Check Point Software: Satisfying the Quality Checklist

The Israeli cybersecurity company has market tailwinds, good quality and competitive advantages

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Nov 22, 2020
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Introduction

Check Point Software Technologies Ltd. (

CHKP, Financial) is an Israeli cybersecurity company headquartered in Tel Aviv. The Company offers its products and services to governments and enterprises globally.

What does cybersecurity mean exactly? The definition that Cisco (

CSCO, Financial) provides on its website is arguably the most appropriate:

Cybersecurity is the practice of protecting systems, networks, and programs from digital attacks. These cyberattacks are usually aimed at accessing, changing, or destroying sensitive information; extorting money from users; or interrupting normal business processes.

Check Point covers all aspects of cybersecurity, from physical threat prevention devices like firewalls and gateways to internet of things security and, obviously, cloud security.

One of the recent growth drivers has been a shifting sales paradigm: the company has kept switching from one-time licenses to a security subscription model. The latter now account for nearly 33% of total revenue, consequently providing a more stable, predictable and recurring revenue stream.

Some investment thoughts and a quality checklist

Check Point belongs to a category which is quite new to my investment list. As Buffett would say, it belongs to the so-called "wonderful companies at fair prices" group as opposed to the "fair companies at wonderful prices" group.

I have been thinking about changing my investment approach for a long time and, while Buffett's statement makes perfect sense, it has been difficult to apply it for a cheapskate like me. I've always been attracted to companies that are cheap in the old, common sense. That is cheap compared to assets, or which sell for a low multiple of earnings or involved in a turnaround, just to provide a few examples.

On the other hand, even if "cheap" companies have served me well in the past, the real issue is that you usually focus a lot on their price, sometimes compromising on quality, which allows troubled or risky companies to enter your portfolio. So you need to be very careful about risk analysis in order to avoid confusing cheapness with risk.

Based on these considerations, I decided to devote half of my portfolio to "quality" companies over time.

As everybody knows,

Charlie Munger (Trades, Portfolio) was critical in shaping Buffett´s investment philosophy. Buffett once said:

"Charlie Munger changed my views - he refined them in a huge way, in terms of looking for the quality companies, and looking out for the ability to make an investment that will work out for five or 10 or 20 years as opposed to something where there might be one more puff left in the cigar.
"

Being a GuruFocus reader had the same effect on me. Apart from the priceless wisdom shared by the big gurus and the stimulating articles from my fellow writers, if I have to name one single investor who has influenced me the most, it would have to be Thomas Macpherson.

Let's look at his investment selection criteria (taken from the article "Stressing Quality and Price...Again"):

"If we invest in a bucket of companies with significant advantages in quality (higher returns on capital, equity, assets, free cash flow margins, no debt, etc.) combined with valuations (a blend of cheaper attributes, including estimated intrinsic value from our discounted cash flow models and cheaper price-earnings ratios), we can expect to outperform the broader markets over the long term."

Let´s build a simple (and minimalist) quality checklist from his sentence:

  • Higher returns on capital, equity and assets.
  • Free cash flow margins.
  • No debt.
  • Cheap valuation.

We can now exaine these criteria individually.

Higher returns on capital, equity and assets

On Sept. 30, Check Point's return ratios were:

  • ROIC: 16.63%
  • ROE: 23.76%
  • ROA: 14.47%

Another very interesting ratio is Joel Greenblatt's return on capital, which is defined as:

ROC %=Ebit/Average of (Net fixed assets + Net working capital)

For Check Point, this has an outstanding value of 1,018%. That's due to the fact that Greenblatt's ROC formula is assuming a value of 0 if net working capital is negative (which in our case heavily depends on a very high level of deferred revenues) and that the company needs very little equipment to produce its profits. Check Point can indeed produce a decent amount of cash flow with relatively low levels of invested capital.

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Free cash flow margins

Check Point's free cash flow margin, at the end of Septembe, was 47.76%: a very good FCF conversion value.

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No debt

Not only does the company not have any long-term debt, but it also has ample liquidity. Cash stands at $248 million and marketable securities and short-term deposits amount to $1.35 billion.

That is equivalent to around $11.5 per share that could be quickly turned into cash. If we also take into account the non-current marketable securities, we'd have $27.6 per share. That's around 23% of the current market price.

Cheap valuation

Using a simple discounted cash flow calculation with a weighted average cost of capital of 5.08% (taken from the stock's GuruFocus summary page) and a base no-growth scenario (let;s be conservative and say the company will earn $1 billion of FCF per year in perpetuity), we get a value of around $158, which is 32% higher than the current market price.

That being said, I don't think the profile of Check Point is that of a no-growth company for two reasons.

The first is purely financial. During the 12 months ended Sept. 30, Check Point repurchased $1.3 billion worth of shares. As it needs very little capital to generate profits, the company can afford to return more money to shareholders. Even if the free cash flow does not grow, that's not the case for free cash flow per share. Something has got to give.

The second (and more important) reason is related to the strong tailwinds offered by the sector in which Check Point operates. As most companies in the world moved or are moving to a work-from-home setting (that will, arguably, at least partially remain in place after the pandemic is over), they have more of their sensible information on the cloud. That means that there will be a way higher chance of being harmed by cyberattacks.

I've read some criticism against Check Point in regard to the fact that it is not aggressively investing for growth. However, the cybersecurity market will likely grow at a very fast rate, so the company will be very busy with new orders even in the presence of very good competitors in the cyber arena.

On the top of that, I like the fact that management is so conservative: it gives you multiple options, which are even more valuable when your competitors are dealing with high debt, low liquidity or a temporary crisis.

As an example, instead of embarking on big acquisitions (which would be feasible given its liquidity levels), Check Point is in the process of acquiring small companies that are intended to add value to one single specific area or division. That is much simpler to handle (no duplications, no high integration costs, etc.) and produces a predictable effect. That reminds me very much of Apple's (

AAPL, Financial) acquisition strategy.

So I will not try to project a precise growth rate for Check Point, but as the no-growth scenario is already providing some margin of safety, the risks are more than acceptable.

Competitive advantages and tailwinds

Another important question is whether or not Check Point has competitive advantages. This is important to understand to determine how long it can keep the current profitability profile.

Intangible assets

I think the expertise of Check Point's employees is the real competitive advantage (in the form of intangible assets). As I work in the software development environment, I know very well how much time and effort it takes to gain an edge over your competitors and how valuable the role of experts is.

Moreover, Check Point crystallized this knowledge by producing a fair amount of intellectual property. On its website, Check Point says it currently holds 73 U.S. patents, has more than 30 patents pending in the U.S. and has "additional patents issued and patent applications pending worldwide."

Customer switching costs

Another competitive advantage Check Point has is high customer switching costs. This advantage can be explained through the following analogy. Once you let someone protect your house and you trust him/her, you will not switch to someone you don't trust (yet) if you can avoid it. That's the same for your company's precious data. This is confirmed by the stable revenue stream provided by the subscriber base.

Conclusion

Check Point is a company with good returns on capital, no debt, a fair margin of safety, multiple competitive advantages, strong expertise, a conservative capital allocation strategy and a strong sector tailwind.

I've built a position over the past several weeks and plan to keep it in my portfolio (or even increase it if the market gives me the chance) as long as the company preserves its quality profile or the market properly re-rates it.

Disclosure: I own shares of Check Point Software.

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