Thursday, May 2, 2013

Check Point Software Continues to Generate Cash Flows, is it Enough?

It’s very easy to get a bee in your bonnet with investing, and there are certain issues and metrics that just become the one big thing that guides the performance of certain stocks. In the case of IT security play Check Point (NASDAQ: CHKP) it is its falling (and now negative) product and license sales growth. In summary, there are mitigating circumstances, and there was some good news in the latest report, but until it gets this metric back on track, it is hard to see the stock aggressively re-rating from its undoubtedly low rating.

Check Point punching below its weight?

As usual, the management was forthcoming in outlining Check Point’s technological leadership and cited the IDC Worldwide 2012 Security Appliance Tracker (which claimed it was the leading firewall and UTM appliance market company) as a reference point. The company is known for the sophistication of its products but also for their high cost. Indeed, the latter is part and parcel of this company’s relatively mature position in the IT security market.  Competitors like Fortinet (NASDAQ: FTNT) may have better growth prospects (from a lower installed base), but no one generates margins and cash flow like Check Point.

Unfortunately, I suspect that these characteristics are part of the reason for the falling product and license sales growth. In other words, Check Point appears to prefer sticking to its high-margin, high-quality razor blade model, rather than stepping up marketing or reducing prices to generate growth.

The results are obvious.

The mitigating argument (I know it because I held it) is that the company is deliberately bundling hardware and software together and trying to get the razors (hardware) installed so it can sell more blades. Moreover, it has increased the number of blades that it can sell to customers in recent years. Consequently, product sales growth should look weaker. 

The problem with this argument is that software sales have started getting weaker, too, and the mid-point of revenue guidance for the second quarter would bring annual revenue growth down to a paltry 1.9%. Growth is clearly slowing.

Why Check Point’s growth is slowing

One explanation for all of this is that Palo Alto Networks’ (NYSE: PANW) growth is eating into Check Points' pie. Indeed the ‘Check Point Killer’ (Palo Alto’s founder is an ex-high-level Check Point employee) is growing rapidly and winning a significant amount of primary firewall business, even as its solutions are regarded as high ticket. On the other hand, Fortinet is usually seen as more of a cost-effective UTM vendor, and in this tough environment it is doing well (albeit with lower-than-expected results the last time around). Fortinet is starting to look interesting after the warning.

Another reason is that Check Point is in the middle of a new hardware platform appliance. This transition can cause some existing customers to hold off purchasing. In addition, in the last quarter the management noted that some customers were enjoying getting the same performance but with less cost, thanks to the increased efficacy of the new products. Of course, in time, their requirements will increase and this pent-up demand could lead to better numbers down the line.

The immediate problem is that investors have seen with Riverbed Technology (NASDAQ: RVBD) what can happen with product refreshes in technology. They can take at least a quarter or two to iron out, and the market takes no prisoners when companies are faced with such short-term difficulties. It took awhile for Riverbed to recover, amid speculation over the maturity of its core WAN optimization market. Indeed, the company has been diversifying its end markets in a view to avoid over-reliance on one marketplace.

Incidentally, this is why I am cautious on F5 Networks (NASDAQ: FFIV) right now.  As with Fortinet, it reported a severe reluctance among telco carrier clients to sign off on deals in the quarter. This would be acceptable if it didn’t coincide with a product refresh. Investors can be understandably concerned that it isn’t a coincidence. In addition, it doesn't have enough revenue outside of core application delivery controllers to make up any shortfall.

The good news

However, it wasn’t all bad news. Europe, which at 38% of revenue is a significant profit generator, saw surprisingly strong performance. Contrary to what F5 and Fortinet said recently, it saw no specific weakness in its telco vertical.  Some super high-end deals failed to close, but that can probably be attributed to the same cautious approach among tech buyers that seemed to hit IBM and Oracle. They could easily bounce back if the political uncertainty lifts.

Probably the most bullish point relates to how deal size improved in the quarter. Management cited that 67% of transactions were at $50k and above, opposed to 60% last year, and 43 customers made transactions at over a £1 million as opposed to 34 last year. The key reasons are a higher average selling price (ASP) driven by a higher revenue product mix. Remember what I said about how Check Point prefers margins and cash flow to revenue growth?

The bottom line

This stock remains a very good value on a price/cash flow basis, and it clearly has market leading products. The increase in ASP is a sign that it is getting over its product transition and customers are starting to buy the new appliances so a bullish case can be easily built for the stock.

The problem is that the market hasn’t wanted to know anything about the stock while its revenue and product and license sales growth are slowing. That may change this year because comparisons are getting easier, but I think this company is going to have to come out and declare it is going for growth, and/or report some better growth numbers before buyers feel confident again.

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