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Check Point Software's Attractive Potential Behind Its Weak Short-Term Earnings

By Herve Blandin - Nov 3, 2019 at 6:46AM

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In the context of modest third-quarter results, the company is poised to boost its profits over the medium term.

Check Point Software Technologies' (CHKP -0.77%) third-quarter earnings came in slightly above expectations. The legacy cybersecurity vendor posted modest year-over-year revenue growth and flat earnings per share, but the company's unexciting results hide its medium-term growth potential. And given its reasonable valuation, Check Point could turn into an attractive investment.

Slow revenue growth is poised to accelerate 

Since some studies estimate the cybersecurity market will grow at an annual rate above 11% over the next several years, Check Point's third-quarter results look weak.

Revenue increased by only 4% year over year and reached $491.4 million, slightly above the midpoint of management's guidance range of $480 million to $500 million. Earnings per share reported under generally accepted accounted principles (GAAP) reached the top of the guidance at $1.25 but stayed flat year over year. And the midpoint of management's revenue guidance for next quarter of $542 million corresponds to modest 3.6% year-over-year revenue growth.

The company is facing the secular decline of its products and licenses segment, in which it sells licenses for its legacy hardware firewalls. During the third quarter, this segment declined 2.4% year over year.

But Check Point is transitioning from one-off licenses to subscriptions. More and more, customers pay recurring fees to use a growing part of the company's portfolio, versus a single large upfront payment. 

As a result, Check Point's revenue from subscriptions increased by 12.9% during the third quarter. This strong performance also highlights the company's growth in its cloud offerings which include Threat Extraction protection, CloudGuard Solutions, and Infinity; all of which are billed in the form of subscriptions. But this transition also contributes to the company's low total revenue growth in the short term since it involves giving up large immediate revenue in exchange for revenue that will spread over several years.

During the third quarter, revenue from the company's subscription business of $153.9 million largely exceeded that of its products and licenses segment of $118.2 million. Over time, the negative impact of revenue from the company's products and licenses segment will diminish, which will boost Check Point's top line. Besides, the current quarter's 8% increase in deferred revenue, a leading indicator of revenue growth, highlights the company's potential over the medium term. 

A man touches the image of a cloud with a padlock icon in its center on a screen to illustrate network security.

Image source: Getty Images.

Ramping up sales and marketing efforts 

Despite Check Point's modest third-quarter revenue growth, GAAP net income dropped to $187.9 million, down 5.2% year over year. And GAAP operating income, which excludes the impact of taxes and interest, decreased by 5.4%. 

Albeit lower compared to last year, the company's third-quarter GAAP operating and net margins of 43.6% and 38.3%, respectively, remain impressive. In contrast, many high-growth cybersecurity companies such as Palo Alto Networks, Splunk, or Proofpoint have been posting GAAP losses over the last several years.

Check Point's lower sales and marketing (S&M) expenses as a percentage of revenue -- 28% during Q3 compared to 45%+ for many competitors -- explain its higher profitability. But that also corresponds to the low revenue growth the company has been reporting. Several quarters ago, Check Point's management recognized it needed to reorganize its U.S. sales force to boost revenue growth. However, executives noted during the last earnings call that the increase in S&M expenses to reorganize the sales force would pay off over several quarters, which means operating margins won't improve in the short term.

Thus, investors should keep an eye on Check Point's S&M expenses. Over the medium term, the company's sales reorganization should translate into revenue growth and it should sustain its impressive operating margin above its current level of 43.6%. Higher revenue growth coupled with improving operating margin will boost Check Point's profits.

Growth potential

At Check Point's current valuation, the market doesn't price in much growth. Given the company's low revenue growth, its enterprise value-to-sales ratio of 7.6 -- in line with its high-growth peers -- looks pricey. But you should consider its huge profit margin. With Check Point's full-year GAAP earnings per share based on the midpoint of the next-quarter's guidance, Check Point's P/E ratio stands at a moderate 20.2 at the time of this writing. Moreover, the P/E ratio doesn't take into account Check Point's large cash position of $4.06 billion, with no debt.

Thus, given Check Point's reasonable valuation and its potential growth, investors should consider it as an attractive cybersecurity stock over the medium term.

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