Performance and Valuation Prime™ Chart
Check Point Software Technologies (NASDAQ:CHKP) develops and markets a portfolio of software and combined hardware products covering network security, endpoint security, data security, and management solutions. After pioneering the industry with the first commercially available software firewall to use, the firm's focus on end-to-end unified protection has allowed it to develop into one of the largest pure-play security vendors in the world, securing more than 100,000 businesses, and receiving numerous awards.
Its world renowned status and unmatched catch rate of malware and other intrusions has allowed the firm to maintain robust profitability levels in the face of increasing competitive headwinds that have crushed the returns of other firms in the industry. This unique attribute makes the firm an ideal investment in a rapidly expanding industry.
While CHKP saw UAFRS-based ROA decline dramatically from its peak of 392% in 2001, it has begun to recover in recent years. After bottoming in 2008 at 67%, Adjusted ROA steadily increased to 184% in 2015. Meanwhile, UAFRS-based Asset growth, which from 2000-2008 ranged from 5-52%, has since been more muted, but similarly volatile, ranging from -17% to 11% since 2009.
For context, the PVP chart below reflects the real, economic performance and valuation measures of Check Point Software Technologies Ltd. after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
The four panels above explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.
This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.
Performance Drivers - Sales, Margins and Turns
It can be helpful to break down Adjusted ROA into its DuPont formula parts, UAFRS Earnings Margin and UAFRS Asset Turnover, which are cleaned up margins and turns metrics used to calculate Adjusted ROA. The chart below details both Adjusted Earnings Margin and Adjusted Asset Turns historically, to help us better understand the drivers of the firm's profitability and performance.
Trends in Adjusted ROA have been driven by trends in UAFRS-based Asset Turns. From 2000-2008, Adjusted Asset Turns declined from 7.8x to just 1.4x, before recovering to 3.9x in 2015. On top of this, while UAFRS-based Earnings Margins declined from a peak of 55% in 2001 to 42% in 2003, they recovered to 50% in 2007, and have stabilized at 45-47% levels since 2009.
As addressed in our prior article about Palo Alto Networks (NYSE:PANW), the industry has seen a much different trend, which has led to somewhat suppressed valuations for CHKP, and these concerns appear unwarranted, given the firm's position as a market leader and its ability to continue commanding a premium for its offerings
Moreover, given the firm's stability in Adjusted Earnings Margins, and consistent trend of improving Adjusted Asset Turns since the depths of the Great Recession, the firm should be able to continue to drive Adjusted ROA expansion as they continue improving Adjusted Asset Turns back towards prior levels.
Industry Analysis - Aggregate Earnings Margins
In the following chart, we have aggregated several firms (PANW, PFPT, IMPV, CYBR, CHKP, FTNT, FEYE) within the cyber security industry in order to better understand trends in Adjusted Earnings Margins.
As we can see above, Adjusted Earnings Margins for the industry have fallen steadily from a peak of 50% in 2007 to just 23% in 2015, driving industry-wide concerns about competitive pressures. However, as we illustrated earlier, CHKP has been able to maintain robust Adjusted Earnings Margins at levels the industry hasn't seen since before the Great Recession. Moreover, in recent years, CHKP has delivered stable Adjusted Earnings Margins almost twice the level of the industry as a whole.
Such a dramatic difference highlights the value of the firm's products. While other competitors have fallen prey to increasing competitive headwinds and have been forced to reduce pricing in order to keep clients, the strength of CHKP's products command a premium that clients are willing to pay. This gives the firm a distinct advantage over competitors, allowing it to sustain substantially more robust Adjusted ROA levels, and alleviating concerns about future Adjusted Earnings Margin compression.
Embedded Expectations Analysis
As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.
CHKP is currently trading at a 14.7x UAFRS-based P/E, which is near historical averages. At these levels, the market is pricing in expectations for declining Adjusted ROA, from 184% in 2015 to 153% in 2020, accompanied by immaterial Adjusted Asset growth.
Analyst and Management Expectations and Alignment
Analysts have bearish expectations relative to the market, projecting Adjusted ROA to decline to 121% in 2017, accompanied by 16% Adjusted Asset growth.
However, Valens' qualitative analysis of the firm's Q3 2016 earnings call highlights that management is confident about the strength of their appliance product line and SandBlast advanced malware prevention, and they generated highly confident markers when saying that studies have shown that Check Point's technology is superior to other technologies in the marketplace. They are also confident about the sustainability of growth in their subscription revenues.
Considering that market concerns largely revolve around the firm's ability to maintain superior margins, management's confidence in their product line, and the premium it commands is highly positive.
Peer Analysis - Valuations Relative to Profitability
A major benefit of adjusting as-reported financial statements is to clear away accounting distortions, to allow for more accurate peer-to-peer comparisons. To this end, we have included a scatter chart below, that plots CHKP against its peers based on their Adjusted Price-to-Assets ratio (P/B) and Adjusted ROA.
Looking across industries, markets, and time, there has been a very strong relationship between a company's Adjusted ROA relative to the corporate average (6%) Adjusted ROA, and the multiple the market will pay above the value of the company's Adjusted Asset base, in terms of a UAFRS-based P/B multiple. A company that generates a 6% Adjusted ROA will tend to trade at a 1.0x Adjusted P/B, and a company that generates a 18% Adjusted ROA will trade at a 3.0x Adjusted P/B, etc.
Relative to its peers in the cyber security industry, CHKP appears miles ahead of the competition with its +150% Adjusted ROA and 23.8x Adjusted P/B. While CHKP may be trading at higher valuations than its competitors, this premium is justified by the firm's substantially more robust Adjusted ROA. Its next closest competitor, CYBR, generates close to a 40% Adjusted ROA and trades at a valuation not terribly far below CHKP's. Given CHKP's ability to maintain robust Adjusted Earnings Margins in the face of increasing competitive headwinds, it is clearly slightly undervalued at worst.
Valuation Matrix - ROA' and Asset' Growth as Drivers of Valuation
When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for CHKP at various levels of profitability (in terms of Adjusted ROA) and growth (Adjusted Asset growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.
To justify current prices, CHKP would need to see Adjusted ROA fall substantially, from 183% in 2015 to 153%, with no growth at all. Given the firm has managed to consistently improve Adjusted ROA since 2008, driven by increasing Adjusted Asset Turns, and sustain extremely robust Adjusted Earnings Margin, this is likely too bearish. Moreover, considering management's confidence about their product performance and value, concerns about the strength of the firm's Adjusted Earnings Margins appear unwarranted.
Should the firm only sustain Adjusted Margins and Adjusted Turns at current levels, equity upside would be warranted. Moreover, considering the firm's ability to maintain Margins, and their recent ability to expand Turns, they may continue to grow Adjusted ROA going forward, warranting substantial upside for the name.
To find out more about Check Point Software Ltd. and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
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.