Context and presentation often matter more than substance, at least in the short term. Many public companies have elevated this notion to a perverse art form - announcing news that is actually quite bad for shareholders, but spinning it in a way that makes it sounds as though shareholders should be grateful to have such far-sighted leadership. Being able to separate the real good news from puffery and double-talk is a valuable skill, and investors should be on the lookout for some of these examples of good news that really is not good news. (For more, check out Can Good News Be A Signal To Sell?)
Tutorial: Stock Picking

Given the end of the Great Recession and the recovery in the economy, it seems more likely that companies will be in a mood to hire and expand rather than restructure and retrench. Eventually, though, there will be another wave of corporate restructuring among public companies. Though analysts and institutions often cheer these moves, savvy investors should be skeptical.

Sometimes restructuring makes all the sense in the world; particularly when a company hires a new management team to improve or turn around a business that has been lagging and underperforming. But what about cases where the management team doing the firing is the same team that did the hiring? Barring a public mea culpa (and perhaps the surrender of some bonuses or salary), why should an investor trust a CEO who is basically saying "I confess … they did it!"

Restructurings can be very bad for morale, and they eat away at the loyalty between employees and employers. Worse still, the roster of companies that have fired their way to prosperity is rather short. When a shareholder sees one of his or her portfolio companies announcing a restructuring, they should carefully examine whether the moves are aimed at long-term success (rather than a short-term earnings boost) and whether current management really has the skill set to build long-term shareholder value and compete effectively in the market. (To learn more, see Cashing In On Corporate Restructuring.)

There has long been a notion in academia that there is a "right" capital structure for each company; the perfect balance of debt and equity financing to maximize earnings and returns and minimize risk and volatility. As readers may suspect, the professors advancing these theories have almost universally never run a company, nor held a position of high responsibility within one.

What a recapitalization often means is this - a company that has had a reasonably good record of cash flow generation and little debt will often go to the market and issue significant amounts of debt. This essentially shifts the company's capitalization from an equity-heavy/debt-light ratio to the opposite.

Why would a company do such a thing? To a certain extent, debt is cheap money. Creditworthy companies often find that the coupon rate on debt is lower than their cost of equity and the interest on debt is tax-deductible (equity dividends are not). Sometimes firms will use this sort of maneuver to raise cash for use in acquisitions, particularly in cases where the stock might be illiquid or otherwise unattractive as deal currency.

In many other cases, though, companies use the cash generated by the debt sales to fund a large one-time special dividend. That is great for long-term investors who get the cash payout and leave, but it creates a radically different company for those who remain invested or buy in after the recapitalization.

Unfortunately, many companies recapitalize themselves during periods of peak cash flow and struggle to survive under the heavy weight of debt payments as economic conditions worsen. Consequently, a recapitalization is only good news for investors willing to take the special dividend and run, or in those cases where it is prelude to a deal that is actually worthy of the debt load and the risks its brings. (To learn more, see Evaluating A Company's Capital Structure.)

Special Dividends
With the popularity (and flexibility) of stock buybacks, special dividends have become less common, but they still do occur. A special dividend is basically what it sounds like - the company makes a one-time payment of cash to shareholders with no particular expectation of making a similar payment again in the near future.

While special dividends funded by debt are dangerous in their own right, there is a problem even with dividends funded by a non-strategic asset sale or cash accumulation. The biggest problem with special dividends is the not-so-subtle message that goes with them - management is basically out of ideas and better options for the company's capital.

Is it better for a company to write a check to its shareholders instead of wasting the money on a stupid acquisition or a new expansion project that cannot earn its cost of capital? Of course. But it would be better still for management to have a plan and strategy in place to continue growing and reinvesting capital at an attractive rate. Though management teams willing to acknowledge that a company has grown as large as it practically can should be applauded for their candor, investors should not overlook the message that a special dividend sends and should adjust their future growth expectations accordingly. (To learn more, see Dividend Facts You May Not Know.)

Poison Pills
What happens when a board of directors is afraid that a company will expose their shareholders to the truth that they could reap a premium by selling their shares in a buyout and management does not want to sell? They initiate a poison pill, or as companies prefer to call them, a "shareholder rights" plan. Poison pills are designed to make unfriendly acquisitions prohibitively expensive for the acquirer, often allowing underperforming management to keep their jobs and their salaries.

In essence, a company sets a trigger whereby if any shareholder acquires more than that amount of the company, every other shareholder except the triggering shareholder has the right to buy new shares at a major discount. This effectively dilutes the triggering shareholder and significantly increases the cost of a deal.

What's really unfortunate about these deals is the embedded paternalism. Management and the board of directors are telling its own shareholders "look, you're not smart enough to decide whether this is a good deal, so we'll decide for you". In other cases, it's simply a conflict of interests - the management or board owns a big slug of stock and just isn't ready to sell yet.

It is true that some studies have shown that companies with poison pills get higher bids (and takeover premiums) than those that do not. The problem is that there is relatively little beyond the threat of lawsuits that shareholders can do to ensure that a board of directors upholds their fiduciary duty to shareholders. If a majority of shareholders wish to sell the company at a given price, a poison pill and management's opinion of the valuation should not be allowed to stand in the way.

The Bottom Line
News always carries a certain amount of nuance with it. None of the actions listed here are universally or automatically "bad" or "wrong" for a company and its shareholders. The problem is that too often dishonest and self-serving managers try to fool their shareholders into believing that quick fixes are a long-term strategy. Investors should foster a healthy sense of skepticism and make sure that "good new" is really as good as management wants you to believe. (For more, see Evaluating A Company's Management.)

Related Articles
  1. Investing Basics

    What is Convertible Preferred Stock?

    Convertible preferred stock is preferred stock that can be converted into common stock as of a predetermined date at a specified ratio.
  2. Investing

    Redefining the Stop-Loss

    Using Stop-losses for trading doesn’t mean ‘losing money’, but instead think about the money you'll start saving once you learn how they work.
  3. Fundamental Analysis

    10 Major Companies Tied to the Apple Supply Chain

    Apple has one of the best supply-chain models. Here are some of the top businesses involved, and the benefits and challenges for all.
  4. Term

    What is a Preemptive Right?

    A preemptive right allows select shareholders to buy newly issued shares in their corporation before the general public.
  5. Term

    What are Non-GAAP Earnings?

    Non-GAAP earnings are a company’s earnings that are not reported according to Generally Accepted Accounting Principles.
  6. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  7. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  8. Stock Analysis

    Fortinet: A Great Play on Cybersecurity

    Discover how a healthy product mix, large-business deal growth and the boom of the cybersecurity industry are all driving Fortinet profits.
  9. Stock Analysis

    2 Catalysts Driving Intrexon to All-Time Highs

    Examine some of the main reasons for Intrexon stock tripling in price between 2014 and 2015, and consider the company's future prospects.
  10. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  1. Sticky Wage Theory

    An economic hypothesis theorizing that pay of employees tends ...
  2. Earnings Before Interest & Tax ...

    An indicator of a company's profitability, calculated as revenue ...
  3. Record Date

    The cut-off date established by a company in order to determine ...
  4. Corporate Social Responsibility

    Corporate initiative to assess and take responsibility for the ...
  5. Corporate Culture

    The beliefs and behaviors that determine how a company's employees ...
  6. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  3. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  4. How can EV/EBITDA be used in conjunction with the P/E ratio?

    Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to ... Read Full Answer >>
  5. How can a company reduce the unsystematic risk of its own security issues?

    Companies can reduce the unsystematic risk of their own security issues simply by doing the most effective job possible of ... Read Full Answer >>
  6. How can I find net margin by looking a company's financial statements?

    In finance and accounting, financial statements represent the fundamental means of analyzing a company's financial position, ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!