As much as investors might dislike stock market corrections, crashes, and bear markets, they’re a normal part of the investing cycle. Last year, all three major U.S. stock indexes were, at one point, mired in a bear market. Worse yet, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite produced their worst returns since 2008.
But amid this poor performance, investors found solace and inspiration among companies enacting stock splits.
Stock-split euphoria has taken hold on Wall Street
A stock split is an event that allows a publicly traded company to alter both its share price and outstanding share count without having any impact on its market cap or operations. A forward stock split allows a high-flying company to reduce its share price in order to make its stock more nominally affordable for everyday investors. Meanwhile, a reverse stock split increases a company’s share price, with the primary goal to ensure it meets the minimum listing requirements on one of the major U.S. stock exchanges.
Forward stock splits are what typically excite investors. Companies that conduct forward splits are usually firing on all cylinders operationally and have seen their shares prices rocket higher. There were a number of high-profile splits in this regard last year, including Amazon (AMZN -2.98%) and Alphabet (GOOGL -1.48%) (GOOG -1.36%) with their respective 20-for-1 splits and electric vehicle (EV) manufacturer Tesla (TSLA -5.70%), which conducted a 3-for-1 split in August.
Among this sea of stock splits, arguably none received more attention than Tesla.
Investors have flocked to Tesla, despite numerous red flags
Tesla optimists love the company for a variety of reasons. To start with, it’s riding first-mover advantages that propelled production and deliveries of its four-model fleet (Models 3, S, X, and Y) past 1.3 million units in 2022. It’s the first automaker to have successfully built itself from the ground up to mass production in more than a half-century.
Tesla is also the only automaker generating a sizable profit from its EV lineup. Although new and legacy automakers are shifting their focus to EVs, they’re all losing money — with the exception of Tesla — on their EV operations as they ramp up manufacturing and battery infrastructure. Tesla has been profitable on a generally accepted accounting principles (GAAP) basis in each of the past three years.
And let’s not forget about Elon Musk, who’s extolled as a visionary by Tesla’s long-term shareholders. Under Musk, Tesla has branched into energy storage, solar panel installation, and even robotics.
But among stock-split stocks, Tesla is very possibly the riskiest investment. There are numerous red flags that suggest its run-up over the past couple of years isn’t sustainable.
For example, Tesla’s rash of recent price cuts in China and the U.S. on its flagship sedan (Model 3) and top-selling SUV (Model Y) are indicative of inventory concerns. Though the company’s automotive gross margin has been notably ahead of its peers up to this point, price cuts of up to 20% on core models in two of the top auto markets in the world are bound to crush its operating margin and seriously reduce its profits in 2023.
Likewise, Tesla isn’t getting any help whatsoever from its ancillary operating segments. The company’s solar installation operations have been a money loser since SolarCity was acquired in 2016.
Elon Musk has become a liability as well. Putting aside the fact that he draws negative attention from securities regulators and appears distracted by social media network Twitter, which he acquired in October, Musk frequently promises new innovations and timelines that he simply can’t deliver on or meet. These unfulfilled promises are a recipe for disaster.
If this still isn’t enough, put Tesla’s valuation under a microscope. Most automakers trade at a price-to-earnings (P/E) multiple of around 6. Tesla commands a P/E ratio of almost 50 in 2023 based on Wall Street’s consensus. That’s a nosebleed valuation at a time when U.S. economic growth looks precarious, at best.
This stock-split stock is a much smarter buy than Tesla
FAANG stocks Amazon and Alphabet, which found themselves in the stock-split spotlight with Tesla, are certainly solid candidates for investors to buy for the long run. Amazon is the dominant player in e-commerce, while Alphabet’s internet search engine Google has accounted for at least 91% of worldwide search share for more than four years (and counting). Both companies are also major players in the high-growth, high-margin, cloud infrastructure services space.
But there’s, arguably, an even smarter stock-split stock to buy over Tesla than either Amazon or Alphabet. I’m talking about a company that largely flew under the radar last year in spite of its 3-for-1 stock split in September: cybersecurity stock Palo Alto Networks (PANW -2.96%).
Whereas Tesla is truly nothing more than a cyclical auto stock that runs the risk of a sizable demand slowdown if the U.S. or global economy were to dip into a recession, cybersecurity stocks like Palo Alto are predominantly insulated from economic downturns. With businesses shuffling their data online and into the cloud at an accelerated pace since the COVID-19 pandemic began, the responsibility of protecting this data has increasingly fallen on third parties like Palo Alto. Since hackers don’t take time off from trying to steal sensitive information, Palo Alto can expect steady operating cash flow in any economic environment.
Beyond just providing a necessity service for businesses, what makes Palo Alto Networks such an intriguing investment is its multiyear transition to cloud-based software-as-a-service (SaaS) solutions. Cloud-based SaaS cybersecurity solutions are nimbler than on-premises security options and more likely to reduce customer churn.
Equally important, SaaS solutions should yield predictable cash flow year in and year out, as well as beefier margins, relative to firewall products. Since the end of fiscal 2018 (July 31, 2018), the percentage of net sales Palo Alto derives from subscriptions and support services has risen close to 18 percentage points to 78.9%.
To add to the above, Palo Alto Networks is making inroads in all the right places. The number of customers with at least $1 million in bookings over the trailing 12 months (ended Oct. 31, 2022) is up 59% from the comparable quarter two years ago. Likewise, more than half of its Prisma Cloud customers have purchased at least two cloud modules. While customer growth is important, getting existing clients to add onto initial purchases is where Palo Alto can recognize its juiciest margins.
Management’s bolt-on acquisition strategy is yet another puzzle piece that’s helped Palo Alto succeed. A steady diet of small acquisitions has helped expand the Palo Alto service ecosystem and created abundant cross-selling opportunities.
With next-generation security annual recurring revenue jumping 67% to $2.11 billion in the latest quarter, and the company’s order backlog rocketing 38% to $8.3 billion, it’s pretty clear that Palo Alto Networks makes for a much smarter buy than a pricey and cyclical automaker.