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Executives

Tal Payne – Chief Financial Officer

Kip Meintzer – Head of Global Investor Relations

Check Point Software Technologies Ltd. (CHKP) Credit Suisse 2012 Technology Conference November 27, 2012 12:30 PM ET

Moderator

All right, good morning everyone. Very pleased to have Check Point joining us again this year. From Check Point we have the Chief Financial Officer, Tal Payne and of course everyone knows Kip and I will turn it over to Kip because I believe he has some forward-looking statements, disclaimers, the Safe Harbor.

Kip Meintzer

So just highlight for everybody, obviously during the course of the presentation there may be some forward looking statements. These are covered in accordance with the Securities and Exchange Act of 1934. The company takes no duty to update any of these forward looking statements. If you’d like a comprehensive list of these statements, you can look at our latest 20-F filed for December 31 2011 and with that, I’ll pass it back to Phil.

Moderator

Great. Tal, one of the things that’s been talked about a lot this year on your various calls has been the ASP impact of some of the new product and platform, the leases and just sort of the trading down effect of people taking these high performance boxes at low price points. Could you just update everyone that might not be as familiar to where we’ve been and what the impact is going forward and when you see this as getting past this.

Tal Payne

Sure. So maybe I’ll start from the beginning just to make sure everybody is with us. Check Point started to sell appliances in 2007 and since then every year we expanded the product line. So we started with UTM and then we expanded to Power-1 and then in 2009 we acquired the Nokia Security business with the IP series appliances and this actually for the first time in our history we refreshed the whole product line at the end of last year. So we took all the products, include the Nokia series and Check Point UTM and Power-1 series and refreshed it to about eight appliances instead of all of the above which in essence provided for every price level on average three times the throughput.

The importance of that for us was that (a) we wanted to provide a lot more throughput to the customers so over time they will be able to adopt our software blades which are software modules and in order to have good performance, they have to have the right products. So that was the idea behind it. The first time we’re doing it and what happened this year we see two phenomena. We started in the beginning of this year to see a big effect and we see on the one hand much more customers buying the product.

So number of units increased significantly. It’s been many years since we saw such an increase in number of units. We see a double digit growth in number of units. Strong growth is going to be between 15% to 25% depends on which quarter from Q1, Q2 and Q3. So we started already for three quarters.

On the other hand, referring to your question, we see a mixed shift of customers choosing on average one level down which created then a reduction in the average ASP. So on the one hand we saw a significant increase in number of units which meant our competitive environment is improving. Our customers liking the product, getting them quickly and buying more units and on the other hand we see a reduction on the ASP which brought us to the results of pretty much flat product revenue growth.

Moderator

So when you restart – should we just think of it as almost anniversary? Do we just need to get through the 12 months, so Q1, Q2, and then we’re starting to actually compare then to apples to oranges. Is that the right way to think about it I guess?

Tal Payne

I think that’s the right way because when you think – luckily for us the transition was quick. So sometimes an anniversary can take two years because if you start only 20% and then 40% and then 605 of your product bookings from the new product line, then it takes longer to see the transition. Lucky or not lucky we saw a very quick transition. That’s why it was a big reduction starting already from the beginning of the year. I think it was more than 50%, probably around 60% of the new product that we sold in Q1 was already the new appliances and in Q3 already around 80%.

It was a very quick transition which means when we get to next year, then Q1 versus Q1 is almost anniversary, like more than 60% is anniversary and then in Q3 it’s already 80% which means next year the comparables when it comes to the ASP is more of a fair comparable and now if we succeed next year to continue to increase the number of units we should see growth in the product booking as well and not only in the units.

Moderator

Now obliviously where you mentioned you were seeing phenomenal growth in the unit side, but also a key part of your strategy has been your blades and blade attach. Wonder if you could just maybe level that for people. What is your blade strategy where we are in the game so to speak and what we’re seeing in terms of blade attach and renewal rates?

Tal Payne

Sure. So in mid 2009 we launched the software blade architecture which an enabled customer that has our software to adopt over time addition of blades. When each blade it’s not a hardware blade, it’s a software blade, think about it like a module, that allows them to add additional security functionality. So a customer could have had only firewall and VPN and then a few years down the road you could have chose to adopt URL filtering, antivirus, anti-Bot, IPS application control and so on.

So every year we introduce a new software module. So far that’s what happened which allowed the customers, assuming they already have the right operating system to adopt this additional functionalities. The benefit is very significant for customers because before our solution customers had to purchase a separate point solution and for each one of them it required a separate hardware. So if you had the firewall on Check Point Gateway and you wanted to have IPS as well, you had an IPS appliance separately and URL filtering separately in a separate appliance and so on.

Now if you choose our solution you will be able to use the same hardware platform or the same gateway and just adopt additional software module in a way that (a) it makes it much more cost beneficial obviously because you don’t have to pay twice for hardware. But also the software is consolidated in a way that it’s increasing the security of the customer. So that’s the software blade. Since we launched it every year we launch a new product.

Just recently we launched the anti-Bot. last year we launched the application control. So those blades are on early day. The most – all of these blades from mid 2009 was IPS and that is as of today number one blade for us. We started from a very small business of the low tens of millions. At the end of last year the run rate reached $200 million and we think that’s a big potential because it’s still a very small portion of the potential.

Many customers still don’t use the blades or these additional blades. Obviously anti-Bot most of them don’t because we just launched it. Application control we already installed tens of thousands for fraction of the point solution. IPS we sold 100,000. So it’s a great potential. Majority of the customers still don’t use most of them so it’s always an additional potential there.

Moderator

Let’s spend a minute just on the application control blade in particular because that seems to be obviously a big focus point in the industry, but also just with the investors. There’s a bet amongst some of your competitors too about just is application control in the blade different than how Palo Alto treats application control. When you talk to your customers and you do the third party analyst of the throughput and the security and the control, the features, how do you I guess compare the two? How do you think your customers feel about the blade strategy versus the way the Palo Alto describes theirs?

Tal Payne

Sure. So maybe I’ll start first with what’s happening in the market in general because I think it will help because it’s happening not only in the application control but in many other adjacent markets. So historically all the markets were separate. You had the firewall market was separate from the IPS market was separate from the URL market was separate from maybe application control market. So it depends where are you on the cycle. And then over time as that point solution becomes more of a commodity, you see it consolidating into the main market as additional solution on the main gateway. And if you look in 2006 you already saw firewall, VPN and then they called it UTM. What is the UTM? Firewall VPN Plus. Plus depends on the vendor. It can be plus antivirus, anti spam, URL filtering, some have plus IPS.

We have plus any software blade you want. So it can be plus 20 different solutions. So it depends which vendor. So what happened in reality over the last few years exactly as we predicted is that you see some consolidation. The more commodity, the more it tends to consolidation. The less commodity the less it tends into it and when you look at the customer base, the lower end you go the more you see a need for consolidation. The higher you go the less because there are more budgets. They want the best breed with the most specific feature and then you see much more solutions at the customer. So I think it depends which customer you look at. When you look at the high end, typically application control just like IPS is a separate solution and there you see us, you’ll see Palo Alto.

So there you’ll actually see most of the players in the security. Two years ago I think, or three years ago Palo Alto had the only products for that adjacent market that’s called application control. Now unfortunately everybody has it. We believe we have probably the best product out there. But you can read different reports saying different things. So it depends who you ask. But in general it’s now a market that everybody plays in as an adjacent market. When you go lower into lower end customers, then they want one product. So one product depends which customer. The ones they want best grid, the most security flexible solution which is our solution.

The lower you go it becomes about a price. It’s typically a war between Fortinet, Cisco, maybe Palo Alto. So I think it depends where you look at. As a seller’s solution, as a point solution, at the high end you will see a few players. Typically it will be us or sometimes Palo Alto. Depends which end it’s coming from. When you go to sell the full solution what the market calls next generation firewall, it’s a new word for the UTM, just slightly more sexy which is okay. But it’s basically selling that consolidated solution to mid low end.

Moderator

And now a lot gets made about the competition between you and Palo Alto, but you’ve got this just kind of my Serengeti thesis, that you don’t have to necessarily fight each other because you’ve got two dead zebras sitting right there you can feed off of in Juniper and Cisco. Don’t tell them I said dead zebra. With that sort of idea, what are you seeing from them? Because they seem to be late to the application control game. I think most reviews would say you guys and Palo Alto and application control, even through these people check the boxes. What are you seeing from those competitors in terms of just pricing versus you guys and just win rates?

Tal Payne

So I think in theory you’re right in the sense that we are doing good and some other big players not doing that great. You mentioned their names, the zebras. But in reality it’s slightly different in the sense that this is a market that is entrenched and if you read the latest IBC report then Check Point for the first time has been declared number one. We’ve always been number one although we think we would be number one but now IBC said we became number one in the main market in the UTM and firewall market. And number two is Cisco and according to their number we are 30%, maybe I’m wrong slightly in the percentage, but together we’re about 60%. 30%, 29%, 60% and number three is with 10% or 12%. So the main players are quite large and it’s not easy to change size. You have a lot of rules.

You have a lot of information in the system. You build a lot of your network around that security solution and you don’t run quickly to change either way from us or from Cisco or from Cisco to us or whoever. You really – it happens very rarely that customers change vendors. So it’s relating in general to all the competition. Typically the – and that’s why I say typically the competition will be for additional solutions. So the customers say I will like to have additional solution or I’m expanding my network, that’s when you will see bids and more competition, unless on the regular day to day refresh and renewal, then of the existing installment. Still that as well, but less than people think.

Moderator

Got it. And last ten minutes here I’ll ask one more question and then I’ll open up for the audience even though I’ve got more here. September quarter there was a lot of confusion about the deferred revenue results that you guys posted. There are four main drivers I think it’s renewal rates, the tax rates, it’s the shifting of when renewals come in quarter to quarter. There’s also some rev rec issues that you talked about too. Maybe you can step us through and sort of say what kind of path in Q3 provides more clarity and how we should think about this going forward.

Tal Payne

It’s not a rev rec issue. It’s more of a – it goes into the deferred when you issue an invoice and some of the booking we didn’t issue an invoice therefore you didn’t see in the deferred and that happens all the time. It’s just that this quarter the number was higher therefore you couldn’t see it in the deferred .but I would start with what happened. Basically when people calculate it, we don’t refer to the booking. We refer to our revenues and deferred revenues. But people calculate billing and according to their calculation it was a negative billing this quarter of I think 1%. So what I provided I provided the date of the booking this quarter specifically just in order to shed more light and actually the booking growing close to mid single digit. A few things affected us. A, we talked about Europe in general. We said Europe was weaker. We sell in dollars. Customers budget in local currency.

So it’s reduced the buying power. Therefore it’s probably pushed more of the mixed shift into the lower level which affected our ISP. So we covered that area. Secondly when you look at the deferred revenues year over year, it actually grew and I think it was 10% or 11%. So it was a good growth. The reason you didn’t see it in the billing because last year we had a lot of long term contracts. So obviously they don’t repeat this year. If you look at Q3 and in Q4 last year you see an increase in the long term contracts. When you have that increase obviously you won’t see it next year in the billing. You will see it in the deferred revenue short term and that’s why you need to look at the deferred revenues .and by the way I always say don’t’ look at the deferred revenues. In total look at the long term and short term separately. Short term is more reflection of run rates. Long term can fluctuate easily. So that’s exactly what happened and I think that’s the main item.

Moderator

Okay. Great. Well, I’ll pause for a moment to see if there are any questions in the audience. Otherwise I’ve got multiple more here. Just raise your hand. We’ll bring a microphone over.

Question-and-Answer Session

Moderator

All right, well people are still thinking about the questions. So I…

Tal Payne

I think you need to give them the next 60 seconds.

Moderator

60 seconds. So raise your hand if you have any. But one of the things that I also want to talk about too is just your margin structure. Obviously you guys have done a phenomenal job on the operating margin side of it the past couple of years, but even in the context of growing revenue and then transition to more appliances, how should we think about just your goals when you think about balancing your topline growth and margins going forward?

Tal Payne

Whenever people ask us we say we don’t manage our margins that way. The reason is that we have quite a high margin from our software sales, from our appliance sales, from software blade sales, from most of our product mainstream product and service revenues carry healthy margins. So our focus is to grow the revenue then when you succeed to do that then everything works in the bottom line as well. You look at the last five years it was from I think from 53 it moved to 58. Depends which quarter, seven, eight, nine, sometimes even 60. So we don’t manage it that way. We focus on growing the revenue. The thing that can affect the margin is obviously which one drives faster, right? Software blades carry very high margins. Appliances carry high margin but obviously lower than the software. So if software blade pulls stronger it can pick the margin up and if appliance pulls stronger it can increase the profit, but reduce slightly the percentage of the margin.

Dollar has effect. 405 of our expenses are in local currency. So when the dollar is getting stronger then it helps you and when the dollar gets weaker then it hurts you. On the other hand in the revenues it’s exactly the opposite because when the dollar is stronger it’s theoretically helped in the translation of our local currency expenses into dollars, but it lays heavy on our customer budget in local currencies. You can look at Europe what it does. So I prefer stability then the customers can plan well and we can plan well. But the dollar is moving in the last two years more than the shares. So I think that can fluctuate and move the margin a few points to the right and to the left and it did as you can see in the last few years.

Moderator

That’s been several points definitely. Let’s talk about capital structure. Obviously Check Point has got a lot of cash which is always a good thing on the balance sheet to have and you’re very cash flow positive. We saw a pretty big increase in the buyback last quarter. Just how do you guys think about capital structure and any changes and obviously the laws in Israel in regards to return of cash?

Tal Payne

Yes. So yes, there is a lot of legislation around it and that’s why it’s a bit complex because many people say why don’t you distribute another one billion. There are many other considerations and we always look at all of these considerations and historically we distributed the 200 and then we increased to 300 in a year because there was a tax trigger that we didn’t think it’s right. Our shareholders didn’t think it’s right and all of the rest of the Israeli companies didn’t think it’s right. So we distributed close to the amount that was possible. At the bottom of that demand we had to pay taxes of 20 something percent. So we chose to distribute that amount and to use the rest of the cash for M&A and obviously working capital needs. So that’s the historical cash. When we look – from the beginning of the year they changed the law which is a great change. They basically said we have to pay slightly more cash taxes.

Our P&L tax rate remains the same because it’s reduced a lot of the tax uncertainties in the law. So in the P&L we kept the same tax rates. In the cash our cash payments increased, but now we are free to distribute the new income from the beginning of the year and as a result, we launched a new buyback plan which we declared up to 1 billion up to two years in order to give us flexibility. So it’s not necessarily a straight line. It would give us flexibility. But it would be linked obviously to the net income as well because we don’t want to trigger the tax event. And there’s another tax change that happened a few weeks ago that relates to some of the cash of the balance sheet. By the way just to make it clear, not all the cash of the balance sheet is under this law. Some of this cash is early collection, deferred revenue, working capital which was early which you can’t distribute because it’s other limitation of – it’s called capital reduction.

So let’s not go into that. But the significant part relating to the previous process and there’s a new law that says we can pay less tax than the original or simplified less tax than the original tax. Instead of 20 something we can pay 10 something. I don’t know exactly how much because it depends on what portion you decide to distribute. But many companies cannot join this new tax rule because there’s a lot of stipulation they not necessarily can meet and therefore companies will review it. They have a year to review that and we are reviewing that as well. There are many uncertainties in that law at this point of time.

Moderator

Got it. So the previous change was the incremental cash generation. This one is about the previous cash and cash on the balance sheet.

Tal Payne

Exactly.

Moderator

Got it. One last question in just the last couple of minutes here. Your M&A. your checkpoint has been very targeted in the past about mostly acquiring technology. Wondering the company’s appetite for M&A right now. How do you feel about the product set and product portfolio?

Tal Payne

Actually, the appetite for M&A always been there. If you look at the last probably six years you will see an acquisition of $600 million and you will see acquisition is five. So for us it wasn’t’ about size, it’s more about is it the right technology or customer base or a geographical penetration? It has to be in security, but we’re very open to M&A. There isn’t some you just see more and some you just see less. It relates a lot to what we need in our product portfolio. Sometimes you need more, sometimes you need less. It depends on how the markets evolve and another thing, it is related to evaluation and sometimes valuations are very high which even interesting companies cannot be acquired in a fair value. So I think that’s probably more of the limitation most of the time.

Moderator

Actually, Kip, I’ve got a question for you. I know we have talked about this before in the past, the idea of replacement and refresh cycles of the appliances because as Tal mentioned, this appliance strategy begun in ’07 and maybe we’re actually just starting and maybe you can come up to just the early edge of replacement and refresh cycle. How should we think about the average ages of appliances and where we start to see that cycle?

Kip Meintzer

I think that the one thing we’ve been consistent with is there is not set cycle and I think it has a lot to do with the economy, how long somebody or what their expectations are for the future. So it’s really tough. So we’ve traditionally said three on good economy. Five and maybe that’s even extended out to six or seven. So in theory you could say if it’s five years maybe we start to see it this coming year. It just remains to be seen. So really I think it has a lot to do with the individual companies and what they’re seeing in their own business.

Moderator

Got it.

Tal Payne

I think I want to expand. The reason we don’t have a clear answer is because we never sold appliances. Once we will start to see I think we will have a better answer what’s the cycle in our industry. I think the belief is that it’s between five to seven. It depends. It’s linked or it should be similar cycle to when you refresh network equipment in general and I think Cisco is talking about five to seven. So I think it’s similar. So we might start to enjoy a refresh cycle in our appliances because 2007, 2012, 2013 it looks like the right time and over the years it should be more because each year we sold more. So yeah, that’s my comment.

Moderator

So the way to hopefully look forward to in the coming years and stuff. All right, on that note I think we’re going to go to the breakout session. So thanks everyone for coming and thank you Tal and Kip for your time.

Tal Payne

Thank you.

Kip Meintzer

Thank you.

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