Valuation Update of Check Point Software after FY 2019 results

Check Point Software Technologies Ltd. released Q4 results and its Annual Report 2019 on February 3rd, 2020. Time to check my underlying assumptions and to update my valuation model if neccessary …

This is not investment advice. Please read the disclaimer.
I do currently own Shares of Check Point Software Technologies Ltd. (CHKP US).

To read about Check Points Business and Products in more detail, please read my initial post on Check Point

Key Topics

• Overall Revenues in Q4 was in-line (+3% YoY, despite included FX headwinds); Billings missed estimates, though.
• Operating Profit Margins came down during both Q4 and FY 2019
• Earnings per Share increased, helped through SBBs
• Check Point continued its SBBs and announced a new 2 bn USD repurchase program with a quarterly max. 325 mn USD.
• CHKPs uninspiring Guidance for 2020

Revenues

Total revenues in Q4 were reported as 544 mUSD (+3.4% YoY) bringing revenues for the full year (ending Dec 31, 2019) to 1,995 mUSD, representing an increase of +4.1% from 2018. I modeled revenue of 1,999 for 2019.

The subscription segment reached over 600 mUSD in Revenue in 2019, driven by Cloud an Mobile and zero-day advanced thread prevention technolgies. Deferred Revenue at the end of 2019 increased further (+3.7%) to 1,387 mUSD (2018: 1,337), indicating continued stonger underlying growth (vs reported) and transition to substriptions. The annual growth of Deferred Revenue favours Cashflows from Operations vs Operating Income, since Cash Inflows occur earlier than Revenue is earned.

Profit Margins came down

Both GAAP and Non-GAAP* Operational Income came down during Q4 and for FY 2019.

Attention: Non-GAAP figures exclude significant Share based compensation (SBC) expenses which should be taken into account when valueing a business.
–> Read why!

CHKP allocated most of its SBCs to General & administrative Costs.

GAAP Op. Income came in at 249 mUSD in Q4, representing a margin of 46% down from 48% in Q4 2018. GAAP Op. Income for the full year came in at 882 m$ resulting in a margin of 44.2% (-4%p) compared to 48% for FY 2018. I modeled 879 m$, representing a margin of 43.9% for 2019.

Non-GAAP Operational Income was 280 m$ in Q4 and 1,003 m$ (50.3%) for the full year.

Increasing operating expenses in FY 2019 were expected and mostly driven by Selling and Marketing (553 m$ vs 501), R&D (239 vs 212) and General and Admin (106 vs 89). Financial Income increase, and Taxes were lower. As a result of the above trends, GAAP Net Income for the full year was 826 m$ compared to 821 m$ for FY 2018, resulting in net margins of 41.4% (-1.4%p) and 42.8% respectively. Stock based compensation (SBC) expenses were higher than expected.

Earnings per Share

Diluted Non-GAAP EpS or earnings per share for the fourth quarter increased to $ 2.02 compared to $ 1.68 for Q4 2018. For the full year 2019, EpS were $ 6.13 vs 5.71 for 2018. Higher calculated EpS were supported by a lower number of diluted shares reported for Q4 148.1m (vs 157.4 for Q4 2018) and 152.1m for the full year (159.4).

Guidance for 2020

Management guides for 2020 Revenue between 2.0 and 2.1 bn USD (Consensus of 2.06) indicating Growth between 0% and 5%.

Analysts expect longer term growth rates to be in line with recent total revenue growth trends of c. +3% and reported net margins decreasing from c. 45% to 41% in 2025 (which I blieve could be too high an estimate).

Valuation Update

The result of my DCF-Valuation did not change much compared to my last valuation as did my key assumptions in my base case are:

• Reported revenue growth is about 3.5% per year until 2025, supported by
  • Higher selling and marketing spend going forward
  • Small technology driven acquisitions along the way
  • Terminal Growth rate of 3.6% in 2025 and beyond
• Operating profit margin (reported EBIT) is pressured further until 2022, stabilizing at c. 40% (vs. an average of 48.4% for 2015-2019, 44.2% in 2019)
• Only minor Net CapEx needs, slightly above depreciation
• Ongoing benefits from an effective tax rate (14.7%) on income being much lower than regular corporate income tax rate (23%)
• Discount rate (wacc) of 6% since high quality business

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Other claims on Equity (past SBC)

Like written above, Check Point incurs significant share based compensation (SBC) expenses annually. These have to be taken into account when valueing CHKP (you might want to read why). Future SBC expenses are incorporated in modeled reported EBIT figures. Past SBCs have to be valued and subtracted from Equity value before dividing through Number of Shares to get to FVpS.

Since the annual report 2019 is not yet released, I had a deeper look into the Equity based compensation section of the annual report 2018 (Form 20-F, p 40ff) and will refer to these figures in the following. Btw, a very intresting fact I read in this section, which I like very much is the following

Mr. Shwed requested to forego his salary and bonus for 2018, as he has done for the past several years.

(2018 Form 20-F, p 40)

Check Point has various equity incentive plans with many different forms of instruments involved such as below. This fact makes it more difficult to value past share based compensation and to adjust Total Equity Value accordingly.

• Incentive Stock Options or ISOs
• Non-statutory Stock Options or NSOs
• Restricted Stock
• Restricted Stock Units or RSUs
• Performance Shares
• Performance RSUs or PSUs
• Deferred Stock Units
• (Non-)approved 102 Options/Shares
• ESPP shares

I assume that all granted equity/share based compensation (past SBC) is included in the below table, i.e. that the “options to purchase 1.3 million ordinary shares at an exercise price equal to 100% of the closing price of the ordinary shares […] on the date of the grant, vesting over a period of 4 years” (p 41) granted granted to Mr. Shwed are included in the below.

Equity Incentive Plans (2018), p 46

I tried to value these claims on equity and came up with a number of 522 mn USD, representing 42% of most conservative assumption or worst case (Outstanding Options, RSU … x current PpS: 10.6m x $117). On the one hand, the real claim on equity is probably (much) lower, since many options are only exercisable, if at all, in some future years, and if certain milestones are met, future values had to be discounted, on the other hand the Share buy backs strongly support the PpS in the long run.

• The two smaller plans (Dome9 and ESPP) were valued just as current shares, resulting in a claim on equity of 81.6 mn USD.
• The other two plans result in a claim on equity of 440 mn USD assuming exercise prices of $50, 75, 85, 95, 115 applicable for one fifth each. Value per Option decreases with exercise price from $67 for strike price of $50 (PpS – strike, no time value) to $32 for strike price of $115 (PpS – strike, + $30 of time value as, being a pure guess only).

Claim on Equity (2018), own calculation

Results

My DCF Valuation results in an estimate for Fair Value per Share (FVpS) of $ 213 (base case) compared to a current PpS of $117 (55% of FVpS). My prior valuation yielded an estimate of FVpS of $ 211.

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CHKP sensitivities are high. Since my estimated terminal growth rate (TGR) is close to the discount rate (DR) used, the sensitivity is high to both valuation parameters. Changing TGR to 3.1% (-0.5%p) and DR to 7% (+1%p) results in an est. FVpS of $ 144 instead of 213. But this is a high quality business and a discount rate of 6% feels about right for me. Check Point operates within a growth industry becoming ever more important in our connected world.

Summary / Decision

I really feel very comfortable with CHKP because I am quite confident about the long term growth outlook. There are competitors that grow faster than CHKP (winning market share), but CHKP offers very high quality products, is investing more in growth going forward, owns valuable client relationship and trust.

I also do believe, that economic downturns (which could be well underway) will only have a minor impact on short term revenues/profits. CHKPs revenues are quite “sticky” and are supported from long term tailwinds (read about cyber security becoming more important here). In general I conclude CHKP is a very high quality but currently significantly undervalued business, so I am inclined to buy more shares in the future.

I hope you enjoyed this blog post. Please feel very welcome to engage in a discussion of my assumptions (growth, margins, quality, etc.) or to give generel feedback 🙂
Best, s4v