Wednesday, January 30, 2013

Check Point Software Disappoints Again

I’ve long been fascinated at how different investment perspectives can produce dramatically different conclusions over stocks. The only sure conclusion I’ve drawn with any certainty over the issue is that investors should stick with the investment approaches that they advocate. With this in mind I decided to sell my position in Check Point Software (NASDAQ: CHKP) not because I don’t think it is a ‘buy,’ but because it has now become much more of a value play rather than the kind of GARP stock that I buy/hold.

Check Point Software Earnings Analysis

Check Point revenues came in below analyst forecasts and slightly below the midpoint of the wide guidance it gave at the last set of results, although non-GAAP EPS came in at the top of internal guidance at 91c. Moreover, the guidance was weaker than expected:
  • Q1 revenue guidance of $320-332 million vs. consensus of $334 million
  • Q1 non-GAAP guidance of 74-80c vs. consensus of 80c
  • Full year revenue guidance of $1.4-1.45bn vs. consensus of $1.45bn
  • Full year non-GAAP EPS guidance of $3.30-3.50 vs. consensus of $3.48
In general the top end of guidance is holding on to the analysts’ consensus. On a more positive note, Check Point does tend to be conservative in its guidance, and the global economy has been weaker in the second half of 2012. Nonetheless there are a few worrying signs here.

Firstly, I want to outline how product sales growth has now turned negative.

This is not a problem in itself because recall that Check Point bundles software blades with its hardware platform, so pricing of software/hardware can change within the bundle. In addition, Check Point has been managing a transition to a new product appliance line and dealing with a weaker global economy (Europe is traditionally around 40% of its sales). Both of which have turned product & license sales growth negative in the quarter. Meanwhile software blade growth has remained impressive.

Deferred Revenues Growth Weaker at Check Point Software

Focusing purely on product and license sales can give a misleading picture. In order to calculate how Check Point is performing I like to add together total revenues plus the change in deferred revenue. This metric has also been in decline.

Indeed the company is aware that investors look at deferred revenues because it outlined the key reasons why growth was lower here.
  1. A tough comparison with Q4 2011 which saw a strong rise in early long term bookings made
  2. Software blades deferred revenues rose less than last year.
  3. Product sales growth slowed (due to the transition) so associated services bookings were lower too.
Furthermore, the product transition also seems to have encouraged some trading down. Check Point argue that the new portfolio of appliances have three times the performance. This has had the unfortunate affect of encouraging customers to pay less in order to retain the performance they had before, and average selling prices (ASP) have been dragged down accordingly.  In other words, customers are taking the opportunity to save money rather than upgrade. Frankly I wouldn’t expect anything less in this environment.

When questioned on the issue of the assumptions made for ASPs in the guidance, management replied that they had forecast them to be ‘stable’ and noted that although they had declined in 2012 there was an ‘improvement in the trend’ in Q3 & Q4. It sounds good, but I’m not sure if this means a de-acceleration in a downtrend or that a trough as been passed in ASPs. Such considerations are important when viewing Check Point’s guidance.

What the IT Security Industry is Saying

Whenever independent analysts like Gartner report on the industry, Check Point is consistently seen as the leading player in terms of sophistication but not necessarily offering the most cost effective solution. Indeed, nascent rivals like Palo Alto (NYSE: PANW) appear to be taking some share from the incumbent firewall players like Check Point, Juniper and Cisco Systems (NASDAQ: CSCO). At the last set of results Palo Alto confirmed the market was still growing and talked of major firewall wins against CHKP and a number of data center security wins vs. CSCO.

Furthermore, it mentioned some aggressive pricing competition in the quarter. Ever since then analysts have been looking to downgrade estimates for the leading firewall players, and investors have to ask whether the decline in CHKP’s ASP is really a pure function of customers trading down because of better ‘bang for buck’ performance or whether there is an attempt by CHKP to kick start unit sales via aggressively pricing hardware/software bundles.  Perhaps the most interesting company right now is Fortinet, whose Unified Threat Management (UTM) solutions are better tailored to smaller companies. It may be a beneficiary of ‘trading down’ as customers look to choose more cost effective solutions over technological sophistication.

Elsewhere Cisco reported good-but-slowing growth in security, and there is a feeling that it needs to make an acquisition here to refresh its approach to the sector. All eyes naturally turn to Palo Alto, which is why I would look away. As a rule I don’t think it’s a good idea to chase richly rated stocks when there is a feeling that speculators are buying the stock and hoping for a bid.

Where Next for Check Point?

This stock is a strong value proposition, but with every value investment there must be a clear pathway to an ‘outer.’ In the case of Check Point ignore the 17x PE and focus on the fact that it is a prodigious free cash flow generator. It just generated 9.5% of its enterprise value in free cash flow and even with only high single digit earnings forecast for this year, the stock looks cheap.

On the other hand, there has to be a clear value outer. To its credit, CHKP is engaging in stock buybacks, but I think it is long since time that the company paid a dividend. The evidence is that when companies like Cisco get with the reality and start becoming an option for income investors then they will get a re-rating

On the conference call the management made it clear that it would not make acquisitions unless they added to the strategy of the company. This seems to be to try to maximize cash flow out of its installed base and from the shift to software blade sales while retaining technological leadership. This is fine but it does indicate a maturing company that is hoarding cash on its balance sheet while its rivals are snapping at its heels. In addition, declining ASPs are never a good sign, especially when accompanied by weak product sales growth.  The hope is that marketplace demand grows into the type of solutions where CHKP is cost effective, but this could take time.

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