When Accumed International Inc. proposed a reverse stock split to shareholders last May, company officials were pleased when the measure was approved by 96 percent of its stockholders.
Not long after the reverse split became effective, with shareholders receiving one new share for every six they held before the split, the phones began ringing at Accumed, a Chicago-based maker of diagnostic screening products. Investors wanted to know: “What is a reverse stock split?”
“They voted overwhelmingly yes, and then called up and said, `What happened?’ ” says Darlene Czaya, Accumed’s director of investor relations.
Investors in other small public companies are likely asking similar questions these days. The number of companies enacting reverse splits is growing. Already this year, about 158 reverse splits have been reported, according to Standard & Poor’s. That’s nearly double the number of reverse splits in 1997, S&P estimates.
Traditionally, the reverse stock split has been a somewhat arcane strategy for boosting a company’s stock price. In a reverse stock split, a company decreases the number of shares held by all stockholders. For example, a one-for-three reverse stock split would result in every stockholder owning one post-split share for every three shares owned before the split.
Typically, the market adjusts the price of the post-split shares proportionately. So, in a three-for-one reverse split, if the stock is trading at $1 before the split, it begins trading at $3 after the split. Like a regular stock split, a reverse split doesn’t change the fundamental value of your holdings.
“It’s like putting things in pounds or ounces or kilos–it doesn’t affect the value by weighing it different ways,” explains Owen Lamont, an associate professor of finance at the University of Chicago Business School. “Usually, companies do (reverse splits) because their price has changed and it’s too low to attract investors. A reverse split helps them get it back up to a more normal range.”
There is no change in the value of the investment, but some experts suggest that having a higher priced stock–say, $5 vs. $1–benefits investors through lower brokerage commissions and increased liquidity, the ability to trade the stock.
A respectable share price is also easier for a broker to sell, which is a reason reverse splits have historically been associated with low-priced “penny stocks” and even sleazy stock promoters, critics say.
The recent rise in companies enacting reverse splits, however, is due mostly to a far less dubious source: the Nasdaq Stock Market.
Since last year, Nasdaq has tightened standards for companies it lists because of “concerns about low-priced stocks and the gaming go on in them,” said David Irwin, director of Nasdaq Listing Qualifications Hearings.
In February, the National Association of Securities Dealers (NASD), Nasdaq’s self-regulatory arm, established new minimum bid price requirements for continued trading on the exchange’s two tiers, Nasdaq National Market and Nasdaq SmallCap Market. Since then, about three-quarters of the companies announcing reverse splits were listed on Nasdaq. The vast majority of them were companies trying to meet the $1 minimum bid price for continued listing on the SmallCap Market.
Companies have scrambled to meet Nasdaq’s new requirements rather than be demoted to the Over-the-Counter Electronic Bulletin Board (OTC-BB), a stock quotation system run by the NASD. With Accumed, the possibility of an OTC-BB concerned the company’s officers so much that they wrote in a federal filing: “The liquidity of the company’s securities could be impaired through delays in the timing of transactions, reduction in security analyst coverage of the company and lower prices for the common stock than might otherwise be attained. Consequently, investors could find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, the company’s common stock.”
Similar concerns have caused dozens of other companies to attempt reverse stock splits in order to maintain their listing on Nasdaq.
“Nasdaq does require companies to meet the new standards, and we recognize the reverse stock split as a vehicle to achieve the new listing requirements,” Irwin said.
Some companies have found that the vehicle doesn’t work, with their shares dropping dramatically following the split, sometimes within a matter of days.
Ajay Sports, Inc., a Delevan, Wis.-based company that makes licensed golf bags, carts and other leisure products, was trading below the minimum $1 bid price required for continued Nasdaq listing. Ajay gained shareholder approval on a 1-for-6 reverse stock split in May, which would bring the stock above the requirement and allow it to stay on Nasdaq. The reverse split was enacted on Aug. 14, and the market adjusted the stock price to about $2.20 per share.
But within 10 days, the stock slid back below $1. Nasdaq subsequently delisted Ajay’s common stock, which now trades on the OTC-BB.
“We are obviously disappointed, especially in light of the significant efforts we have made to maintain this listing,” Ajay CEO Thomas W. Itin said. Ajay has posted two profitable quarters, restructured its debt and expanded its international distribution so far this year, he said.
“Our common stock price decline after the reverse split and the very difficult market for small-cap and micro-cap stocks over the past few months were things we could not control or overcome,” Itin said. The company said it intends to appeal Nasdaq’s decision to delist the stock.
Financial analysts seem to agree that the reverse-stock split is just one thing to consider in evaluating and tracking companies. However, investors should be wary of companies doing reverse splits that have not been able to improve their stock price through traditional means such as improved performance, experts say.
“If a company was in danger of delisting or something like that, and I was confident in the underlying performance of the company, I don’t see anything wrong with a reverse split,” said Steve Reid, portfolio manager of the Chicago-based Oakmark Smallcap Fund.
But Reid also added, “If their performance is lagging and their stock is going down, I would hope I wasn’t in the stock.”
Performance aside, there are a few other issues that investors should know about companies enacting reverse splits.
Unlike a forward split, reverse stock splits generally require shareholder approval, depending on where the company was incorporated.
Another difference relates to a temporary change in the stock’s ticker symbol. Virtually every Nasdaq stock has a four-letter ticker symbol. Following a reverse stock split, the company’s symbol will carry a “D” at the end of the stock for a period of 20 trading days.
At the end of the day, though, investors must also realize the reverse split usually reflects a change at the company–for better or for worse.
“Traditionally, reverse splits have been used in reorganizations, refinancings or other situations like a Chapter 11 where the company got into trouble,” says a source at S&P, who asked not to be identified.
“Even today, the companies that are doing reverse splits are all cheap (stocks),” he says. “You have to realize you’re buying something that has a greater risk factor than the average company. There’s a situation happening there and you’ve got to do your homework.”
