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The Dow is back in the bull zone above the critical 10,725 level. According to Charles Dow, co-founder of Dow Jones & Company, when the public mind has a well defined tendency, either bullish or bearish, it is not easily changed. Scores or hundreds of people may change, but the mass press on in the same direction.

Now that the recovery is on the way, corporate IT spending is ramping up. NThe network security sector stands to be beneficiaries of the growth in this market as governments and organizations begin to see the desperate need to meet regulatory and compliance rules.

The Network Security Market

The worldwide network security appliance and software market is forecast to grow to $5.8 billion in 2013, according to Infonetics Research. The security market is currently buoyed by growing interest in cloud computing, virtualization and services. Increasing identity theft, spam, data breaches and recent Google (NASDAQ:GOOG)’s cyber attack in China could force consumers and businesses to upgrade security to protect their systems against attack.

The other trend is that IT giants such as IBM (NYSE:IBM), HP (NYSE:HPQ), Microsoft (NASDAQ:MSFT) and SAP (NYSE:SAP) could enter into information security market by acquiring existing pure-play vendors.

Major Players in This Industry

Cisco (NASDAQ:CSCO) is still the dominant vendor with a market share of 28%, even though its share of the market dropped a staggering 22% year-over-year. Its competitors are catching up. Some of the smaller companies in the industry appear to have better prospects.

Followings are major security-related companies’ trailing P/E and 1-year-forward P/E:

Name (Symbol)

P/E

Forward P/E

PEG Ratio

P/S

3Com Corporation (COMS)

61

21

2.4

2.5

AsiaInfo Holdings (NASDAQ:ASIA)

36

17

0.7

5.4

Blue Coat Systems Inc (NASDAQ:BCSI)

98

18

1.3

2.8

Check Point Software (NASDAQ:CHKP)

20

14

1.4

7.8

Cisco Systems, Inc. (CSCO)

25

15

1.4

4.2

F5 Networks, Inc. (NASDAQ:FFIV)

50

24

1.6

7.5

Fortinet, Inc. (NASDAQ:FTNT)

22

46

3.1

4.6

Juniper Networks (NYSE:JNPR)

136

21

1.4

4.8

MCAFEE, Inc (MFE)

38

14

1.1

3.4

NETGEAR, Inc. (NASDAQ:NTGR)

96

15

1.2

1.3

Novell, Inc. (NASDAQ:NOVL)

-

19

3.3

2.4

SonicWALL, Inc. (SNWL)

38

18

1.3

2.5

Sourcefire, Inc. (NASDAQ:FIRE)

80

36

1.8

6.9

Symantec (NASDAQ:SYMC)

45

11

1.2

2.4

A New IPO

Fortinet, Inc (FTNT) is a leading network security provider and worldwide leader of unified threat management (UTM) solutions. The company has shipped over 500,000 units of consolidated network security appliances worldwide. Customers include a majority of the Fortune Global 100. Founded in 2000, Fortinet went public on November 18, 2009 at a price of $12.50 per share. The stock price rose 33% on its first day of trading.

The following chart from Google shows Fortinet’s revenue increased from less than $100 million in 2005 to $252 million in year 2009:

The company has had positive cash flow from operations every fiscal year since 2005. In 2009, 55% of total revenue was services revenue. With zero debt and a pile of cash on hand, this company is poised to take advantage of a growing security market.

High SG&A Expense and Low Margin

Once development costs have been recouped, software companies tend to have small expenses. For smaller companies, the difficult part is developing and selling the products. The following table shows that even though Fortinet decreased its Selling/General/Admin Expenses (SG&A) year over year, in 2009 SG&A still accounted for 45% of its revenue.

Year

2009

2008

2007

2006

Gross Margin

72%

69%

64%

67%

Selling/General/Admin. Expenses ( SG&A)

45%

49%

60%

54%

Research & Development

17%

17%

18%

17%

Operating Margin

10%

2%

-14%

-5%

Over half of the company’s 2009 net income was from tax expense, which makes trailing P/E of 22 much lower than forward P/E of 46.

Main Tech/Software/Network ETFs

Fund Name (Ticker)

Net Assets

Expense Ratio

PowerShares QQQ (QQQQ)

16.23B

0.2%

Technology Select Sector SPDR (NYSEARCA:XLK)

4.25B

0.2%

iShares S&P North Amer Tech-Software (NYSEARCA:IGV)

307.09M

0.5%

iShares S&P North Amer Tech-Multimd Ntwk (NYSEARCA:IGN)

178.02M

0.5%

On the other hand, if you want to short tech sector, you might use Short QQQ ProShares (NYSEARCA:PSQ)

Conclusion

According to Yale professor Robert Shiller, the efficient markets theory represents one of the most remarkable errors in the history of economic thought. Today, the theory has given way to counterintuitive hypotheses about human behavior, psychological models of decision making, and the irrationality of the market. Investors overreact, under react, and make irrational decisions based on imperfect data, according to Justin Fox, author of The Math of the Rational Market.

Investors generally should pass on buying hot IPOs due to the lack of trading history. Also, new issues can be more volatile than more mature stocks when lockup period expires. During this period, which usually lasts 90 to 180 days from the IPO, company insiders are forbidden to sell any of their shares. If no change in trade patterns occurs at this time, it may tell you that Fortinet’s insiders, who currently hold 48% shares, are bullish.

I will keep this company in my watch list.

Disclosure: Author is long QQQQ. Data are from Google and Yahoo Finance as of March 18, 2010.

Source: Fortinet IPO: Joining the Hot Network Security Sector