Why Firms Issue Targeted Stock

Transcription

1 Why Firms Issue Targeted Stock Julia D'Souza* Johnson Graduate School of Management, Cornell University John Jacob College of Business, University of Colorado at Denver August 1999 Abstract: Several diversified firms have, in recent years, issued separate stock to track different industry segments ( targeted stock or tracking stock ). This paper analyzes market reactions to announcements of proposed targeted stock issuances and investigates possible motives for this choice of organizational structure. We find a statistically significant positive abnormal return of 3.61% within a three-day window around the announcement of proposed targeted stock issuances. This positive reaction may be attributable to the expectation of greater availability of information on each targeted stock segment, as well as the monitoring and motivational advantages of linking a stock directly with an industry segment. We find a lower incidence of tax loss carry-forwards among firms that have issued targeted stock compared to those that have spun off segments, suggesting that tax reasons may be partially responsible for the choice of this organizational structure. We also find that the stock returns and cash flows of targeted stock segments are influenced more by their common corporate affiliation than by industry factors, although industry influences are also strong. * Corresponding author. Mailing address: Johnson Graduate School of Management Cornell University 368 Sage Hall, Ithaca, NY address: jd48@cornell.edu Telephone: (607) Fax: (607) We are indebted to A. Garcia, formerly with Lehman Brothers, for his assistance. We also thank Ajeyo Banerjee, J. C. Bosch, Richard Cook, Beth Cooperman, Woody Eckard, Charles Lee and Naomi Soderstrom for helpful comments. The insightful suggestions of an anonymous referee greatly helped to improve this paper. Financial support from the Johnson Graduate School of Management and the College of Business at the University of Colorado at Denver is gratefully acknowledged. 1

2 1. Introduction This paper focuses on the issuance of targeted stock (stock that 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 industry segment, the segment for which the targeted stock is issued remains legally a part of the consolidated company. It has therefore been conjectured that managers of conglomerates use targeted stock to obtain some of the benefits of a spin-off (e.g., reduction in the diversification discount, increased security analyst interest) without the attendant loss of corporate control. 1 The financial press and some academics have been critical of the use of targeted stock (see, for instance, Strom (1994), Pulliam and Lipin (1995), and Reingold (1995)). The New York Times quotes Professor Bruce Greenwald of Columbia University as saying, "It is absolutely the purest form of financial engineering and it yields no benefit at all" (July 12, 1994). Proponents however argue that issuing targeted stock has very real advantages over having a single stock for a conglomerate or spinning off divisions. 2 Our first research objective is to present empirical evidence to shed some light on this debate. Is the issuance of targeted stock accompanied by an increase in equity value? We find a significantly positive market reaction of 3.61% within a three-day window around announcements of proposed targeted stock issuances, similar to the market reaction to spin-off 1 Target stock, targeted stock, tracking stock, letter stock and alphabet stock are some of the names that have been used to describe stock which represent an interest in the earnings of one division of a diversified firm. To date, 14 companies have issued 37 targeted stocks that, at one time or another, have traded in public markets. Several other companies have announced their intention of issuing such stock. A recent example is AT&T, after its merger with TCI. 2 For example, Brian Finn of CS First Boston asserts, "Letter Stock is not always appropriate, but given the right set of circumstances it's a terrific structure." (WSJ, April 10, 1995) The advantages of targeted stock over spin-offs are described in greater detail in section 3. 1

3 and equity carve-out announcements. The market appears to view targeted stock issuances as value-enhancing. Our second research objective is to investigate whether issuance of targeted stock achieves its ostensible aims: obtaining an independent valuation for the industry segments of a diversified firm, and stimulating greater security analyst interest. We analyze whether the segments represented by targeted stocks operate independently, or whether their corporate affiliations cause their performance to track their firms more than their industry groupings. We find that the contemporaneous correlation between the returns of two targeted stocks of the same firm is, on average, significantly higher than the corresponding correlation between independent stocks in the same industries. Also, the returns of a targeted stock are more highly correlated with the returns of other targeted stocks of the same firm than with the returns of independent firms in the same industry, even though the different targeted stocks of a firm operate in different industries. The firm effect (which is likely to arise because of shared management, services and liabilities) appears to dominate the industry effect. 3Although the issuance of targeted stocks is an attempt to obtain an independent valuation of diversified segments, targeted stocks of the same firm do not appear to trade independently of each other, nor are there significant increases in analyst coverage subsequent to issuances of targeted stock. Our third research question focuses on why firms that issue targeted stock opt for this organizational structure in preference to spinning off one or more segments. We compare targeted stock firms to spin-off firms along three dimensions: tax status, within-firm transfers, and financial leverage. 3 We should note, however, that the industry effect is not smaller than that exhibited by other independent firms in the same industry. On the contrary, targeted stock segments appear to track their industries more than independent firms do, possibly because they are closer than other independent firms to being pure plays in their respective industries. 2

4 In contrast to targeted stock issuances, spin-offs are often taxable. We find that significantly more spin-off firms than targeted stock firms report tax-loss carry-forwards in their financial statements in the year prior to the organizational structure change (26.22% versus none). Tax-loss carry forwards are likely to mitigate the adverse tax consequences of spin-offs. Our findings suggest that tax-related issues influence the choice between spinning off units or issuing targeted stocks. Issuing targeted stock enables a firm to keep different segments under the same corporate umbrella, and might therefore be the preferred organizational choice when there are significant inter-segment transfers. To investigate this possibility, we compare the ratio of inter-segment to total sales for targeted stock and spin-off firms in the year prior to the organizational change. We find no significant differences between the two samples, suggesting that it is not the desire to maintain control over sources of intermediate products that motivates the decision to issue targeted stock in preference to spinning off a unit. Spin-offs have more direct, potentially adverse consequences for bondholder wealth than the issuance of targeted stock, since the assets of the original firm that collateralize its debt are divided in a spin-off. Bondholders have on occasion filed suit following the announcement of a proposed spin-off (e.g., Marriott Corp.). Financial leverage could therefore be a factor influencing the choice of organizational structure. However, we do not find significant differences in either the debt-to-total assets or the interest coverage ratios between the two sets of firms in the year prior to the organizational change. In summary, firms appear to issue targeted stock to achieve some of the benefits of a spinoff without the associated adverse tax consequences and loss of corporate control. Investors perceive targeted stock issuances to be value-enhancing; we document significantly positive stock 3

5 price reactions around announcements of proposed issuances of such stock. However, business segments represented by different targeted stocks of the same firm do not operate independently of one another, nor is there evidence of greater analyst following subsequent to the organizational change. Targeted stock issuances may nevertheless represent good news from an information perspective because of the comprehensive financial statements that firms have to provide for each targeted stock segment. 2. Evolution of targeted stock issuances The earliest use of the concept of targeted stocks was General Motor's introduction of an independently traded stock for Electronic Data Systems, in conjunction with GM's acquisition of EDS in EDS s previous owner, Ross Perot, had expressed concern that the performance of EDS managers would have little impact on undivided GM stock. The introduction of a separate tracking stock for EDS helped convince Perot to sell the firm. 4 GM used essentially the same mechanism when it bought Hughes Aircraft in It introduced an additional targeted stock (GMH) that tracked the performance of the new subsidiary. USX followed this lead by issuing targeted stock in USX had two major divisions: U.S. Steel and Marathon Oil, which operated in widely different industries. USX management felt that its undivided stock was undervalued by the market. When Carl Icahn bought 13% of USX's stock, he demanded that the company spin off its steel division to enhance shareholder value. In response, the company decided to issue targeted stock for its steel and oil divisions, instead of spinning off the steel division. The USX targeted stock issuance differed from the letter stock issued by GM in two respects. First, the targeted stocks provided for the relative voting rights of the two classes of shareholders to be periodically adjusted to conform to the relative market 4

6 values of the two targeted stocks. GM's letter stocks had fixed voting rights which could cause distortions if the relative market values of the stocks changed. Second, the targeted stocks provided for proceeds to be paid to the shareholders of targeted groups in the event of a disposition. Under equivalent circumstances, letter stock is exchanged for stock of the parent company. 5 A number of other companies have since issued targeted stock. Pittston introduced separate stock for its minerals and services divisions in 1993 and then split the services stock into two targeted stocks in CMS Energy introduced a targeted stock for its Consumer Gas subsidiary. Ralston Purina issued a targeted stock for its Continental Baking division in 1993, before selling the division in US West and Tele-Communications Inc. both introduced targeted stock in (US West spun-off, as MediaOne, the division represented by one of its targeted stocks in 1998.) Georgia Pacific introduced a targeted stock for its timber division in 1997, as did Circuit City for its automobile retail unit. Sprint introduced a tracking stock for its Sprint PCS unit in Several other companies, including AT&T after its merger with Tele-Communications Inc., DuPont and Quantum Corp., have announced plans for targeted stock issuances. Ziff-Davis and Donaldson, Lufkin & Jenrette, both of which have internet operations, have announced targeted stock that will track their internet interests. Fletcher Challenge of New Zealand, introduced a targeted stock for its forest division in The company issued three further targeted stocks for its paper, building, and energy divisions in EDS was ultimately spun off entirely by General Motors in This provision was the source of conflict between GM and Class H (Hughes) shareholders when GM later wanted to sell some of Hughes operations to Raytheon. GM wanted Class H shareholders to forego their right to convert Class H shares into ordinary GM shares at a 20% premium over the prevailing price. 5

7 Several other companies have attempted but failed to issue targeted stock. In 1993, RJR Nabisco's shareholders approved the issuance of a targeted stock for the Nabisco Food business. However, the targeted stocks were never issued, possibly because the owners of this targeted stock would not be insulated from tobacco litigation. Kmart, in 1994, tried to introduce a tracking stock for its specialty stores but, in the face of shareholder opposition, had to sell the stores instead. In August 1995, MCI announced its intention to create targeted stock to separate its long distance business from its other investments. MCI called off its plan in September 1995, claiming that the timing was not right. 3. Characteristics of targeted stocks Targeted stock is a class of a diversified company's common stock linked to the performance of a particular business unit. A company may have two or more targeted stocks. Targeted stock does not represent direct ownership interest in the targeted business, but rather an ownership interest in the entire company. Holders of a targeted stock are generally entitled to vote on matters pertaining to the entire company. The number of votes that a targeted stockholder is entitled to may be either fixed at the time of issue of the targeted stock, or may float with the market value of the different targeted stocks. The issuance of targeted stock does not entail a legal division of the company. The businesses represented by the targeted stocks remain a part of the consolidated entity and share a common board of directors. Although the firm's assets and liabilities are attributed to the various targeted businesses for financial reporting purposes, legal title to the assets and responsibility for the liabilities remain with the consolidated entity. Financial statements conforming to GAAP are prepared separately for each targeted business. Earnings per share and dividends are also computed separately for each targeted group. 6

8 The income reported by the targeted business is the basis for the payment of dividends. Thus a company can pay dividends to shareholders of one targeted stock and not to those of others. 6 Holders of targeted stock of a division of a company receive financial statements for that division in addition to the financials for the company as a whole. The interests of the shareholders of the various targeted stocks may not always coincide. This is particularly the case when there are sizable corporate cost allocations, or a large volume of intra-company transactions such as goods sold or services provided by one targeted group to another. The Board of Directors assumes the responsibility of ensuring that the various targeted groups transact at arm s length. Some companies that have issued targeted stock have established a separate committee of outside directors to deal with such matters. 3.1 Targeted stocks versus equity carve-outs Issuance of targeted stock has some similarities to "equity carve-outs" which are initial public offerings of subsidiary equity. Equity carve-outs are a source of cash to the parent firm through a public sale of equity that has a claim on the subsidiary's assets alone. Usually, the parent retains a controlling interest. The difference between an equity carve-out and an issue of targeted stock is that, in the case of targeted stock, there is no parent-subsidiary relationship. In addition, issuance of targeted stock usually entails no external financing, so there is no dilution of the ownership interest of the original shareholders. 6 For instance, Circuit City paid dividends to shareholders of Circuit City Group, but not to those of CarMax Group. Dividend payout and dividend yield ratios are generally different across different targeted stocks of the same firm. For five of the seven firms for which there are enough observations to compare dividend yield time series across targeted stocks, we find that these differences are statistically significant at the 0.05 level or better. 7

9 3.2 Targeted stocks versus spin-offs The issuance of targeted stock has some advantages over a spin-off as a restructuring mechanism. It is tax-free, since targeted stock is regarded as a class of the undivided company s stock. A spin-off can only qualify as tax-free if it satisfies several fairly restrictive conditions. A company can also continue to file a consolidated tax return after the issuance of targeted stock, thereby allowing one division's losses to offset other divisions' profits. 7 Issuance of targeted stock has no adverse implications for bondholders because the company is still legally undivided. While stockholders often prefer pure plays in a single industry, bondholders are likely to prefer the more stable earnings stream of a diversified firm. 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. Finally, a common top management and shared corporate costs are likely to result in greater cost efficiencies when firms opt for the issuance of targeted stock in preference to a spinoff. Aron (1991) models the trade-off between the potentially improved managerial incentives derived from a spin-off and the economies of scope that come from association with the parent firm. The issuance of targeted stock allows a firm to benefit from both these potential advantages. Several reasons have been suggested to explain why use of targeted stock has not become more widespread. First, the ownership of targeted stock does not, in general, give the holder ownership rights to the assets of the industry segment it represents. Voting control of the entire 7 The CFO of U S West's Media Group estimated that issuing targeted stock, instead of doing a spin-off, was likely to save U S West $200 million in potential taxes over a few years (Reingold (1995)). However, there is some doubt whether targeted stock issues will continue to be tax-free. The Treasury department has proposed legislation to tax companies on their gain if they sell targeted stock. Congress is scheduled to take up this legislation in autumn

10 company has to be obtained in order to gain control of the segment s assets. For this reason, targeted stocks may not benefit from the same takeover premium as spun-off firms. Second, it may be possible for management to effect wealth transfers between different sets of targeted shareholders, because it has discretion over prices for inter-segment transfers of goods and services, interest rates for inter-segment loans, and use of the resources of one segment for the benefit of another Sample and data Our sample consists of all firms that have issued targeted stock. We also include, in some tests, firms that have attempted to issue targeted stock but failed to do so, and firms that have announced their intention of issuing targeted stock in the future. We list the firms that have issued targeted stock, along with the relevant dates, in Table 1. Table 1 also lists companies that have announced their intention of issuing targeted stock in the future, and those that attempted, but failed, to issue targeted stock. We extracted financial statement information from Standard & Poor s Compustat database, Compustat Industry Segment Database, and from individual annual reports. Data on stock prices came from the Center for Research in Security Prices (CRSP) tapes and the Wall Street Journal. We identified announcement dates of targeted stock issuances from the Wall Street Journal and companies 8-K SEC filings. We used the IBES database of Lynch, Ryan and Jones to obtain information on analyst coverage. 5. Research questions and empirical results 8 For example, Greising (1998) notes that the Timber Group of Georgia Pacific is legally obligated to sell 80% of its products to the other group at a price that matches the average price the latter pays to other suppliers. He suggests that this price is lower than the price that the Timber Group could get from external customers. 9

11 5.1 Announcement period effects Hite and Owers (1983), Miles and Rosenfeld (1983) and Schipper and Smith (1983), find significantly positive stock price reactions to spin-off announcements. If the issuance of targeted stock confers some of the benefits of a spin-off on shareholders, the market should also react favorably to announcements of proposed targeted stock issuances. We test this empirically using an event study methodology. We identify the date on which news of each proposed targeted stock issuance became public using the Wall Street Journal index, the corresponding full text article, and 8-K SEC filings by the company. We discarded six data points because the announcement of the targeted stock issuance coincided with the announcement of the acquisition of the company for which the targeted stock was to be issued, and 11 data points because of unavailability of data. 9 This left us with a sample of 12 announcements of proposed targeted stock issuances, representing ten different companies (listed in Appendix I). To ensure the robustness of our results, we used three different event study methodologies and three event windows to estimate the market reaction to announcements of targeted stock issuances. The three windows are one, two, and three days in length, ending with the day of the announcement of the proposed targeted stock issuance in the Wall Street Journal. First, we used a traditional event study procedure described in Dodd et al. (1984) with a 200-day estimation period ending 15 days prior to the announcement of the proposed targeted stock issuance in the Wall Street Journal. The parameters from the estimation period were then 9 GM's issuance of targeted stock for its EDS and Hughes subsidiaries, Genzyme's issuance of targeted stock for its Tissue Repair division, Inco's announcement of a targeted stock issue to finance its acquisition of Diamond Fields Resources, and the issuance of targeted stock by Conectiv were discarded because they coincided with acquisition or merger announcements. Announcement dates for proposed targeted stock issuances could not be found in the Wall Street Journal for three companies: CMS Energy, Kmart, and MCI. For eight companies (Sprint, AT&T, Agouron Pharmaceuticals, DuPont, Ziff-Davis, Donaldson, Lufkin & Jenrette, Quantum, and J. C. Penney), announcement dates are too recent for Compustat or CRSP data to be available. 10

12 used to find the abnormal returns of each firm on each day of the event window. We find a cumulative average abnormal return of 3.61 % (t-statistic: 3.89) for the three-day event window, 3.67% (t-statistic: 4.86) for the two-day event window, and 1.76% (t-statistic: 3.29) for the one day event window. All these t-statistics are statistically significant at the 1% level. Next, we used a non-parametric event study methodology described in Corrado (1989). The procedure involves ranking the magnitude of the abnormal return for each firm over the estimation and event periods, and testing the significance of the rank of the abnormal return in the event period. The Z-statistics from this test for the three-day, two-day and one-day event windows are respectively 3.08, 3.77 and 2.73, all statistically significant at the 1% level. Our third methodology used a cross-sectional test described in Pilotte (1992), to allow for possible increases in return variances during the announcement period. The t-statistics from the this test for abnormal stock performance during the event period are 3.35 (significant at the 1% level) for the three-day event window; 4.21 (significant at the 1% level) for the two-day event window; and 2.42 (significant at the 5% level) for the one-day window. These results, which are consistent across methodologies and event windows, indicate a favorable market reaction to news of a planned targeted stock issuance. 10The magnitude of the cumulative average two-day abnormal stock price return (3.67%) is comparable to that documented for spin-offs by Schipper and Smith (1983) (2.84% over a two-day window). It is also comparable to the (approximately) 2% abnormal return reported for equity carve-outs by Schipper and Smith (1986) and Allen and McConnell (1998). The expected potential benefits of a 10 Two recent working papers, Zuta [1999] and Billett and Mauer [1998] also document a positive market reaction to news of proposed targeted stock issuances. 11

13 targeted stock issuance therefore appear to be comparable in magnitude to those of spin-offs and equity carve-outs. 11 The significantly positive abnormal return in response to announcements of proposed targeted stock issuances could have several causes. It is possible that a "pure play" stock in a single industry is expected to attract greater analyst and investor interest. A firm issuing targeted stock may also become more attractive because of the additional disclosures it will now have to provide (specifically, separate financial statements for each targeted stock segment). The ability to directly monitor managers of divisions represented by targeted stocks may represent another value-enhancing feature of the new equity structure. 5.2 Do targeted stock segments operate independently? One of the reasons advocated for spin-offs and for the issuance of targeted stock is that the market undervalues diversified firms. A spin-off remedies this deficiency by granting complete independence to the industry segment. Targeted stock tries to achieve some of the same effect by uncoupling the earnings and dividend streams of targeted segments. We investigate whether this objective is achieved by examining whether the stock returns, earnings, cash flows and dividends of targeted stocks track the industry to which the targeted segments belong, or whether they instead track the firm with which the segments are affiliated. We also compare the operational performance and valuation of segments represented by targeted stock to those of a control sample comprising independent single-segment firms in the same industry, in an attempt to determine 11 We tested whether the magnitude of the abnormal returns at the announcement of targeted stock issuances is significantly higher than those at spin-off announcements (Schipper and Smith (1983)) and at equity carve-out announcements (Schipper and Smith (1986) and Allen and McConnell (1998)), by constructing the Bonferroni 90% joint confidence intervals, described in Neter et al. (1985) around these estimates. We find that the confidence interval from our study overlaps with those of these prior studies, implying that the abnormal returns documented here are not significantly different from those reported in prior studies. 12

14 whether targeted stock segments track their industry. The sample used for these tests (listed in Appendix II) represents all targeted stocks issued prior to Correlation between financial performance metrics of targeted stocks and independent firms in the same industry Critics of targeted stock issuance argue that targeted segments do not enjoy the operational independence that exists between a spun-off firm and its parent. Cross-dependence is likely to arise as a consequence of shared assets and liabilities, shared corporate services, and a common top management. One implication of these commonalities is that the financial performance measures of different targeted stocks of the same firm could be more positively correlated than similar measures for independent firms in the same industry or a spun-off firm and its parent. On the other hand, if the common management of the firm permits cross-subsidization across the divisions represented by the targeted stocks, there could be a negative correlation (or a reduction in the positive correlation) between the financial performance measures of these segments. Decisions that could induce such a negative correlation include allocations of common costs, transfer prices for intra-company sales, and interest rates for loans from one division to another. We compare the correlation between the performance of targeted stocks of a single firm to the corresponding correlation between the performance of independent firms operating in the same industries. If targeted stocks of the same firm operate independently of each other, these correlations should be similar. We examine five financial performance metrics: monthly stock returns, daily stock returns, quarterly earnings, quarterly cash flows from operations, and quarterly dividend yields. For each targeted stock, we identify independent companies operating 13

15 in the same four-digit SIC industry classification. 12 For each performance metric, we compute the contemporaneous correlation between the metric for targeted stocks of the same firm. The mean and the median of these correlations are presented in column (1) of Table 2. For each metric, we then compute the average correlation between independent firms in the same four-digit SIC classification codes as each pair of targeted stocks. 13 Column (2) of Table 2 presents the mean and median values of these average correlations. If targeted stock segments of the same firm operate as independently as do their industry-matched stand-alone counterparts, we would expect to find no significant differences between correlations of targeted stock with each other and the correlation of independent firms in the targeted stocks industries with one another. We use the paired non-parametric Wilcoxon signed-rank test to test for differences in the computed correlations between targeted stocks of the same firm and the corresponding average correlation between independent firms in the same industries. Using both monthly and daily data, we find that the correlation between stock returns of targeted stocks of the same firm is significantly positive, as is the average of the corresponding correlation between pairs of independent firms in the same industries as the targeted stocks. For both measures, the positive correlation between two targeted stocks of the same firm is significantly greater than the correlation between their industry-matched counterparts. Targeted stocks of the same firm do not appear to trade independently of each other. Shared top management, services, and liabilities appear to induce greater dependence in stock returns. 12 When there were more than 15 independent firms in the four-digit SIC code classification, we randomly chose 15 of these using a random number generator. This restriction is imposed because the number of correlations to be computed increases exponentially with the number of firms. 13 We first found all possible pairings between firms in the two SIC codes corresponding to each pair of targeted stocks. We then averaged the performance metric correlation between all identified pairs of independent firms. 14

16 The correlation between contemporaneous quarterly earnings of targeted stocks of the same firm is not statistically different from zero. In addition, the contemporaneous correlation between the earnings of targeted stocks of the same firm is not statistically different from the corresponding correlation for the matched independent firms. Shared corporate affiliation does not appear to induce dependence in the earnings of different targeted stocks of the same firm. The contemporaneous correlation between quarterly cash flows from operations for targeted stocks of the same firm is significantly positive, as is the corresponding correlation for their industry-matched independent firms. The difference between the cash flow correlation for targeted stock segments versus their industry-matched independent counterparts is significant at the 5% level (two-tailed). Cash flows have traditionally been regarded as less subject to manipulation than earnings. The results of this test suggest that there is greater dependence between the cash flows of two targeted stock segments of the same firm than would have obtained had they operated as independent firms. The contemporaneous correlation between the quarterly dividend yields of two targeted stocks of the same company is not significantly different from zero, or significantly different from the correlation between the dividend yields of their industry-matched firms. The dividend streams of targeted stocks of the same firm, like the earnings streams, appear to be independent of one another. 14 The results so far indicate some significant commonalities in financial performance metrics of targeted stocks of the same firm. In the next sub-section, we compare the strength of these commonalities to those induced by industry effects. 14 Several of the targeted stocks and matched firms did not pay dividends throughout the sample period, so we could not compute correlations in dividend yield for these stocks. 15

17 5.2.2 Strength of firm influences relative to industry influences The results of the tests described in section indicate that there are significant commonalities in some financial performance measures of targeted stocks of the same firm, induced perhaps by a common senior management team, and shared assets and liabilities. To gain insight into the relative strength of firm-induced versus industry-induced commonalities, we next examine whether a targeted stock s within-firm correlation exceeds its correlation with its industry. As in the previous set of tests, we match each targeted stock with independent firms in the same industry. For each performance metric, we measure the contemporaneous correlation between the performance of the targeted stock and each independent firm in the industry, and compute the average of these correlations. Column (3) of Table 2 presents the mean and median values of these average correlations between targeted stock segments and their industry-matched independent firms. As mentioned earlier, Column (1) of Table 2 shows mean and median contemporaneous correlations between performance metrics for targeted stocks of the same firm. The statistical significance of differences between the within-firm and within-industry correlations is tested using the non-parametric Mann-Whitney U-Test. The contemporaneous correlations of the monthly stock returns, daily stock returns, quarterly earnings, quarterly cash flows from operations, and quarterly dividend yields of targeted stock segments with the corresponding variables for the industry-matched independent firms [column 3] are all significantly positive, indicating significant industry effects for these metrics. For both the monthly and the daily stock returns, the contemporaneous correlation between two targeted stocks of the same firm is significantly more positive than the corresponding average correlation between the targeted stock and its industry-matched independent firms. Firm-level commonalities appear to be stronger than industry influences. A 16

18 similar result is evidenced for quarterly cash flows from operations; firm effects dominate industry effects. For quarterly earnings and dividend yields, however, the correlations between targeted stocks and independent industry-matched firms are not statistically different from those between targeted stocks of the same firm. Thus, for three of the five measures examined (monthly stock returns, daily stock returns, and quarterly cash flows from operations), the firm effect induced by targeted stocks operating under the same corporate umbrella dominates industry commonalities. For none of the measures is the industry effect significantly stronger than the firm effect. Targeted stocks appear to track the firm more than the industry. Next, we examine whether the correlation of the performance metrics of each targeted stock with corresponding industry measures is lower than that exhibited by independent firms in the same industry. For each metric, we compute the average industry correlation as the mean of the corresponding correlation between all possible pairs of independent firms in the industry. The mean and median of these average correlations for the five financial measures are presented in column (4) of Table 2. We compare these correlations with those between the targeted stock and independent firms in the industry. We test for the statistical significance of differences between these two sets of correlations using the Wilcoxon signed-rank test. For both daily and monthly stock returns, we find that the average correlation of the targeted stock with independent firms in their industries is higher than the average correlation between the stock returns of the independent firms themselves. We conjecture that this could be a result of a targeted stock being closer to a pure play in an industry than independent firms in the same SIC classification, because independent firms could have significant involvements in other industries. There are no statistically significant differences between columns (3) and (4) in Table 2 for quarterly earnings, 17

19 quarterly cash flows from operations, or quarterly dividend yields. 15 There is therefore no evidence that the targeted stock structure causes the industry segments that these targeted stocks represent to be less correlated with their industry than they would otherwise be. On the contrary, targeted stock segments appear to track their respective industries more closely than other independent firms do Differences in selected financial ratios between targeted stock segments and stand-alone firms in the same industries For all years subsequent to the issuance of targeted stock, we compare ratios that measure operational performance (return on assets and return on equity); stock performance (market return); financial soundness (debt to total assets and interest coverage); market valuation (price to earnings and market to book); and dividend policy (dividend payout and dividend yield) across the targeted stock segments and the control sample of independent firms in the same industries. We compare targeted stock segments to all independent single-segment firms in the same industry, using the four-digit SIC code to define industry when there are at least five independent firms within a classification. If this criterion is not met, we use the three-digit SIC code (and in a few cases the two-digit SIC code) to define industry affiliation. For each industry and year, we compute the median of each financial ratio for all single-segment independent firms in that industry. The first column of Table 3 reports the median ratio differences, across the time period 1989 to 1997, between the targeted stock segments and independent single-segment firms in the same industry. Since each targeted stock segment is represented in the sample in multiple years, these observations are not strictly independent. For comparison with a sample where the 15 When we test for differences across all performance metrics jointly, we find that the correlation between the performance of a targeted stock and that of its industry is significantly higher than the corresponding correlation for independent firms. 18

20 observations are independent, the second column of Table 3 reports results for a single year, 1996, the year with the highest number of observations. Each targeted stock segment is represented once, at most, in this sample. The most striking difference between targeted stock segments and their comparison firms is in the dividend payout and dividend yield ratios. Targeted stock segments paid out 12% more of their earnings in the form of dividends than did comparison firms. This difference is significant at the 1% level in both the 1996 and the overall samples. Similarly, the dividend yield of target stocks is 1.3% higher than that of independent single-segment firms in the industry. We conjecture that the stability that comes from being associated with a diversified firm may allow these firms to pay out a greater proportion of earnings in the form of dividends. It is also possible that these firms pay higher dividends to signal to skeptical market participants that their rather controversial equity structure is viable. Although targeted stock segments appear to reinvest relatively lower proportions of earnings, they are not characterized by higher levels of external financing via debt than their independent counterparts. However, ratios involving assets or liabilities have to be interpreted with caution for targeted stock segments. Although assets and liabilities are assigned to each targeted stock segment for financial reporting purposes, the corporate entity retains legal title to all assets, and bears legal responsibility for all liabilities. The return on equity of targeted stock segments is on average significantly higher than that of single-segment firms in the same industry. It should be noted, however, that higher dividend payments reduce the book value of shareholder equity, biasing the return on equity upward for targeted stock segments relative to their independent counterparts, all other factors being equal. 19

21 None of the other ratios analyzed differs consistently between targeted stock segments and their comparison firms across columns 1 and 2 of Table 3. Interestingly, the price-to- earnings ratio of targeted stock segments is not significantly lower than that of independent firms in the same industry. Thus there is no evidence that the earnings of targeted stock segments are undervalued relative to those of their independent single-industry peers Targeted stock issuances and changes in analyst following It has been suggested that conglomerate firms may be undervalued because security analysts find it difficult to value firms that cross industry lines. For instance, Bhushan (1989) documents that an increase in the number of business segments within a company is accompanied by a drop in analyst following. Analysts generally specialize in one industry, developing industryspecific expertise. This expertise becomes less of a competitive advantage when an analyst follows diversified firms. Forecasting earnings and stock prices also becomes more complex, because forecasts for various divisions have to be aggregated. The issuance of targeted stock has the potential to alleviate this problem by providing pure plays in single industries. If analysts avoid stocks of diversified firms because of the complexity introduced by conglomeration, then there should be an increase in analyst following after the issuance of targeted stock. We test this empirically by comparing analyst followings before and after the issuance of targeted stock, using the Lynch, Ryan and Jones IBES database of analyst forecasts. We define analyst following before the issuance of targeted stock as the number of analysts who issued at least one forecast of earnings for the company during the year. Analyst following after a targeted stock issuance is defined as the number of analysts who issued earnings forecasts for at least one of the targeted stock segments. We again exclude companies whose targeted stock was issued to 20

22 facilitate mergers and acquisitions. We are also forced to exclude instances where the targeted stock was issued after 1995 because of lack of forecast data availability. Table 4 compares analyst following for the years before and after targeted stock issuances. After the issuance of targeted stock, we report (in the first row) the number of different analysts who issued forecasts for at least one of the targeted stock segments of the company, and also (in the following rows) the number of analysts who issue forecasts for each of the targeted stock segments. It is evident that there is a significant overlap in the analysts who follow the targeted stocks of a company. An analyst who follows one targeted stock of a company also generally follows any others. When we investigate changes in analyst following before and after the issuance of targeted stock, we find that both the sign test and the Wilcoxon signed-rank test indicate no statistically significant change in analyst following. In other words, the issuance of targeted stock does not appear to generate an immediate increase in analyst interest. Because all but two issuances of targeted stocks occurred in the mid-1990s, however, we are not able to examine analyst following beyond the first year after the issuance. It is possible that analyst following increases in subsequent years. In addition, because we compute analyst following solely from the IBES database, we do not pick up analysts who work for brokerage houses that do not supply forecasts to IBES. This may lead to understatement of analyst following, but we do not believe that it systematically biases our test. An analyst s valuation task is likely to be facilitated by the comprehensive financial statements that firms have to provide for each targeted stock segment. If the market assigns a lower valuation to firms that cross industry boundaries because of the increased risk resulting 21

23 from the paucity of information, the issuance of targeted stocks may still be viewed as good news from an information perspective, despite no change in analyst following. 5.4 Targeted stocks versus spin-offs For insight into the motivations of firms that issue targeted stock, we compare them to a sample of firms that undertook spin-offs in the same period. Since the firms that issued targeted stocks presumably considered and rejected the option of spinning-off the targeted stock segment, we look for systematic differences between firms that issued target stock and those that undertook spin-offs. We identified a sample of 64 firms that undertook spin-offs in the period , the period during which most of the targeted stocks were issued. 16 We then compared the firms in the two samples along several dimensions in the year prior to the organizational change. Table 5 presents the result of these analyses. A significantly higher proportion of spin-off firms reported tax-loss carry-forwards in the notes to their financial statements (26% versus 0% for targeted stock firms). Tax-loss carryforwards are likely to mitigate the adverse tax consequences of a spin-off. The finding that firms in the two samples differ significantly along this dimension lends credence to the anecdotal evidence that several of the firms that issued targeted stock instead of spinning off the segment did so for tax reasons. It is also possible that firms with a significant proportion of inter-segment transactions may be more inclined to issue targeted stock rather than spinning off a segment, in order to retain all segments under the same corporate umbrella. However, we do not find that the inter-segment to total sales ratio of firms issuing targeted stocks is higher than the corresponding ratio for spin- 16 The sample of spin-offs is identified from CRSP using the distribution code for spin-offs. The targeted stock sample consists of all firms that issued targeted stocks prior to 1998, except for Fletcher Challenge (Compustat data for this firm are not available for the year prior to the organizational change). 22

24 off firms. The desire to maintain control over sources of intermediate products thus does not appear to be a major factor in the decision not to spin-off segments. We also investigate whether, prior to the organizational change, the financial leverage of spin-off firms is systematically different from that of firms that issue targeted stock, given that the two organizational structures have different implications for bondholder risk. We do not find significant differences in either the debt-to-total assets or the interest coverage ratios across the two sets of firms in the year preceding the organizational change. Nor do indicators of profitability or future growth prospects differ significantly across the two sets of firms Summary and conclusions Targeted stocks represent a single-industry segment of a diversified firm. Holders of a targeted stock are entitled to benefits from the stream of earnings of the targeted business, but the business segment remains legally a part of the parent company. Proponents of targeted stock view it as a means to mitigate the diversification discount that may otherwise penalize firms operating in multiple industries. This paper focuses on three research questions. First, does the market view the issuance of targeted stock as value-enhancing? Second, do targeted stock issuances serve to obtain more independent performance and valuation of targeted segments? And third, are there systematic differences between firms that issue targeted stocks to track different units and those that opt to spin off units? We first investigate whether targeted stock issuances are viewed by the market as mere cosmetic changes, or whether they are accompanied by an increase in equity value similar to that 17 The high mean of the price-to-earnings ratio for the targeted stock sample is primarily due to one firm with a priceto-earnings ratio of

25 documented for spin-offs. We find a significantly positive market reaction at the time of announcement of targeted stock issuances. 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. On the second question, we examine whether targeted stock segments of the same firm operate and trade independently, or whether their common corporate affiliation induces dependence. We find that the stock returns of targeted stocks of the same firm are more positively correlated than those of industry-matched independent firms. Targeted stocks of the same firm do not appear to trade independently. We find that both stock returns and cash flows from operations of targeted stock segments seem to track their firm more than their industry. There is no evidence of increased analyst following after targeted stock issuances. However, the valuation task may be facilitated by the comprehensive financial statements that firms are required to disclose for each targeted stock segment. Finally, why might targeted stock might be the preferred organizational form in some instances? Are there systematic differences between targeted stock firms and spin-off firms prior to the organizational change? We find that firms that issued targeted stock are more likely to have tax-loss carry-forwards that could alleviate the adverse tax consequences of a spin-off. There is no evidence that targeted stock firms are characterized by a higher proportion of inter-segment transactions, a characteristic that might predispose firms to retain segments under the same corporate umbrella. We conclude that firms issue targeted stock in an attempt to achieve some of the benefits of a spin-off without the adverse tax consequences and loss of corporate control. The market appears to regard the issuance of targeted stock as good news. The increase in value could stem 24