts.
Balancing Costs and Benefits
A tracking stock equity structure does not come without costs, however. In addition to the out-of-pocket expenses of undertaking a recapitalization and issuing a new class of security, tracking stocks impose other, longer-lived costs.
Conflicting interests: A house divided? Segregated shareholdings can lead to conflicts of interest. A tracking stock structure effects a financial reporting separation of a diversified company into different business groups. But these groups do not enjoy any independent legal status. Though a tracking stock represents an economic stake in one such business group, holders of the stock do not have any direct claim against the group's assets. In a bankruptcy, the assets of the entire company remain available to satisfy creditors of any one business group. Corporate policies and actions that disproportionately affect the fortunes of a company's different business groups may create ambiguities regarding the board's fiduciary duties of care and loyalty owed to the respective holders of the stock that tracks each such business group. The consequences of such ambiguities are likely to be much more severe where, as in the case of an integrated utility, one of the company's two business groups enjoys a monopoly status subject to regulatory oversight while the other group is exposed to competition.
Several companies that have adopted tracking stock equity structures have sought to address shareholder fairness issues by setting up separate board committees to oversee the relationship between their different business groups.[Fn.11] In order to minimize the potential for conflict between holders of its generation and T&D tracking stocks, a utility would have to put in place similar institutional arrangements that safeguard the interests of each set of shareholders.
Removing the Welcome Mat for Corporate raiders. Tracking stocks may also deprive their holders of a premium for control that often is embedded in the share prices of potential acquisition targets. A raider cannot acquire control of the tracked business group merely by accumulating shares of the tracking stock. Lack of a control premium, coupled with concerns about conflicts between the interests of the shareholders of the different business groups, has led some commentators to speculate that tracking stocks trade at a discount, ranging between 5 percent to 10 percent, to their so-called "peers," independent companies engaged in similar businesses.[Fn.12]
However, for an issuer, the more relevant inquiry, and the bottom line, is whether a tracking stock would increase the company's total market capitalization. By this measure, as the telecommunications success stories demonstrate, tracking stocks usually have lived up to expectations.
Even when one looks at the performance of individual tracking stock issues, instead of focusing on the combined equity securities of an issuer, recent research suggests that comparisons with peers are not as unfavorable as analysts might have believed. A Lehman Brothers' study shows that although more than half the tracking stock issues examined had lagged their peer groups in the short-term, after six months almost 80 percent of these tracking stocks had outperformed the competition.[Fn.13]
Everybody's Doing It: Reason Enough?
Tracking stocks are enjoying a surge in popularity as diversified companies of all types use them to obtain higher earnings multiples for their "new-economy" businesses. But are they right for integrated utilities?
Though tracking stock equity structures may work well for some utilities, their costs might prove overwhelming for others. Utilities that are likely to derive maximum benefits from such structures are those with extensive T&D operations, often spanning several jurisdictions, that are also making significant investments in deregulated businesses. Some of these companies may have made strategic decisions to retain their utility operations while simultaneously moving to compete aggressively with independent power producers and merchant plants in the deregulated generation sector. For others, tax-related reasons or impending restructuring in one or more jurisdictions in which they operate may have rendered an immediate divestiture of either their generation or T&D operations impractical.[Fn.14] In both cases, a tracking stock structure at the holding company level could reduce the utility's overall cost of equity capital. A separate stock linked to its utility operations also would enable such a company to reserve the benefits of this business exclusively for a narrowly defined group of shareholders while shielding the rest from regulatory risk. CMS Energy's decision to institute a tracking stock structure reflects both of these motivations.
Electric industry restructuring is requiring utilities to rethink their current business structures and practices. There is no reason why a utility's existing capital structure should be excluded from such a review.
1 "Country Briefing, USA Finance: Tracking-Stocks Experience Revival," CFO Magazine, Nov. 9, 1999.
2 For a detailed discussion of the major securities laws, corporate governance and tax considerations and implications of a tracking stock equity structure for an integrated utility, see Ajay Gupta, "Tracking Generation - Financial Innovation For A Restructuring Industry," The Electricity Journal, May 2000.
3 See U S West Inc., Proxy Statement And Prospectus, Sept. 5, 1995, at 40, 45.
4 Lashinsky, Adam, "Will the Boom In Tracking Stocks Derail Investors?" Fortune, Jan. 10, 2000, 210.
5 See infra note 10 and accompanying text.
6 Mehta, Stephanie, "Global Crossing CEO Quits After A Year In Post," The Wall Street Journal, March 3, 2000, at B8, Col. 1.
7 Kanell , Michael E., "Atlanta Tech: Tracking Stock Might Have Right Ring For BellSouth," The Atlanta Journal and Constitution, Jan. 12, 2000, at 1D.
8 Cantwell, Rebecca, "Split Is Likely To Be A Hit; US West Breakup Turning State's Largest Employer Into Two Pricey Companies," The Denver Rocky Mountain News, May 31, 1998, at 1G.
9 US West itself has agreed to merge with Qwest Communications International. See Henry Goldblatt, "Qwest's Latest Fashion Makeover; Joe Nacchio Creates A Global Telecom Contender," Fortune, Aug. 16, 1999.
10 Goodman, Peter S., "Questions Greet MCI-Sprint Deal; FCC Chief Raises Price Concerns," The Washington Post, Oct. 6, 1999, at A1.
11 See generally Erica H. Steinberger and Jeffrey J. Hass, Introduction to Tracking Stocks, in Acquisitions, Mergers, Spin-Offs, And Other Restructurings, 523 (PLI Corporate Law & Practice Course Handbook Series No. B-825, 1993).
12 Scherreik, Susan, "Tread Carefully When You Buy Tracking Stocks," Business Week, March 6, 2000, 182.
13 "Country Briefing, USA Finance: Tracking-Stocks Experience Revival," supra note 1.
14 Gupta, Ajay, "Tracking Generation- Financial Innovation for a Restructuring Industry," supra note 2, discussing factors that would make a spin-off a taxable transaction. See id. for examples of regulatory constraints on a divestiture of a utility's generation or T&D operations.
15 Banham, Russ, "Tracks Stars; Tracking Stock," Journal of Accountancy, July 1, 1999, 45.
16 See main article and text accompanying main article's notes 3, 8, and 9.
17 Hoff, Christina, "K-Mart Weighs Its Options After Defeat by Shareholders at Stock-Sale Proposal," The Wall Street Journal, June 6, 1994, at A2.
18 Neish, Stephen, "Creating Value With Targeted Stock," Corporate Finance, June 1995, 27-35.
19 Louis, Arthur M., "Tracking Stock Can Unleash a Unit's Value," The San Francisco Chronicle, May 11, 1999, at C1.
20 Barr, Stephen, "On The Right Track?" CFO Magazine, Nov. 1, 1999, 105.
21 Schiesel, Seth, "AT&T Revamps to Win Local Phone and Internet Gains," The New York Times, Dec. 7, 1999, at C15, Col. 1.
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