Tracking Stock: Definition, Benefits, Risks, and Example

In this article, we will discuss

• What is Tracking Stock?
• Understanding Tracking Stock With an Example
• Why do Companies Issue Tracking Stock?
• What are the Advantages of Issuing Tracking Stock?
• What are the Risks Associated with Tracking Stock?
• Conclusion

The U.S. stock market is one of the most developed and mature financial markets in the world. It is also very innovative, with companies constantly looking for different ways to maximise shareholder value and optimise their capital structure.

One of the many ways in which companies in the U.S. streamline their financial and capital structures is through the issue of tracking stock. The concept of tracking stock was first introduced in 1984 and quickly caught on. However, its usage has decreased drastically.

In this article, we are going to delve into the concept of tracking stock and understand the various risks and benefits associated with issuing it.

What is Tracking Stock?

A tracking stock is a type of common equity share that is issued by a company. It is designed to reflect the financial performance of a specific sub-division, subsidiary, or particular business segment of the company.

Similar to regular equity shares, tracking stock is listed and traded separately from the issuing company’s primary stock. Investors who purchase stock trackers will only gain exposure to the specific business division that they track, not the parent company as a whole.

Large conglomerates with several successful divisions may issue tracking stock tied to one of their businesses. This allows the company to separate the financials of the business division. The performance of the tracking stock will be dependent on how the division performs and will not have any bearing on the overall financial performance of the parent company.

Understanding Tracking Stock With an Example

Now that you are aware of the definition of tracking stocks, let us try to understand how it works with the help of a hypothetical example.

Company A is a large conglomerate with five major business divisions. This includes a manufacturing division, a financial services division, a petroleum products division, a telecommunications division, and a textiles division. Of the five major divisions, the telecommunications segment has performed well financially for the past couple of years.

Company A decides to issue a tracking stock that tracks the financial performance of its telecom division. Once the stock is issued, it will be listed on the exchanges separately and traded alongside Company A’s stock.

Meanwhile, the financial statements pertaining to the telecom division will be separated from those of Company A. The performance of the tracking stock will now be based on the performance of the telecom division and not on Company A. So, if the division performs well financially, the stock price will rise, and if its performance lags, the stock price will fall. This simplifies share-tracking for investors since they do not have to evaluate the entire company.

Investors who want to gain exposure to just the telecom division of Company A can purchase the tracking stock from the exchanges. Since the division is not technically separated from the parent company, the stock’s investors would still be listed as shareholders of the parent company. However, depending on the terms of issuance, the investors may or may not get any voting rights in the parent company.

Why do Companies Issue Tracking Stock?

Conglomerates often have multiple business entities and sub-divisions that may or may not be related. At the end of every financial year, these conglomerates consolidate all of the financial statements of all of their divisions and publish them together. This activity significantly increases the administrative burden and costs for the companies.

However, by issuing a tracking stock, the parent companies can isolate the financial statements of their divisions, effectively making them semi-independent. It also reduces the administrative burden since the parent companies do not need to consolidate their financial statements and can instead publish them separately. Additionally, it makes investment tracking easier for investors interested in assessing the performance of a particular division alone.

Another major reason why companies may choose to issue tracking stocks is to separate the divisions that are performing well without having to resort to complex restructuring methods such as demergers or spin-offs. Demerging a company or spinning off a business division into its own legal entity entails significant expenses, regulatory approvals, and legal hurdles. In addition to this, the parent company must also compensate its shareholders by offering shares of the new entity. By simply issuing tracking stocks that track a specific business division, companies can work around the exhaustive legal and financial procedures involved with demergers and spin-offs.

What are the Advantages of Issuing Tracking Stock?

Tracking stock offers a plethora of different benefits to both the issuing company and investors. Let us explore a few of the key advantages.

• Unlocks Value

One of the major advantages of issuing stock trackers is that it allows companies to highlight the value of a high-performing business unit that may be overshadowed within a larger corporate structure. By offering a separate stock that reflects this business unit’s performance, companies can enhance the overall valuation of the company. This could potentially attract more investors, especially those who are interested in that particular business segment.

• Helps Retain Control

When companies spin off or demerge a particular business division into its own legal entity, they risk losing control over its finances and operations. However, by issuing a tracking stock based on the business division, they can effectively prevent the loss of operational control. Furthermore, companies can also avoid the various regulatory complexities and costs associated with the full separation of a business unit.

• Provides Additional Capital

Tracking stock also enables companies to raise capital without having to lose control or relinquish ownership in the parent company. The parent company can use the capital that it receives from the issue to reduce its debt, streamline its financial statements, or fund the division’s expansion. Additionally, it can also use the tracking stock as currency during mergers and acquisitions involving the tracked business division.

• Increases Focus and Accountability

By separating the financials of a business unit by issuing a tracking stock, the management can focus more intently on improving its performance. In addition to performance improvement, the parent company can also increase transparency and accountability by providing clearer metrics for evaluating the division’s success.

• Facilitates Future Strategic Moves

Companies can use tracking stock as a means to test the waters for a full spin-off of a business unit. If the unit performs well on a standalone basis, the management can consider making it a separate legal entity.

Alternatively, if the business unit does not perform as expected or if market conditions change, it can be easily integrated back into the parent company, which may not be feasible if it were spun off into a separate entity. That’s not all. Since tracked stocks establish a clear market valuation for the division, selling them off to a third party also becomes a lot easier. 

What are the Risks Associated with Tracking Stock?

Although the various advantages make tracking stocks an attractive option, it is important to note that they also come with potential drawbacks and risks. Here are some of the crucial risks associated with them:

• Profitability Risk

Tracking stock is meant to make things easier for both companies and investors. However, there is always a profitability risk associated with investing in such stocks. For instance, the investors could end up with losses if the tracked division does not perform well after separation. Even if the parent company does well financially, the tracking stock investors may still lose their capital.

• Market-Related Risks

Another major risk that tracking stocks faces is market-related. For example, the stocks could trade at a heavy discount or suffer from low liquidity due to less investor interest, which can increase volatility. An accurate valuation may also be challenging due to the close link between the parent company and the tracked division.

• Limited Voting Rights

As you have already seen, investors of tracking stocks are still considered to be shareholders of the parent company. However, since they have only invested in a particular division and not the company as a whole, they usually get limited or no voting rights. This can be highly disadvantageous for investors since they would not get to influence company management despite investing their capital. In the case of a conflict with the parent company, holders of tracking stock may not be in a position to defend their interests.

• Difficulty During Unwinding

If the tracked division does not perform well, unwinding the arrangement could potentially increase the complexities and costs. It could also lead to uncertainty and volatility in the parent company. In the case of the unwinding of the parent company, the original shareholders may still stake a claim on the tracked division, even if it is profitable and thriving, pushing out the holders of the tracked stock.

Conclusion

The concept of tracking stock is a very useful one for large conglomerates with multiple profitable and unrelated business segments. Instead of going through complex restructuring methods, the conglomerates can issue tracking stock for each division. This not only unlocks value but also makes portfolio tracking easier for investors.

Although these stocks have been in existence in the U.S. stock market since the early 1980s, the concept has yet to make its way into the Indian market. Its introduction, if it happens, could revolutionise the domestic stock market once again.

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