Check Point Looks To Manage Its Own Threats

By Stephen D. Simpson, CFA | July 20, 2011 AAA

Most companies of any repute strive to be the best in their industry, but of course only a very few ever manage to pull it off. Even for those who succeed, and security specialist Check Point Software (Nasdaq:CHKP) deserves to be on that list, it is not all parades and plaudits. The trouble for Check Point, as it often is for industry leaders, is the pressure to stay on top of the game and preserve both growth and margins. It's no easy task and the extent to which Check Point succeeds will determine how much is left in the stock.
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Secure Second Quarter Results
Check Point had a respectable second quarter. Revenue rose 15% from last year (and about 7% sequentially) and that was enough to surpass the surprisingly tight range of analyst estimates. Growth was well-balanced between products and services, as both grew at about the same 15% clip. Billings growth was solid, but the small uptick in days sales outstanding would seem to suggest that more orders came later in the quarter than before - a development that does not seem so serious now, but bears watching.

Check Point's margin performance was also solid. Gross margin ticked up a bit from last year's level. Operating income also improved - up 23% by GAAP accounting and up 18% by the company's non-GAAP methodology, with a decline in amortization expenses comprising most of the difference. One minor detail that jumps out of the operating items is the company's sales leverage - Check Point saw a 15% increase in sales, but just an 11% increase in sales and marketing spending; that is sales leverage that is sorely lacking among some of the cloud plays of the day like Red Hat (NYSE:RHT) and Salesforce.com (NYSE:CRM).

Whither the Margins?
One of more common concerns around Check Point is whether the company can continue to explore new avenues of growth and also maintain its margins (and, by extension, it's incredible cash flow conversion). The company is doing well, for instance, in its move into security appliances (where it seems to be taking share from Cisco (Nasdaq:CSCO) and at the very least holding its own against Juniper (Nasdaq:JNPR), but hardware typically does not carry the same margins as software.

Likewise, there is a threat that at least one of the companies among the likes of Fortinet (Nasdaq:FTNT), Intel (Nasdaq:INTC), Symantec (Nasdaq:SYMC) or Sourcefire (Nasdaq:FIRE) might try to fight for share on the basis of margins. After all, unwise as it may seem, there are certainly customers out there that will settle for "good enough" security solutions instead of paying up for best-of-breed. To be sure, it is unlikely that there would be an industry-wide price war, but it only takes one or two companies desperate to make numbers for a few quarters to get the Street in a tizzy for the whole sector.

Time For Some More M&A?
There's no getting around the fact that M&A is a way of life in the software space. While the "must-have" product category may change from time to time, and applications and middleware now looks rather picked-over, security is almost always of interest to someone. Might Oracle (Nasdaq:ORCL) , Microsoft (Nasdaq:MSFT), or Google (Nasdaq:GOOG) take a run at an up-and-comer like Fortinet (despite its high valuations)? Or maybe Cisco has not entirely sworn off M&A as a way to turn its ship around.

Whatever the case, M&A cannot be ruled out as both opportunity and hazard. Investors would probably not be thrilled to see Check Point do a major deal, nor is this company likely to get a bid itself, but the risk of a new entrant swooping in on one of Check Point's smaller rivals cannot be entirely dismissed.

The Bottom Line
Check Point is a trying stock for the value-oriented investor. Admittedly tech is not a very hospitable home to value investors in general, but Check Point offers that maddening trade-off of great market share, great margins and great returns on capital ... in exchange for multiples and a cash flow model that don't look screamingly cheap. Perhaps the best simplification of Check Point is this - investors who believe that Check Point can maintain or improve margins should like even today's prices, while those worried about erosion due to a changing product mix may want to hope for a sell-off/pullback before stepping up to buy. (Find out how the PPI can be used to gauge the overall health of the economy. Check out Predict Inflation With The Producer Price Index.)

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