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Check Point Software: Value In Cybersecurity

About: Check Point Software Technologies Ltd. (CHKP)
by: Tsachy Mishal
Tsachy Mishal
Long/short equity, Deep Value, value, contrarian

Check Point Software is one of the most heavily shorted large-cap stocks, despite steady growth and an undemanding valuation.

Check Point is the most profitable cybersecurity company in the world, and its growth is poised to continue.

Check Point's low valuation, steady growth, and hefty share repurchases are likely to upset the shorts and make investors in the company money.

Check Point Software (NASDAQ:CHKP) stands apart from other heavily shorted stocks in both its conservatism and its attractive valuation. Tesla (NASDAQ:TSLA) is a good example of a typical heavily shorted stock. Whether you're a fan of Tesla or a hater, it isn't hard to understand why the stock has attracted so much short interest. While the company is an innovator in the automotive space, its CEO is a magnet for controversy and the company floated an ill-considered, "funding secured" buyout at "$420" a share. Additionally, Tesla trades at a sky-high multiple that requires a big leap of faith, so it is natural that there will be a lot of cynics.

What's a mystery is why Check Point Software, a conservative cybersecurity company that has grown steadily for years, has a level of short interest that approaches that of Tesla:

For the past 27 years, Check Point has been run by its founder and CEO, Gil Shwed, who is now the longest-tenured CEO on the Nasdaq, narrowly beating out Jeff Bezos. Shwed invented the internet firewall that forms the basis for today's cybersecurity industry. Under his leadership, Check Point has become a $17 billion company that is the most profitable cybersecurity company in the world. Shwed also continues to personally own 19.5% of Check Point's stock.

So, why are the shorts after Check Point? Check Point has grown steadily for years, generating consistent cash flow, which it returns annually to stockholders through significant share buybacks. In 2017, 2018, and 2019, for example, Check Point completed share repurchases of $1 billion, $1.1 billion, and $1.28 billion respectively. In 2020, the company is expected to buy back $1.3 billion of its stock, representing roughly 10% of the public float at the current price. And more importantly, unlike other heavily shorted companies, Check Point's valuation is well below the market average - trading at just 12x free cash flow (net of cash). Through free cash flow generation and buybacks, Check Point will be at just 11 times free cash flow by year-end 2020 (if the stock price remains static).

The bear case for the company is that it will continue to slowly cede market share to its competitors. But even under that bear(ish) scenario, the stock is simply way too cheap. Check Point has been growing steadily for years. And the company's slow-but-steady organic growth, combined with its massive stock buybacks, do not equate to a falling stock price. How low can the stock reasonably trade? Should the world's most profitable cybersecurity company trade at nine times multiple? Will that happen in the face of billion-dollar-plus buybacks?

And, on the other side, there is a clear path for Check Point to transition to stronger growth in the next few years. Historically, Check Point has been more of a technology company than a sales organization. It had the best firewall on the market and its products largely sold themselves. While its competitors spent money on sales and marketing, Check Point elected to forego these expenses and keep its wide profit margins. But more recently, that has changed. Check Point has begun growing its sales force and spending more on marketing. The company continues to have a top-rated suite of products, which should position it well to retake share from its competitors.

There have been two other changes to Check Point's business, which should benefit the stock long term. First, Check Point has begun to sell more products via subscription services as opposed to one-time sales. While that masks the company's growth rate in the short run because it recognizes less revenue upfront, in the longer term, subscriptions provide predictable and recurring revenue streams that boost the company's prospects.

Second, Check Point has begun targeting a wider market by bundling its products into a suite that the company refers to as "Infinity." Under this program, instead of using multiple vendors for different products, customers can get all of their products from Check Point at a discount and control those products through a single dashboard. The net effect is that customers pay less and Check Point's share of their customers' spending increases. It also means that smaller companies, who previously couldn't afford Check Point's products, now can.

In the face of these realities, I've struggled to understand why investors have continued to short Check Point's stock. The best explanation that I've heard is that many of the shorts really aren't betting against Check Point at all. Instead, long-short hedge funds, which are required to balance their long positions by shorting other stocks, are apparently using Check Point as a funding short so that they can be long other software companies. Their theory seems to be that since 25% of Check Point's market cap is in cash and it's relatively unlikely that Shwed will pursue a sale, they're unlikely to get burned by shorting the stock. In reality, Check Point, which is a low beta stock, is a terrible hedge against long positions in high flying software names. But analysts at long-short hedge funds need to balance their books.

In my view, shorting Check Point is much riskier than the hedge funds may think. Short interest in the company is now approaching 20 days of trading volume. If these hedge funds all need to exit at the same time, the door will be narrow. And while a Tesla-like short squeeze is unlikely, I wouldn't be surprised to see something similar on a smaller scale. Regardless, in the fullness of time, Check Point's steady growth and hefty share repurchases mean that the company's stock should do well.

Risks to the thesis include but are not limited to lower than expected cybersecurity spending. Larger than expected market share losses and/or large acquisitions that do not do enough to improve Check Point's market position.

Disclosure: I am/we are long CHKP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.