The Wall Street Journal

Debunking the wisdom behind Citi's reverse stock split

May 13, 2011: 11:03 AM ET

Citi did a 1-for-10 split this week. Investors should realize they're paying for vanity not returns.

Are reverse stock splits the single biggest waste of corporate money? Big institutions that have seen their shares decimated for one reason or another occasionally employ this classic subterfuge to try and erase history. They rarely succeed.

This week's offender: Citigroup (C). On Monday, the beleaguered financial services conglomerate instituted a reverse 1-for-10 split, a transaction that instantly moved its stock price from just above $4 to over $40. Things must be on the up-and-up down there on Park Avenue! (Maybe even the same way they were at AIG (AIG) in July 2009, when the flailing insurance giant did its own 20-for-1 split.)

But, of course, nothing has changed for Citi beyond this fancy footwork.

Let's run through (and debunk) the usual excuses for going into a reverse:

1) The stock is too cheap for big funds. This is the big Kahuna of excuses. Everybody uses it, and some journalists obligingly repeat it as if it were true: the idea that some institutional investors are prohibited from buying stocks that trade below $5 or $10 a share. I called three of the biggest institutions in the country yesterday: T. Rowe Price, Franklin Templeton, and BlackRock. Guess what? No restrictions. I then called the head of equities at a large investment bank, and he said none of his clients had that issue either. This excuse, in other words, is bogus.

An ancillary argument is that there are higher transaction costs for buying and selling low-priced stocks, and large long-term investors therefore merely choose not to buy them. Citi CEO Vikram Pandit told investors at the annual meeting that a desire for "a broader audience of investors" was one reason for the split, because some institutional investors just didn't buy stocks under $10 a share. Really, Vikram? Would you mind telling us just who those institutional investors are? Because I can't find any. And what's a few pennies if you're in it for the long-term? This argument only works if you're talking about people trading in and out of your stock frequently. And aren't those the people big companies say they want to avoid? Which brings me to my next point.

2) Reverse splitting will shoo away the speculators. A Wall Street Journal article this week suggested exactly that.

Citi shares had recently been most popular with hedge funds and high frequency traders, who were likely attracted by the potential for large percentage gains when the sub-$5 stock moved by even a few pennies.

The first part is true: high frequency traders have been attracted to the stock. But the argument as to why misses the mark.

Whoever has been trading in and out of Citi shares of late has been attracted by one of two things. First, and most obvious: the potential for large percentage gains in the event that the stock makes a large percentage move. Meaning, they think Citi will continue to be as volatile as it has been of late. And it has been very much so, with a beta of 2.56 -- tops among its peers.

But Citi stock is volatile because no one knows what the heck is going on over at that place. That's the same reason it was trading for under $5. It's not volatile because it was under $5. Citi stock would still have been wandering aimlessly under $5 even if the high-frequency gang hadn't shown up in the first place.

And even though the Journal proceeded to interpret light trading volume Monday as a possible indication that "the high frequency trading crowd may have already left the building," it looks like they've already returned to the building. Trading on Wednesday and Thursday was well above the already massive 50-week volume average for this stock.

(That said, another article in the Journal on Thursday quoted an options trader saying that option volume will decline with the higher priced shares. Who knew?)

The second reason is more obscure, but apparently no less powerful. High-frequency traders get rebates sent to them by exchanges in return for sending them volume. Those rebates are calculated per share, so a lower-priced stock is actually more attractive to trade for that sole reason. But that's a lot different than the argument that traders are attracted because it takes a smaller absolute move in a lower-priced stock to account for a large percentage gain. That, people, is mere math, and not a reason to buy or sell anything.

3) Having billions of shares is hard to manage internally, and reducing that amount will provide cost savings. The argument goes something like this: Administering Citi's now-outstanding 2.9 billion shares is going to be materially cheaper than administering 29 billion of them. Guess what? It's pretty much all electronic, folks. The costs are inconsequential.

There may be some savings from sending out dividend checks and proxy statements, but not enough to justify the costs of a reverse split, which I'll get to in a minute. Why? Because it's not like they'll have 1/10th the number of shareholders. And what if those mythical institutional investors who so badly wanted to buy the shares but couldn't bring themselves to buy under $10 a share actually show up? They might end up with more shareholders than before!

So why do companies do reverse stock splits? Optics, of course. A $40 stock looks better than a $4 stock. That's it. That's all you need to know. And a $0.10 dividend looks better than a $0.01 dividend, even though the yield remains the same. Citi has ducked into the men's room, changed their tie, and come out claiming to be someone else.

I called Citi and received this statement from Vikram Pandit in response: "Executing the reverse stock split and our intention to reinstate a quarterly common stock dividend are important steps as we anticipate returning capital to shareholders starting next year. Taken together, we believe these actions will reduce volatility while broadening the base of potential investors. Now that we have established consistent profitability, we are working towards our next goal of responsible growth."

I love the "taken together" part. Starting to pay a dividend will surely attract more investors. But that would happen with or without a reverse split.

The irony, of course, is that reverse stock splits cost money: they're spending shareholder funds to make those shares look better. While the actual tab for Citi's move depends on how many shareholders the company actually has and in what form those shares are held—physical or electronic. The cost can run all the way up to $25 per shareholder for those still holding physical certificates. We're talking about $5 million or even more for a company with as many shares outstanding as Citi — not a backbreaker for Citi, but still a pretty expensive tie.

So, all other things being equal, Citi stockholders can feel a little better when they look at their individual shares -- but they're actually a little worse off than they were before.

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