Palo Alto Networks (NASDAQ: PANW) recently completed its three-for-one stock split. Tech stock splits have been hot in 2022, even amid a vicious bear market. Companies with high stock prices might be announcing these splits to try and attract investor attention and attract investors who are not as willing to spend large amounts of capital per share.
As for Palo Alto Networks, it hasn't needed much help. Even before the stock split was announced, shares of the leading cybersecurity company were already handily beating the S&P 500. But here's the real reason for the stock split -- and the real reason this company is worthy of your attention.
The real reason for this stock split
Companies often split their stock to attract investor attention. In fact, Palo Alto Networks isn't the only cybersecurity company to split this year. Fellow security leader Fortinet (NASDAQ: FTNT) completed a stock split just a couple months prior. There are some additional benefits to stock splits like increasing access to retail investors with a lower share price, although that benefit is dissipating today. Many online stock brokers allow for fractional share purchases, eliminating the need for a company to lower its price per share. Nevertheless, a split announcement tends to generate lots of positive media buzz.
Why else split a stock? A lower stock price can often help a company better manage the stock-based compensation it pays to employees. Stock-based compensation is common in the tech world, as it helps a company attract and retain talent. It has become deeply ingrained in the tech start-up and business culture of Silicon Valley. But stock-based comp is also often a hang-up for many investors. A company with out-of-control stock-based comp has an increasing pool of shares outstanding, which dilutes the value of ownership for existing shareholders that aren't employees.
Palo Alto Networks falls into this camp. During its recently completed 2022 fiscal year (the 12 months ended in July 2022), stock-based comp totaled $1.07 billion. That totaled over 19% of fiscal 2022 revenue, or about 2.1% of the company's market cap at the conclusion of the fiscal year. During the first few years of his tenure, CEO Nikesh Arora oversaw nearly a dozen acquisitions of small cybersecurity peers to bolster Palo Alto Network's technology. That has contributed to the high level of stock-based comp. However, now that the frenzied pace of acquisitions is likely over (though more acquisitions could be coming, but at a slower pace), Arora has said that driving down stock-based comp is a priority.
A stock split might help this security leader accomplish this, as a smaller share price could help the company manage the value of new stock awarded to employees -- both existing and future hires.
Declining share counts bolster profitability
Getting stock-based comp under control and driving down share count could be a huge boost to Palo Alto Networks' shareholders. Over the last five years, Palo Alto Networks' total shares outstanding have increased by nearly 8.6%. Acquisitions and employee equity awards were the driver, partially offset by share buybacks -- which the company has been able to fund with its positive free cash flow and excess cash on balance.
In spite of this rising share count, though, Palo Alto Networks has still delivered fantastic returns. Both revenue per share and free cash flow per share (a metric that factors in a rising share count) have both increased at a healthy pace.
There's room for improvement, though. As Palo Alto Networks business matures, revenue and profit growth will naturally slow. That's where slowing, and eventually reversing, total shares outstanding can deliver more shareholder returns. Fewer shares means more profit to go around for those shareholders remaining. A stock split can also help with managing share buybacks as the company repurchases stock off the open market.
As of this writing, Palo Alto Networks trades for 29 times enterprise value to free cash flow. For a business that has demonstrated its ability to maintain a double-digit-percentage growth rate for many years, and sustain positive and growing free cash flow along the way, it's a reasonable price tag. Don't buy because of the stock split, but rather on the prospect Palo Alto Networks could be gearing up for a bigger push to return more value to shareholders in the coming years.
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Nicholas Rossolillo and his clients have positions in Fortinet and Palo Alto Networks. The Motley Fool has positions in and recommends Fortinet and Palo Alto Networks. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.