This blog is devoted to helping investors make informed decisions. It will be regularly updated and provide opinions on earnings results. It is not intended to give investment advice and should not be taken as such. Consult your investment advisor.
Whether rightly or wrongly, the market always seems to want
technology companies to deliver growth, or they will be punished with
low valuations. Consider the case of low-rated IT security specialist Check Point Software(NASDAQ: CHKP). The
company generates huge cash flows, and holds a significant portion
(over 30%) of its market capitalization in cash. On the other hand, it’s
estimated to only grow earnings in the 6% to 8% range over the next
couple of years. Is now the time to buy the stock?
Great cash flow, low rating
Frankly, the main attraction of Check Point is its cash flow. For
example, by my calculations, the company has just generated around $944
million in free cash flow over the last four quarters. In other words,
that cash flow represents nearly 8.8% of its current market value.
Putting this into context, if the company only did this for
the next 11 years (with no growth) then it would have generated the
equivalent of its market cap in cash. However, the company is still
growing earnings and cash flows, so why is it so low-rated?
One possible explanation is that the market is concerned about its
falling product & license revenues. Check Point has a
razor/razorblade business model, which means its hardware products are
sold into customers in order to generate future software blade sales.
The fear is that falling hardware sales will ultimately lead into
falling software sales.
The following chart (sourced from company accounts) demonstrates how
its product & license growth has turned negative over the last year.
If this isn’t worrying enough, then investors only need look at how competitors like Fortinet(NASDAQ: FTNT) and Palo Alto Networks(NYSE: PANW)
have lowered guidance this year due to a weakening environment.
Fortinet gave a weak set of results for the first quarter, and reduced
its full year revenue guidance by about 5% from its previous forecast.
Moreover, its guidance for the second quarter looked weak, and implied that conditions weren’t improving. A month or so later, Palo Alto disappointed the market by claiming that its end-market conditions remained weak going in to June.
So if Check Point’s hardware sales are falling, and its competitors
are warning, can investors feel comfortable with the company’s
prospects?
Six reasons why Check Point investors can feel secure
Firstly, Check Point’s average selling price (ASP) has been
increasing in recent quarters, and its management stated that the ASP
was back to its level of two years ago. The improvement is partly due to
selling a higher proportion of larger deals.
For example, Check Point disclosed that 68% of its deals were at
$50,000 or above, versus 66% last year. This is clearly part of a
positive trend, because in the last quarter’s results, the same
percentage went up to 67% from 60%.
Second, on previous conference calls, Check Point had spoken of a
trading-down effect due to its product refresh. Essentially, its
customers were holding off purchasing its new higher-end solutions in
favor of buying the new lower-end solutions. The customers’ rationale
was that they were getting the same performance as before, but at a
lower price. However, the rise in the ASP in the current report suggests
that the trading-down effect has come to an end.
Third, the company has long been regarded as offering relatively
expensive solutions that hinder its opportunity to sell into the small-
and medium-size business market. The good news is that Check Point now
has a lower-priced ($400 to $1200) entry-level product with its new 600
series. This is a market segment that Fortinet has traditionally been
strong in, so look out for increased competition here.
Fourth, potential investors always need to remember that Check Point
uses bundling as part of its sales strategy. In other words, it tends to
try and accelerate software sales by bundling them with hardware sales.
As the company is increasing the amount of software solutions that work
on its hardware, it is reasonable to expect that hardware sales will
fall as a percentage of the total bundled amount. Don’t panic too much
over falling hardware sales.
Fifth, the guidance looks conservative. Based on company accounts and
the guidance given on the conference call, I have graphed revenues and
implied assumptions for revenue growth in the next two quarters. It
doesn’t look like an aggressive forecast, and Check Point has a history
of being conservative with guidance.
Finally, Cisco Systems(NASDAQ: CSCO) recently announced its plan to acquire IT security company Sourcefire in a $2.7 billion deal.
Cisco’s security revenues fell 5.2% at its last set of results, and
this deal is clearly an attempt to regain positioning. It’s exactly the
kind of deal that Cisco needs to do in order to counteract slowing
growth in its core switching and routing divisions. The immediate
takeover speculation will focus on fast growing companies like Fortinet
and Palo Alto. However, this sort of deal usually helps to guide
investors a sector, and Check Point can expect to benefit too.
The bottom line
In conclusion, while the recent results didn’t have many
positive things to say about the IT spending environment, Check Point
did report some underlying positives. Moreover, the valuation of the
stock is attractive, and it’s a stock well worth considering for value
investors looking for some tech exposure.
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