Some perspective for the future.
fortune.com
LOW-DOWN STOCKS
Yikes! My Stock's in Single Digits!
Shocking, ain't it? Yesterday's bull-market icons keep hitting new lows.
FORTUNE
Monday, May 27, 2002
By Andy Serwer
There is something strange about Focal Communications' stock chart. Very strange. No, it's not just that its shares recently traded at $3. That, as we all know, is hardly a mark of distinction these days. It's that a couple of years ago the chart shows FCOM trading at around $3,000!
Come on, really? $3,000 to $3! Is that right? Actually, yes and no. You see, Focal Communications, a competitive local-exchange carrier (CLEC) based in Chicago, has just pulled off a 35-to-1 reverse stock split. The stock was selling for pennies, and this was an attempt to boost the price by reducing the number of shares outstanding--in this case, by a factor of 35. But the split also had the effect of making Focal's split-adjusted high $3,000, instead of its actual trading price of around $85.
Sound wacky? Well, it's definitely not situation normal--though one could ask, What is, these days? Nor is this kind of capital-structure engineering practiced only by small, obscure companies. AT&T is reportedly considering a reverse split when it completes the sale of its cable assets to Comcast. Ma Bell execs apparently fret that selling those properties will send its stock price down below $5. (T recently traded at $13.) A reverse split would pop it back up to double digits.
Yes, it has come to this. We are at a moment in stock market history when corporate icons are contemplating what many would consider desperate measures to boost their share prices. And the problem is hardly isolated to a handful of troubled companies. Some of the most notable names on the FORTUNE 500 now trade in the single digits--a fact that has sent a new wave of trauma through post-Sept. 11, post-recession, post-bubble Wall Street.
Recent recruits to the sub-$10 club include heavyweight techs and telcos: Oracle, Sun, EMC, Gateway, and Qwest. Throw in erstwhile highfliers like Rambus, E*Trade, Ciena, CMGI, and Inktomi. And it goes well beyond tech too. Other sectors of the economy, from airlines (US Airways) to media (Gemstar-TV Guide) to insurance (Conseco) to engineering and construction (Foster-Wheeler), are represented. We're not even counting basket-case bankruptcies like Kmart and Bethlehem Steel.
For many of the companies the fall has been so hard and so deep that it is hard to comprehend. Companies like Ask Jeeves, DoubleClick, and i2 weren't just hot stocks, they were supernovas, trading in the three figures not much longer than 24 months ago. Consider the mammoth collapse in the value the market assigned to them. InfoSpace, for instance, trades at about $1 today and has a market capitalization of some $275 million. At its peak in March of 2000, its stock closed as high as $130, giving the company a value of over $26 billion. CEO Naveen Jain once boasted this would be the first trillion-dollar-market-cap stock. Right.
For others, the new third-class status is more a question of shame than survival. Unlike many of their fellow "single-digit midgets" (hey, it's not our term--it's Wall Street's), there's little chance that an Oracle or Sun is going to go belly-up anytime soon. Oracle, for instance, which made $2.6 billion in actual profit on $11 billion in sales last year (never mind its $4.5 billion trove of cash), continues to be a software titan. But even so--and we're sure Oracle CEO Larry Ellison knows this well--it can be easy to skip over the company's blue-chip balance sheet when you're racing through its low-rent neighborhood. (Just down the street, after all, are WorldCom and Lucent.)
That brings up Question No. 1: How did such blue chips slide into skid row? Recall the reverse-splits above. Think of this trend as a mirror image of the last one. "Many of these companies are in this situation," says Kari Bayer, senior U.S. strategist at Merrill Lynch, "because the stock prices got ahead of themselves and they kept splitting and splitting and splitting." And then some. There were almost 400 stock splits in the S&P 500 between 1997 and 1999. Stock splitting became its own mini-mania. In retrospect, it certainly looks like a poor decision that both Sun and Oracle split their stocks two-for-one, at $60 and $50 respectively, in late 2000. Sure, both did splits about a year earlier at around the same prices and both stocks continued to climb. But didn't anyone wonder if the party was going to end at some point? Or didn't anyone notice that shares outstanding at Sun had ballooned to more than 3.2 billion, and to nearly 5.5 billion in the case of Oracle? (Even with their stocks in single digits, both companies still sport blockbuster market caps: Sun at $20 billion and Oracle at $46 billion.)
With the new, young-gun companies, oversplitting was even more rampant. Market analyst Steve Galbraith of Morgan Stanley recently wrote a piece about this share inflation entitled "Splitting Headache." (At the height of Irrational Exuberance, Galbraith reminds us, there was a service that would page investors to tell them of splits.) Witness CMGI, which split its stock six times between 1995 and 2000. The stock now trades at $1. More remarkably, between July 1999 and March 2000--nine months--JDS Uniphase twofer'd its stock three times. It's now at $4. You can see how JDSU execs might have gotten caught up in the madness. Even with those splits, the stock topped out near $150.
There's no reason why a company ever has to split its stock. Splits do nothing except psychologically entice investors into believing that a $30 stock is cheaper than a $60 stock. (It's not, of course--the lower-priced stock is entitled to half the earnings stream.) Warren Buffett, CEO of Berkshire Hathaway, has never split his company's stock--it now trades for around $75,000 per share. Like a restaurant seeking a certain type of clientele, Buffett is known to say, an uncleaved stock attracts a certain type of investor to Berkshire.
On the flip side, however, overly cheap stocks can put off the "right sort" of investors--the institutional kind, that is, who tend to hold their stakes for long periods of time. A number of mutual funds and pensions have guidelines that steer money managers away from single-digit stocks. (In large part that's due to price instability. Morgan Stanley's Galbraith points out that sub-$10 stocks have averaged about 20% greater volatility than the rest of the market.) It's worse for under-fives. Some stock indexes, including FORTUNE's own e-50, aren't allowed to hold shares that trade for less than $5. That hurts companies with sub-$5 price tags because it means that investors who have a strategy of matching an index won't buy their stocks.
On top of that, some brokers won't allow a stock selling for less than $10 to be used as collateral for margin loans. Merrill Lynch, among others, won't let its brokers solicit trading in many low-rated stocks that sell for less than $5 (though they can take an order for one by client request). That means that even if a broker or analyst thought WorldCom--the nation's second-largest long-distance company, which still has a $5 billion market cap--was a good buy, he or she couldn't recommend it to a customer. (Remarkably, WorldCom, which now trades at around $2, sells for less than a share of the much-maligned theStreet.com, the price for which has more than tripled to $3.50 over the past five months.) Think the fact that Merrill shuns WorldCom's stock won't hurt that company's chances for recovery?
For once-mighty companies, the march over the digital divide (from double to single) can even contribute to a business' descent into a death spiral. Simply put, when a stock falls below $10, investors start thinking about Chapter 11. "I usually tell my clients not to fish around down there," says Charles Payne, CEO of Wall Street Strategies. "It's not really worth it. Why mess around in a stock that the market is telling you could easily go bankrupt?" It isn't just the bad PR and trading restrictions that hang over the company's head. A super-low stock price also can mean a strategic handicap, since it makes for poor currency when doing mergers and acquisitions. Raising capital via stock offerings becomes almost impossible. And then, naturally, there are the company's workers to consider. When stock prices sink, so generally does the chance of cashing in stock options--and that can be demoralizing for employees from top to bottom.
Beyond oversplitting, the reasons so many stocks have sunk so low are obvious. Yes, yes, the tech bubble ... the telecom meltdown ... the energy shakeout. Add to the mixture a tepid economy that has exposed weaknesses in marginal businesses. To wit: Construction company Foster-Wheeler has been severely hurt by an ailing Asian business. And long-struggling US Airways seems stuck on the tarmac in the wake of the Sept. 11 travel slump. Overshadowing all of these elements, however, is the unforgiving Mr. Market. "It's the flip side of the 1990s and 2000," says Byron Wien of Morgan Stanley, who's been studying stocks and markets for decades. "We were overzealous to the upside; now we have these huge moves to the downside. Frankly, in some sense I think we're getting what we deserve."
What we deserve, apparently, is more single-digit midgets than we've had in a while. As of May 2000, some 1,332 stocks on the Nasdaq, or 38% of those traded on the exchange, sold for under $10, according to FactSet Research Systems. By May 2001, the figure had jumped to 1,726, or 50%. Right now, the figure is 1,658--or 51%. The percentage is up because the total number of stocks trading on Nasdaq is down almost 200 companies from a year ago, mostly due to delisting of sub-$1 issues. Indeed, many of the biggest names in the sub-$10 club, such as EMC, Oracle, and Sun, joined within the past 12 months.
From a historical perspective, all of this low-riding isn't as outrageous as it seems. Turns out, interludes like this seem to occur about once a decade. Wien recalls that stocks fell apart back in 1973-74, and also in 1982. In fact it was right around the beginning of 1982 that Chrysler shares dipped below $4 during its near-fatal crash and burn.
At that point, Lee Iacocca was already at Chrysler's helm working his magic, and by year-end the stock was up at around $18. The early 1990s was another swampy era for stocks. In May of 1992, a far greater percentage of Nasdaq stocks--63%--sold for under $10 than do today.
Financial-services companies were particularly hard hit back then. Citigroup (then Citicorp) fell under ten in late 1991 and all of Wall Street was sure the world was coming to an end. Well, not everyone thought so. It was about that time, you may recall, when Saudi Prince Alwaleed bin Talal stepped in and bought $590 million of Citi stock. The shares took off shortly thereafter, creating a multibillion-dollar windfall for the prince. Another stock in single digits then (and now back in singles) was Oracle. That stock broke 10 bucks (unadjusted for splits) in 1990 before Larry Ellison was able to orchestrate one of his patented pull-the-company-out-of-the-nosedive moves and send it on a long highflying run in the 1990s.
One point investors should take note of here before charging in to buy today's single-digit stocks: In the case of both Citi and Chrysler, the U.S. government stood at the ready to save the company. There is not even the slightest hint that the Bush Administration would lift a finger to bail out any of today's battered companies. Rightly so. It's difficult to argue that even WorldCom or Oracle are vital to our economy or our national security. The thinking in Washington to a large degree is that these companies made their own beds, and now must lie in them.
So how often do single-digit stocks come back? It depends. For tech stocks, according to a study done by Merrill Lynch analysts last spring, the answer is rarely. Merrill's then Internet infrastructure services analysts Thomas Watts and Christopher Giordano examined tech stocks that sold for under $10 in each year going back to 1987, checking to see how many climbed over $15 a year later. The grim results: On average, just 3.4% of these stocks made it past the threshold.
Steve Leuthold, of the Leuthold Group in Minneapolis, says the Merrill study's emphasis on tech paints an overly dark picture. Leuthold says it makes sense to avoid Internet and tech junk in the single digits, but investors should not categorically exclude nontech issues. The comeback chances of the latter group is much better, he says. Morgan Stanley's Wien likewise predicts that some huge winners will emerge from the discount heap. "The percentage gains can be enormous. Look at Cisco just the other day. It was up over 24%. That's a huge move." (There's that volatility we were talking about.) But for real sustained gains, Wien says investors should look beyond techs.
Barring some huge market move to the upside, one can't help but wonder if we're likely to see lots more dramatic reverse stock splits, like the one done by Focal Communications, as a matter of course. Focal's CFO Jay Sinder seems to doubt it. "You don't do a reverse split for grins," he says. "You don't know how they will turn out. These things aren't a science." Case in point: Since its 35-1 reverse split in March, Focal's stock has settled at $5 and change, down some $3.
DrRisk |
