Less is More?
Reverse stock splits can shore up a stock's price,
but it often signals caution.
By Lynn N. Duke, Staff Writer
Stock splits. Most investors are familiar with the traditional two-for-one split, when they watch their brokerage accounts grow fatter with shares, even while their overall stake in the company remains the same. But many investors may not be familiar with the stock split's cousin, the reverse split, which is often engineered to boost share price and gain a foothold on some of Wall Street's more legitimate turf.
Reverse splits have gained some attention lately, since the NASDAQ tightened its listing requirements to include a minimum bid price and a minimum market value for a company's public float.
Between Jan. 1 and June 30, 64 companies have recorded reverse splits. Some, inevitably, are using it as a tool to maintain a Nasdaq listing. NASD officials said several hundred companies have been notified of de-listing since the new rules went into effect Feb. 28. But the agency has no hard numbers on exactly how many are trying to save their listing through a reverse split. Other companies split stock backward in an attempt to gain a wider audience, figuring a better listing and stronger market value will follow.
First, let's explain both splits: The most common is a forward split, when a company increases the number of shares outstanding and lowers the share price. For example, company X has 10 million shares outstanding at $100 per share. After a 2-for-1 split, the company will have 20 million shares outstanding, each worth $50 per share. Investors are not immediately affected, since someone who owned 10 shares at $100 apiece now owns 20 shares, each worth $50. But market mentality usually considers a split a sign of strength, and share prices tend to rise after the split.
In contrast, a reverse split increases a stock's price while depleting the number of shares outstanding. A company with 10 million shares outstanding at $1.00 per share that conducts a 1-for-10 reverse split will have 1 million shares outstanding each valued at $10 when the split is complete. Again, the market cap is the same, and an investor's stake is still the same. Someone who owned 100 shares at $1.00 per share now owns 10 shares worth $10 apiece.
Interestingly, both forward and reverse splits seek the same effect, but for different reasons. A company splitting its stock to lower the price hopes to attract more investors by making its shares more affordable to a larger audience. Conversely, companies who reverse split are hoping to attract more investors, particularly institutional investors, by increasing share price. A higher price, it's hoped, will make the stock seem more attractive 0to analysts and investors.
That's the main reason Integra Life Sciences performed a reverse 1-for-2 split this spring. The company wanted to raise its profile, according to Stewart Essig, Integra's president and CEO and a former investment banker with Goldman Sachs. "Research analysts said they wouldn't pick it up under $5," Essig said. Brokers shy away from penny stocks as well. "Nobody wants to ride it at such a high commission structure. There were too many shares outstanding. This makes it attractive to more investors at an appropriate price."
Before the split, Integra was trading in the $3.50 range, but has held steady in the low to mid $7 bracket since splitting May 22.
"With a reverse split, you know there's going to be short term pressure on the stock," Essig said. "It's almost the inverse of when people do (forward) splits. People tend to think that signals strength and you see the stock run up a little bit. So they tend to think a reverse split signals weakness."
In fact, a glance at stocks that have recorded reverse splits in the first six months of this year shows they have not fared well. Of the 64 stocks reviewed by Stock Detective, 50 have lost ground compared to their pre-split price when that price is adjusted for the split. On average, the 64 stocks have declined 19 percent. Take out a couple of big gainers - stocks that have increased 200 and even 500% - and the average loss increases to 30 percent. Considered on their own, losing stocks average a 42 percent decline, while the 13 gainers increased an average of 71 percent. One stock had no change. But take out the big players again, and the average gain is 18 percent, right in line with the overall average.
Essig admits most investors don't like reverse splits and companies run the risk of destroying credibility while shoring up share prices. "People worry about, 'is this the last reverse?' You don't want people to think they'll become systemic. We won't do another because we don't need to. People don't want to think you're only focusing on financial shenanigans."
Jeff Hooke shares Essig's enthusiasm for reverse splits as a way to build credibility. "A number of exchanges don't like listing stocks under $5," said Hooke, a former investment banker and author of "Security Analysis on Wall Street."
"If you can get a better listing on more exchanges, you'll get better market making, and you're more likely to get research coverage, which is very, very important," Hooke said.
But others view reverse splits with disdain and say they are the mark of weakness and often a last gasp for a floundering company.
"I always take a jaundiced view of reverse splits," said Michael Farr, president of Farr, Miller & Washington, an investment management firm in Washington, D.C. "Typically it indicates that management is frustrated and unable to accomplish with the market what they feel they should be able to accomplish."
Farr said the Pink Sheets (more commonly known as the Over-The-Counter Bulletin Board) serve a purpose, and trying to wiggle off of them through a reverse split is cutting corners. "Stocks that have found themselves on the Pink Sheets, are on the Pink Sheets for a reason," Farr said. "Companies and management that are going to make a profit and develop year after year aren't going to be on the Pink Sheets for long."
But even Farr says there are times when a reverse split is justified. "If you are a small cap company with no following, and you can raise your exposure by moving from the Pink Sheets to the NASDAQ, if you find yourself struggling with strong earnings fundamentals, then it makes sense," Farr said.
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