United States: Down But Not Out: Properly Implementing A Reverse Stock Split And Leveraging The Opportunity It Creates

Reverse stock splits are widely viewed as a cosmetic fix by public companies to raise the price of common shares. Reverse stock splits are generally thought to be utilized for two principal purposes: (1) to remain listed on an exchange; or (2) to entice greater breadth of stock ownership, usually targeted at institution al investors.

Furthermore, reverse stock splits are viewed by many as a late-in-the-game effort by under-performing and/or out-of-favor companies to reverse their fortunes without improving the underlying business. Yet, empirical data shows that some companies are able to implement a reverse stock split and, after that inflection point, ultimately thrive. This intriguing point led us to look more closely at why some companies succeed post-reverse stock split while others fail.

From 1962 to August 2008, there have been over 2,000 occasions in which a U.S.-listed entity implemented a reverse stock split when its share price was less then $1 per share the day before the split execution date.¹ Academic literature suggests that the resultant lack of marketability and/or liquidity for a stock after a delisting can be significant, with a first day market capitalization contraction of 18-20% and continued subsequent price deterioration.²

FTI Consulting, Inc. ("FTI") has independently reviewed the facts and circumstances surrounding many of the entities that have implemented reverse stock splits since 1962, and has also conducted an extensive review of published research on reverse stock splits. The purpose of FTI's research was to isolate success stories and examine the common denominators of these successes. In sum, although the general trend for companies that effect a reverse stock split is a reduced market capitalization, there are numerous situations where market capitalization of the reverse splitting-entity hold or even increase. Please see the table below for several recent examples.

Gaining a better understanding of the factors associated with the success stories is critical to assist management teams, boards of directors and shareholders in making the determination of whether or not to approve and move forward with a reverse stock split.

In general, we found that the companies which succeed subsequent to the implementation of a reverse stock split proactively formulate a business plan to address any perceived or actual operational underperformance, combine a properly sized reverse stock split with effective communication to the investor community about the merits of the company's underlying business plan, and provide detailed, post-reverse stock split communications regarding the progress in executing its business plan. Variations of this formula can cast a reverse stock split as a critical inflection point whereby management can attract the attention of investors, build credibility and direct investors' attention to the existing and growing value in the underlying business.

WHY IMPLEMENT A REVERSE STOCK SPLIT?

Two of the most common reasons that a company would implement a reverse stock split are: (1) to maintain listing on an exchange; and (2) to attract new pools of existing and future investors to the market for its stock.

MAINTAIN A LISTING ON AN EXCHANGE

NASDAQ and the NYSE have somewhat different requirements for initial and continued listing, yet both exchanges have listing standards that require listed companies to maintain a minimum stock price of $1 per share. Once a stock trades below $1 for a given period of time, at some point, depending on the applicable grace period, the listed company must address the issue. Given the difficulty for management to reliably increase the price of the company's common stock when the shares are already trading below this threshold, both NASDAQ and the NYSE allow, and in some cases have encouraged, their listed companies to implement a reverse stock split in an effort to satisfy the minimum share price requirements for both initial and continued inclusion on the respective exchanges.

On October 16, 2008, NASDAQ suspended its minimum $1.00 per share bid price requirement, citing "extraordinary market conditions".³ In February, NYSE Euronext suspended any enforcement of its minimum $1.00 share price rule for similar reasons. However, after subsequent extensions by the exchanges, both the NASDAQ and NYSE Euronext moratoria are set to expire on July 31, 2009, at which time companies will again face suspension and delisting procedures to the extent they have not regained compliance with the minimum share price rules.

TO ATTRACT NEW POOLS OF EXISTING AND FUTURE INVESTORS TO THE MARKET FOR ITS STOCK

Many institutional investors have rules that limit holdings of stocks that trade under $1 per share or, in some cases, under $5 per share. The reason is because low-priced stocks are easily affected by sizeable buy and sell orders, capitalizations are typically too small to affect a large fund's bottom line and a stock's low share price can increase a portfolio's volatility.⁴ For example, if a stock trading at $1 per share decreases in price by only $0.20 to move to $0.80 per share, then an investor suffered a 20% holding loss. Consequently, the same price fluctuation on a stock valued at $10 per share only results in a 2% holding loss. In addition, the Securities and Exchange Commission has "suitability" rules designed to discourage inexperienced investors from buying so-called "penny stocks".⁵ In today's market, hundreds of companies are trading at or below this threshold, which often reduces liquidity and visibility. Even some Internet message boards discourage discussions related to penny stocks. For example, the popular Motley Fool website does not allow discussion of stocks on message boards unless they trade at over $5 per share.⁶

The additional restriction placed on a stock by institutional ownership is not the only issue—when a stock is trading at a very low share price, many investors are also faced with a lack of market information and visibility. Typically, brokerage firms do not follow penny stocks and therefore financial analysts do not rate them.

Finally, there are leveraging restrictions imposed by federal regulators that limit the purchase of stocks trading under $1 by many investors. The Federal Reserve Board's Regulation T sets the minimum average bid price at which a currently trading stock can be margined at $2 per share. If a reverse stock split increases a company's share price to a point where there are fewer restrictions on institutional investors, and the stock becomes marginable, then a company doing a reverse split has added two new potential pools of existing and future investors to the market for its stock, increasing the liquidity and market for its shares.

REVERSE SPLIT FACTOR

Even if the split itself is not a clear market signal, empirical data supports the premise that the size of the split factor provides an important signal to investors.⁷ There are no hard and fast rules to guide companies as to the most appropriate reverse split factor in which to use. However, empirical data generally indicates that the higher a reverse split factor, the greater the decline in post split stock performance. To raise the stock price to any specific level, the board and management must forecast the price of the company's stock several days in advance of the split date, which comes with some degree of uncertainty. In addition, many states require stockholder approval of reverse splits, requiring management to seek stockholder approval of a range of split ratios, in some cases several months prior to the effective split date.

To help mitigate this uncertainty, FTI developed a cross-sectional regression model incorporating the explanatory variables of: (1) firm size, (2) reverse split factor, (3) momentum of stock price, (4) risk of the firm, (5) pre-split stock price and (6) listing venue. The Standard & Poor's 500 Index was added as a constant to the model to take into account market changes. These variables were chosen as most relevant to determine the split factor ratio based upon FTI's analysis of empirical data and published academic research. By properly analyzing these variables along with the other exchange listing requirements, the optimal reverse split ratio can be determined to maximize the company's market capitalization.

MARKET REACTION

Not surprisingly, empirical data indicates that reverse stock splits are utilized primarily by small companies, as measured by market capitalization, with stock trading at low prices. These firms' market characteristics are different from larger companies in terms of transaction costs (bid/ask spread), trading liquidity, institutional ownership and short-selling constraints. They have most likely exhibited recent poor operating performance and have higher leverage as measured by a ratio of debt to total assets.

Due to these and other variables, the subsequent market reaction to a reverse stock split varies greatly by industry and an individual company's circumstances. In addition, the impact on a company's market capitalization is not confined to the event day, but rather is spread out over a longer period as more information about the company becomes available.

A recent study⁸ published in the summer 2008 issue of Financial Management (a publication of the Financial Management Association) shows size-adjusted buy and hold abnormal returns for a sample of 1,528 firms that performed reverse stock splits as follows:⁹

The ex-split month is from the ex-split date to end of the month. The 1-Year, 2-Year, and 3-Year buy and hold returns are for the time periods following (and excluding) the ex-split month. The Pre-12 month buy and hold returns are the 12 months prior to (and excluding) the ex-split month.

Post-reverse stock split price erosion varies significantly by certain industries and firms. A better assessment of a company's future stock price performance can be determined by analyzing companies that have initiated reverse splits in the same and similar industries and applying firm-specific characteristics. In doing so, we found that management can dramatically affect future stock price performance and, in some cases, can negate the negative signal a reverse stock split can send to investors.

At the same time a company is faced with initiating a reverse stock split, it may also be confronted with other operational uncertainties. After the development of a business plan to put a company on the path to success both within the capital markets and with its customers and other stakeholders, the next step is to increase visibility to the investor audiences. This is done through increased investor targeting and outreach, enhanced investor relations materials and events (earnings, conferences, etc.), and the publicizing of the company's short and long-term story. In today's market, the messaging needs to show how the company will successfully navigate the current market environment as well as capitalize on the eventual market rebound in order to effectively resonate with the investment community.

CONCLUSION

Studies show that reverse stock splits generally result in the reduced value of the splitting firm, with many researchers arguing that reverse splitting conveys negative information about the firm. However, FTI's research shows a group of companies that were able to counteract the negative inferences associated with reverse stock splits by: (1) the development and execution of an appropriate and realistic business plan; (2) utilization of the appropriate reverse stock split ratio; and (3) taking actions both in preparation for and subsequent to the implementation of the reverse stock split to effectively communicate corporate developments in the context of the company's long-term plan. Communications are designed to attract investor attention and build investor confidence.

Footnotes

1. Results based on filter of the Center for Research of Security Prices "US Stock and Indices Database"

2. Harris, Panchapagesan, Werner, March 2008 – Fisher College of Business Working Paper Series, Off but Not Gone: A Study of NASDAQ Delisting, pg. 15

3. See SR-NASDAQ – 2008-082

4. High Volatility Investments by James Andrews, 2004 – www.wisertrader.com

5. See the Securities Enforcement and Penny Stock Reform Act of 1990

6. http://boards.fool.com/request.asp?source=ifltnvsnv0000001

7. Brennan and Copeland, Journal of Finance Economics, 1988 – Stock Splits, Stock Prices, and Transaction Costs

8. Klein, Rosenfeld and Tucker, published in 2008, dated January 10, 2006 – Return Performance Surrounding Reverse Stock Splits: Can Investors Profit?

9. Size-adjusted abnormal returns take the raw buy and hold returns and then subtract the return of a portfolio of NYSE/AMEX/NASDAQ stocks in the same size-deciles (market capitalization) as the sample firm.

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