Reverse splits aren't always reversals of fortune

The reverse stock split is a mechanism increasingly being used to prop up tech shares--at least temporarily--that are languishing at gumball-machine prices.

Dawn Kawamoto Former Staff writer, CNET News
Dawn Kawamoto covered enterprise security and financial news relating to technology for CNET News.
Dawn Kawamoto
4 min read
Investors in battered technology shares have a new term to learn: the reverse stock split.

While investors spent much of last year tabulating triple-digit percentage gains on numerous tech stocks, this year has provided a sobering lesson in the unique problems faced by stocks that slip below $5 or are even delisted from major exchanges.

Now, along comes the reverse split, a mechanism that is increasingly being used to prop up tech shares--at least temporarily--that are languishing at gumball-machine prices. Last month, for example, PlanetRx announced its intention to conduct a 1-for-8 reverse split.

Under a normal stock split, investors typically receive two shares for each share they hold, and the price is cut in half. For example, a person holding a stock worth $80 receives two shares of the same stock, but the price is cut to $40.

With a reverse split, the investor may receive just one share for each 10 shares held, but the price is multiplied 10-fold. For example, a person with 1,000 shares of a 10-cent stock would end up with 100 shares of a $1 stock.

Reverse splits are typically used to keep a stock price at a high enough level, such as $1, that the shares are not booted off the Nasdaq. However, in many cases the higher price proves to be temporary as the shares once again slip into penny-stock status.

According to the Nasdaq, 32 stocks this year--10 of which are tech companies--have gone through reverse splits. However, 22 percent of those stocks have slipped back below $1 and into penny-stock status, including that of online marketing company PopMail.com.

In August, PopMail's stock dipped below the $1 mark. To get its stock price above the $1 mark, the company announced plans to conduct a 1-for-10 reverse stock split.

PopMail's stock, which had closed at 34 cents Oct. 11, suddenly became a $3.40 stock the following day when the split took effect. The company's shareholders, meanwhile, received one share for every 10 shares they previously owned.

But just 15 days later, PopMail's stock was again under the $1 mark, where it remains.

"Since it's done for purely cosmetic reasons and doesn't change a company's finances, the market knows it and the company gets penalized. Most companies end up seeing their stock prices continue to slide," said Pamela Peterson, a finance professor at Florida State University and co-author of a 1992 research report, "A further understanding of stock distribution: The case of reverse stock splits."

Jon Johnson, editor of Texas-based newsletter StockSplits.net, agreed.

"Reverse splits have a negative stigma. A lot of investors we talk to don't have a lot of confidence in a company that gets its stock up through a reverse split. They think the company is playing games and trying to get credit for something they don't deserve," Johnson said.

What's the motive?
But for most companies in the current climate, a reverse split is conducted out of a need to remain listed on an exchange, rather than solely to prop up the share price.

Companies that find Trading on thin icetheir share prices fall below $5 or $1, depending on the particular Nasdaq category they fall into, receive a notice from the exchange that if their stock remains at that level for 30 days they risk being delisted, said Nasdaq spokesman Wayne Lee.

If the shares remain at the depressed level for 30 days, a new clock starts ticking. At this point, companies have 90 days to get the price above the threshold for 10 consecutive trading days to come into compliance, he noted.

Ten Nasdaq-listed tech companies initiated reverse stock splits this year out of 32 companies that took such measures.
Company Reverse split ratio
Clariti Telecommunications 1-for-4
eGlobe 1-for-4.7
GSV 1-for-5
Infogrames 1-for-5
Liberty Livewire 1-for-2.5
Musicmaker.com 1-for-10
On-Point Technology Systems 1-for-3
PacificNet.com 1-for-3
PopMail.com 1-for-10
Wire One Technologies 1-for-2
Source: Nasdaq and FactSet Universal

Shares that are delisted typically move to the over-the-counter market, a market that is less liquid because it is more difficult to match buyers and sellers.

The Nasdaq allows companies to initiate numerous reverse splits, but it's a double-edged sword. While a stock price goes up following a reverse split, the number of shares outstanding contracts.

Many institutional investors, for example, shun companies with fewer than 10 million shares floating in the public market, said Greg Vogel, an analyst with Banc of America Securities.

And if a company's Nasdaq float drops below 1.1 million, or 750,000, depending on the category the company falls under, it also may be delisted, Lee said.

For these reasons, many companies do not seek a reverse split.

"It's hard to make a case in doing a reverse split, unless you can argue there should be some reason for someone to buy the stock," said Tom McManus, equity portfolio strategist for Banc of America Securities.

He added some companies may opt to avoid the effort if it appears they'll be closing their doors soon or landing a buyer, as was the case this week with Garden.com.

Some companies, however, take the plunge anyway.

Risking it
CareMatrix, a retirement home operator, conducted a 1-for-18 reverse split in September. Two months later, the company filed for bankruptcy protection.

"My impression is reverse splits are a strategy of last resort," said Neal Macneale, editor of the 2-for-1 Stock Split newsletter in Menlo Park, Calif.

Although the markets this year pushed more than 30 Nasdaq-listed companies to seek a reverse split, it's surprisingly fewer than the number last year, when 81 companies filed for reverse splits, Lee said.

"1998, for all intents and purposes, was a recession year for a number of industries. And through 1999, a lot of companies continued to suffer, even though the Nasdaq did well," McManus said. "The Nasdaq did well because there was a surge in tech spending and it was concentrated in relatively few companies. Without the largest companies, the stock market returns would have been poor last year."