ZS - Check Point Software Technologies Produces A Mixed Quarter

2023-11-01 12:00:43 ET

Summary

• Check Point Software Technologies had another typically Check Point quarter, with fodder for both bulls (above-Street revenue, subscription growth acceleration, above-Street margins) and bears (weak billings, yoy margin decline).
• Check Point's recent acquisition of Perimeter 81 will improve the company's offering in the attractive Secure Access Service Edge, or SASE, segment.
• Enterprise IT budgets are likely to remain limited in 2024, but enterprise security is rarely an area where companies look to make meaningful budget cuts.
• CHKP's weak top line growth prospects are often a headwind for the shares, but the shares can do better in periods where the market is more nervous about tech growth.

As often the case, Check Point Software Technologies Ltd. ( CHKP ) Q3 quarterly earnings have provided fodder for both bulls and bears. Bulls will point to the above-expectations revenue result, acceleration in subscription revenue growth, double-digit Infinity growth, and better-than-expected margins, while bears will note the weakness in product revenue, the year-over-year decline in operating margin, and the third straight quarter of negative billing numbers.

In Q3 , CHKP revenue rose about 3% year over year, beating by about 1%, with product revenue down 14%, subscription revenue up 15%, and update/maintenance revenue up about 2%. Subscription revenue growth has accelerated over the last few quarters, while update/maintenance revenue has been relatively steady.

Gross margin improved almost two points from the year-ago period (to 89.6%), with the company benefitting not only from better gross margin on product sales (80.4% vs. 73.3%), but a richer mix of higher-margin (94.4%) subscription revenue. Operating income rose more than 2%, beating by 3%, with operating margin down 40bp YOY to 45.1% (beating by more than a point).

Billings declined 5%, missing by 5%, and would have been down closer to 6% without the Perimeter 81 acquisition. This was the third straight quarter of negative comps for billings, and short-term billings were down about 2%. Management blamed various factors, including duration headwinds and a reluctance on the part of customers to commit to longer-term deals.

Guidance for the next quarter was likewise mixed, with revenue guidance a little weaker (3.5% revenue growth at the midpoint versus prior Street expectations of over 4% growth), but stronger EPS suggesting better margins.

Tougher Times, But Security Usually Outperforms

With the economy slowing, these are not great times for enterprise tech spending. The Street has shifted its attention from growth to margins and cash flows, and many companies are pulling back on spending and delaying non-essential IT investments.

In the past, this has typically favored cybersecurity companies and I expect this cycle will be consistent with that history. IT security has seldom ever been an area where companies have looked to cut spending to support/boost margins, and with ongoing growth in cyberattacks (and ever-higher price tags attached to those attacks), I really don’t see companies looking to skimp here.

It's still relatively early in the reporting cycle, so we’ll see what other companies say about their bookings trends and whether they’re seeing customers pulling back on committing to larger or longer-term deals. I suspect there will be some of that in small-to-medium-sized businesses, but that’s never really been Check Point’s core addressed market. On the other hand, I could see companies reallocating spending toward those areas where they don’t already have adequate coverage for emerging threats. Given Check Point’s position as more of a “fast follower,” this could be a relative negative.

All in all, though, I don’t have a lot of macro concerns about Check Point. I don’t expect 2024 to be a great year for the sector, but I see far less incremental risk in this sector than I do with other areas in enterprise software.

Check Point's Sizable Deal Should Help Address A Meaningful Market Opportunity

I liked Check Point’s announcement of the acquisition of Perimeter 81 back in August. Although the price tag was not exactly low ($490M for a company with around $20M to $25M in annual recurring revenue), that’s not an unusual or unreasonable price for a fast-growing cybersecurity company with relevant technology in a growing market.

Perimeter 81’s primary focus is on zero trust network access, and Secure Access Service Edge (or SASE) is definitely an area where Check Point needed to improve. While the company has a SD-WAN offering, Perimeter 81 will allow for a more complete SASE offering and should make Check Point more competitive with Cloudflare (NET), Fortinet (FTNT), Palo Alto Networks (PANW), and Zscaler (ZS) in a fast-growing security market segment that Gartner has estimated will be worth $20B in 2026.

I also note that the company more recently acquired Atmosec, a company focused on malicious SaaS apps, and this too will help boost the SASE offering. It will likely take around a year to fully integrate Perimeter 81 with the SD-WAN offering and the Infinity platform, but I like the move, and this return to larger-scale M&A (this was Check Point’s largest deal in over 15 years).

The Outlook

In some respects, not a lot has changed about the core Check Point story. The company has continued to lag peers like Fortinet and Palo Alto in terms of quarterly/annual growth, and the company has continued to lose share in legacy businesses. And, as I said above, the company is not moving off of its fast-follower strategy, so it will never represent the cutting edge of enterprise security.

By the same token, though, the company still generates substantial annual revenue and has a strong core customer base that has been with the company for years – and security software is not the sort of thing that companies commit to or change lightly. The company likewise generates exceptionally high margins and rich cash flows.

Revenue growth has slowed from the double-digits to around 6% over the past decade, and I expect growth to continue slowing toward a 3% to 4% growth rate. Relative to my prior expectations, growth in 2021 and 2022 were within 2% of my estimates, respectively, and not a lot has changed in the basic outlook since then.

Margins, though, have come under a little more pressure, and the company has more recently underperformed my expectations for operating margin and free cash flow generation. With that, my expectations for the next couple of years has dropped from the mid-to-high 40%’s to around 43%-44%, though my FCF margin assumptions are still in the low-40%’s. Here too there has been erosion over time – from the high-50%’s to low-60%’s to below 50%, and I’m expecting little leverage over the next decade, with a FCF growth rate in the 2% to 3% range.

Discounted cash flow does still suggest undervaluation below $140. A matrix approach that evaluates revenue growth and margin relative to what the market has historically paid in the software space suggests less undervaluation, but that’s nothing new (that CHKP fares well in a DCF valuation, but not so well in a growth-driven approach).

I will note that while these relationships are durable over time (investors pay up for growth and margins in software, with a preference for growth), in times of increased uncertainty, the premiums for growth do shrink. I also think that there’s an implicit M&A backstop here – I think Check Point would likely be an M&A target if it underperformed too substantially (though whether management would willingly sell and whether antitrust would sign off on a deal are different questions).

The Bottom Line

It’s been a while since I’ve published updated thoughts on Check Point, and part of the reason is that there’s only so many times you can say variations on the same thing – Check Point is a high-quality cybersecurity player in many respects, but the company has long come up short on growth and that’s often a serious issue where software share price performance is concerned.

To that end, while Check Point is up about 8% since my last update , outperforming the First Trust NASDAQ Cybersecurity ETF ( CIBR ) by a good margin, Palo Alto, a name I’ve long preferred, is up more than 90%. In fairness, though, I’ve also preferred CyberArk ( CYBR ), and those shares have modestly underperformed Check Point over that same time.

Check Point Software Technologies Ltd. is a cash-generating machine, even if it is doing so at a modestly lower rate than in the past, and looks attractively-priced on a discounted cash flow approach. The “but” is that software stocks often trade more on a blended revenue growth and margin mix that heavily favors revenue growth, and that’s not a metric where Check Point scores highly. I believe that explains at least some of the long-term lackluster performance (an annualized return of 9% over the last decade), but that may be good enough for some investors.

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