Check Point: A Buy Based On AI Growth Drivers And Earnings Strength

After reaching a peak of $166 in March, Check Point Software Technologies (NASDAQ:CHKP) lost ground as part of a broader market move impacting other cybersecurity stocks according to Seeking Alpha News, and this is despite the Israel-based company performing better than expected during the first quarter of 2024 (Q1) financial results.

This lackluster stock performance could be attributed to the revenue guidance of $622 million (mid-point of $607 million and $637 million) for Q2 constituting only 5.6% growth, or lower than Q1’s 5.76% as shown in the chart below. This would imply it may not have yet recovered from last year’s slump, when revenue dipped to below zero amid a challenging environment for enterprise spending.

However, this thesis thinks otherwise and aims to make an investment case by showing that the growth trajectory should trend higher as revenues are likely to exceed guidance based on the investments made in three new products including the Infinity AI Copilot developed in collaboration with Microsoft (NASDAQ:MSFT) and firewalls to secure data centers against threats from the cloud built in partnership with Nvidia (NASDAQ:NVDA).

At the same time, a surge in bookings points to a pickup in demand normally beneficial to pricing power, which could help to achieve better earnings than the $2.15 (midpoint of $2.10 and $2.20) guided for Q2.

I start with the growth drivers.

Infinity AI Copilot with Microsoft/OpenAI Collaboration

As for the Copilot, it has been possible through a collaboration with Microsoft Azure OpenAI service and can be envisioned as a personal AI security assistant already supported across many of Check Point’s products. By using a chat-based interface, its purpose is to enable administration tasks like responding to an incident or mitigating risks to be done faster, by up to about 90%.

Thus, by asking simple questions in a highly interactive way for example why I cannot assess a service or asking if a system is protected against a specific vulnerability (malware) and obtaining easily understandable answers similar to ChatGPT, security admin tasks become easier. As per the CEO, Infinity is enabling more comprehensive security and benefiting from bigger budgetary allocations by customers, something which appears plausible given the way OpenAI’s intelligent application gained rapid adoption and may have already been used by 23% of U.S. adults in February this year. Moreover, in sharp contrast to previous generation machine learning where one had to master complex computing codes, one converse with Infinity easily, and in a natural language like English.

Talking figures, the traction the company has been getting for Infinity resulted in annualized new bookings in Q1 growing at double-digits as shown in the chart below, surging from less than 5% in Q4.

As pictured above, this acceleration was also made possible by two other products, the first one being Harmony SaaS for quick discovery of a company’s cloud-based applications. The intent here is to reduce the surface area of attack, thereby mitigating threats of data being compromised. Such protection is important as companies are subscribed to multiple cloud providers, providing hackers with more possibilities (surface) to carry out cyberattacks.

AI Cloud Security in Partnership with Nvidia but also Factoring In Competition

Second, there is Quantum Force, which is an AI-powered firewall that protects the internet gateway for cloud-based applications. It is used in the most demanding data center use cases as it is equipped not only with the latest generation CPUs but also Nvidia’s latest ASIC (application-specific integrated circuit) technology. This may be why it scored the highest among peers during Gartner’s report on critical capabilities for network firewalls.

That was in May 2023 and to be realistic, this is a rapidly evolving industry where competitors like Cisco (CSCO), Fortinet (FTNT), and Palo Alto Networks (PANW) possess considerable financial clout and technological firepower to make up for their shortcomings since they also have more scale evidenced by their higher market caps and revenue levels in the table below. Moreover, Cisco also has a partnership with the semiconductor giant.

Then the question is whether faced with such competitors, Check Point can drive product sales in an ROI-friendly manner or benefit from enough pricing power to drive up profits.

This seems to be the case when looking at its profitability metrics. First, its gross profit margins of 89% as per the above table show that with its high-value intrusion protection systems and cloud security products, it can command pricing power. This is also helped by its greater emphasis on software that can be developed faster, scaled more rapidly, and at a relatively lower cost than more hardware-based products. Second, its higher EBIT margins show that it has been able to limit sales and marketing expenses needed to drive sales to a higher degree than competitors.

Valuing the Company based on the ability to Generate more sales, and Profitably

Now, going forward, while competition remains fierce, the market seems to be improving. Thus, according to the CEO, who remains cautiously optimistic, the company has “returned from the down market they were in a year ago”. This means relatively more demand, a possibility also confirmed by Gartner which states that IT spending should increase by 8% YoY in 2024 with software increasing by 13.9% from 12.6% in 2023. As for Data center systems, it should surge by 10% this year or 600 basis points better than in 2023, explained mostly by the need to host GPUs that support Gen AI-related training models.

Now, these models need protection, especially during the training phase where the related datasets are vulnerable to poisoning cyberattacks and this is where Check Point’s collaboration with Nvidia for AI Cloud Protect imparts protection while making sure that performance is not impacted while scrutinizing data residing in the cloud for threats. Here, the company’s competitive advantage is that it has already been using Nvidia’s chipsets on its firewalls for two years, and, as such, only needs to carry out some adjustments based on implementation specifics.

Therefore, with its three growth drivers including AI-driven administration (Infinity Copilot) and cloud protection capabilities, the company could not only beat sales expectations but also exceed analysts’ earnings consensus. Thus, the stock deserves better but comparing its multiples with the wider IT sector would fail to consider its IT security strengths.

For this purpose, I make a more targeted comparison of the price-to-earnings and price-to-sales multiples with peers Cisco, Palo Alto, and Fortinet which are strong players in firewall and cloud security, as shown in the table below. Based on Check Point’s stock trading at a discount relative to the average value of both multiples, I target a potential upside of 18.63%. This translates to a target of $185.6 based on the current share price of $156.49.

Discussing the Risks Due to Geographical Exposure and Platformization

Now, this may appear to be a low target, especially given the 28.57% appreciation potential based on the P/E but applying moderation is important because of its exposure to the EMEA (European Middle East and African) market which accounted for 46% of its sales in Q1 as shown below.

Now, in addition to the Middle East’s geopolitics where the Israel-Hamas war persists, the political situation in France has become uncertain after the President dissolved the assembly and the stock market has lost about 6% of its value in less than one week. Some fear this could result in a Brexit-style uncertainty in case of contagion risks to other parts of the Old Continent. This may dampen enterprise spending, in turn denting Check Point’s “very strong” momentum seen in Europe in Q1.

Second, the AI data center opportunities while being “pretty big” could take time to translate into sales because on April 25, or at the time of the earnings call, the company was still in the process of developing the related business cycle including identifying the supply chain and distribution channels to customers. In the same vein, a new competitive threat has emerged in the cybersecurity industry after Palo Alto resorted to a “platformization” strategy or luring customers to use its entire portfolio instead of discrete products. This may come with reduced pricing as is normally the case when goods are purchased in bulk and may cause potential customers to rethink their purchase strategy, especially at a time when interest rates remain high while above-3% inflation grinds into corporate spending power.

A Buy after Considering Risks

On the other hand, it is unlikely for companies who are spending billions of dollars on Nvidia’s GPUs to build cutting-edge Gen AI infrastructures to have second thoughts when it comes to spending money on IT security. This means that they are likely to choose the best enterprise firewall products, which according to the Miercom Security Benchmark is currently Check Point’s Quantum Titan release R81.20, ahead of Palo Alto’s PAN-OS 11.1.1.

In this case, the Israeli company should see higher demand, which should translate into better pricing power, also justified by the fact that their earnings projection of $2.15 (mid-point) for Q2 is above the $2 achieved in the same period last year by 7.5%, while sales are expected to increase by only 5.6%. This tends to show a relatively more profitable product mix.

Along the same lines, as shown below, this is a company that has consistently beaten earnings estimates, achieving a beat ratio of 100% over the last sixteen quarters. Therefore, there is a big chance that it will beat earnings in Q2.

Furthermore, the company could beat topline guidance with bookings growing at double digits in Q1 and two strong growth drivers in Infinity Copilot and Quantum firewalls. This growth could also be supported by subscription fees-related revenue that surged by 15% in Q1, thanks mainly to strong performance by Harmony E-mail and Infinity.

Finally, I have a buy rating with the potential for an 18.6% upside based on both the sales and earnings multiples.