Fortinet Inc. (FTNT, Financial) is a cybersecurity company that was rated as a leader in enterprise firewalls by both Forrester and Gartner. The company has been growing at a rapid pace over the past couple of years and continued to produce solid growth in the second quarter. However, management adjusted its guidance downward moving forward and billings has begun to slow.
This caused a huge sell-off in the stock as shares plummeted by 27% between the end of July and mid-August. However, there could be a potential opportunity as the valuation is looking less aggressive and guru investors were buying in the prior quarter, so it is hard to say that too much has changed.
As such, I will break down Fortinet's business model, financials and valuation. Let’s dive in.
Secure business model
Fortinet has created a “security fabric” platform solution. Historically, the cybersecurity industry has been categorized by a variety of single point solutions, which solve an individual issue, such as endpoint (PC or laptop) security or cloud security. However, this can cause high operational overhead for the management of the products and also can lead to higher costs, as it is hard to get discount on just a single solution
Fortinet solves this problem with its single platform solution, which covers everything from threat detection to network security and cloud security, which is becoming a hot topic. The company also offers a zero-trust access solution. This basically offers users access to only the applications they need, whereas in traditional network security once a user is logged in, they can move laterally to any application, which, for a hacker, is a dream.
A report by IDC indicates that Fortinet has been number one in the firewall market for a decade with over 50% market share by both units sold and revenue.
Solid financials
On Aug. 3, Fortinet reported financial results for the second quarter of 2023. Its revenue of $1.29 billion missed analyst forecasts by $9.33 million, but still rose a solid 25.5% year over year. This was driven by non-FortiGate revenue growth of greater than 45% and service revenue growth of 30%. Security subscriptions contributed to 55% of all service revenue, increasing by 34%.
Product revenue expanded by 18% to $473 million, while billings grew 18% to $1.54 billion. This was driven by non-FortiGate billings of over 30% growth, which contributed to 34% of total billings, which reached close to a $2 billion annual revenue run rate.
In terms of industry verticals, total manufacturing billings as a percentage of the total increased by close to 50%. Government and construction revenue rose by 30% year over year.
Geographically, emerging markets showed surprising momentum, followed by Europe and Latin America.
Lower guidance
Despite the solid results, the business did report headwinds from the macro environment, which has caused enterprises to slow down buying decisions. This impacted billings, which was expected to be higher. The company also lowered its revenue guidance to between $5.35 billion and $5.45 billion from a high of $5.48 billion expected previously.
New product features
Fortinet has vertically integrated its system via a proprietary application-specific integrated circuit.
Its operating system (FortiOS) also enables security to be managed across both on-premises and cloud environments.
Earlier this month, the company launched its new FortiGate 90G, a next-generation firewall. This is integrated with its FortiGuard (artificial intelligence-powered) security, and the business claims to have a security rating 16 times greater than competitors, while using 90% less power. This was also backed up by an independent analysis by Forrester, which detailed the cost savings and benefits of the solution.
Another analysis report by Enterprise Strategy Group discovered that customers which deployed Fortinet Security Operations reduced their time to detect and respond to incidents from three weeks to just one hour.
Generative AI is expected to be integrated to help improve efficiency, threat detection and even network troubleshooting. The first example of this its FortiGuard Threat Analyst, which uses machine learning to detect threats and then update the hack signature across the network.
Margins and balance sheet
Moving on to margins, Fortinet reported a gross margin of 77.9%, which rose by 140 basis points year over year.
Service revenue was also surprisingly higher at 86.2%, which offset the higher costs for labor.
As for profitability, the company reported an operating margin of 26.9%, which rose by 210 basis points. Operating income was $227 million, up 43% year over year. This was down sequentially, but that may be due to seasonality and the timing of orders.
It recorded earnings per share of 38 cents, which rose by 58% year over year.
Free cash flow grew 55% year over year to $483 million, at a 38.5% free cash flow margin. This benefited from a $190 million tax payment deferral.
Capital expenditures were $77 million and the company’s share buybacks rose by $500 million, with total share buybacks of close to $2 billion.
Valuation
Fortinet trades with a price-sales ratio of 9.14, which is lower than its five-year average. The company is also trading slightly cheaper than competitors such as CrowdStrike (CRWD, Financial), Palo Alto Networks (PANW, Financial) and ZScaler (ZS, Financial), as you can see in the chart below.
The price-earnings ratio of 43 looks expensive, but is below its five-year average.
Based on historical ratios, past financial performance and future earnings estimates, the GF Value Line indicates a fair value of $78.99. Thus, the stock is modestly undervalued at the time of writing.
Guru interest
In terms of guru investors, Paul Tudor Jones (Trades, Portfolio)' firm purchased 4,250 shares, which traded at an average price of approximately $68 each during the second quarter, which means the stock is around 14% cheaper than that level at the time of writing.
Jefferies Group (Trades, Portfolio), PRIMECAP Management (Trades, Portfolio), Jim Simons (Trades, Portfolio)' Renaissance Technologies and Ken Fisher (Trades, Portfolio) also purchased shares in the second quarter.
Fortinet competes with Zscaler in the world of “zero trust.” Interestingly enough, Jones has bought and sold that stock multiple times since 2021. Then, in the first quarter of this year, Tudor Investment Corp reduced its position by 43%. This could be for a variety of reasons, but one could be a change in the competitive landscape.
Final thoughts
Fortinet is a leading cybersecurity company that has continued to produce solid financial results. Its billings growth has begun to slow and, with guidance adjustments, this could be a sign of an economic or psychological slowdown with decision-makers. However, the company’s valuation is starting to look enticing, so could be a good opportunity for the long term.
