Wednesday, July 11, 2012

Check Point Software Earnings Review

Sometimes investors will do the funniest things. Israeli IT security company Check Point Software $CHKP gave pretty steady results and the market greeted them by selling the stock down to as low as 10% on the day. Go figure!

In a sense, I suspect this sort of thing runs in line with current market jitters. Technology companies like Riverbed and Cree have given results and been summarily massacred when they missed guidance or guided lower. The difference here is that Check Point beat on revenues and estimates and gave guidance that is pretty much consistent.

To understand these results better, it's worth starting by saying that Check Point usually does beat guidance and that management are usually conservative in outlook. A quick summary of the results here:
  • Q1 Revenues of $313.1m vs. estimates of $312.8m
  • Q1 Non-GAAP EPS of 74c vs. estimates of 72c
  • Q2 Revenue guidance of $324-336m vs. estimates of $333.7m
  • Q2 Non-GAAP EPS guidance of 74-77c vs. estimates of 76c
It's a beat on revenues and EPS. However, the guidance is a little light. I had hoped for a bit more but remember, Check Point are conservative in guidance.

Check Point Guides Lower?

To graphically explain what I think the market is worrying about:

Note that the mid-point of Check Point’s guidance (shown in the graph) is below previous years. However, the top of the guidance range is above and Check Point tends to guide low.
In addition, if I take the average of the last three years' sequential movements and extrapolate out, the company will surpass the analyst consensus forecast of $1.38 billion in year end revenues. So, it hardly looks worrying, but what about the underlying market conditions?

Key Conclusions from the Results

For those that don’t know Check Point Software, its business model (despite the name) is to sell its hardware into a client and then sell them a series of add-on software blades. Its principal rivals are Cisco $CSCO and Juniper Networks $JNPR, although, it doesn't seem that Check Point is losing market share to them.

Cisco has a broad suite of internet security products and was previously the leader in this segment. However, the company is undertaking significant restructuring amidst refocusing on its core network business. It's not clear whether it is ready to take back the top spot from Check Point.

As for Juniper, according to Gartner, its strength lies in the upper-end midsize business (500-999) but it has "limited channel support for the midmarket." This makes Juniper competitive with Check Point but only at the higher end.

Another interesting new potential rival is F5 Networks $FFIV, which gave impressive results recently and made bullish noises about their expansion into the high-end security market. F5's core competency is in application delivery networking, which suggest it should be able to cross sell its emerging security solutions. It is a potentially dangerous rival.

Fortinet $FTNT will give results soon and, although they are more focused on the small and mid size business market, its results will also be seen as a gauge for how the market is doing. It offers Unified Threat Management (UTM) products, which are intended to be an all-encompassing security solution. In the future, as companies grow their internet infrastructure, their security needs may become more complex, so it is possible that Fortinet's core market may migrate upwards toward Check Point's strength at the upper end.

In Check Point’s case, the argument could be made that things are improving. Interpolating from the conference call, I've made the following key points.
  • Management announced that due to Israeli tax reforms, the reported tax rate will be reduced next year to around 18-20%
  • Margins are expanding due to software sales growing faster than products
  • Renewal rates on blades are higher than management had forecast
  • The company is launching new software blades
  • The competition appears to be ‘weakening’ and not more ‘threatening’
An interesting new solution is ThreatCloud, a collaborative network that is intended to help fight cyber crime. It’s basically a network to report attacks, which can then be responded to quicker, by anyone in the network. It is already being integrated into the latest software releases.
In fact, it is this type of software upgrade that is driving sales at the moment. And since, software tends to have higher margins than products, Check Point reported operating margins of 55.2% as opposed to 50.2% last year.

Analysts did, however, question one aspect of growth. Specifically, that whilst software sales were up 15.2%, the increase in products was a miserly 4.7%. Surely, a sign of slowing underlying growth?
Perhaps not. Check Point is a company that manages profits and revenues rather than margins. In any case, software and hardware are not initially sold separately. So, as more software is sold in the initial deals, it is natural for the company to move more of the sale into the software revenue line, rather than the product line.

In fact, management noted that over 10% of initial sales are coming from the software part now, when the figure would have been much lower a few years ago. The underlying run rate was described as "healthy."

What about the Share Price?

We’ve just seen this company generate nearly $800 million in free cash over the last four quarters, in other words 6.7% of its Enterprise Value. It has affirmed full-year guidance of 10% EPS growth. Margins are expanding due to increased software sales. The future tax rate appears to have been lowered and its competitive positioning seems to be strengthening.

Longer term, network and gateway security issues are on the rise and Check Point is a clear market leader in its segment. I think it there is every reason to expect upside from here.

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