Check Point: Don’t Look Back, Palo Alto May Be Gaining On You

Check Point: Don’t Look Back, Palo Alto May Be Gaining On You

Check Point: Don’t Look Back, Palo Alto May Be Gaining On You

We think Check Point Software Technologies (CHKP) remains a strong value in the software technology industry.  We are surprised that the company’s shares have dropped from a high of $65 in April, to a low of $40.60 recently, in the wake of soft guidance after it released its Q3 2012 earnings. While we reduced our target price from $65.65 to $58.19 recently, we believe that the company will see its momentum rebound next year, plus it is still generating strong free cash flows.

What reinforced our thesis behind Check Point was the announced expansion of its share repurchases.  Check Point had previously made $200M of gross repurchases in 2010.  In 2011 and the first half of 2012, it increased that to $300M annualized.  After CHKP’s results were released, the company announced that it was expanding the repurchase authorization to $1B over a two year period, which represents 10% of the company’s market capitalization, as of July 23rd.  We see that Israel’s recent tax reform has enabled CHKP to set a more assertive share repurchase program, and we are expecting that this tax reform will enable CHKP to potentially pay a dividend.  This has borne itself out as CHKP doubled its share repurchase spending on a year-over-year basis, starting with Q3 2012.  Even with CHKP spending over $1.8B in share repurchases, net of proceeds from employee stock program issuance over the last 10 years, CHKP has seen its cash and liquid security holdings increase from $1.3B in 2002, to $3.25B in Q3 2012.  Over 36.5% of CHKP’s market capitalization consists of cash and marketable securities held by the company.  If we were to compare that to fellow IT security infrastructure firm Fortinet, Inc. (NASDAQ:FTNT), we would see that CHKP’s Cash/Market Cap ratio is higher than Symantec Corporation (NASDAQ:SYMC), Fortinet, Inc. (NASDAQ:FTNT), and its new rival, Palo Alto Networks Inc (NYSE:PANW).

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Source: Morningstar Direct

CHKP’s Q3 2012 was in line with our expectations.  Revenues reached $332M and represented a 7.8% increase from the $308M reported in Q3 2011.  Slow growth from its product and license segment sapped the momentum from strong growth in its software updates, maintenance, and services segments.  To elaborate further on the product and license segment, product and license revenues were flat, versus the prior year’s period, due to the challenging macroeconomic environment and headwinds from the stronger US dollar.  The company achieved strong double digit growth in its Enterprise Gateways product suite, which was offset by customers opting to purchase slightly lower-end models, due to the weak and volatile macroeconomic environment.  The company also saw pricing pressure as the euro and other foreign currencies weakened against the US dollar.  Because of the recent bout of weakness, with regards to the euro versus the dollar, we believe that CHKP should follow the example of other multinational companies, and also report constant currency adjusted results as well.  This would provide greater clarity to investors, and allow them to determine whether revenue growth is slowing due to organic volumes, or whether it is due to currency fluctuations.

Source: Morningstar Direct

Revenue from software updates, maintenance, and service reached another all-time high of $211.3 million this quarter, with outstanding year-over-year growth of 12.6%. Growth was driven by CHKP’s annuity software blades, which are recognized as subscriptions. Deferred revenues as of Q3 2012 were $506 million, an increase of $51.5 million or 11% over Q3 2011.  CHKP continues to gain larger contract deals: CHKP had 31 customers that each has transactions with a value greater than $1 million, compared to 35 in the same period last year.  Transactions greater than $50,000 accounted for 66% of total order value, which increased relative to the 63% achieved last year in the same period.

Source: CHKP Q3 Earnings Call

CHKP continues to enjoy positive operating leverage.  CHKP’s GAAP operating income was $183M in Q3 2012, which was an increase of 15.5% from Q3 2011 levels.  CHKP’s GAAP operating margin for the quarter was 55%, which increased from the 51.3% in Q2 2011.  We can see that this is significantly higher than what we see from Fortinet, Palo Alto, and Symantec.  We believe that CHKP’s strong operating margins should allow it greater flexibility, with regards to investing in R&D, in order to develop next generation technologies, or to undercut its rivals with regards to pricing or marketing promotions.

Source: Morningstar Direct

We love the company’s ability to generate free cash flows from operations.  The company generated $179M in free cash flows for the quarter, versus $152.5M in the prior year period.  We are absolutely enamored with the fact that its capital investment costs are primarily research and development, which flow through the income statement and is immediately written off as a tax-deductible business expense.  CHKP doesn’t have to spend much on capital expenditures for hard, illiquid assets like property, plants, and equipment.  Its all-time high for annual CapEx was $7M in 2011.  CHKP’s 2012 YTD free cash flows were $609M, versus $530M in 2011.  On a linked-quarter basis, the company reduced its Days Sales Outstanding ratio by 3 days, and it now stands at 69 days.

The company is managing its European exposure well.  North America is Check Point’s biggest market, and it posted double digit revenue growth year-over-year from product and service revenues.  Europe’s revenue performance was stable, relative to last year’s levels.  IDC recommended Check Point’s Security Appliance products as being #1 in its Appliance Report that was published in Q3 2012.  The company projects that Q4 revenues will be in the range of $355-$387M and its operating EPS will be in the range of $.84-$.91, with a $.07 adjustment to GAAP EPS.  We noticed that consensus estimates for CHKP’s Q3 EPS were $.90 and that was at the higher end of the management’s guidance range.

During the quarter, the company introduced the Check Point Virtual Systems, which is a new solution for private cloud environments and data centers that enables the consolidation of up to 250 security gateways on a single hardware platform.  Check Point also offers the Check Point ThreatCloud™, which that automatically detects and shares new attack information in real time by, collecting and correlating attack information from Check Point customer’s gateways and a dedicated attack sensor network.  Check Point even offers a Cloud-Managed Security Service for as little as $19/month.  CHKP’s CEO, Gil Shwed, predicts that CHKP will continue to increase its security from the Cloud and for the Cloud.

We believe that CHKP should not underestimate Fortinet and Palo Alto Networks.  Although both companies are trading at significantly higher PE Ratios than CHKP; and although both companies are generating lower operating margin levels than CHKP; and although CHKP is returning cash to shareholders while both of its peers are issuing shares, we can’t help but notice that CHKP’s revenue growth is less than Fortinet, Inc. (NASDAQ:FTNT) and Palo Alto Networks Inc (NYSE:PANW).    We also noticed that CHKP is spending less on research and development and marketing than either Fortinet and Palo Alto, and we believe that CHKP may want to sacrifice a few percentage points of operating margin in order to increase its R&D and advertising budgets, in order to better compete against Fortinet and Palo Alto, and to create a next generation IT security product.  CHKP’s operating margin is larger than the combined operating margins of FTNT, PANW, and Symantec Corporation (NASDAQ:SYMC), and we can see that even if CHKP was to double its R&D/Sales budget, CHKP would still have operating margins in excess of 45%.

Source: Morningstar Direct

In conclusion, since the price of the stock as of October 22nd ($42/share) is 3% off its 52 week lows, we will be looking at adding to our position, as we believe that the company’s shares are reaching a bottom.  We are pleased that the company is able to generate solid growth, in spite of its exposure to the sick old man known as Europe.  We are pleased that we are seeing additional clarity with regards to how the company will utilize its ultra-liquid balance sheet, in order to return cash to investors and increase shareholder value.  We like that it offers the best risk/reward potential in the security software and solutions industry. However, we also believe that the company should keep an eye peeled on Palo Alto Networks and to a lesser extent, Fortinet.



Past performance is not necessarily indicative of future results. All investments involve risk, including the loss of principal. This report is confidential and may not be distributed without the express written consent of the original author, and does not constitute a recommendation, an offer to sell, or a solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential private offering memorandum.

Investments may currently or in the future buy, sell, cover, or otherwise change the form of its investment in the companies discussed in this letter for any reason. The author hereby disclaims any duty to provide any updates or changes to the information contained here, including, without limitation, the manner or type of any of the investments.

All of the views expressed in this research report accurately reflect the research analysts’ personal views regarding any and all of the subject securities or issuers. The research analyst is not registered with FINRA, and may not be subject to FINRA rule 2711 restrictions on: communicating with the subject company, public appearances, and trading securities held in the research analysts’ account. No part of the analysts’ compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. The analyst responsible for the production of this report certifies that the views expressed herein reflect his or her accurate personal and technical judgment at the moment of publication.

Under no circumstances must this document be considered an offer to buy, sell, subscribe for, or trade securities or other instruments.

Disclosure: The author has a long position in CHKP

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Saibus Research is an independent research and advisory firm based in Boston, MA that provides specialized investment research to investors and professional money managers. Saibus Research seeks to uncover investment ideas that have significant upside relative to their intrinsic value. Using thorough fundamental analysis and financial statement analysis we identify stocks that are trading at a discount. Saibus’ core expertise lies in deep value stocks, special situations and turn-arounds, and fund due diligence. Saibus Research has an extraordinary track record of offering sound fundamental research that add additional value to investors.
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