Sunday, September 2, 2012

Check Point Looks Good Value

Technology investors can be forgiven for thinking that the sky was about to fall on them in the last few months. Granted, some companies have given eye watering warnings and the macro environment has unquestionably weakened, however, a ‘one size fits all’ approach in technology investing has rarely been more ill advised. Not all companies are seeing revenues collapse and because catastrophe is priced in, there is upside even if they only report in line with earnings and give moderate guidance.  Such was the case with IT security company Check Point Software $CHKP

Whisper Numbers Were Just Whispers

I must confess I’m fed up of hearing the phrase ‘whisper number.’ It usually refers to some commentator or other trying to guide consensus in the direction of his trade on the stock. With Check Point, we seemed to hear it all before these results.

According to the whispers, its relatively high European exposure was about to cause a collapse in revenues. Upstart IT security company Palo Alto was supposed to be positioning itself as the ‘Check Point Killer.’ Fortinet $FTNT was achieving its success by grabbing market share from the Israeli competitor. Product and licence sales were in a consolidated decline. The stock got trashed.
Dealing with these points in turn, Europe contributed 39% of revenues in the quarter and growth was described as mixed across the region. I’m writing this from Austria and, I assure you that conditions here do not seem anything like as bad as in, say Spain. Analysts asked about Palo Alto on the conference call and the management stated that it had seen no competitive changes from them. Trading conditions in the US were described as ‘great.’

Similarly, it stated that it thought Juniper $JNPR  and Cisco $CSCO were still losing market share.  Fortinet is a fine company and it does talk about winning business from Check Point, but the fact is that its core market is in its SMB stronghold. Check Point mainly generates its revenues from mid-large size companies who require a more sophisticated solution.
As for product sales, some explanation is needed here.

Why Product and Licence Sales are Weaker

The first thing to acknowledge is that product sales have been trending weaker for a while now. Here is a graph of product & licences and software sales growth.

Clearly product sales growth is weakening but there are mitigating circumstances. Check Point is increasingly bundling its product and software services together and, with more software blades being offered, more of the revenue is being recognized as software.

Essentially, technology companies sell products (hardware and software) but they also sell services which tend to be long term. So when a customer is taken on, the company books revenue for the products and bills for the full service contract. However, the full contract is not recognized as revenue until the service work is incrementally done. No matter, the work is billed. Therefore, investors can’t just look at revenues or product sales in isolation.

Moreover, the mix of sales between services and product will dictate the mix between revenues and current deferred revenues. In order to demonstrate this I want to show a chart of the growth of a selected metric. This chart shows the growth rate of revenues plus the change in deferred revenues. I think it is a good way to see how a technology company is trending.

Growth is moderating but then again the yearly comparables are getting tougher. In conclusion, Check Point’s underlying growth is still good.

Warning Signs?

Despite the positive tone of this article I am not going to conclude by saying that everything is firing on all cylinders. Growth is moderating. If conditions continue to deteriorate then Check Point could disappoint.  The guidance given for the next quarter was very wide (revenues of $316-345m) which indicates an amount of increased caution over current trading.  The company also talked of new customers wanting smaller size deals.

More competition is coming and particular from a company like F5 Networks $FFIV which reported decent results and confirmed that its nascent security offering was gathering traction. F5 has a powerful position in its core application delivery market and can leverage this to grab market share.

The Bottom Line

The company also has an annoying tendency to hoard cash. It is a high cash generator and has nearly 14% of its market cap in cash or cash like instruments. On a trailing basis its free cash flow generation is $784m or 9% of its Enterprise Value.  This makes Check Point a rare breed of stock that appeals to both value and growth investors. Frankly, I think it’s time for it to do more for the former. The $1bn buyback approval is a good move, but I think a dividend would drive the stock price higher and also encourage longer term value investors into the stock.

In conclusion, Check Point looks like good value down here. The evaluation is attractive and security is one of those areas of IT spending that may turn out to be a lot less discretionary than the whisperers would have you believe it.

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