Description

Business Description:  Tel Aviv-based Check Point Software Technologies Ltd. is a leading provider of network security solutions.  The founder and CEO of Check Point, Gil Shwed, basically invented the modern firewall in 1992.  Check Point remains the dominant firewall provider today, though it has grown its product line and also offers a host of other security solutions including: intrusion prevention, data loss prevention, web filtering, anti-virus & anti-malware, anti-spam & email security, virtualized security, endpoint management, and security management. All of these solutions have two things in common (in addition to a bunch of fancy names):  1) They are aimed at enterprise customers (Check Point solutions typically cost $10,000+) and 2) Their primary goal is to keep the bad guys from getting a business’s data and/or harming that business.

Investment Thesis:

• We believe growth in cloud computing, software as a service, and the Internet in general is going to drive incremental demand for enterprise security solutions.  When a customer gives his confidential information to suppliers of various services in the cloud, he expects that data to be protected.  Check Point’s solutions remain a critical part of that protection and as the cloud grows to encompass the everyday work processes of more and more traditional businesses, we expect businesses to continue to buy more Check Point solutions to keep customers’ data safe.
• We believe that the bad guys will keep trying to beat the system.  IT security is an ever escalating arms race between hackers/thieves and enterprise IT managers at large corporations.  We expect the race between the two will continue for some time.  Checkpoint will benefit as an arms supplier to the corporate IT managers.
• Checkpoint has an incredibly strong balance sheet (over $3.1 billion in cash and investments and no debt) that will enable them to do good things for their shareholders like acquire good businesses and/or buyback stock.  Management has historically allocated capital prudently and we expect that to continue.  The company has reduced its share count by 18% since 2004 and recently re-upped its buyback plan for another $1 billion over the next two years (10% of company at current prices). Note that Israel basically changed their tax law to accommodate Check Point’s buyback (would that the U.S. Congress would be so responsive to the needs of large business). The co-founders Gil Shwed CEO and Marius Nacht Vice Chairman still own over 20% of the company, so they are aligned with shareholders.
• Checkpoint’s business is sustainable.  Nearly 60% of Checkpoint’s revenue comes from software updates, maintenance, and services.  This should be a steady stream of revenue, even if the market for new capital spending slows down.

Why does this opportunity exist?

We think Check Point shares are trading cheap for three primary reasons: 1) Palo Alto Networks recently came public and pitched themselves as a Check Point killer on the roadshow, which we think is very optimistic 2) Worries over European customer spend.  3) General worries over owning Israeli companies ahead of potential military engagement with Iran.

1)      Palo Alto Networks

We think that primary reason for Check Point’s recent decline (the stock has fallen 28% from recent highs of around $65 in April) is the vocal bashing the company received from Nir Zuk, a former employee, and founder of Palo Alto Networks which recently IPO’d to much acclaim.  Zuk’s license plate has been CHKPKLR for many years now, so we think what he says needs to be taken with a grain of salt.  Basically, Zuk claims that old firewalls that use ports are dead because many apps today can mask what they are up to with SSL or port hopping.  His solution eschews the use of ports to block traffic and instead uses a database of safe and unsafe applications (they call it App-ID) to decide what comes through.  A simple version of the Palo Alto pitch is here: http://www.bdtcorp.com/pdfs/palo_alto_whitepapers/Firewall_Feature_Overview.pdf

To make a long story short, we believe that many customers of Palo Alto use that solution in addition to a traditional firewall.  This article suggests as much:  http://www.enterprisenetworkingplanet.com/netsecur/next-generation-firewall-buyers-guide.html  Aside from marketing fluff, we have been able to find very little in the way of real users saying Palo Alto is good enough to rip and replace Check Point.

Furthermore, we have consistently seen a trend towards unified threat management which Check Point has successfully been able to address with blades that add the functionality as competitors come out with products.  We think Palo Alto’s next generation firewall is basically just an application identification engine which is very hyped and that Check Point should ultimately be able to respond to that.  To be sure with $250 million in revenue expected this year, Palo Alto is a threat, but there have always been competitive threats and Check Point has consistently responded to them.  This time should be no different.

For a little more on next gen firewalls see here:

http://www.techrepublic.com/blog/security/next-generation-firewalls-its-all-about-tuples/6969

Furthermore, Palo Alto faces a significant IP suit from Juniper (Nir Zuk’s former employer)-- see their S-1.  One bad court ruling may end up making Palo Alto a paper tiger.  Even if it all goes epically badly for Checkpoint on the new product front, 60% of their revenue is recurring/maintenance which would be quite persistent for many more years under almost any competitive scenario you can imagine.  This helps provide a margin of safety to an investment.

2)      European Customer Worries

There is no getting around the macro, but this too shall pass. 39% of Check Point’s revenue comes from Europe.  On their most recent conference call Check Point Gil Shwed summed up the Europe situation as follows:

“In Europe, we have been able to win large projects and deliver significantly more units overall, while the economy puts some pressure on pricing with local currency weakness against the dollar contributing as well. We have seen a different factor in different countries in Europe, some are demonstrating healthy growth like Germany, France and Italy this quarter, along with several other northern countries, while some other countries are not performing as well.”

The reality is that Europe has been a difficult place to do business for a while now and Check Point has managed through it, just like they did when the world fell apart for macro reasons in 2008/2009 (revenue grew through the downturn back then).  This too shall pass.  Demand for network security will remain, even if spending gets delayed.

3)      War in the Middle East

This is always a risk.  If it happens, Check Point will survive as it is a global business and their products aren’t even really manufactured in Israel (though they have many engineers there).  I’d be buying more  Check Point on the day war breaks out and so would Ben Graham.

Valuation:

Price: $46.37

Dil Shs Out: 211.3

Mkt. Cap: $9,798

Net Debt: -$3,201 (Yup that is $15.15 per share)

EV: $6,597

                                2011                       2012E                    2013E

Revs                       1,247                     1,358                     1,483

EBITDA                    734                         806                         868

Net Income*           588                         651                         718

FCF                         721                         795                         853

EPS*                      $2.72                     $3.10                     $3.44

(GAAP except excludes amortization of intangibles but includes SBC expense)

Implied Multiples

EV/EBITDA          9.0x                        8.2x                        7.6x

P/E                     17.0x                     15.0x                     13.5x                    

P/E ex cash        11.5x                     10.1x                     9.1x                       

P/FCF                 13.5x                     12.3x                     11.5x
EV/FCF               9.1x                        8.3x                        7.7x

The numbers sort of speak for themselves here.  The company is trading cheap for what has historically be a very high quality business.  This could be an excellent use of overseas cash for some of the slower growing tech behemoths with a smaller security footprint than they would like (e.g. CSCO).  The stock does not screen well on a pure P/E due to a significant portion of the cash being invested in safe debt with maturities of greater than 1 yr.

Risks:

• Check Point is an Israeli company.  While its business is global, many key executives and R&D engineers live in Israel.  Should Israel go to war, it may be disruptive to the business.
• Check Point faces competition from several companies including Palo Alto Networks, Cisco, Juniper,Fortinet, McAfee, Symantec, SonicWall, and others. You can see Gartner’s magic quadrant here: http://www.checkpoint.com/products/promo/gartner-firewall/index.html  Check Point has historically been very successful at fending off competition and this is a big market (~$8 billion annually and growing high single digit) with room for many players, but competitive threats do exists and Check Point must stay vigilant to stay ahead of the competition. We believe Check Point’s focus exclusively on network security is a benefit to them versus less focused competitors like Cisco and Juniper.  We have addressed why we think Palo Alto is not a Check Point killer above.
• Check Point is exposed to a general slowdown in enterprise spending.  In particular new network deployments (and therefore security purchases) can be delayed for a little while in the event of a short-term downturn in business.  Eventually, Check Point will get that revenue back, but delays in corporate IT spending can happen and would be detrimental to Check Point’s business in the short-term.  

Catalysts:

• Aggressive stock buyback
• Europe macro malaise lifts
• Potential consolidation candidate for someone like CSCO
• Continued execution by the company in its core market, despite competitive noise

Disclaimer:  We and our affiliates own Check Point shares.  We may buy or sell these shares at any time.  Please do your own due diligence.  The information provided above is not investment advice, may be inaccurate, and should be used at your own risk. 

Catalyst