On Friday, April 19, Virgin Galactic (SPCE 22.11%) told investors that it was planning to conduct a reverse split of its stock, potentially reducing every 20 shares of space stock they owned (or 15, 10, 5, or just 2) to just one single, solitary share.
And Virgin Galactic investors did not like that news one bit.
Over the next two days, Virgin Galactic stock plunged a total of 22.5% from its preannouncement price. The stock has bounced back somewhat. But at a closing share price of $0.86 Thursday, Virgin shares remain down about 11% from where they started.
Why is that?
What is a reverse stock split?
Let's start with the headline announcement: The reverse stock split itself.
As the name suggests, a reverse split is the opposite of an ordinary stock split. Whereas in an ordinary split, a single share costing, say, $20 might be divided into 20 shares each costing $1, in a reverse split the reverse happens. Twenty shares that each cost $1 are effectively glued together into one mega-share costing $20.
In either case, the value of the investor's ownership interest in the company does not change. It was $20 before the change, and remains $20 afterwards. But psychologically, investors tend to prefer stock splits (because they end up with a bunch of extra shares at the end). Conversely, investors spurn reverse splits, because they "take away" shares that investors thought they owned.
Hence the investors' knee-jerk reaction: selling Virgin Galactic stock on news of the reverse split.
Why do companies reverse split?
Now, Virgin Galactic probably anticipated this reaction, yet it did it anyway. Why?
Because it kind of had to. Under New York Stock Exchange rules, stocks must maintain share prices of $1 or more, or risk getting delisted. NYSE doesn't want a bunch of penny stocks cluttering up its feed, you see.
To abide by NYSE rules, and also to make its own stock look more respectable to institutional investors, Virgin Galactic had two choices: One, it could improve its business, make a lot of money, and attract investors to bid up its stock price. Or two, it could reverse split its stock and artificially pump up the share price.
Virgin Galactic chose the latter.
Virgin Galactic's other bad news
You can look at this decision in one of two ways. Viewed most charitably, splitting the stock is the simplest solution to avoiding the stock getting delisted from the NYSE -- which would make it harder to trade, and hurt the value of the penny stock even more. It's a way to protect shareholder interests.
Viewed less kindly, Virgin Galactic is choosing the "easy way out" here. Instead of taking its low stock price as a hint that it needs to work harder to earn a profit, it's dodging the issue. (It's also kind of hinting to investors that it can't earn a profit, and that a reverse split is its only option). That fact alone would have convinced at least some investors to sell the stock this week. But there's a second reason for them to sell, too.
On pages 80 through 89 of its proxy statement filed with the Securities and Exchange Commission (SEC), Virgin Galactic confirmed the contemplated reverse split "would not [reduce] the number of shares of common stock that the Company will be authorized to issue." To the contrary, it will effectively increase the number of shares it can issue -- and indeed, Virgin Galactic already has authorization to sell up to $400 million worth of new stock should it so desire.
To put that number in context, Virgin Galactic's entire market capitalization right now is less than $400 million. Selling $400 million in new stock could easily cut the ownership stake of any current Virgin Galactic shareholders by more than 50% -- which Virgin Galactic admits would amount to "significant" share dilution.
Is Virgin Galactic stock a sell?
Investors should not discount this risk.
Virgin Galactic currently has only $382 million left in the bank, net of debt. It's burning cash at the rate of $492 million per year, and will be in a net debt position before the year is out -- yet still needs to spend tens or hundreds of millions of dollars building its planned fleet of Delta spaceplanes and motherships to launch them. The likelihood that Virgin Galactic will soon use its authorization to raise the cash it needs by selling new shares -- at new and improved post-reverse split prices -- I suspect, is near 100%.
That makes the risk of shareholder dilution near 100% as well.
With this prospect in mind, I'm more convinced than ever that Virgin Galactic stock is a sell.
