Familiar Concerns At Check Point

| About: Check Point (CHKP)


Wall Street is once again worried about top-line lackluster growth at Check Point, though this time it seems more related to accounting treatment and not underlying demand or market share.

Check Point has stepped up its R&D spending and has shown that it can adroitly combine internal R&D with select, small acquisitions, but the "fast follower" perception is a drag.

A mid-$80s fair value doesn't inspire much urgency in either direction, and I believe Check Point remains a solid, but not spectacular, way to play IT security growth.

A few things seem to be perpetually true about Check Point Software Technologies (NASDAQ:CHKP). Despite a prominent position in the market, including leading firewall market share, nobody is ever really happy with this Israeli IT security company. The company's growth is no longer in the double digits. The company doesn't spend as much on R&D as Palo Alto (NYSE:PANW) or Fortinet (NASDAQ:FTNT). The company doesn't "play to win," but instead focuses on more or less holding steady in the market. And so on.

I can't and won't dismiss these concerns out of hand - most of them are factually true. It's also true that Fortinet and Palo Alto have blown past Check Point in terms of share price appreciation over the last five years, though CHKP has outperformed (it has gone down less) in the past year as the security stock market has come off a pretty crazy bullish bender.

I really do think this is a case of "it is what it is." What Check Point is today is what it will be tomorrow - a smart, well-run IT security company with a huge installed base, a "fast follower" strategy that mitigates risks and supports margins, and a better-than-credited core technology. With a fair value in the mid-$80s, it's a little undervalued today, but not dramatically so. I think Check Point is a good way to play long-term trends in security spending (which I would think would grow around mid- to high-single digits most years), with opportunities to build/lighten positions as market sentiment ebbs and flows.

Okay Results, But Guidance Is A Problem

Revenue rose 7% in the second quarter, which was fine relative to expectations. Product revenue rose 3% while blade subscription revenue rose 21% and update/maintenance revenue rose 4%. Gross margin was basically stable while operating income rose 3% (adjusted) and operating margin shrank about two points as the company significantly boosted R&D spending (up about 22% on an adjusted basis) and sales & marketing (by almost 17%).

While billings and deferred revenue looked okay (and aren't always as predictive as you might hope), management lowered guidance. Check Point's model is changing. Because the company is bundling in threat protection and extraction, it has to change its accounting treatment for the revenue, and that shifts sales out of appliances and into subscriptions. It doesn't have a meaningful impact on the cash flow, but it makes the reported results look ugly as product revenue is likely going to decline for a few quarters.

A more concerning issue is that the company has had to discount its maintenance services and that is also a part of the negative guidance revision. Maintenance is absurdly lucrative (gross margins around 90%), so any harm to this line item is unwelcome, and it is not unreasonable to ask if this is a sign that rivals like Palo Alto, Fortinet, and Cisco (NASDAQ:CSCO) are a bigger problem here of late.

More R&D? Not A Bad Idea, But Not A Quick-Fix Either

More than a few analysts and investors have lamented Check Point's prioritization of margins over growth. Given that Palo Alto and Fortinet both surpass Check Point in reported R&D spending (despite smaller revenue bases), are growing much faster, and taking share in the market, I can see where some of this concern comes from.

Check Point arguably doesn't get enough credit for how it pursues product development. The company's new SandBlast threat emulation platform was a byproduct of both strong internal development and the integration of acquired technology (especially Hyperwise). It took less than a year, I believe, to translate that existing internal R&D and Hyperwise into a real product, and the company has ongoing projects in threat prevention. I believe this directly addresses a claim that Palo Alto has made in the past regarding other security companies focusing on mitigating attacks as opposed to stopping them outright. What's more, with only single-digit share and double-digit growth today, this can be a nice driver for Check Point in the next couple of years.

Check Point is also leveraging its Lacoon acquisition and investing more resources into mobile security. While I of course think there will be more competition in the future, the market for securing mobile devices connected to the enterprise is large enough to matter for Check Point and growing fast.

I like the fact that Check Point doesn't suffer from "Not Invented Here Syndrome," and all you have to do is look at the biotech/pharma sector to see that spending billions on R&D is no guarantee of future revenue. Still, I think Check Point can do more. The company has great core technology and an enormous installed base into which it can sell new products. Palo Alto and Fortinet have been chewing on that base for a while now (Fortinet more on price, Palo Alto more on tech/product capabilities) and Cisco seems to have its act together again in security. I'm not suggesting that Check Point needs to invest substantial sums into risky "moonshots," but I think it would help the company's market share and market sentiment if it could come with a little more "wow" a little more often and appear to cede innovation to companies like Palo Alto (at least not as often).

Resizing The Opportunity

While Check Point's revenue guidance necessitates some changes to the model, not all that much has changed from a cash flow perspective, and I'm still looking for long-term growth in the range of 5%. That supports a fair value in the mid-$80s, and I think my slightly higher revenue growth assumption (in the low 5%s) does anticipate some ongoing share loss. If Check Point can grow with the market, there would be upside here (provided the company doesn't have to radically alter its margin structure).

I do worry that Check Point is too reactive and too willing to be that "fast follower" to companies like Palo Alto. So with that, I'm somewhat concerned that the company does over-prioritize its thick margins and is liable to "playing not to lose" - something that rarely works well in competitive markets. On the other hand, I don't think Check Point is a broken company, and if something's not broken, you have to be careful about just how far you go in trying to improve it.

The Bottom Line

Check Point isn't quite cheap enough for me to be really excited about it, but that's not uncommon. I think this is a well-run company that will more or less grow along with the underlying market, but I do worry that a lack of reported growth and a perception that it is not dynamic enough will be a recurring issue with multiples, valuation, and stock performance.

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.