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Morningstar | Narrow-Moat Check Point Software Reports a Solid, Stabilizing Quarter; Raising FVE to $116

Narrow-moat Check Point Software’s second quarter of 2018 came within our expectations, and we are raising our fair value estimate to $116 per share from $115, due to the time value of money. This quarter served as a stabilizing earnings session, in our view, particularly as the last three quarterly results have underwhelmed or brought forth reduced guidance estimates from management. The firm had a solid second quarter on the bottom line, with the prevailing news that management plans to double its stock buybacks. Management maintained its guidance for the full year. Only weeks earlier, shares not only traded at a discount to our fair value estimate, but a reasonable fundamental multiple relative to the security industry. After a recent rally, and with only a modest discount of 3.5% to our estimate currently, we see the name as largely fairly valued today.

Leadership indicated that subscription revenue in the quarter was largely driven by its more traditional products. Strength from nascent offerings was attributed to SandBlast mobility installations and management indicated they got more visibility into the long-term prospects of the emerging Infinity platform. Check Point has steadily increased deferred revenue historically, but its long-term deferred revenue decreased quarter over quarter. Management mentioned that there were some deals in the quarter not fully invoiced. In terms of segment financials, we are beginning to see the segment transition from product to subscription, particularly as the growing flagship offering, Infinity, is recognized entirely as a subscription service. We expect year-over-year revenue declines in the product segment over the next five years. The firm’s cash and marketable securities position continues to expand, and we would encourage tack-on acquisitions at the right price to bolster growth.

Check Point is to be admired for its industry-leading GAAP margins, with operating margins this quarter of 47.9%. We have posited in the past that the firm might be eschewing near-term margin compression at the expense of long-term revenue growth. The past few years, we’ve noticed that Check Point’s marketing environment has become more competitive. Check Point’s growth rates are underperforming those of competitors like Palo Alto and Fortinet, who seemingly have a win-at-any-cost approach, spending aggressively, with a high proportion of revenue going to sales and marketing costs. In contrast, Check Point has been criticized for salesforce execution problems. This quarter, we saw some progress, as Check Point upped its sales and marketing expenses to 26.6% of revenue, the highest proportion and absolute number we have seen from the business. However, the firm noted that it still has a number of salesforce openings. Longer term, Check Point may have to continually increase its marketing expenses, especially as we believe the firm may have to increase visibility around nascent products such as Infinity and CloudGuard.

Check Point now has $3.74 billion in cash and marketable securities on its balance sheet. We expect the firm to perennially buy back its own stock, as it spent nearly $250 million on buying back what we view as undervalued shares in this quarter alone. We applaud the updated buyback, as in lieu of acquisitions, we have advocated for an increase after previous quarters. Under the updated plan, the firm plans to increase the quarterly repurchase by 30%, up to $325 million, with the overall program increasing 100% to a total of $2 billion.

Check Point has historically been opportunistic in its acquisitions, only buying businesses that they believed to be well below fair value or in instances where management felt they could not build the product internally. The firm bought Nokia’s security appliance business at the trough of the 2008 recession, and tack on acquisitions like Hyberwise and Lacoon were on the smaller side, at $80 million and $100 million, respectively. The latter two acquisitions serve to bulk up Check Point’s threat protection and mobile security offerings. Given the cash balance and decelerating growth, we would be amenable to bolt-on acquisitions to move the firm into high growth areas. Each subsequent quarter, management has seemingly fielded additional questions regarding a potential major acquisition, with leadership indicating that they do not see attractive targets and that they are witnessing robust innovation in-house.

At a macro level, we posit that the recent melt-up among numerous cyber companies over the past month could be a result of investors extrapolating that heated U.S. and China tariff tensions could renew cyber strains between both nations, causing American businesses to up their security spending budgets. We see some truth to this, but iterate that valuations ran up among Check Point’s peers in 2015 on the back of high-profile breach scandals, which manifested in sell-offs in 2016, as growth was more muted than the market expected.