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2/14/2003
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Taking Stock: Looking For A Little Bit Of Security

NetScreen's approach to the VPN firewall market is gaining fans

According to Goldman Sachs, capital-expenditure studies indicate a further 10% drop in IT spending in 2003. As if we needed that news along with the ongoing threat of a war with Iraq, the revival of Osama Bin Laden, and news that North Korea has ballistic missiles that can reach the U.S. West Coast (where I happen to live).

It looks as if security issues will remain a hot topic for some time. And speaking of security, I recently examined the valuations of two security vendors that have been front-and-center of late. In terms of price, the two have been going in opposite directions. One, NetScreen Technologies Inc. (NSCN--Nasdaq), a market leader in integrated VPN firewall security appliances, has been hitting new highs; the other, Check Point Software Technologies Ltd. (CHKP--Nasdaq), the market leader in VPN firewall software, has seen its share price struggle.

It would be easy to surmise that NetScreen is beating Check Point in the marketplace and that's why the prices are moving in opposite directions, but the answer isn't that simple. First, the overall market is growing at 25% to 30% per year. Clearly, NetScreen's approach to the VPN firewall market is winning attention. It has a custom ASIC-based appliance that allows for higher performance in some uses. With its own proprietary operating system embedded within the appliance, you'd expect to see high performance, and this will appeal to some high-end enterprise clients. It's little wonder that the company saw 24% quarter-over-quarter and 76% year-over-year growth rates in revenue.

However, market leader Check Point isn't resting on its reputation. In many of its markets and for many of its partners, Check Point's software is clearly a better answer. The company saw revenue increase 6% quarter over quarter, in line with industry growth, and 15% year over year. Offering a software solution allows it to partner with any hardware vendor. This flexibility appeals to many of its business partners, including Hewlett-Packard, IBM, and Nokia.

NetScreen's share price is $18.21 with consensus Wall Street earnings-per-share estimates of 55 cents for 2003. This makes for a 2003 price per earnings ratio of 33.1, roughly half the growth rate of the company last year. You can actually see growth-equity managers drooling when they talk about this stock. As long as NetScreen can continue to grow at that high rate, the price may not be as obscene as it looks. Still, management will have to prove the growth rate is sustainable before investors pay up, and the company may have trouble getting much higher multiples in spite of its potential.

Check Point, on the other hand, sells at a modest 2003 consensus price-per-earnings ratio of 14.2, based on consensus earnings per share of $1.01 and a share price of $14.32. However, its projected growth rate is probably in the 10% to 15% range for the following year. Looking a bit deeper also reveals that Check Point has $1.3 billion in cash, or almost $5.35 per share, with no debt. Also, it has had pre-tax operating margins in the 60% range for some time, even during the downturn. This shows sound financial management during a very turbulent time. As you can see, either type of investor -- aggressive or conservative -- can find security in this market.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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