Not too many tech stocks get a second act, and Check Point Software's (Nasdaq:CHKP) heyday was back in the mid-to-late 90s, alongside companies like Cisco (Nasdaq:CSCO) and Symantec (Nasdaq:SYMC) that have likewise been unable to recapture former glories. The question for shareholders, though, is whether oncoming next-gen competition will damage this business as much as feared and whether they have the patience for the Street to come back around to the value of this business.
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Q2 Results More Relief Than Remarkable
Check Point's second quarter results didn't dismiss the concerns about its declining growth rate, but at least they seem to be broadly better than feared.
Revenue rose 9% from last year and 5% from the first quarter, as product revenue increased 12% sequentially (on a 20% increase in enterprise appliance unit volume). Service revenue growth was more subdued, though, growing 1% from the first quarter. Curiously, while Check Point's large exposure to Europe (roughly 40% of sales) is seen as a threat, sales in this region grew faster than in the Americas.
Check Point continues to operate a supremely profitable enterprise. Gross margin improved more than a half-point to over 88%, while operating income rose 4% from the first quarter on higher selling and marketing spending.
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Can Check Point Withstand Next Gen Competition?
Check Point's territory has gotten substantial more crowded in recent years, and it looks like competition is only going to intensify on the hardware side. Palo Alto Networks looks set to be the new darling in security hardware, and both Fortinet (Nasdaq:FTNT) and Palo Alto use a more advanced technology than Check Point.
If that weren't enough, Cisco (Nasdaq:CSCO) seems serious about trying to stay relevant in security, and F5 (Nasdaq:FFIV) believes this can be a growth market for it as well. And then there are also companies like Sourcefire (Nasdaq:FIRE), Intel (Nasdaq:INTC) and Dell (Nasdaq:DELL) all looking to make their mark.
That's a crowded space (and there are still more companies I could list), and it puts substantial pressure on Check Point to continue to innovate. Unfortunately, if the bears are right, Check Point may be boxed in and forced to compete on the basis of offering cheaper, less cutting-edge solutions. That wouldn't necessarily doom the business, but it won't help sentiment at all. Of course, the alternative - upping R&D spending and/or doing an expensive deal for an up-and-comer - carries its own risks as well.
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Go Bigger or Go Home?
I still happen to believe that Check Point's long history and solid reputation in enterprise security gives it some leverage against those competitors that view security as more of an add-on market. Nevertheless, Palo Alto and Fortinet are clearly making their mark at a time when it seems Check Point is more interested in talking about large buybacks.
I do wonder if a company like EMC (NYSE:EMC) would think about acquiring a security business, but given EMC's preference to pay up for tomorrow's technology, I'm not sure that Check Point would fit the bill. EMC isn't the only fish in the sea, but I wouldn't bank on the thesis that Check Point draws a bid - rather, I think Check Point ought to be thinking about the investments it needs to make to stay near the top of the leaderboard in what is still a very attractive market for the long-term.
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The Bottom Line
I'm a fan of Check Point, but to check my own enthusiasm I try to take a more conservative stance on their forward growth prospects. To that end, I forecast less forward revenue growth (mid-single digits) and less free cash flow conversion than even those sell-side analysts who rate these shares as "Neutral." Even still, an estimate of 5-6% forward free cash flow growth still produces a fair value in the mid-$60s.
While I think there is definitely value in Check Point shares, investors need to be realistic about how an investment here might play out. The stock still carries a double-digit EBITDA/EV multiple and Wall Street is well-nigh obsessed with top-line growth at tech companies. Consequently, this could be a stock that just muddles through for long stretches of time and investors need to have a long-term horizon to see the value come out in these shares.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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