One of the things Buffett consistently refers to when evaluating the quality of a business is the amount of cash it produces relative to the amount of cash it needs to maintain the business. Buffett calls this cash flow "owner earnings," which is basically free cash flow. Buffett defines owner earnings as the cash flow a business produces less the capital expenditures a business has for maintaining the business (he excludes growth capex).
Free cash flow is the easiest way to approximate Buffett's "owner earnings" definition, and in some ways it's more conservative because it typically includes both maintenance and growth capex.
CHKP - A Cash Machine
For weeks, I've noticed that Check Point Software (CHKP) has been at the top of the list in Value Line's weekly "Biggest Free Flow Cash Generators" screen. CHKP has generated an astounding 71 times more cash than it has needed to invest back into the business (more than two times the ratio of the next highest stock). That is an incredible cash flow machine.
CHKP is a leading provider of software that protects computer networks from malicious attacks. I haven't done any detailed research on the business itself, and it's not extremely cheap, but on an EV/FCF basis, it looks somewhat attractive, especially given the incredible growth the company has experienced. In the last 10 years, the average annual growth rates are as follows:
- Sales 12.0%
- Cash Flow 9.0%
- Earnings 9.5%
- Book Value 15.0%
I don't know if the business can continue growing at these rates (most businesses don't grow as fast as they did the previous decade), but I can tell you that based on the basic metrics, this is one of the most consistent decades of performance and one of the cleanest balance sheets that you'll be able to find.
Here are some of the key metrics:
Free Cash Flow
Look at the incredible amount of operating cash flow relative to the capital spending, which of course leads to significant free cash flow. The company is currently priced at around 9 times free cash flow (using EV/FCF), which is excellent in and of itself. But it has grown its free cash flow at an average rate of 16.7% per year over the last 10 years.
This FCF has allowed the company to buy back about 20% of its shares over the past decade, a trend that will likely continue. The company pays no dividend, but given the extremely high internal returns it generates, that is actually a positive for shareholders. Better to keep the money in the business to continue compounding.
Notice the incredibly high (and consistent) gross margins. Buffett said a company with consistent 40% gross margins likely has a competitive advantage. I don't know much about the business model yet, but I do know that a company that consistently has gross margins in the 80's and operating margins the 40's is doing something very well.
Return on Capital
One of the easiest and quickest ways to identify the quality of a company is to look at the returns it has generated on its capital. I look at ROE and ROIC, which in this case are identical because the company operates with 100% equity (CHKP has no debt). Like the margins, notice how consistent the returns have been:
- $1.385 Billion in Cash
- $0 Debt
One thing I mentioned above is how incredibly clean the balance sheet is. The company has grown steadily and consistently, but operates with no debt, and hasn't used debt in the last 10 years. The company has a market capitalization of $9.0 billion with $1.4 billion in cash and no debt, giving CHKP an enterprise value of about $7.6 billion.
To Sum it Up
CHKP has a market cap of about $9.0 billion and an enterprise value (EV) of about $7.6 billion at its recent stock price. In the last 12 months, the company has produced $897 million in free cash flow, giving the stock a 11.7% free cash flow yield on an EV basis.
This unlevered free cash flow has allowed the company to steadily buy back shares and grow its book value at a rate of 15.0% per year over the past decade. Sales, earnings and free cash flow are all growing at roughly the same rates. The company produces an incredible amount of cash relative to the capital expenditures it needs to maintain and grow the business.
The company already has a large market share in the internet security space, but this type of industry is prone to competitive pressures and fast changing technology, so this could certainly change. However, with a balance sheet like it has currently, it should be able to weather any storms that arise, and it will be better equipped to deal with adversity than competitors with inferior balance sheets.
I am basing this initial post exclusively on the numbers, so please do your own research.