Check Point Enjoying A Rare Tailwind, But It Won’t Last (NASDAQ:CHKP)

I had mixed feelings on Check Point Software Technologies (CHKP) a year ago, as I thought the shares were priced for some decent returns, but also didn’t see much going on with the business that would break it out of its prolonged doldrums where growth was concerned. Since then, the shares have basically kept pace with the S&P 500 and Palo Alto (PANW), but have been left behind by smaller players like Fortinet (FTNT), Sailpoint (SAIL) and Zscaler (ZS).

This current environment may be about as good as it can get for Check Point, with security spending holding up as an essential area where enterprises won’t look to cut costs, work-from-home driving some incremental sales opportunities, and Check Point’s large recurring revenue base providing some security at a time when there are still a lot of modeling uncertainties. I’m still worried about Check Point’s relatively modest leverage to cloud security, though, and what that could mean for margins five or 10 years down the road. The valuation isn’t bad here, but I believe near-term outperformance would be more likely driven by another wave of pessimism/fear hitting the markets.

Good Second Quarter Numbers As Product Revenue Growth Comes Back Into The Picture

Check Point had a good second quarter, as those aforementioned positive drivers all chipped in to help. Revenue beat expectations by 4%, with a nearly 14% beat on the product line and a small 2% beat at the subscriptions line. Gross margin was slightly better than expected, while reduced operating expenses helped drive a 10% operating income beat and a nearly three-point operating margin beat.

Revenue rose 3.6% this quarter, almost exactly in line with the quarterly average over the past three years. Product revenue rose 1%, the first growth in almost three years, helped by increased demand for physical firewall appliances in general and good initial acceptance of the new Quantum line (introduced in April). Subscription revenue rose 10%, while maintenance revenue rose 1%.

Gross margin was stable with both the year-ago and quarter-ago periods, while operating income improved 5% and operating margin improved 60bp from the year-ago period. Operating income also rose about 5% sequentially, with margin up about 260bp.

Deferred revenue rose 4% yoy and fell 4% qoq, with short-term deferred revenue up 5% yoy and down 3% qoq. Billings were strong, up 7% yoy and 10% qoq, beating expectations by 11%, and I believe there was actual growth in product billings, something that I don’t believe has happened since the second quarter of 2017.

Serving An Essential Market

Enterprises are not going to look at their IT security budgets as a rich source of cost-cutting opportunities, and in fact many CIOs have reported that attacks have increased – I’d guess that would-be attackers would assume that companies are distracted given the challenges and chaos created by COVID-19. What’s more, in order to support increased work-from-home loads, many customers are reported adding more firewall appliances to data centers.

That’s all good for Check Point, and I believe the company is also getting a boost from its new Quantum appliances. These new products include higher-value subscriptions (like Sandblast) and they’re a better suite of products overall in terms of performance characteristics, but Check Point has priced them at prices similar to the older generation, leading to an attractive value proposition and strong initial interest. It’s also worth noting that Quantum appliances are integrated with Maestro – Check Point’s hyperscale security offering.

Check Point also introduced the 1570R appliance – a security product for critical industrial functions like industrial control systems (or ICS) and SCADA (supervisory control and data acquisition). Think about the havoc that someone could wreak by hacking into a refinery’s control systems and you can understand why this product gets my attention – particularly in the context of more companies adopting industrial IoT and remote maintenance/monitoring functions and creating some new system vulnerabilities/attack points.

Is This Enough?

While this should be a relatively good time for Check Point, again I note that growth was simply in line with the average of the past few years, and I don’t see a meaningfully acceleration as particularly likely.

A big part of the problem is that Check Point remains overweight to what I’d call more “legacy” applications (like physical firewall appliances), and the company hasn’t been as aggressive as peers like Palo Alto, CyberArk (CYBR), Okta (OKTA), Zscaler and others in building up its capabilities in areas like access management, secure remote access, and cloud security.

Check Point did offer some rare detail about its cloud business, disclosing that it is about 10% of the overall business and growing at 70%, but I’m worried that this business can’t grow fast enough to offset pressures on the legacy operations. Yes, Check Point does have a strong recurring revenue base and a large base of installed customers that aren’t going to be ripping out their systems, but I worry about what the margins will look like in the coming years as these areas of security are seen as less “core” and competition shifts more toward price than feature sets.

The Outlook

The fate of margins makes a big difference in a discounted cash flow model. Over the last decade, average adjusted trailing FCF margins have migrated from the high 50%’s to the low 50%’s. If Check Point’s adjusted FCF margins decline from a recent multiyear average of around 51% to 47% (over the next decade), fair value is in the mid-$120’s. If Check Point can somehow maintain a steady level of FCF generation (51% adjusted FCF margins), the fair value jumps into the low $130’s. Revenue growth also certainly plays a role here; my base-case estimates drive a long-term revenue growth rate of around 3.5%, and my growth expectations are a little higher than the Street’s.

A blended growth and margin model is a little more generous to Check Point, supporting a forward revenue multiple of around 7x and a fair value in the high $120’s.

The Bottom Line

I don’t dislike Check Point. Appreciate it for what it is, and it is a pretty impressive company. I do think, though, that the company has under-invested in new growth opportunities, and I worry that Check Point’s historical “fast follower” strategy is going to lead to the company getting left behind, leaving growth stuck in the low-to-mid single-digits. High-margin/low-growth software names can work, but they can also be frustrating names to hold, and while Check Point’s valuation can still support a high single-digit annualized return from here, it’s not my preferred idea.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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