Palo Alto Networks is Starting to Look Good Value

Analyzing the network security sector sometimes gives you the feeling that you are researching the only one company, just at different stages in its development. Most companies tend to evolve in a similar fashion, from high-growth start up to mature GDP growth type cash cow.  Check Point   and Cisco's    security division would definitely represent the later stage of this hypothetical company's development. Palo Alto Networks    is at the high-growth end of the spectrum and Fortinet   lies somewhere in the middle.The question is which company has the best risk/reward profile?

Network security rebounds
It's been a varied year for the sector. After a weak first quarter, where companies like Fortinet, Palo Alto and F5 Networks disappointed with results, the last two quarters have been relatively good.

It's hard to pinpoint exactly what happened back then, but sequestration appears to have had an effect on confidence. Furthermore, some unexpected weakness in telco provider spending also hit the market. No matter, the sector has reported some pretty good results since then.

The mature companies
Check Point finally managed to get product sales growing positively again. In addition, its new low-end product range is making inroads in the small and medium size business market. Meanwhile, it continues to generate huge amounts of free-cash flow. By my calculations free-cash flow was $925 million over the last year, representing around 8.6% of its current enterprise value. However, it's only forecast to grow earnings in the mid-single digit range for next few years.  It's attractive if you favor low growth value plays.

Meanwhile, Cisco Systems has revamped its security offering with its acquisition of Sourcefire. Although, Cisco is not a pure-play security company, the way that is able to buy growth by an acquisition is typical of a mature late stage company. Cisco's main strength is the ability to bundle solutions to the other equipment that it sells to Governments and enterprises. Indeed, listening to Palo Alto's management on its conference call, the Sourcefire acquisition actually created a positive opportunity:

We've also seen confusion in the market from the Sourcefire customers about what that deal means... ...We've been able to develop hundreds and hundreds of leads from dissatisfied or confused Sourcefire customers... ... it's been a positive

Fortinet matures, unusually
Fortinet also beat estimates in its last quarter. Revenue came in at $154.7 million, beating the high-end of its guidance range by 1.6%. In common, with Check Point, Fortinet's guidance for the fourth quarter looks a bit conservative. Check Point has averaged 13.7% in fourth quarter sequential revenue growth over the last five years, while this year's guidance implies sequential growth of just 10.4% Meanwhile,despite beating estimates in its third quarter, Fortinet kept its full year revenue and EPS guidance constant. Here is how its full-year guidance has changed this year.

Source: Company presentations

Eagle-eyed readers will note that its free-cash forecasts have been progressively lowered throughout the year. Frankly, this is a cause for concern in an otherwise attractively valued company. Fortinet has had to lower its inventory turns, and therefore use up more cash in holding inventory on its books. It's not a major issue, provided it stabilizes as expected. However, it's something for Foolish investors to look out for. Companies usually start converting more income into cash flow when they mature, not the other way around.

Why Palo Alto Networks is the pick
It seems odd to talk about Palo Alto as the best value in the sector, but on a risk/reward basis the argument stacks up for three reasons.

First, Palo Alto's revenue for the full year is forecast to be around $559 million , a figure noticeably smaller than Check Point's estimate of around $1.4 billion or Cisco's trailing year security revenue of a similar amount. In other words, even if all four of these companies share the market equally, Palo Alto will see the most growth.

Second, Palo Alto is doing a pretty good job of converting revenue into free-cash flow.

source: Company accounts, author's analysis

If Palo Alto converts 22% of its forecast revenues of $559 million and $734 million then investors can expect around $123 million and $161 million in free cash flow in the next two years. That's not bad for a company that has a current enterprise value of $2.83 billion. 

Third, Palo Alto has a favorable geographic mix of revenue. The most recent quarter saw 67% of the company's revenue coming from the Americas, with only 19% from Europe and 14% coming from the Middle East & Africa and Asia-Pacific.  With companies like Cisco and IBM recently warning that emerging market spending was weakening, it's good for Palo Alto to be focused on the Americas.

All told, Palo Alto may not be the cheapest-looking stock in the sector right now, but it looks a good value based on its stage of development. Pure value orientated investors may prefer Check Point, or even a mix of the two.

Reasons to Buy Check Point Software

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.

Check Point Raises Estimates

Check Point $CHKP gave results and both revenues and earnings were above consensus. Furthermore, Check Point raised revenue and earnings estimates for the full year, and the stock responded by crashing through a 52 week high. So is everything looking positive for the stock? I think it is.

Check Point was covered in an EarningsView research report linked here and this should provide some good background for the current results. Turning to these results a few key takeaways are

• Q3 Revenues forecast at  $300-308m
• Full Year Revenues Forecast raised to $1.23-1.25bn vs. a previous estimate of $1.19-1.23bn in January
• Full Year EPS forecasts raised to 277-284c vs. a previous forecast of 265-275c

Check Point Sequential Revenues

To put these numbers into context I’ve broken down the sequential revenues here.

 

(m)	Q4 08	Q1 09	Q2 09	Q3 09	Q4 09	Q1 10	Q2 10	Q3 10	Q4 10	Q1 11	Q2 11
Revenue	217.6	195.0	223.6	233.6	272.1	245.1	261.1	273.2	318.5	281.3	300.6
Seq growth %		-10.4%	14.7%	4.5%	16.5%	-9.9%	6.5%	4.6%	16.6%	-11.7%	6.9%
Cur Defer Rev	290.0	283.1	330.0	322.8	384.3	380.9	377.0	362.9	424.2	421.9	413.4
Seq growth %		-2.4%	16.6%	-2.2%	19.1%	-0.9%	-1.0%	-3.7%	16.9%	-0.5%	-2.0%
LT Defer Rev	40.8	41.9	32.1	37.4	41.0	38.9	37.7	33.4	40.4	38.6	43.5
Seq growth %		2.8%	-23.4%	16.4%	9.8%	-5.1%	-3.0%	-11.4%	20.8%	-4.5%	12.9%
Tot Defer Rev	330.8	325.0	362.1	360.1	425.3	419.8	414.8	396.3	464.6	460.4	457.0
Seq growth %		-1.7%	11.4%	-0.5%	18.1%	-1.3%	-1.2%	-4.4%	17.2%	-0.9%	-0.7%

Clearly, these results are good on a historically sequential basis and, it is no surprise that revenues and earnings forecasts were upgraded. Check Point is a relatively mature business that generates high amounts of cash flow conversion and provides investors with a compelling mix of value and growth. It is often compared with the likes of Fortinet $FTNT but Check Points end markets tend to be the larger enterprises who are in need of a comprehensive Network Security solution. In addition, the company is capable of scaling up margins and cash flow when markets are good because they offer a number of ‘blades’ with different functionality. In other words, once a company buys the platform from Check Point than they immediately become a potential customer for more blades.

Frankly, Check Point is the best in class in the sector and given continued global economic growth there is no reason why the company cannot continue to generate margin expansion. The main competition for Check Point comes from Juniper $JNPR and Cisco Systems $CSCO and with the latter in a stage of restructuring, for now, Check Point looks capable of growing market share. The question is whether the stock is correctly priced or not?

Check Point Evaluation

Turning to analyst estimates of EPS of $2.78 and $3.08 it seems that Check Point is set for low double digit growth in the next couple of years. At the current price of $59.3 (an EV of $11.43bn) Check Point trades on 21x and 19.2x earnings. Although, this seems rich, the high free cash flow conversion (around $684m) means that the share presents a compelling value proposition and I think there is a 15% upside potential to the price. A target price of $67.5 seems better value and I will wait for a dip before buying back in with that target in mind.

Check Point Still Growing Strong

A super set of results from Internet Security specialist Check Point saw the stock price initially sell off, but I believe any weakness will provide a good entry point. There has been a lot of 'selling on the news' recently in the sector and Check Point doesn't seem immune.

Firstly, turning to the results, it was a substantial beat.

• Revs of $318.5m vs. $306m estimate
• Non-GAAP EPS of 73c vs. 69c estimates

Guidance

• Q1 Revs of $268-279m vs. $276m estimates
• Q1 EPS of 59-62c vs. 62c estimates

They subastantially beat estimates but the Q1 guidance was a little lighter than analyst forecasts. However, it should be noted that this company traditonal guides under and then beats forecasts. I think the evidence suggests that Check Point will do the same in the coming quarter.


 Internet Security Sector Doing Well

In general the sector has reported positive results in the last quarter of 2010. For example, Fortinet gave very strong results, although Fortinet is more focused on the small and medium size market in Unified Threat Management. Check Point is more focused on larger enterprise solutions.

Indeed, the market seems to be on a similar growth path to what it was in 2009. This is notable because usually the first year of recovery is the strongest for corporate investment. I think this confirms that this sector is capable of super GDP growth.

In order to demonstrate this, I wanted to look at sequential revenue and deferred revenue growth.


Check Point Sequential Growth

Revenues and deferred revenues break down like this

 

(m)	Q4 08	Q1 09	Q2 09	Q3 09	Q4 09	Q1 10	Q2 10	Q3 10	Q4 10
Revenue	217.6	195.0	223.6	233.6	272.1	245.1	261.1	273.2	318.5
Seq growth %		-10.4%	14.7%	4.5%	16.5%	-9.9%	6.5%	4.6%	16.6%
Cur Defer Rev	290.0	283.1	330.0	322.8	384.3	380.9	377.0	362.9	424.2
Seq growth %		-2.4%	16.6%	-2.2%	19.1%	-0.9%	-1.0%	-3.7%	16.9%
LT Defer Rev	40.8	41.9	32.1	37.4	41.0	38.9	37.7	33.4	40.4
Seq growth %		2.8%	-23.4%	16.4%	9.8%	-5.1%	-3.0%	-11.4%	20.8%
Tot Defer Rev	330.8	325.0	362.1	360.1	425.3	419.8	414.8	396.3	464.6
Seq growth %		-1.7%	11.4%	-0.5%	18.1%	-1.3%	-1.2%	-4.4%	17.2%

 This confirms that sequential revenues in the fourth quarter were comparable to previous years. In addition deferred revenues look similar. This is actually quite positive considering Check Point's revenues are shifting slowly towards selling a higher percentage of application solutions. Much of software companies deferred revenues comes from services paid for upfront, sometimes for a few years in advance. All of which augers well for future growth.


Check Point Outlook

Indeed, listening to the conference call the management sounded bullish about prospects. However, Check Point was cautious not to attribute the growth solely to industry acceleration. Management seemed to believe that the company is grabbing market share as well as generating growth.

One aspect that is favouring Check Point, is that its offering is a diversified and multi faceted approach. Check Point sells a variety of software blades of various applications. This means that average selling prices can expand as Check Point, sells more blades into its established base. The model is proving scalable.


However, it is not just about the established base, because the company seems to be generating new clients and this is demonstrable by looking at the deferred revenues. Cash flow generation and margins remain very strong and I would expect some analyst upgrades after these results.

Political uncertainty coupled with the general climate of selling tech after results may conspire to weaken the stock price and I think this could create a good buying situation.

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Fortinet A Fast Growing Network Security Play

Fortinet is an interesting stock to research because it is a good way to play the growing computer network security market. There are a few options to investing in stocks focused on network security, but I think Fortinet is one of the best options. Fortinet is the worldwide leader in Unified Threat Management (UTM), which is a grandiose way of saying that their network security solution covers all the core security requirements of an enterprise’s connection to the internet. As such, this encompasses firewalls, virtual private networks, intrusion detection and prevention and, anti malware.

The UTM market is primarily targeted at the small to medium size enterprise (SME) and Fortinet is the leading player in this market. Competitors like Cisco are focused on large enterprise solutions, whilst similarly for Check Point Software their UTM offering is only part of their product range. IBM is a competitor but has recently been seen as a potential purchaser of Fortinet due to their tardiness in establishing market share. Fortinet is attractive to IBM because they possess a proprietary technology. Fortinet do not resell other companies products.


Fortinet's Growth Prospects

 I think Fortinet has good growth prospects and I see their key share price drivers

• Growth in the economy seeing an expansion in SME market and a willingness to free up IT spending
• Growth in internet functionality of SME market
• Benefit of a UTM ‘One-Stop-Shop’ solution for SME’s in securing inbound and outbound traffic through one appliance
• Growth in cyber crime raising awareness of security needs
• Growth in Fortinet’s top line leading to operating margins that are closer to, say, Check Point Software
• Takeover potential. IBM are strongly rumored to be looking at them

I think the first point two points are contingent upon your view of the economy. However, should the economy grow next year I think that SME IT spending has the capacity to expand in excess of GDP growth due to the fact that companies have cash on their balance sheets. Moreover, most of the surveys are indicating a loosening of the purse strings in this regard.

The increasing importance of E-commerce and the utilization of internet portals to increase globalization of trade, should drive SME’s to increase their internet functionality. In addition, there will be more emphasis placed on monitoring internet (internal and external) based threats, given the inexorable rise in cyber crime. Similarly, corporations may seek to reduce energy and personnel cost by adopting a one-stop-shop solution with a UTM system. Whilst, this is not seen as an option for a larger enterprise, an SME will have different priorities.

However, I think the key driver for Fortinet’s share price will be top line growth and its effect on their key margin metrics. If we look at the last three years we see a nice trend developing in Fortinet's numbers. I've included Check Point's metrics to 2009 by way of comparison.

Fortinet 2008 2009 Rolling to Q3 2010 CheckPoint 2009 Revenue 211791 252115 301808 791,147 Gross Mgn 71.10% 74.93% 72.87% 85.58% SG&AMgn 49.27% 45.55% 43.02% 30.00% R & D Mgn 17.49% 16.74% 15.90% 9.71% Op Mgin 2.33% 10.05% 13.95% 44.89% FCF Mgn 16.47% 22.76% 28.14% 59.82%
source: fortinet,check point software, earnings view
The last column of Fortinet numbers are the rolling four quarters to the third quarter of 2010. The drop in gross margin is explained by the fact that Q4 is normally a large quarter. Indeed, analysts have revenue forecasts of $86.57m for 2010 Q4 vs. $70.71m last year. Gross Margins for Fortinet have increased every quarter this year.  I would also caution that Q4 2010 included a tax gain of $32m which somewhat flatters the free cash flow margins in the last two Fortinet columns. However, excluding that quarter-by calculating free cash flow margin for first three quarters of 2010- still shows they are translating 30% of revenue into free cash flow. Fortinet Margin Expansion Clearly, these numbers indicate that Fortinet has room to expand margins and cash flow generation as they grow their revenue numbers. I have included Check Point Software as a benchmark for Fortinet. However, I think it worth noting that Check Point is likely to have lower SG&A margins because they sell a lot of their product range into larger enterprises (fewer customers, bigger ticker values). In spite of this, I think there is plenty of potential for Fortinet to grow and for these catalysts to be realized in the share price. Fortinet Evaluation Fortinet trades at a price of $31.35 and a market cap of $2.31bn with $290m in net cash. On a back of envolope assumption of 30% FCFMargin and analyst forecasts of $370m in revenue for 2011 I would say that a forward FCFYield of 4.8% is cheap for a business growing revenues, earnings and cash flow at mid teens plus rate. You won't get this kind of growth by buying a 10 year note! I picked some up.