Why firms issue targeted stock

1
Why firms issue targeted stock

• Julia DSouza and John Jacob
• Journal of Financial Economics
• 2000

2
Introduction

• Targeted stock (also called tracking stock,
  letter stock or alphabet stock) represents an
  interest in the earnings of one division of a
  diversified firm
• Although ownership of targeted stock entitles the
  holder to the benefits of the earnings stream of
  a particular segment, it remains legally a part
  of the consolidated company
• To date (as of 2000), 14 companies have issued 37
  targeted stocks

3
List of companies issued or announced issuance of
targeted stock
4
List of companies issued or announced issuance of
targeted stock (Contd)
5
List of companies issued or announced issuance of
targeted stock (Contd)
6
Introduction (Contd)

• The financial press and some academics have been
  critical of the use of targeted stock
• Reingold, 1995 Wall Street Journal, April 11
  1995, p.7 New York Times, July 12, 1994, p.D1
• Bruce Greenwald (Professor of Columbia
  University)
• It is absolutely the purest form of financial
  engineering and it yields no benefit at all
  (July 12, 1994, p.D1)
• Proponents argue that issuing targeted stock has
  very real advantages over spinning off divisions
  or having a single stock for a conglomerate
• Brian Finn (CS First Boston)
• Letter stock is not always appropriate, but
  given the right set of circumstance its a
  terrific structure (Wall Street Journal, April
  10, 1995, p.6)

7
Characteristics of targeted stocks

• Targeted stock is a class of a diversified
  companys common stock linked to the performance
  of a particular business unit
• Two or more targeted stocks
• No direct ownership interest in the targeted
  business but rather an ownership interest in the
  entire company
• Entitled to vote on matters pertaining to the
  entire company
• Not entail a legal division of company
• Financial statements are prepared separately for
  each targeted business

8
Targeted stocks versus equity carve-outs

• Differences
• In the case of targeted stock, there is no
  parent-subsidiary relationship
• Equity carve-outs a source of cash to the parent
  firm through a public sale of equity that has a
  claim on the subsidiarys assets alone.
• Issuance of targeted stock usually entails no
  external financing.

9
Targeted stock versus spinoffs

• Advantages of issuance of targeted stock over
  spinoff
• Tax free
• No adverse implications for bondholders because
  the company is still undivided
• Other things being equal, the cost of capital for
  a firm issuing targeted stock is likely to be
  lower than for a firm that spins off a segment

10
Research objectives

• Present empirical evidence to shed some light on
  the debate (Is the issuance of targeted stock
  accompanied by an increase in equity value?)
• Investigate whether issuance of targeted stock
  achieves its ostensible aims of obtaining an
  independent valuation for the industry segments
  of a diversified firm and stimulating greater
  security analyst interest
• Why firms that issue targeted stock opt for this
  organizational structure in preference to
  spinning off one or more segments

11
Data

• Wall Street Journal
• 8-K SEC filing
• Standard Poors Compustat database
• Center for Research in Security Prices (CRSP)

12
Tests

• Announcement effect
• Significantly positive stock price reactions to
  spinoff announcements Hite and Owers (1983),
  Miles and Rosenfeld (1983), and Schipper and
  Smith (1983)
• Three different event studies
• Traditional event study (Dodd et al.(1984))
• 200-day estimation period ending 15 days prior to
  the announcement of the proposed targeted stock
• CAR 3.61(t-stat3.89), 3.67 (t-stat4.86),
  1.76 (t-stat3.29) for three, two, and one day
  window, respectively

13
Test (Contd)

• Nonparametric event study (Corrado(1989))
• Z-stats for the three, two and one day event
  window are, respectively, 3.08, 3.77 and 2.73,
  all statistically significant at the 1 level
• Cross-sectional test (Pilotte (1992))
• T-stats from this test for abnormal stock
  performance during the event period are 3.35
  (significant at 1) for three day window, 4.21
  (significant at 1) for two-day and
  2.42(significant at 5) for the one day window
• Three event windows (one, two and three days in
  length

14
Tests (Contd)

• Do targeted stock segments operate independently?
• Correlation between financial performance metrics
  of targeted stocks and independent firm in the
  same industry
• Strength of firm influence relative to industry
  influences
• Difference in selected financial ratios between
  targeted segments and stand-alone firms in the
  same industries

15
Correlations of financial metrics of targeted
stocks
16
Median differences between selected financial
ratios of targeted stocks relative to single
segment firms in the same industry
17
Test (Contd)

• Targeted stock issuances and changes in analyst
  following
• Targeted stocks versus spinoff

18
Analyst following around targeted stock issuances
19
Targeted stock versus spinoff firms
20
Summary

• Does the market view the issuance of targeted
  stock as value-enhancing?
• A significantly positive market reaction at the
  time of the announcement of targeted stock
  issuance
• This suggests that investors expect the
  organizational change to provide information
  advantages, to result in better monitoring or
  motivation for divisional managers, or to reduce
  suboptimal divisional cross-subsidization.

21
Summary (contd)

• Do targeted stock issuances serve to obtain more
  independent performance and valuation of targeted
  segment?
• The returns of targeted stocks of the same firm
  are more positively correlated than those of
  industry-matched independence firms
• Both stock returns and cash flows from operations
  of targeted stock segments seem to track their
  firm more than their industry
• No evidence of increased analyst following after
  targeted stock issuance

22
Summary (contd)

• Are there systematic differences between firms
  that issue targeted stocks to track different
  units and those that opt to spin off units?
• Issue targeted stock are more likely to have
  tax-loss carryforwards that could alleviate the
  adverse tax consequences of a spinoff
• No evidence that targeted stock firms are
  characterized by a higher proportion of
  intersegment transactions

23
Conclusions

• Firms issue targeted stock in an attempt to
  achieve some of the benefits of a spinoff without
  the adverse tax consequences and loss of
  corporate control.
• Market appears to regard the issuance of targeted
  stock as good news.
• The increase in value could stem from the
  availability of more detailed information on each
  targeted stock segment as well as from the
  monitoring and motivational advantages of having
  a stock directly linked with an industry segment

24
Conclusions

• Targeted stocks of the same firm do not trade
  independently of each other.
• Firm-level commonalities appear to dominate
  industry-related effects.