Fundamental Valuation of Check Point Software (CHKP)

~ searching4value

Check Point Software Technologies Ltd. is an Israeli Company, that develops and sells Information Technology Security products. It is growing much slower than its highflying peers (Palo Alto, Fireeye, Fortinet) but it is very profitable. I do not have a good IT knowledge, but anyway, I wanted to perform a DCF Valuation of this Company for a long time now!

This is not investment advise. Please read the disclaimer.

Company Description

From its IR-Website:

CEO Gil Shwed founded Check Point Software Technologies Ltd. (NASDAQ: CHKP) in 1993 [and currently holds 16.4% of CHKP Shares and seems to have the owner perspective]. From our inception, we had a vision of making Internet communications and critical data secure, reliable and available everywhere. Since then, we have grown to be the largest pure-play security vendor globally and provide industry-leading solutions to protect customers from all types of cyberattacks.
At Check Point, we secure the future.

IR-Website

Resources

Quick Observations & Facts

  • Industry: Information Technology / Cyber Security; long-term tailwinds could be there.
  • Very solid Balance Sheet with no Financial Debt but more than 4 bn USD Cash & Equiv. (rather constant)
  • Valuation: Market Cap of 17 bn USD with a P/E of 20.5x and a Cash adj. P/E of 17.3x, using est. GAAP ’19 EPS of 5.46 USD.
  • Highly Cash Generative: FCF (as reported) of about 1bn annually
  • Capital Allocation: Cash going mostly into Share Buy Backs (SBBs) and some smaller M&A activity. No Dividends.
  • Shares Outstanding (Diluted) declined from 192m to 159m; currently at 152.2m.
  • Owner Perspective: Company Insiders own c. 20% of Shares:
    • Gil Shwed (CEO): 16%
    • Marius Nacht (Co-Founder): c. 4%
  • Profitable Revenue Growth: from 1.5bn Sales in 2014 to 1.9bn in 2018, with
    • EPS (GAAP) grew from 3.43 to 5.15 USD.
  • The Company’s stock is traded on the NASDAQ Stock Market under the symbol CHKP; WKN 901638; ISIN IL0010824113)

Navigation

This is a rather long article. I hope this links help you to navigate: >> Products >> Financial Analysis >> Industry >> Competition >> Model Inputs >> DCF Valuation >> Summary

General Financial Reporting Structure

CHKPs Financial Years are ending December 31.
Attention: Adj. Numbers are sugarcoated / significantly better, since Share based Compensation or SBC of c. 90m USD in FY’18 were omitted.
–> for more on SBC and why to tread them as real expenses see Number of Shares Outstanding.

Check Point currently reports revenues by category of activity
1) Products and licenses
2) Security subscriptions
3) Software updates and maintenance
It is not fully clear to me which products and services are included in which of the three categories, but CHKP states the following, which leads me to the assumption, that they are at least partially, interconnected…

Our arrangements typically contain multiple deliverables, such as products and licenses, security subscriptions and software updates and maintenance, which are generally capable of being distinct and accounted for as separate performance obligations.

AR 2018, p. 28.

Products

Check Point offers a whole lot of Security Products. Most of them sound pretty fancy for my to be honest. I do not want to even pretend (to you or to myself) that I even understand half about what I read on their Products website. Working at a bank I once used an USB stick that was encrypted with a Check Point Product. This was maybe 10 years ago, but I believe they used the exact same logo as nowadays 😀

What I do understand is, that CHKP offers good products, winning industry awards. What I also understand is that they have more legacy products vs some fast growing competitors, (more focused on modern products with higher sales dynamics?). But I also know that big corporations, can be pretty slow to adapt any new software solutions because its such a big hassle. (More on adoption of new software products below)

Reading the Q3 Earning Call I especially liked some comments from Gil Shwed (CEO and Founder) about CHKPs products, listing some of them below.

The quote shows me that (i) Check Point is able to win large enterprises, and these customers tend to be slow to change vendors, which is of course good for CHKP if they won the respective customer in the first place; and that (ii) CHKP has a diversivied customer base regarding industries.

We place a lot of emphasis on the cloud and we believe we have the most comprehensive architecture to secure cloud environment. As a result, we’ve seen nice successes. Cloud business results continue to be healthy, growth percentage remains quite high. Some recent example of nice wins in the cloud space include two of the world’s largest accounting firms, two of the world’s largest consulting firms, one of the world’s largest business media firms, two of the world’s largest retail franchises, two of the world’s largest stock exchanges, and the list goes on with many of the world’s top companies including shipping, financial, telcos, and government.

Q3 2019 Earning Call

Another one

[…] a new customer, an energy company in America. We asked them what made them choose Check Point. They quoted few major reasons. One is that only Check Point has real time threat prevention. The competition simply lacks these capabilities as their threat analysis work in the background and don’t stop the attack. The second reason was the superiority of our management. Our interface is more comprehensive and much easier to use. Things that takes hours with the competition, simply takes minutes with Check Point. Overall, we felt that Check Point has a better architecture […]

Q3 2019 Earning Call

It seems CHKP is winning new customers

[…] I was very pleased to see many wins that we’ve seen all around the world. I think what we’d like to do is to first get more new customers. That’s a big focus. By the way, this quarter we did see a nice increase in the number of new customers.

Q3 2019 Earning Call

Many comments from Gil left me with the impression that Check Point is not trying to drive short term financial indicators (i.e. selling hardware to clients not really needed) but is rather focussing on improving products where needed.

Financial Analysis

In the following I will have a look at Balance Sheet, Sales, Operational Expenses, Profitability, Non-Operational Expenses, Capital Allocation and Quality. This should help to navigate.

Balance Sheet

  • No Financial Debt. I am currently not aware of pension liabilities.
  • Cash and Cash Equivalents of 4 bnUSD.
  • Total Equity stands at 3.7 bn (adding Treasury Shares brings it at 10.6 bn for an indication).
    • Goodwill stands at 950 m, resulting in a Goodwill-to-Equity ratio of 25% or below 10% if calculating with Total Equity adj. for Treasury Shares, which is pretty low (38:00).

Sales

CHKP writes in its Annual Report 2018:

Total revenues in 2018 grew by 3% compared to 2017. Product and license revenues decreased by $33 million, or 6%, from $559 million in 2017 to $526 million in 2018, which was attributed primarily to customer transitions to security subscriptions solutions. We continued to deliver increasingly more of our latest security offerings as subscriptions resulting in increased sales of our security subscription packages, including advance threat protection, Sandblast and CloudGuard solutions. As a result, security subscription revenues increased by $62 million, or 13%, from $480 million in 2017 to $542 million in 2018. In 2018, product and license and security subscription revenues as a percentage of total revenues were 56%, similar to 2017. Software updates and maintenance revenues increased by $34 million, or 4%, from $815 million in 2017 to $849 million in 2018, primarily as a result of renewals of existing and sales of new maintenance contracts.

AR 2018, p. 32

Some Notes on Sales

  • Kind of subscription like B2B revenues which should be rather sticky over time and during a potential economic downturn
    • In fact, I tend to argue/conclude that basically all of CHKPs revenues are kind of subscription like B2B revenues. Most of the companies will just buy the next product, update a software or renew an expiring contract or, in the end using a subscription. No matter how it is called…
    • The CFO stated in the Q3 2019 earning call, that revenue came in at $ 1 mn above the midpoint of CHKPs guidance. That indicates the forecastability and quality of revenues.
  • Growing Revenues profitably for many years in a row. It is not growing super fast compared to other Technology Companies (see below), but Revenues grew steady and profitably (see below). Overall Growth rates came down over the last 10 years, with Year-over-Year or YoY Growth of Q3 2019 being the most current Reporting period, coming in at 4.3%.
    • over the last 3 years at about 5.5% p.a. (CAGR FY’15-’18)
    • over the last 5 years at about 6.6% p.a. (CAGR FY’13-’18)
    • over the last 10 years at about 9.0% p.a. (CAGR FY’08-’18)
  • Revenue Segment ‘Security Subscriptions’ is growing much faster as other Revenue Segments.

Subscription Revenues

Check Point points to the fact (above quotation) that customers are transitioning to subcription products and accounting [AR 2018, p.76/125] numbers clearly suppor this notion, as Deferred Revenues increased by 100 mUSD from 2017 to 2018 (+11.6%).

I can imagine, that underlying sales growth is actually stronger (higher) than plain show numbers, since the customer transition to subscriptions. Based on this transition, I guess billings and bookings are growing stronger than revenues, resulting in growing deferred revenues. Below a little excurs on Bookings, billings and revenue:

Bookings […] refer to when a customer “books” your product or service, and commits to spending money with you. When someone signs up for a paid plan with your SaaS, that counts as a booking […]
Your billings drive your cash flow. […] It’s common for companies to get an influx of business (ie: bookings), and suddenly need to hire to cope with the additional workload. Here, companies who haven’t billed their customers upfront might be caught in a bind. […]
Your revenue […] is the actual amount that you’ve earned (in return for providing your product/services) from your customers.

https://abel-finance.com/saas-bookings-saas-billings-saas-revenue/

Operational Expenses

Operating costs primarily consist of Selling and marketing and R&D costs, both are expected to rise further relative to Revenues, since fierce competition. Amortization is negligible. CHKP reports as follows

Historic trends show slightly declining profit margins since about FY 2012/13. Profit margins should trend lower based on high competition and sales and marketing as well as R&D expenses expected to be higher.

Profitability

Check Points profitability is very high — especially compared to peers — both measured as Operating Income Margin or EBIT Margin or Net Income Margin, with Net Income being artificially high through Interest Income and a low Tax Rate.

Non-Operating Costs

Non-Operating costs are negligible. Check Point earns significant interest income on its cash balance of c. USD 4 bn.

Capital Allocation

Returning Cash to Shareholders

CHKP does not pay a dividend. But it is buying back Shares at a steady pace with most of its Earnings/Cashflow, which I am going to like very much, if and only if the current share Price is (significantly) below my fair value estimate. CHKP pays substantial SBC to employees, but still, Diluted Shares Outstanding are down significantly over the last years: in FY’18 159.5 mn, down from 166.6 (’17), 183.6 (’15), 216.6 (’08).

Acquisitions

CHKP does use cash for some smaller Aquisitions from time to time, i.e. 155 mn USD for acquireing of Dome9, which is a provider of cloud security Solutions, According to their Annual Report ’18, Consolidated Statements of Cash Flows, p80/125.

Quality Assessment

Check Point seems to be a high quality business to me, because…

  • It provides a quality product that wil be even more essential in the future
  • Revenue is growing from year to year with long term trend in good order
  • Rock-solid balance sheet with no financial debt but a hughe cash pile providing stability and enabling the company to:
    • buy competitors (i.e. if opportunities arise during next downturn),
    • do Share Buy Backs, or
    • instating a dividend policy.
  • Profitability. Check Point operates at constantly high Profit Margins (EBITDA, EBIT, Net Income), even if these could trend a bit lower in the future
  • History of small acquisitions
  • Founder is still with the company, Owner Perspective is given.
  • Industry development should provide tailwinds for many years to come
  • Israel is well known for its cyber security sector and expertise, probably resulting in a tendency for Governments to Support the Sector/Company (if for strategic reasons). [In fact, in Note 12: Taxes on Income on p. 110/125 in AR 2018 I found the expressions Preferred Enterprise status and Technological preferred or Preferred Enterprise resulting in lower effective Income Taxes for CHKP]
  • Easy to understand business model, without understanding the resellers/partners or the products in much detail.

Industry Trends and Outlook

Cyber Security is becoming more and more important with the world becoming more interlinked every day. In a world of ever increasing cyber risks, companies as Check Point should do well. In fact, Oliver Bähte (CEO of German Insurer Allianz) posted in January 2020 on LinkedIn that Cyber Incidents became biggest worry for risk managers globally for the first time (lnkd.in/dKBSbfj).

LinkedIn

Industry growth rates are slowing down, but still estimated to be in the high single digits. Since 2015, Check Point did grow about 4%-Points slower than the Network Security Market as a whole. Its only reasonable to assume lower than average growth for the near future. Industry is fragmented, more M&A is likely in the fututure. Bigger Players are mostly buying niche produxcts to filll there gaps in product offerings.

Competition

Like stated above, CHKPs market is growing at healty rates, but the Industry is highly competitive! Especially some smaller competitors seem to eschew profits for now in order to gain market share and grow their revenue/customer base above industry average. Check Point has a whole bunch of competitors: Symantec (bought by Broadcom), Fortinet, Palo Alto Networks, Fireeye, Oracle, … , with Palo Alto, Fortinet and FireEye growing at much faster rates, partly through acquisitions.
However, some of the competitors may not be as profitable (PM: Net Income Margin) as Check Point is. Fortinet, Palo Alto Networks and Fireeye each boast a relation of Marketing & Sales Expenses (Selling Expn) to Revenue of > 40%. The rate for CHKP stands at 26% only for FY 2018.

Company Outlook & Model Inputs

Growth Rate for Revenue

I tought about three ways to model CHKPs total revenue. In the end I decided to go with option 1.

  1. Revenue modeled as CHKPs growth derived from overall market growth minus a lag (i.e. -4%), based on historic numbers
  2. Overall growth rate, some higher growth is liekly to kick in a few years into the future, since customers are adoptiong subsriptions (delaying legacy products)
  3. Modeling each revenue-line separately, subscription higher than others, and total revenue as sum of products (–> extrapolation of hist. trends). Long-term growth rate should be more than long-term global GDP growth, since CHKPs products is getting more important.

Operating / EBIT Margin

R&D and Sales & Marketing Expenses are expected to grow faster than Sales with other Costs being flat relatively to sales. Share based Compensation or SBC should grow in line with EBIT. This should pressure Operating Margins in the future. I model an EBIT Margin of 44% for FY 2019. This will fall to 39.4% in 2025 in my base case (bear: 38.9%, bull: 39.9%).

Financial Income

Interest Income on Cash Balance is a Non-Operating income and is not taken into account when performing the DCF valuation.

CapEx

CapEx should basically be low and about equal to Depreciation. So I do not model it explicitly. Every few years some small M&A (-CapEx) of about 50 mn annually, being lower in the final year (2025), amortized very long-term.

Valuation Parameters

  • WACC at 6% feels about right for me [FYI: Bloomberg states 5.8%], its composition could turn out as:
    • Risk Free US (Israel) 10yrs: 1.8% (0.8%) –> 1.3%
    • basis ERP –> +6%
    • Technology sector –> +1%
    • Subscriptions –> -1%, High Cash / No Debt: -1%
  • Terminal Growth Rate is 3.8% in my base scenario
    • Bear: 2.2%
    • Bull: 4.9%
  • My Margin of Safety (MoS) is rather low based on the very high quality I assign to Check point.

DCF Valuation

Perfoming my DCF Valuation resulted in an estimated Fair Value per Share or FVpS in my base case of 233 USD or 210 EUR, indicating a current discount of 50%.

Potential Catalysts & Risks

  • Multiple Expansion, based on higher share of (sticky) subscription-revenue, and thus better forecastability and an updated market perception
  • Using Cash more aggressive, i.e. instating dividend payments (Net Cash of c. 4bn, incl. securities)
  • Changing Growth Trajectory by sacrificing Profit Margins and/or M&A activity (see above: Using cash…)
  • Being regarded as M&A target by competitor(s) or big IT player Oracle/Microsoft/… (I believe that’s is rahter unlikely though)

Summary

I regard Check Point as a very high quality technology company with steady and profitable growth, even if some competitors are showing much higher growth rates. Additionally I believe that my assumptions are rather sound and that external factors are rahter limited. If my estimated FVpS is about right, future Share Buy Backs will provide much value to current shareholders.

Final Decision

Like stated before, this was my follow-up post about CHKP writing down my more detailed analysis. I already bought an initial position but I strongly believe I will buy more CHKP shares based on my above insights.

Outlook

I am looking forward to read your views, comments, opinions and to a useful and interesting discussion, abou the company, my model, my assumptions, etc.
Furthermore, I would be very happy if you would decide to follow my blog for future posts 🙂
I already have a bunch of new research ideas…
Best, searching4value.