Chapter 6

Shareholders' Equity Analysis

Are The Stockholders Really Owners?

During my youth, every May and June, when the annual reports and proxy statements were published, my father and I would read and discuss every company he owned. I loved to look at the pictures of the companies' products and facilities; it helped me understand what the companies did, and gave me a sense of ownership. We actually read the proxy statements and voted for the directors and issues accordingly. One of the companies he owned was SCM. One year, they were in a proxy fight; one of the directors called our house and asked my father to vote his 400 shares a certain way. At the time, the director was also the Chairman of RCA! That was the way it was years ago; from a youth's perspective, even the small shareholders felt as if they were company owners.

When proxy statements are mailed to me these days, I usually throw them out with the junk mail. Most investors spend around ten minutes reading their annual reports. I'm not even sure that "non-financial" type investors know what a 10k is. Some companies, in their annual reports, don't even show pictures any more. It seems that management has forgotten that a lot of investors like to see what they own and have a sense of pride in their stock portfolios. By not showing off one's company in the annual report, it leaves the impression that management just doesn't care about the company's products.

I recently reviewed the 2003 annual report of Lucent Technologies; they only showed the studio shots of the board of directors. I would have like to see a picture of their latest 5E-XC high-capacity switch! The 2002 annual reports for Schlumberger and El Paso both had very nice picturesque covers, but with no additional pictures contained inside that would help investors visualize their complex organizations. These are examples of some of the finest companies in the world, and they are not showing their strengths in the stockholder's annual reports. This is also one of the reasons their stocks are not properly valued in the market place.

Today many investors no longer feel a sense of ownership.

Corporate governance starts with shareholder involvement. I recently listened to a shareholder meeting of Elan in Dublin Ireland. Their management team knows exactly how their investors feel. These types of active and vocal meetings are needed in the United States.

A few years ago I was the CFO of a small public company listed on the American Stock Exchange. For a few weeks prior to the annual shareholder meeting, I prepared all my materials, memorized all the figures and rehearsed the script that the attorneys gave me to read. The meeting was held in a nice hotel a few blocks from the office. I was dressed in my best Hickey Freeman suit and Robert Talbott tie. Everyone showed up: the management team, the auditors, and the attorneys; everyone but the investors. Almost no outside investors attended. To put salt on the wounds, the auditors had us do the entire script with practically no investors. That highlights one of the major problems with corporate governance in the United States.

Corporate governance is now coming to America from Europe, but not because of the corporate scandals and legislation publicized in the news. It's being driven by a population that is getting older and realizing for the first time that stocks are worth real money. The stocks are paying for their kids' college education. The dividends received are being used to go out to dinner. This is the first time that the post World War II generation sees, for itself, the value of securities. Buying and trading stocks is one element of investing, but understanding their value is another aspect of owning stocks. It is like if one receives a large inheritance, it's a good practice to take out a small amount and buy something. It makes one understand the value of what they have. This generation is just beginning to understand the value of wealth, and that stocks have real purchasing power. With the internet bubble behind us, investors are starting to appreciate the monetary value of the stocks that they have, and are paying more attention to the companies they own, and how they are run. The emphasis has now shifted from trading stocks, to owning diversified investments.

The advent of web sites and live shareholder meetings on the Internet are two of the new
technologies that are reconnecting companies to their investors. However, investors need to have an adult perspective on the realities of stock ownership.

Shareholders have a financial interest in a company, but they are not "real" owners. Owners get monthly financial statements. Owners regularly review forecast and budgets. Owners tour facilities and meet with customers. Owners get involved in product development. Owners have inside information. They may even get a free T-Shirt or a company pen. Owners can have lunch with their families at the company's cafeteria. Don't be fooled by the rhetoric. Most investors have no input what-so-ever in how a company is run. There is a difference between having a financial interest in a company and being an owner. That said, let's review shareholders' equity.


Where Are The Actual Shareholders' Equity Dollars?


Equity is defined as Assets - Liabilities = Shareholders' Equity.

Investors must realize that as "owners" they have the last claim on the assets of a company. The bankers, note holders, suppliers and other creditors usually have claims on the most liquid and valuable assets of a company. Except for the most pristine credit quality companies, the shareholders' equity dollars are invested in those assets that are the most subjective in value and the hardest to sell. If a company has any bank debt, usually the lenders have liens on most of the valuable assets as collateral for their loans.

Being the last claim on assets, the shareholders' dollars are invested in intangible assets like prepaid expenses, capitalized internal-use software, and goodwill. The equity dollars are also used to fund the past due receivables that fall out of the bank's borrowing base or the inventories and facilities in foreign countries that won't be financed by US lenders. If a company's equity is invested in physical assets, they are usually the ones that are hardest to turn into cash.

Please don't misinterpret the previous concept. It's not that the equity assets have no value; it just takes more work and a longer lead-time to realize their value. For example, if you own stock in a leasing company, the banks and insurance companies usually would have a lien on the lease payment streams, leaving the equity holders to fund such assets as the un-guaranteed residuals, the past due and written-off leases, uncollected late charges, and securitization servicing rights. These assets have value, but it takes time to convert them into cash. This is one of the reasons that in bankruptcies, the equity holders get wiped out. It's because the creditors lose patience and sell out at any cost, leaving nothing for the equity holders. The Japanese understand this concept very well and slow down the liquidation process, so where possible, the equity holders also realize their values.

Microsoft is a simple example to understand, as to where the shareholders' equity is invested, primarily because they have so much cash. As of 9/30/03 they had shareholders' equity of $67 billion, with net tangible assets of $63 billion. Additionally, they had $65 billion in cash and investments. The majority of their equity is in cash or assets that are easily convertible into cash.

At the opposite end of the spectrum is Sumitomo Mitsui Banking Corporation ("SMBC"); not because it's a foreign company, but due to its more sophisticated financial structure.

SMBC, is a Japanese money center bank, in size similar to JP Morgan Chase (before they acquired Bank One). Their March 31, 2002 year-end annual report reported their total assets at $766 billion and stockholders' equity at $24 billion versus JP Morgan Chase's December 31, 2002 total assets of $694 billion and stockholders' equity of $42 billion.The main issue with SMBC is that out of $24 billion of equity approximately $26 billion is tied up in problem assets that are classified as bankrupt, quasi-bankrupt, or doubtful assets. Additionally, they have another $18 billion invested in substandard loans. Most of SMBC's equity is now used to fund its credit-impaired loans.

This is why it is important to understand where a company's equity really is.

SMBC is a typical risky turn-around type stock play. The hope is that the government won't force one of its best financial institutions out of business, and that eventually the real estate market in Japan will appreciate enough to allow the mortgages to be paid off.

I would value the stock at a multiple of book value, then subtract its questionable assets. Given its strategic global position, this may be an interesting stock maneuver. Keep in mind that impaired assets may also be supported by substantial collateral. One may be able to acquire a very valuable Asian financial institution, today for $4.95 a share, which a decade from now may be considered a good price. In the early 1990's the American banks were in a similar situation; today they are some of the premier companies in the world.

It's important for investors to understand where the equity of the company is being
deployed.


How Comprehensive Income Can Affect Stock Values


Comprehensive income is mandated by an accounting regulation that requires companies to bypass the P&L and charge certain transactions directly to shareholders' equity. One can make arguments either way as to the appropriateness of charging shareholders' equity versus the income statement. Outlined below are the four types of transactions that are affected by the accounting pronouncement (SFAS #130):

* Foreign currency translation adjustments
* Minimum pension liability adjustments
* Unrealized gains or losses on marketable securities
* Unrealized gains or losses on derivative instruments

This is more then a "geography" discussion as to where on the financial statements certain items should be classified. Many times, comprehensive income adjustments become hidden expenses; for some companies, the amounts are enormous.

For example, for the year ending December 31, 2002 Boeing reported net income before accounting changes of $2.3 billion, down from $2.8 billion in 2001. (Not bad for a company whose customers and main markets were devastated after 9/11.) In 2002 they also had a $1.8 billion asset impairment charge, primarily from their space and communication segment, relating to a new accounting regulation on handling goodwill and acquired intangibles. The write-down basically resulted from projected cash flows from their acquisitions, which did not cover the goodwill and other intangible assets that were recorded on their balance sheet. In effect, the future business prospects of their acquisitions did not justify the price paid for them. This resulted in Boeing reporting $492 million net earnings for the year, with the Company proclaiming that they had a "solid performance in dynamic markets from Boeing's balanced portfolio of aerospace businesses."

Then, when reviewing the equity section of the financial statements, one finds that equity was reduced by a staggering $3.1 billion for the year, or a 29% reduction in equity from the prior year. Most of it originated from a $3.6 billion (net) pension adjustment, or $5.7 billion before taxes. Keep in mind that the focus of this web site is the stockholder. While the company's operations did have a solid performance, the equity owners took a bath; first, on the $1.8 billion P&L asset write-down, then on the $3.6 billion equity pension adjustment. This is why I call comprehensive income adjustments hidden expenses. Dividends aside, the stockholders started the year with $10.8 billion in equity and ended the year with $7.7 billion in equity. It took approximately 86 years to build up that equity only, to lose 29% of it in one year! That said, Boeing is still a world class organization and is usually a good buy on price dips (assuming and praying there are no more terrorist attacks using commercial airplanes).

A contrasting example is NEC Corporation of Japan. NEC did an admirable job in presenting comprehensive income. On their Consolidated 2003 Statements of Operations (P&L), they first reported a net loss of $208 million, then added another $1.5 billion loss from other comprehensive income items, for a total comprehensive loss of $1.7 billion. This is a more straightforward representation of what transpired during the year; this type of reporting is becoming widespread in the United States. The question now is: what is the true EPS figure?

I've always had the conviction that all transactions should "run through" the current year's P&L. Charging equity directly or restating past results tend to disguise the reality of a situation.

Investors must focus on net income, as well as comprehensive income, when measuring stock values. If book value is reduced, it ultimately will reduce the value of one's stock.


Liabilities With Equity Attributes Can Give Your Stock A Boost


Companies usually issue stock to the public to finance their growth or a particular project. Many companies have other stakeholders who also indirectly provide cash that can be used to fund operations and growth. In effect, these stakeholders provide economic "assets" that are classified as liabilities, but have many of the same financing characteristics as equity. These liabilities with equity attributes add to the profitability of a company, by reducing the amount of debt financing a company needs, and improving their leverage and profitability ratios. This results in a positive impact on the stock price of the company, with increased EPS, as well as a higher P/E ratio.

Listed below are some examples:

Customer Contributed Equity - These are normally customer cash advances for future services.

Moody's Corporation is a good example of a company with customer contributed equity. As of December 31, 2002 the company reported negative shareholders equity of $327 million. The majority of the negative equity was the result of their purchasing treasury stock. Their liabilities, however, reflect $170 million of current deferred revenue, plus another $28.5 million of non-current deferred revenues. This represents money that was collected or accrued as a receivable, and therefore could be borrowed against, for future rating agency fees and monitoring activities. Their creative collection feature acts as equity, and is one of the reasons a company with a negative book value commanded a market capitalization of approximately $8.5 billion as of December 10, 2003.

Supplier Contributed Equity - These are supplier accounts payable. Many suppliers offer extended credit terms to their customers without any formal lending security agreements. This can enable the purchasing company to convert the merchandise into cash, which can be used in their operations until the credit terms become payable. In effect, these suppliers are providing free short-term financing. If one's business is non-cyclical and consistent in nature, then this supplier financing essentially has many of the same characteristics as equity.

Government Contributed Equity - The government offers various forms of temporary tax relief to companies, in order to stimulate the economy. The best known of these techniques is the use of accelerated tax depreciation. This and other tax incentives give companies larger tax deductions, or reduced taxable income, deferring their tax payments. These benefits are hopefully reinvested in additional capital purchases that will aid in growing the company. This generates jobs, more profits, and eventually more taxes for the government. These initial tax savings are reported on the balance sheet as deferred taxes. Individually, these tax benefits reverse as the transaction unfolds, but in a consistently growing business, the aggregate amount of the cash tax savings actually grows and is always outstanding. This gives the organization a free source of capital that can be used to grow the business, similar to how equity dollars are invested.

GE is a good example; as of 9/30/03 the company reported, in its SEC form 10Q, shareholders' equity of $72 billion dollars and intangible assets of $50 billion, resulting in a tangible net worth of approximately $22 billion. Also, the company had an additional $12 billion in deferred income taxes. Another way of analyzing GE's deferred taxes is that it represents an additional 17% of their book value. While some of their tax benefits may have been passed through to their customers, there is still a lot of interest free money that can be used for acquisitions, stock repurchases and the like. If GE had to raise an additional $12 billion dollars in the equity and debt markets, their earnings and financial ratios would all be negatively affected. Irrespective of deferred taxes, GE is still one of the best companies in the world, and their use of deferred taxes is a nice perk to their shareholders.

The unrestricted use of interest free funds can give a nice boost to a company's stock price.


Cost of Equity Versus Cost of Capital


This is the anticipated rate of return that investors expect to earn from their investment. It is a basic concept that is understood and used by practically every investor who buys stocks. The mathematicians, however, have made a simple concept so complicated that it frightens investors. Most investors just "roll their eyes" when they hear the words Capital Asset Pricing Model ("CAPM").

I knew a successful investor that never graduated high school, who regularly used this concept without knowing that the calculation was called the CAPM. The cost of equity is calculated by taking the interest rate that banks or treasury bonds are offering, (the risk free rate), and adding to it an extra premium rate that investors get for taking the added risk of investing in the stock market. Historically, approximately 7% is used. Finally, one needs to factor in another premium or discount percentage factor for the individual business risk of one's particular stock. The Value Line Investment Survey reports stock beta's on every company it follows. The cost of equity = the risk free interest rate, plus the market risk premium, times the stock's beta).


Cost of Capital


The cost of capital represents the opportunity cost it takes to raise money for a company. Companies use it as a hurdle rate to evaluate various investment opportunities. It is calculated by taking the weighted average cost of all the components of a company's funding sources. Listed below are the standard funding sources and their associated cost methodologies:

* Common Stock - The cost of equity rate = CAPM rate
* Retained Earnings - The cost of equity rate
* Preferred Stock - The coupon rate
* Bonds / Debt - Incremental - prevailing interest rate, minus the company's tax rate

The cost of capital rate is just the weighted average cost of a company's equity and outstanding interest bearing debt borrowings.

The cost of equity is important because it represents the investors expected rate of return from stocks. The cost of capital is more of an internal calculation used by a company to prioritize and evaluate specific projects.


Dividend Policy


- Watch out for your dividends - no one else will!

I knew an investor who transferred her no-load mutual fund to her brokerage account, at a very reputable firm, so that all her investments would be on one statement. After a few years, she noticed that the balance of that particular fund never grew, while the fund was always listed in the newspapers as one of the better performers in its group. To keep the story short, the brokerage house was not posting the annual stock dividends of that fund to her account. When she discovered it, the firm researched it and immediately made her whole. Mistakes sometimes happen and can be easily rectified, but it's important for investors to personally review their monthly statements. I hope this example brings home the importance of reviewing your statements.

Most investors, especially those with many stocks, don't focus on specific stock dividends until they do their taxes. While most individuals are astute as to annual dividend amounts, many may not be aware of the implications of all the various dividend dates. This may cause them to innocently lose money, by trading shares and not realizing when the next ex-dividend date is. Even experienced investors sell stocks immediately before the ex-dividend date, thereby losing the dividend. In effect, they are giving the dividend away to the buyer. In reality, the dividend may or may not be built into the stock price.

Most brokerage statements show when a dividend was received, and what the anticipated income and yield will be on the shares held. Most statements don't show ex-dividend dates, nor do many annual reports or company web sites. One needs to read the actual press releases issued by the company. The Value Line Investment Survey shows dividend information in fine print on the very bottom of each page. Some stock sheets disclose an "X" by the particular stock's volume figures, if the stock is trading ex- dividend. Yahoo does a very nice job of reporting dividend payment dates and ex-dividend dates under their key statistics section. Additionally, certain stock price / volume charts show a very small tick mark on the bottom date axis, which represents ex-dividend dates. The important cash dividend dates are listed below:

Declaration Date - The date the dividend is authorized by the board of directors and announced in a press release, usually over the business wire. The company notifies the exchanges, as well as the transfer agent (paying agent) and depository trust company ("DTC"), of the declaration date, record date, payment date and amount.

Date of Record - The date on which the investors must be shareholders to qualify for the dividend. Keep in mind that the brokerage firms need three days to settle the trade. To qualify as a shareholder on the record date, one must purchase the stock at least three days before the record date. The record date is also the cut-off date for determination of rights to receive proxy materials, annual reports and the like.

Ex-Dividend Date - The date that the new investors are not eligible for the dividend. The prior owner of the stock, who owned the stock immediately prior to the ex-dividend date, receives the dividend. If one purchases a stock on or after the ex-dividend date, they will not receive the cut-off dividend. The stock exchange sets the ex-dividend date usually two business days prior to the record date.

Dividend Payment Date - The date the investors are paid. The company wires the total dividend payment, beforehand, to the transfer agent, who then disburses the dividends to the individual shareholders of record, as well as to the DTC. The DTC then forwards the dividend to the brokerage firms who hold the investors' shares in street name. The brokerage firms then credit the individuals' accounts.

On the website of Duke Energy under Investors & Shareholder Return, they present a simple but excellent chart, listing all the important dates and amounts of their dividends. Hopefully, the ongoing accounting reform will make this type of disclosure a requirement for all companies.


Stock Splits, Stock Dividends, and Reverse Stock Splits


Technically, stock splits, stock dividends, and reverse stock splits, have no monetary effect on one's investment. They just change the number of shares owned, resulting in a proportionate change in the share price, with no overall change in the total value of the investment. There are no tax consequences for non-cash stock reallocations. The nuances of each are discussed below:

Stock Splits

Stock splits are an increase in the number of total shares outstanding of a company, with a proportional decrease in the share price and dividend of the company. Stock splits have no effect on the overall market capitalization of the company. The individual shareholders receive more shares, but their percentage ownership is the same, as is their overall cost basis, dividend, and original purchase dates. Usually, companies have 2 for 1, or 3 for 2 splits, but other combinations can also be used.

The investment strategy of buying a stock when a split has been announced and selling when the split occurs is no longer in favor. Companies split their stock for various reasons, such as:

* Maintaining a price that is attractive to the average investor
* Increasing the company's outstanding floating shares
* Broadening the company's investor base

Stock splits are usually indicative of a forward moving company that is growing and improving shareholder value.

Accounting Treatment: "Memo" accounting entries are made with stock splits that increase the authorized and outstanding shares of the organization. Also, the company's par value per share is proportionately adjusted, as well as all the historical stock charts.

Newspaper Treatment: Some newspapers identify those stocks that had a split during the prior 52 weeks by having an "S" next to the company's name. They also restate all prior share price statistics to reflect the stock split.

iStock Dividends: iStock dividends are theoretically similar to a stock split, in that the number of shares outstanding increase, with a proportional decrease in the share price. The scale of a stock dividend is much smaller, usually between 1% to 20% or 25% of thedividend is much smaller, usually between 1% to 20% or 25% of the outstanding shares; after that it is considered a stock split. As with a stock split, the shareholders receive more shares, but their percentage ownership is the same, as is their total cost basis and original purchase dates. The original dividend rate may or may not be reduced; every transaction is different. While most of the stock charts and newspapers automatically make the proportionate changes for small stock dividends, some may not note it on the charts, because of spacing issues. In effect, one often receives more shares, with the same dividend rate. Additionally, management's intent in paying a non-cash dividend is to show shareholders and the investing community, that the organization is growing in value, and is rewarding its shareholders. A cash dividend may not be available to the shareholders, but remuneration is still intended.

Accounting Treatment: Stock dividends are accounted for as a non-cash dividend. As such, the accounting records are adjusted by debiting retained earnings for the FMV of the dividend and crediting common stock at par value, with the difference being credited to additional paid in capital. This has zero impact on shareholders' equity, but reduces the retained earnings of the company, for the value of the dividend.

Tax Treatment: Generally, stock dividends, as well as stock splits, are non-taxable. There are a few exceptions, such as: if the company gives one an option for cash or stock, that option may make the transaction taxable, irrespective of the owner's choice. Additionally, if the shareholders are not treated the same, and receive disproportionate distributions or different amounts, types, classes or terms, the distribution may be taxable.

If shareholders receive any inequitable treatment, the transaction may be taxable. If common shareholders receive certain preferred stock, the transaction may be taxable. With unusual distributions, always consult with the company or the IRS, as to the tax consequences, before filing the annual 1040 tax return.

Stock dividends are a good way for management to show investors that the company recognizes their ownership position, and is working at increasing the value of their investment.


Reverse Stock Splits


A reverse stock split is the opposite of a regular stock split. Usually the company has had a "series of eroding fundamentals; it is a last ditch effort to keep the stock listed on exchanges as a marginable security." It's a natural process in reflecting the declining value of an enterprise. Usually, dividends have already been discontinued. Most stocks need to trade above $1 per share to maintain their listing on the stock exchanges and trade at or above $5 per share to be marginable. Shareholder approval is not needed for reverse stock splits. I believe, in most cases, these stocks continue to decline until they ultimately go out of business.

There are, however, cases where a stock previously bottomed-out, and now fundamentals are improving, and the institutional investors and analysts are recommending that the company reverse split their shares, to increase its stock price, thus making it eligible for institutional purchase. Reverse splits also reduces trading costs. These are the types of turnaround companies that speculative investors should look for.

Lab Corp of America is a good example. Their product is a healthcare necessity in today's world. Emergency room doctors cannot be certain that a critically ill patient is having a heart attack until a series of blood work is done over a prolonged period of time. Blood testing is essential in the healthcare industry. Back in the mid-to-late 1990's Lab Corp had a series of mishaps, combined with changing governmental billing procedures at the doctor level, which took time to implement. This resulted in a company that was obviously improving, but was not yet recognized by Wall Street. They first had a 10 for 1 reverse split in 2000 followed by two, 2 for 1 splits in 2001 and 2002. This is obviously a success story.

Lab Corp's example may also be the footprint that some of the post-bubble technology companies can use, to correct the distortion between their stock price and their fundamentals. This can be a valuable and potentially profitable case study for investors.


Spin-offs, tracking stocks and determining new cost basis


Historically, public companies have found it beneficial to distribute to their shareholders businesses that deviate from core activities. The two main methods used to restructure an organization are discussed below:

Spin-offs - This involves distributing a subsidiary or division to the shareholders, which usually does not have synergies with the core parent company. Usually, these are non-core and / or under-performing business units. It's an easy way for a company to reduce cost and rid itself of low profit margin segments, thus improving the consolidated margins on the remaining businesses. Additionally, by shedding the weaker divisions, it refocuses management's attention to its main business. The resulting higher margin business may make favorable impressions on the stock analysts and investment bankers, resulting in higher valuations for the parent company.

The newly created spin-off may also benefit by not being constrained by the bureaucracy of a larger parent company, and might become more entrepreneurial and profitable. When the shares are initially distributed as a new public company, however, these issues may not meet the portfolio criteria of many investors, and may be sold, sometimes regardless of price. One may also wind up with only a small number of shares, and the securities might becomes more of a nuisance to hold rather than valuable assets. Additionally, stock analysts can only cover a dozen or so stocks at one time, many times leaving these companies with no coverage. This culmination of events leads to initial selling pressure on the stock. The investment strategy should be to wait until the selling subsides and the price stabilizes at its fair value, before making a decision. Additionally, be aware of those instances where management loads up the spin-off with debt, making it difficult for the new company to make a fair return for its new investors.

There are also a few situations where a company's mix of businesses is confusing to the investment community, resulting in a total market value that is lower than the sum of the individual businesses. This is the same issue as the drawbacks of the conglomerates in the 1960's. Normally, in these situations, the parent company can either have a full or partial distribution of certain divisions or subsidiaries.

Partial Spin-offs - A partial distribution behaves as a short term tracking stock or "carve-out." The company will have an initial 15% to 20% IPO of the valuable subsidiary. Usually, the proceeds will go to the parent company, and at some subsequent date the remaining portion of the subsidiary will be distributed to the shareholders. Here the market results are mixed. In some situations, the market values these businesses at a premium; the future short-term upside may be limited for investors. The investment landscape includes many companies like ATT Wireless or Kraft Foods, which are great franchises, but may take a decade before their shareholders substantially profit. In other cases, such as when Eli Lilly spun-off Guidant in 1994, the market for pacemakers, leads and implanted defibrillators was uncertain. Thus, the initial shares were reasonably valued, rewarding both the initial investors, and the IPO investors, many times over. The investment strategy for partial spin-offs is more difficult. Often, the hype of the IPO inflates demand, pushing the stock price up, leaving investors in a quandary.

Tracking Stocks - These are stock investments where a parent company is raising equity by selling a minority interest in one of its highly visible divisions to the public. The valuation ratios of the tracking stocks are usually higher then that of the parent company, in effect advertising to the investment community that the parent has a prized asset. Additionally, because of the higher valuation of the tracking stock, it can be used as currency to make acquisitions, furthering enhancing the prospects of both companies. The tracking stock can also be offered to management as a form of sweat equity, as an incentive to conserve cash while motivating their employees. The new investors only have an interest in the public tracking stock.

The board of directors of the parent company usually governs both companies. In many cases, the shareholders of the tracking stock have fewer rights than the parent company's shares, as well as fewer votes per share. The parent will still control the subsidiary.

Additionally, such administration functions as SEC reporting, taxes, etc. are usually handled by the parent company. The parent company may cross-collateralize the debt of the tracking stock, keeping interest expense low, as well as establish tax-sharing agreements to fully utilize tax benefits.

Many tracking stocks have high growth potential and investor appeal, and are issued at high valuations. Parent companies can take advantage of this appeal by pushing the negative aspects of growth to the tracking stock. Often, growth requires up-front cash outflows, initial losses, as well as higher debt levels and capital needs. These negative attributes can be transferred to the tracking stock, thereby improving the fundamentals of the core parent company, sometimes at the expense of the tracking stock, while also controlling the future profits of the tracking stock.

In most situations, the strategy is to invest in the company that ultimately controls the profits of the tracking stock. Most business professionals tend to hold onto their most valuable assets and sell their least attractive or most overvalued businesses first. These securities are relatively new to the investment community, and extreme caution should be exercised when purchasing them.

Determining New Cost Basis ñ Spin-offs are the result of a parent company breaking off a division into a separate public company, resulting in two separate stocks. This distribution is normally tax-free until either of the companies is sold. When sold, the investor is required to file a capital gain or loss schedule D with the annual 1040 tax return to the IRS. The complicated part for schedule D, is how to allocate the original cost basis between the two securities.

Generally, one's cost basis is allocated based on the fair market value of the combined securities when first traded. Normally, the company will supply this information to its shareholders. Additionally, the investor's original purchase date is used for both securities. Below is an illustration:

A person purchased 50 shares of an oil company 50 years ago, at $20 per share. Six 2 for 1 stock splits later, the stock is now trading at $20 per share. At that time, the company spins off its industrial machine tool division and the investor now receives an additional 320 shares of the new industrial machine tool company, initially trading at $10 per share. Here is the cost basis distribution:

1,600 oil company shares at $20/share + 320 machine tool company shares at $10/share = $32,000 + 3,200. TOTAL = $35,200

This is a typical example of a buy and hold strategy. The rate of return, in the above example, excluding the dividends, is approximately 8.78% per year.


Stock Rights


Stock rights are options given to shareholders to purchase additional shares, usually at a discounted price, and with a ten-year expiration date. Normally the distribution is 15% or less of the total shares outstanding and is granted only if certain predetermined conditions are met.

Stockholder rights plans are usually designed by the board of directors of a company to prevent hostile takeover attempts. They make it more expensive for an acquirer to take over a company without the target's board of directors' approval.

When the plan is first approved, the rights are attached to the common stock. They are not exercisable, however, nor can they be traded separately, unless certain conditions are met. These conditions normally require an outside party to acquire about 15% of the ownership of the company before the rights become activated. The board of directors may also retain the right to cancel or change the plan at any time, even after the conditions are met.

Stock rights are really a hindrance to the shareholders, giving the board of directors of a company more power and control over takeovers than they are entitled to. This makes it harder for an acquiring company to solicit the stockholders directly, and to bypass the board of directors.

There are also companies that distribute stock rights to shareholders, which are separately traded on the exchanges. Normally, stock rights are non-taxable until the rights or the stocks are sold. Contact the company and the IRS for specific tax instructions.


© 2004 Joseph Spimella