Is This The Turn For Check Point?

By Stephen D. Simpson, CFA | July 18, 2013 AAA

Waiting for the right time to jump into Check Point Software (Nasdaq:CHKP) was a trying exercise as the company's product revenue growth continued to grind lower and then turn negative. And now with the shares up almost one-quarter over the last three months, it looks like Wall Street has already moved on the recovery trade. The one solace for investors who've missed the move (myself included) is that even with exceptionally conservative assumptions, Check Point still does not look like an expensive stock and this company virtually mints money.

Results Still Weak, But Are They Turning?
At the risk of being accused of trying to spin Check Point's results in a positive light, I think this is a case where soft-looking results are actually starting to look better.

Revenue was up 4% this quarter and slightly ahead of expectations (less than 1%). More interesting to me is that the revenue was up 5% sequentially. Likewise in product revenue – year-on-year, Check Point saw another decline (-2%), but revenue grew 13% on a sequential basis.

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Margin and profit performance was likewise somewhat lackluster, and without the same sequential improvements. Gross margin was basically flat on a year-on-year basis, and down slightly sequentially, while operating income rose 2% from last year and fell 3% sequentially.

Will The Trade-Down Ease Off?
One of the challenges that Check Point has been dealing with, in addition to the generally unappetizing IT spending environment, is that its systems are arguably too good for the company's own good. In many cases, customers have stuck with Check Point products, but taken advantage of the constant improvements to upgrade the performance relative to their existing system, but at a lower price (in other words, the “feature-adjusted” price is now lower).

Hopefully Check Point is largely past that cycle. At the same time, the company has introduced two new attractive appliance lines (the 600 and 1100) that should help perk up revenue later this year, the former (the 600) offering an interesting potential challenge to Fortinet (Nasdaq:FTNT) in the smaller business space. Elsewhere, the company is turning more of its attention to threat emulation (where it will challenge Palo Alto Networks (Nasdaq:PANW) and mobile information protection. Of course, Palo Alto isn't going to take this lying down, and major rivals like Cisco (Nasdaq:CSCO) and smaller contenders like Fortinet and Sourcefire (Nasdaq:FIRE) aren't going to ease up either.

Will The Market Allow For Continued Success?
I do still see some threats to the Check Point story. For starters, I would expect that the weak IT environment has clients/customers increasingly pitting companies against each other in the attempt to force one to cave on price to get the deal. Longer term, I wonder if the trend towards consolidating data centers and shifting more business towards PaaS vendors like Amazon (Nasdaq:AMZN) is going to undermine market growth – although Check Point could actually benefit from that, as they would seem to be better-suited to meet the higher demands of a larger, consolidated data center.

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I'm also still concerned with margins and cash flow generation. You just don't see companies regularly convert 60% of revenue to cash flow, and I don't expect Check Point to be able to keep it up. Consider the 600 appliance, for instance. I just don't see how the SMB market will support 50%-plus operating margins, so Check Point is going to have to think about how much margin it is willing to trade for better growth.

The Bottom Line
For as long as I've followed Check Point (and thought the stock was undervalued), missing the roughly 25% move over the past quarter has been aggravating and frustrating. That said, I think this “meet and maintain” quarter will represent the bottom of the cycle, and I believe the company should start reporting better growth in the coming quarter. It won't be the sort of growth that has investors confusing this company with Palo Alto, but any growth will help at this point.

Even very conservative assumptions suggest these shares are still cheap. If I project 5% revenue growth and less than 2% free cash flow growth (assuming a big reduction in margins/free cash flow margin), the resulting fair value is still more than $61. Moreover, with Check Point having so much cash on hand that management could take Scrooge McDuck-style swims through it, the opportunity to add growth through acquisition or continue on with substantial buybacks should help underpin the shares.

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