Tickers in this Article: CHKP, PANW, FTNT, FIRE
It's probably true that Wall Street predictably and consistently undervalues the service/maintenance revenue streams for tech companies - I thought it was true of Quest, which was recently acquired by Dell (Nasdaq:DELL), and I think it's true of both CA (Nasdaq:CA) and Check Point (Nasdaq:CHKP) today.

The problem for Check Point, though, is that the enterprise security market is changing and it's not clear that Check Point has invested enough R&D dollars to stay competitive. While it will be some time before rivals such as Palo Alto (NYSE:PANW), Fortinet (Nasdaq:FTNT), Sourcefire (Nasdaq:FIRE) or Dell's SonicWall can take their lunch money, better product growth is going to be an essential part of maintaining the value of this business.

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Q3 Growth Grinds to a Lower Gear
Decelerating growth has been a challenge at Check Point for a while now, and it didn't get any better this quarter. While the company continues to grow (revenue was up 8%) and it met expectations, flat year-on-year growth in products was disappointing. A 1% decline in billings was also unwelcome news, though this number tends to be volatile. It's also worth noting that neither Sourcefire nor IBM (NYSE:IBM) impressed the Street with their respective performances this quarter.

Profitability was fine for this quarter. Gross margin actually improved more than two points, helped in part by the greater contribution of services/software. Operating income jumped 15% on a GAAP basis, setting up a curious dichotomy with Sourcefire - where the revenue growth was much stronger, but the operating income performance was significantly weaker.

SEE: Understanding The Income Statement

So, How Much Should Investors Worry About Growth?
Even for a company with Check Point's absurdly high margins and free cash flow production, growth is the driving concern for most investors. On that front, ongoing deceleration in revenue, despite new product launches, is hardly encouraging news.

However, maybe things aren't that dire. It's true that Sourcefire and Palo Alto use different, more advanced technology in their hardware, but that's largely only needed for the biggest and most complex clients - for much of Check Point's core client base, that's simply more horsepower (and cost) than they need.

Moreover, Check Point is seeing some trading-down during this period, as customers opt to go with cheaper options. Although that's not a good thing in its own right, at least that business is staying within Check Point - and maybe reflective of a tougher/weaker macro environment than analysts and industry participants have been willing to acknowledge.

There's Still Opportunity, but the Window Won't Stay Open Forever
Obviously, I'm concerned that Check Point has underspent on R&D and can't go toe-to-toe with companies like SonicWall, Palo Alto, and Fortinet in terms of technology. I'm also concerned that the company didn't take full advantage of the opportunity to exploit Cisco (Nasdaq:CSCO) and Juniper (NYSE:JNPR) when they were distracted and under-executing. Last and not least, I worry about whether management still thinks in terms of shaping/leading the market, or whether it is content to farm its considerable client base and simply react to what newcomers like Palo Alto and F5 (Nasdaq:FFIV) do in the market.

The good news is that the company still has a large user base and a very large amount of cash on the balance sheet. I don't mean to suggest that reestablishing technology leadership is a simple matter of throwing handfuls of cash at engineers or patching over past missed opportunities with M&A, but it's a lot easier to get a business back on track without the pressures of a bad balance sheet.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
I don't have an especially great amount of confidence that Check Point management really wants to shake things up and challenge the likes of Palo Alto for leadership in aspects of security that only engineers are likely to fully appreciate. While I respect that Check Point's growth potential is likely underestimated and that the company can continue to drive good profits and cash flow from its existing configuration, I also realize that Wall Street isn't going to buy that so long as revenue growth keeps shrinking.

I realize that a company with a double-digit EV/EBITDA multiple and a six times-plus multiple on trailing sales is not cheap at first blush. However, when you consider cash flow, just 4% free cash flow growth (almost one-third the rate of growth over the trailing decade) is enough to drive a fair value above $60. Consequently, I do believe there is real value in these shares, but I think it's going to take patience and maybe even some investor activism for that value to make its way into the actual share price.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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