The wretched truth about reverse stock splits
These desperation moves -- bundling shares for sale at a higher price -- rarely lift faltering stocks for long. Odds are better for short-sellers. Here’s what to keep in mind.

By Michael Brush

In a last-ditch effort to cling to their listings on the major stock exchanges, many companies such as Lucent Technologies (LU, news, msgs) may be resorting to the market’s version of the Hail Mary pass in coming months.
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Pay attention, because these desperation plays, known as reverse stock splits, can signal sharp declines ahead that could wipe out a good part of your wealth.

A reverse split is simply a maneuver to get a stock up above $1 and thus free of the danger zone that gets companies booted off an exchange. Managers typically cobble together as many shares as it takes to get one share worth more than $5 to win their reprieve.

Though the intentions seem sound, it’s better to look at a reverse split as a flashing red light warning that you may need to kick a stock out of your portfolio. As many as 75% of all stocks wind up trading lower after a reverse split.

Investors who failed to sell shares in several reverse splits in just the past few months have seen their holdings get hit by 60% or more in no time, despite the overall market strength.

Big losses
Internet-strategy consulting firm Razorfish (RAZF, news, msgs) narrowly clung to its Nasdaq listing with a 1-for-30 reverse split last July. The move readjusted its share price up to about $5 from less than 20 cents. Since then, the stock has drifted down 67% to $1.69. Click Commerce (CKCM, news, msgs) lost 63% in the three weeks following its reverse split in early September, trading down to $1 from around $2.75. Likewise, Holiday RV Superstores (RVEE, news, msgs) shed around 67% to trade under $1 from about $2.75 less than two months after its early August reverse split.

Other companies recently launching reverse splits -- or mulling them – include AT&T (T, news, msgs) and many of the other former high-fliers trying to repair the damage suffered since the market bubble burst. Palm (PALMD, news, msgs) and fiber-optic component maker Stratos Lightwave (STLWD, news, msgs) have recently resorted to reverse splits. So have Internet software providers Commerce One (CMRC, news, msgs), Verticalnet (VERT, news, msgs) and Docent (DCNTD, news, msgs).

Some companies using reverse splits will survive and prosper, of course. But on average, shorting them can bring gains of up to 37%. That’s how much, on average, stocks tend to decline by three years after a reverse split, according to academic studies. (Investors short stocks by borrowing shares, selling them and replacing them later at a lower price.) A good portion of that decline often happens in the first few months.

Smaller companies -- or those under $500 million in market capitalization -- tend to do the worst. On average, they fall up to 44% three years after the reverse split, says Crocker Coulson, of the investor relations firm Coffin Communications Group. Reverse splits are harder on Nasdaq companies than those listed on other exchanges.

The reverse split jinx
Why do stocks usually sink after reverse splits? The answer is simple. “A stock isn’t trading under a dollar unless it is pretty close to bankruptcy or it has some other serious troubles,” says Charles Jones, who teaches finance at Columbia Business School. “And that is not changed by a reverse split.”

Put another way, reverse splits are like a message from management that the underlying business trends are so rotten, they won’t be enough to get the stock price up to snuff.

To be sure, companies cite lots of good reasons to do reverse splits, beyond the need to meet listing requirements. Many fund managers shun stocks under $5 because they appear too speculative. Investors can’t use margin to buy stocks under $5. And Wall Street brokerages are reluctant to push stocks down in this trading range. All of these factors limit demand.

What’s more, a lot of companies simply have too much stock outstanding after the excesses of the market bubble days when they created huge numbers of shares to support stock option bonanzas and pointless acquisitions. “We are still recovering from the great binge of the late 1990s,” says Coulson.

The pitfalls of shorting reverse splits
Even though 75% of reverse splits end up declining, it is not as easy making money shorting them as you might think. “The 25% that go up can go up so much they wipe you out,” says Andrew Lo, a finance professor at Massachusetts Institute of Technology’s Sloan School of Management.

For example, j2 Global Communications (JCOM, news, msgs), which provides messaging services, shot up an impressive 800% to more than $27 recently. Its reverse split came just 18 months ago. With that kind of risk to shorting these stocks in mind, here are the key investing rules to keep in mind.

Avoid shorting companies whose prospects improved around the time of the reverse split. Interstate Hotels and Resorts (IHR, news, msgs), a small Washington, D.C.-based hotel management company, slipped to $2.50 per share from $3.40 immediately after it announced a 1-for-5 reverse split at the beginning of August. Anyone who stayed short through that reverse split would have gotten crushed by now, however. The stock has moved up 60% to around $4 per share recently, in part because of moves to cut costs and improve financial strength following a merger, says John Emery, the president of the company.

You also have to consider the fundamentals for a company’s sector, of course. Lucent, which is asking shareholders for permission to do a reverse split because its shares are hovering dangerously close to the $1 mark, believes it will be profitable next year. But if overcapacity and weak demand for telecom equipment continue to plague the sector, Lucent shares will be a good short if it goes through with a reverse split that would take shares back up above $15.

Avoid shorting the reverse split stocks with decent financial strength. Ethyl (EY, news, msgs), a small Richmond, Va., producer of fuel additives and lubricants, might have appeared to be a good short candidate after it did a reverse stock split at the end of June. But a closer look would have revealed good enough cash flow to survive -- despite high debt levels that were troubling investors.

Sure enough, Ethyl -- which has no coverage by Wall Street analysts -- recently tacked on a short-killing 50% when it announced good quarterly results. “Most of the penny stocks that do reverse splits have cash flow problems,” says David Fiorenza, finance chief for the company. “But we make stuff and sell stuff and we have good cash flow.” The company is also around 30% owned by insiders, another sign of strength to watch for.

Avoid shorting companies doing a reverse split for appearances. After AT&T spins out its broadband business to Comcast (CMCSK, news, msgs) in the days ahead, the phone company’s shares will trade in the $5 to $7 range. That’s not low enough to get kicked off the New York Stock Exchange. But it seems too low a price for a company with $40 billion in annual revenue. That’s one reason AT&T plans to do a 1-for-5 reverse split to move its shares into the upper $20 range.

Other tips
Remember that reverse stock splits that don’t take a company’s shares above $5 may be difficult to short, because it’s often hard to short stocks below $5. Most reverse splits, however, do move shares back above $5. Typically the less dramatic reverse splits -- like a 1-for-2 swap -- don’t suffer as much. If you are hunting for reverse splits to short, look for cases where massive changes are needed to get a stock up to a respectable price level, like Palm’s conversion of 20 shares into one share.

Despite some exceptions, the bottom line is that most reverse splits spell trouble because they’re simply cosmetic changes that do nothing to reverse ugly trends at a company. Perhaps Yogi Berra put it best. When asked once how he wanted his pizza cut, he quipped: "You'd better make it four. I don't think I can eat six pieces."
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column.