Check Point Software Technologies Ltd.
Cybersecurity is and will continue to be one of the most important industries of the next decade.
From its humble beginnings as an academic and government file sharing network, the Internet now is critical to business and government all over the world. It is the technology behind a true historical revolution that has upturned and redefined countless traditional industries, including media, communications, commerce, healthcare, and many others.
As a result, computer networks have become a prime target for malicious attacks. Attackers stand to gain access to financial information like credit card numbers, personal information which can be used for identity theft, corporate secrets and plans, and even classified government and military secrets. Perhaps even more frightening, attackers may be able to shut down or control these networks, which would be extremely disruptive or even debilitating to large organizations. Protecting these networks is absolutely critical.
MagicDiligence likes critical industries. These are "inevitables". Companies with strong competitive positions in inevitable industries are virtually assured of predictable sales and cash flows, regardless of larger economic conditions.
It is even better when this critical industry is one that should grow at above-average rates for decades to come. Indeed, the need for network security is only going to grow as long-term trends such as e-commerce, machine-to-machine communications, and ubiquitous cloud computing continue to take hold. In fact, cybersecurity at large is projected to grow at a 10% annual rate, surpassing a market size of $170 billion by 2020. That is one ENORMOUS market.
Check Point's Razor and Blades
Check Point operates on a business model that sort of looks like Gillette's classic "razor and blades" strategy. The "razors" in this case are computer hardware "appliances", which can be loaded with different software-based "blades", such as firewalls, VPNs, antivirus, data loss prevention, access policy management, and other security-based applications. As a company builds out its network, it can opt to purchase additional blades to extend its network security.
About 34% of Check Point's revenues are from hardware and initial software "blade" licenses. But more enticing are that 46% of sales are from ongoing software update and hardware maintenance and service contracts, while 21% of are from subscription licensing. Both of these sources of revenues are recurring, and given the importance of securing a network, renewals are highly predictable.
The Growth Story and Valuation
Check Point is not a pure growth play, per se. This is not a company that is going to blow the doors off with top line growth. Over the past 5 years, sales have grown at about 6% annually. I think Check Point should be able to match that and maybe slightly surpass it, given the growth in the underlying industry and the company's nascent efforts entering the cloud and mobile security arenas. So that is a decent start.
Margin expansion is not something I would expect, either. Check Point's operating margins have fluctuated between 51% and 55% over the last 5 years (which is pretty impressive in itself), and given the competitive environment, just maintaining those levels will be an achievement.
However, earnings per share growth should be sustained by share buybacks. Check Point has been an aggressive repurchaser, retiring an average of 4% of their shares in each of the past 5 years. Given the company's massive free cash flows and measured acquisition strategy, more buybacks are almost assured. Check Point is also a ripe candidate to institute a regular dividend, although it does not pay one as of today.
All together, I see average-ish 5% top line growth, slightly declining margins, and 3-4% annual share buybacks supporting 5-6% annual earnings growth over the next 5 years. With Check Point's entrenched position and recurring revenues, I assign it my "par" discount rate of 10.5%, yielding a target price of just over $100. That's not bad - over a 35% gain from today's prices in the mid-$70's.
By far the main risk in Check Point is the company losing share or pricing power in what is becoming a very crowded industry.
Check Point's direct competitors is a literal "who's who" of gigantic IT companies. It competes against Fortinet, Cisco (CSCO), Juniper (JNPR), Palo Alto Networks (PANW), McAfee (a part of Intel INTC), Symantec (SYMC), and Microsoft (MSFT), just to name a few. The number of new IT security firms seems to grow by the day, and with the size and growth potential of the market combined with relatively low barriers to entry, this will likely continue for years. New competition not only makes it harder to win (and keep) clients, but it also pressures pricing. Check Point investors will need to keep a close eye on operating margins to make sure the firm's competitive position is not deteriorating.
Currently, the company is in good shape. It is a clear leader in IT security, ranking in Gartner's "Leader" quadrant for Enterprise Network Firewalls, Unified Threat Management, and Mobile Data Protection. The company also has the #1 market share in firewalls, according to both Gartner and IDC. CEO and co-founder Gil Shwed - who was instrumental in inventing the modern firewall - and his founding partner Marius Nacht still own 25% of the company. I love to see founder-run companies, as they are generally more focused on the big picture and long-term health of their companies than hitting quarterly financial goals. This and the company's solid reputation give me faith that Check Point can compete - and win - in this market.
Check Point is a company with strong market share in a large and growing market with a reasonable valuation. The stock's 9.7% free cash flow yield looks positively attractive to me given the reliability of cash flows. This is not a stock that will blow the doors off with revenue growth and a doubling or tripling stock price, but it looks poised to generate market-beating returns over the next year or two. It appears to be an attractive Magic Recipe stock.
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