Near-Term Business Momentum Looks Good For Check Point (NASDAQ:CHKP)

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Forthcoming Revenue & Earnings Surprises

Compared to Wall Street we’re more optimistic in revenue projections as we feel the tone of, and evidence from, the 3Q20 earnings call has been unnoticed. For the first time since the onset of the pandemic management submitted guidance and Shwed’s (founder & CEO) and Payne’s (CFO) mood was materially upbeat compared to recent quarters and the two were noticeably more assertive. And this change in confidence appears to be underpinned by increased demand for Maestro and Infinity. We project revenue and EPS will comfortably beat expectations in 4Q20E and expand the 8.0x NTM P/S at the time of writing to 52-week highs of 8.8x. This would deliver 10{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} upside to $132 from now through to a couple of weeks following the 4Q20 earnings release on 3rd Feb 2021, in our opinion. Alternatively the anticipated earnings surprise will expand the NTM P/E to 52-week highs of c. 19.4x which would produce a $134 share price (12{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} upside). Both these price forecasts are based on the current consensus NTM forecasts once 4Q20E results have been released on 3rd Feb 2021.

Current (27th Nov 2020) 8.0x 17.4x
52 week high 8.8x 19.4x
Sales per share EPS
4Q20E earnings (3rd Feb) Beat Beat
Consensus NTM after 4Q20E earnings 15.01 6.91
Convequity NTM after 4Q20E earnings 15.76 7.87
Consensus-based new price $132.09 $134.05
Convequity-based new price $138.79 $152.68

The NTM P/E is based on diluted non-GAAP EPS which excludes stock-based compensation (SBC) and amortization of acquired intangibles, as this version of EPS is more of a focus of the tech investment community than the GAAP version. Based on our EPS forecasts a return to a forward P/E 52 week high of 19.4x would push the price up to $153, however, based on our DCF valuation we don’t believe the stock will rise this high, especially not on the time horizon through to mid-February.

Healthy Maestro Orchestration Sales

The Work-From-Home (WFH) conditions has resulted in traffic bottlenecks as the high majority of employees connect to their enterprises’ IT resources from remote locations. Moreover, consumers are purchasing more products online due to restrictions and health concerns. This has put immense strain on firewalls that need to inspect all data packets flowing in and out of the corporate network. Maestro has appealed to many companies because it enables old security appliances to be combined to deliver orders of magnitude greater capacity in an on-demand manner. By using this solution firms can avoid replacing old with new hardware and the costs associated with over-provisioning. Instead the Maestro orchestration can scale capacity, performance, and threat prevention up and down according to the flow of network traffic by using existing hardware. Most of Maestro demand is coming from CHKP’s existing SMB customers as typically this customer type has less resources to instigate a cloud transformation like many of the larger companies have been doing in the wake of the pandemic. Therefore, as CHKP’s mid-market customers continue to weigh up their options for handling dynamic network traffic both now and in the future, Maestro will be a strong cross/up sell for the next 2 to 3 quarters.

Infinity Platform Gaining Momentum

In contrast, Infinity has been gaining popularity among the enterprise segment. In the 3Q20 earnings call Shwed said Infinity sales ‘almost doubled compared to last year’ so it seems as though the security platform is finally beginning to appeal to the larger companies that want to consolidate their security and eradicate the plethora of point solutions that their SOC have to manage. Covid-19 has only expedited the need for consolidation by making it more arduous to manage the innumerable point solutions. The progress with Infinity, however, has been very slow, especially in comparison to Fortinet’s (FTNT) and Palo Alto Networks’ (PANW) equivalent platforms Fabric and Prisma. Infinity was released in 2017, Fabric in 2016, and Prisma in 2019 and by our estimations the annual run rate of the latter two platforms is circa $1bn whilst CHKP’s is generating $50m to $100m. This is one of many lens’ to which investors can observe the incompetent S&M and GTM functions of the Israeli-based vendor. Notwithstanding, the continuing recent momentum in Infinity will make increasingly larger contributions to overall revenue numbers and underscores our relative revenue growth optimism.

Greater Optimism from Management

In the 3Q20 earnings call management gave guidance that 4Q20E revenue will be between $525m and $575m. The mid-point of $550m appears overly conservative given this equates to only 1.1{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} YoY growth compared to 3.5{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} YoY growth in 4Q19. On a sequential basis this equates to only an 8{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} growth rate compared to 11.6{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} in 4Q18 and 10.8{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} in 4Q19. The consensus has tightly anchored their forecast to the guidance mid-point, projecting $556m. In context of the rhetoric, tone, and confidence of Shwed and Payne in the latest call coupled with momentum from Maestro and Infinity we believe this is too conservative. Our forecast of 5{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} YoY growth equates to $571m of revenue in 4Q20E – close to the top-end of the guidance range.

Post 4Q20

Beyond 4Q20E our Base Case view is that Maestro sales will taper off though Infinity will grow in importance for overall growth. The following chart shows how the product & licenses revenue stream began to halt the decline in 3Q18 and is now growing rather than contracting. The recovery coincides with the introduction of Infinity that realistically would have began making a material impact roughly 1 year after it was launched.

Given that CHKP is struggling to grow on the cloud front, without Infinity it appears that overall growth would be flat. If we take the $50m to $100m annual run rate for Infinity sales that we estimated earlier and apply it to 3Q20 – estimating that platform sales contributed about $20m – then if we subtract this from the $509m revenue in the quarter the YoY growth would indeed have been 0{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2}.

Therefore, we consider Infinity crucial for CHKP’s future success and in its ability to prevent declines in revenue. Based on our overall growth forecasts for the next 5 quarters and our $20m estimate for Infinity sales in 3Q20, we conducted some backward induction to understand how the growth of the platform may impact overall revenue growth.

The following sensitivity table shows that if 3Q20 Infinity sales were $20m, grew 85{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} YoY in 3Q20, and the YoY deceleration in this growth is 10{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} for each of the next 5 quarters, then this would equate to an average YoY growth of 5.2{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} – which is Convequity’s Base Case average YoY projection through 4Q21E (see previous table). However, assuming other revenue components perform to meet our Base Case forecasts, if instead Infinity sales grew by 90{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} in 3Q20 with a 15{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} realized decay through 4Q21E, then the average overall growth would only be 2{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2}.

Infinity’s Potential Impact on Future Overall Revenue Growth

The average YoY revenue growth rates highlighted in purple indicate the outcome of a realistic combination of the 3Q20 growth rate of Infinity and the platform’s growth deceleration. For example, if Infinity grew by only 70{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} in 3Q20 then it is reasonable to expect its growth to diminish by less, perhaps a 5{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} to 10{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} YoY decay – if this materialized then we believe overall growth would be 5{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} to 0{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} through 4Q21E. There is much speculation exhibited in this analysis, however, given that Shwed stated Infinity sales ‘almost doubled compared to last year’ we think 85{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} YoY growth in 3Q20 is the best estimate and a 10{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} quarterly decay resulting in a 40{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} drop in growth in 1 year seems the most realistic. If this does transpire, we believe our total revenue forecasts through 4Q21E will come to fruition. And interestingly, such growth in Infinity now that it has reached a meaningful revenue level and overall revenue growth is sluggish at 3{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2}-4{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2}, Infinity will rapidly grow to be a major portion of revenue by the end of FY21E.

In summary, Infinity is set to have a big impact on the future revenue trajectory though given CHKP’s dismal GTM track record of during the past few years, investors should not expect too much upside.

Product Refresh Cycle

Another driver for short-term revenue support is the installed base’s product refreshment that is underway. Quantum is the new range of security gateways released earlier this year and as per the typical refresh cycle existing customers will replace their 3-5-year old appliances with newer and more powerful appliances. Given that the Quantum range delivers 2x the performance and half the energy consumption of the previous range for a similar price, it is expected that most of CHKP’s installed base will indeed refresh their security gateways.

SD-WAN Partnerships

The final driver for short-term revenue is contingent on the resurgence of the WAN Infrastructure market. The WAN Edge Infrastructure market has taken a bit of a hit by the pandemic WFH dynamic which has postponed many larger-scale SD-WAN implementations. As employees are, in the large part, working from home, CISOs on a tightened budget have needed to spend more on cloud-enabled network and security rather than on new office equipment. However, when the pandemic fades and life returns toward normality large SD-WAN deployments should be back on the agenda for more enterprises. CHKP are one of two preferred security choices for SD-WAN vendors – the other being Zscaler (ZS) – therefore, when the market does rebound, we suspect it will be a sales-supportive tailwind for the Israeli-based vendor. Moreover, compared to FTNT and PANW, a strengthening WAN Edge Infrastructure market should deliver better short-term ROI, margin improvements, and FCFF considering the relatively lower SD-WAN-related expenses and investment.

Share Price Support

CHKP’s TTM FCF margin is an impressive 53{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2}. Given the high FCF even without any expected future growth the stock could be theoretically valued at c. $100:

  • Convequity FY20E forecasted FCFE per share = $6.05
  • Normalized cost of equity = 6{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2}
  • VPS = $6.05 / 0.06 = $100.83

So, yes CHKP does lack growth which concerns us in the longer-term within the context of a relatively high growth cybersecurity space, though the downside looks somewhat truncated given the current high FCF levels. Of course, the issue is that the lack of growth that potentially turns negative in the next 5 to 10 years will affect the cash flow generation. However, until that point, amid CHKP’s low growth and high FCFs the stock price should see support.

The huge share buybacks are also a significant pricing mechanism, which are currently at $2bn per annum, providing somewhat of a floor for the stock. And the low volatility, partly caused by the buybacks, results in a low beta contributing to a very low cost of equity. We calculate a bottom-up beta of 0.86 which is quite low for a software stock though supportive for the valuation.

We ran a Monte Carlo simulation to stress test the Base Case VPS to understand where the level of support, if any, for the stock could be. Below are the variables we randomized according to a uniform distribution.

Monte Carlo Stress Test Variables

As can be seen, we added more downside to the 5-year revenue CAGR and the beta in order to test the possible lows. The ERP distribution was almost symmetrical as we genuinely believe the true ERP is within the 5{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} to 7{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} range and the ERP for CHKP’s revenue distribution just happens to be in the middle. And due to the low 10-year US T-bond yield of c. 1{633f08c73793f55612965c612e212a445c31ddab6c84ff3f095b66eb6ebb4cc2} we couldn’t add downside to the sustainable growth rate variable whilst also having a meaningful range; as a result, this variable actually adds some upside instead. Below is the distribution of Base Case VPS from 500 runs.

As the chart presents, the distribution to the downside appears to be truncated around $90 to $100. It’s almost as if there is a floor preventing even an outlier from penetrating this level. On the upside there are a few outliers scattered up to as high as $370. This positive skew is interesting given that two of the variables’ ranges were set to produce a negative skew whilst the ERP was set to be symmetrical. We don’t know for sure but within the 500 runs we suspect there was at least one instance where each variable was at its most unfavourable for CHKP, and we speculate that this event produced the minimum VPS of $91.08. So, the worse case scenario for the stock – assuming no repeat of a Covid-like crash we experienced in March 2020 – is probably around $90.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CHKP over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.