Fortinet: Fortifying the Network

Includes: CSCO, FTNT, JNPR
by: Renaissance Capital IPO Research

Traditionally, enterprises have employed a variety of point solutions, such as firewalls and virtual private networks, to combat network security threats. With the increasing complexity of threats and importance of network performance, however, the need for a more integrated, easy-to-manage solution has given rise to the market for unified threat management (UTM) systems, which incorporate multiple security features (firewall, intrusion prevention, antivirus) into a single box.

Fortinet (NASDAQ:FTNT) was founded by the same duo that started NetScreen Technologies, which was acquired by Juniper (NYSE:JNPR) in 2004 for $4 billion. Fortinet has used a proprietary solution to secure a leading 15% share in the UTM market, a segment of IT security spending that is expected to reach $3.5 billion by 2012 (22% CAGR). The company plans to offer 12.5 million shares, including 6.7 million from insiders, at a price range $9-$11. Morgan Stanley, J.P. Morgan and Deutsche Bank are acting as lead managers and the deal is expected to price Tuesday, November 17 and list on the NASDAQ the following day under the ticker FTNT'

Impressive Technology

Fortinet's flagship FortiGate appliance integrates several core security functions, such as firewall, VPN, antivirus, intrusion prevention and web filtering, onto a single proprietary platform, that incorporates a proprietary operating system (FortiOS), hardware architecture, and high-performance application-specific integrated circuits (FortiASICS). This product has allowed the company to rapidly gain share in a large and growing market, and Fortinet has shipped more than 475,000 appliances to over 75,000 end customers, including the majority of the Fortune Global 100. Nearly all product sales (45% of sales) are indirect through over 5,000 channel partners and pricing ranges from $300-$3,000 for SMBs and $46,000-$1.1M for enterprises.

Cash is King

Under annual contracts, the company offers subscription services/support (50% of sales) for its appliances that provide updates to the majority of security functions on a daily basis and offers 24/7 support through a team of over 100 threat research professionals. As contracts are paid up-front, this allows for strong recurring revenue and substantial free cash flow, and the company's margins should continue to improve with scale. Year-to-date, EBITDA margins grew nearly 4x and the company generated $41.5 million in free cash flow (23% of sales).

Security Breach?

The biggest risk to the long-term story is competition from networking giants, such as Juniper and Cisco (NASDAQ:CSCO), which command a 9% and 6% share of the UTM market, respectively. Additionally, the economic downturn has pressured year-to-date product sales, which are up only 1%, and the overall market for IT spending remains challenging. Typical to the industry, the firm's quarterly results can be lumpy (strong 4Q) and product sales are usually back end loaded.

Priced Attractively

The IPO market recovery has been led for the most part by larger PE-backed companies, whose financial sponsors are searching for liquidity. Most of these deals were priced with full valuations as these firms seek to maximize returns; however, this has caused performance to decline with investors becoming more price sensitive. Fortinet represents one of the few venture-backed growth stories to come to market this year and the deal is being priced at an attractive discount relative to other security software and network system providers on both multiples to revenue and cash flow.

Additionally, its close peer SonicWALL beat estimates in late October and Cisco provided a more bullish outlook on IT spending trends on its latest earnings call. These factors should combine to drive significant interest in the deal and make for a solid debut.