The reverse split of this ultra-high-yielding dividend stock is a warning sign

Mortgage Real Estate Investment Trust (REIT) Annaly Capital Management (NLY -2.52%) has long offered investors a double-digit dividend yield. It now sits at a whopping 18% – even higher than usual – as the company’s recent 1-for-4 reverse stock split appears to have upset investors a bit. Normally, stock splits aren’t particularly significant events, but in this case, concern on Wall Street may be appropriate.

What is a stock split used for?

The most important thing to know about stock splits is that they don’t actually change the underlying value of a company, or the relative size of the slices of it held by each shareholder. The only things that change after a split are the number of shares each investor owns and the price of those shares. For example, if you owned a stock that was trading at $100 and it was split 2 for 1, you would end up with two stocks worth $50 each. Effectively the same thing. A reverse split works in the opposite direction, so a $50 per share that splits 1 for 2 would leave you with a stock worth $100. Again, there is no change in the value of your stake, or your ownership interest in the business.

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Yet investors often read stock splits. Regular stock splits are considered positive. Inverted divisions are generally considered negative. It’s probably not appropriate to give a lot of weight to a stock split, but a reverse split can really be a sign of trouble.

Most major exchanges – like the New York Stock Exchange or NASDAQ, for example – have minimum stock price requirements. If a stock trades below, say, $1 per share, for too long, the company will receive a warning from the stock exchange that it is at risk of delisting. This is bad for a business, as it can limit its ability to raise capital. Most often, reverse splits are done to increase the price of a stock so it can avoid being delisted.

As such, a reverse split can be a warning sign. This suggests that investors are not interested in providing the company with the capital it needs, often because the company is struggling.

But Annaly was in no danger of being struck off. So at first glance there doesn’t seem to be a problem here.

One more problem

However, once you dig into the history of the Mortgage REIT and learn the reason behind its reverse, split stock, you will have reason to worry. For starters, in the press release announcing it, management noted that “…the company believes the reverse stock split will make common stock more attractive to a wider range of investors…” is normally a reason companies offer when they want to do a regular split, because it drives down the stock price. But how would a higher price achieve the same result for Annaly?

The answer is that some institutional investors, such as insurance companies and pension funds, have minimum price rules for the companies they own. It appears that Annaly had to increase its share price so that its shares could continue to be held by institutional investors. That’s not necessarily bad, until you look at what got the REIT to this point.

NLY Chart

NLY data by YCharts

Its quarterly dividend payout has trended downward over the past decade. This caused the stock price to fall. For income investors, this is a terrible outcome. The yield, which remained high due to lower prices, may have masked the trend somewhat for those who didn’t dig deeper. However, if retail investors are less likely to be interested in Annaly due to its lower dividend and stock price, then it becomes more important for the REIT to please the institutional types. And to do that, he needs a higher price.

Most will be better elsewhere

A complicating factor here is that Annaly is a mortgage REIT, which is a unique niche in the REIT space. In fact, Annaly is generally considered a well-managed mortgage REIT. However, given its track record, its inverted distribution is another warning sign that dividend investors should probably look elsewhere. Its yield is attractive, but the risk/reward trade-off just won’t be worth it for anyone who cares about dividend consistency.

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