Why Check Point Should Pick Off Palo Alto Networks
Feb 8th 2013 5:15PM
Updated Feb 8th 2013 6:25PM
Without question, enterprise security services have become a huge market. Although Check Point has a meaningful lead in this area, investors are starting to feel insecure about the company's growth momentum (or lack thereof). Then again, there aren't many balance sheets on the market that can compare to Check Point's, including $1.5 billion in cash and zero debt.
Be that as it may, this brand of detail rarely matters in the tech sector, where the top line rules. And with young guns such as Palo Alto Networks boasting sales growth at 50% clips, Check Point's disappointing fourth-quarter revealed that this company has some tough decisions to make if it wants to preserve its lead.
Unable to stop the growth bleeding
Heading into the fourth-quarter report, the Street wasn't expecting the numbers to be breathtaking. Management had issued guidance considered by many to be very conservative. Plus there were still macro concerns related to Europe and weak corporate enterprise demand, all of which sent the stock plummeting down 13% following the Q3 report. I was nonetheless surprised that report arrived worse than expected.
For the period ending in December, Check Point posted revenue of $368 million, or growing by just 3% year over year. For company that typically reaches the high-end of its projections, this was very substandard, especially for a tech company trading at a P/E 4 points higher than rival Cisco . And when compared to Fortinet's 25% revenue growth in Q4, Check Point's numbers are more disturbing.
However, these comparisons aside, there are clear underlying performance issues here. I will give management a tip of my hat for having navigated the company through the tough challenges of 2012, but patience has a limit. And unless Check Point figures out a way to return to its glory days, investors will begin to question if the premium is deserved, especially since growth has now slowed to the low-single digits.
It's time to sacrifice the balance sheet
All of that said, it's hard to abandon a company the size of Check Point that is growing profits annually by 9%. For all of the punishment the company deserves for its horrendous growth, an equal amount of credit is warranted that the bottom line remains so impressive. For instance, not only did GAAP operating income surge 15% sequentially, but it climbed 9% from last year's quarter.
In other words, although growth has come to a crawl, Check Point is doing well squeezing out every penny possible from the customers that it does have. The company also continues to do an excellent job managing costs as evident by only the slight uptick in general and administrative expenses. Then again, it begs asking if this is a good long-term strategy?
Granted, the bottom line looks good. But something's got to give with the top-line looking so weak. And it seems that Check Point has become comfortable with that, as the company spent less this quarter on sales and marketing. By contrast, not only did Fortinet report a 20% increase in sales and marketing, but Fortinet also increased research and development expenses by 25% versus Check Point's 8.8%.
It is this lack of aggressiveness that raises doubt about Check Point's long-term market position. While the strong balance sheet serves to minimize the investment risk, there is no compelling reason to own this stock in the absence of growth. And the competition is not going to make this easy. Margins may be strong today, but eventually there will be pressure.
In that regard, it doesn't appear as if Check Point's management cares a heck of a whole lot about this very possibility. But eventually, this chicken will come home to roost, as it did for IBM a decade ago. And Check Point's management would serve the interests of investors by sacrificing some cash today for a better future tomorrow.
Check Point should buy its way into growth
There are always at least two ways to meet the competition head on, either through investments in research and development or via an acquisition. In both areas, Check Point has been passive. Conversely, Cisco has been on an M&A shopping spree while spending over $1.4 billion in R&D for Q1. Meanwhile, Dell recently spent $1.2 billion for enterprise security giant SonicWall.
Whether or not it was the right move remains to be seen. But for Dell, it is hard to argue against the justification. The security industry is growing rapidly and the leaders are beginning to level off. For this reason, I think Check Point should look at Palo Alto as an acquisition target. Granted, Palo Alto is young, and expensive for that matter. But this is a company with impressive growth.
Then again, growth is only one attractive aspect. Palo Alto also has pioneered what is considered next-generation security along with one of the most innovative platforms in the industry. Not to mention the company ended its recent quarter with zero debt while posting cash and equivalents of $322 million. Better still, Palo Alto is expanding its customer base, which now stands at over 10,000.
Check Point can't continue to sit idle and get picked off by Fortinet and Cisco while ignoring these synergies with Palo Alto. And considering Palo Alto's enterprise value of $3.3 billion, it would only cost Check Point $4.5 billion to close this deal. This is money that Check Point can easily raise considering the company ended the year with $3.3 billion in cash and assets that grew 18% year over year. Plus with Check Point's strong cash flow of $202 million, this is a deal it can't pass up. Its future depends on it.
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The article Why Check Point Should Pick Off Palo Alto Networks originally appeared on Fool.com.Fool contributor Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends Check Point Software Technologies and Cisco Systems. The Motley Fool owns shares of Check Point Software Technologies and International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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