Looking at the pace of upgrades, Wall Street has fallen back in love with Fortinet (FTNT) and its growth potential in the unified threat management world. From 12 strong buy/buy ratings three months ago to 18 today, the shares have gone from a sub-$17 dip in early December back into the low $20's. Perhaps just as important, though, is a more general recovery in security market conditions for Fortinet, Check Point (CHKP), and Palo Alto Networks (PANW).
Execution is still a concern, as the company needs to reverse this recent slide in margins. Likewise, there are still questions as to whether Fortinet's proprietary ASIC-driven performance advantages can stay relevant as the security market evolves. Those are valid questions, but I think Fortinet is likely to be a long-term winner, unless a buyout precludes that opportunity. The 25% rally in the shares has taken some of the cheapness away, but I still think this is an undervalued tech stock worth further research.
Good Growth, But Margins Are A Work In Progress
As I said in the open, the recent earnings reports from security companies like Check Point, Palo Alto, and even Symantec (SYMC) have been pretty encouraging. This comes despite what has otherwise been a shaky (or at least unpredictable) enterprise spending environment.
Fortinet has definitely been a part of this trend. Fourth quarter revenue rose 17% yoy and 15% qoq, with identical yoy growth in the product and service lines. Billings were up 20% and almost twice as strong as most sell-side analysts expected, and the company saw 37% yoy growth in deals worth $500K or more. Management talked about competitive wins, particularly against Cisco (CSCO) and Juniper (JNPR).
Margins still need work. Gross margin declined on both an annual (almost three points) and sequential (almost two and a half points) basis, and operating income declined 8% yoy (while rising 24% sequentially). With that, non-GAAP operating margins are still lower than I'd like to see them and lower than what investors got accustomed to in prior years.
A New Product Cycle Should Help The Sales Momentum
Various sell-side surveys have suggested that security spending remains a priority with enterprises and that 2014 should see solid underlying growth. That sounds great, but readers would probably do well to remember that there long been a difference between what companies say they will do (via sell-side surveys) and what they actually do.
Whatever the real market situation in 2014, Fortinet is looking to help itself with some new product introductions. The FortiSandbox product is Fortinet's new solution for advanced persistent threats, where it will compete with FireEye (FEYE) and Palo Alto in this relatively new sub-market.
Fortinet is also looking to leverage a new ASIC-driven product cycle. As a reminder, Fortinet uses proprietary ASIC processing chips to run its security appliances, and these chips deliver performance that is as much as 10x better than in competing appliances using Intel (INTC) chips (at least in some applications). These chips give Fortinet a major edge when it comes to throughput, and only Check Point is really a serious competitor at the very high and "ultra-high" throughput levels where list prices can run many multiples (3x to 10x-plus) to mid-market enterprise products.
An ASIC-based product refresh should be good for growth later in the year, even if it carries some risk of postponed/deferred sales earlier in the year. It is worth asking, though, if this key differentiating factor will remain so in the future. Enterprise security is increasingly about rapid-response and while Fortinet can role out new software updates as quickly as anybody else, that doesn't necessarily maximize or optimally leverage its proprietary ASICs. Likewise with this overall move towards virtualization and software-defined networking, which both prioritize software over hardware.
Better Margins Are A Must-Have
Like Check Point, Fortinet was caught at least somewhat unawares by the introduction of next-gen firewalls from Palo Alto and Sourcefire (since acquired by Cisco). Both have adapted and I believe Fortinet continues to maintain a leading position in unified threat management and a significant position overall in enterprise security appliances (well behind Check Point and Cisco, but in the mix for #3 with Juniper and Palo Alto).
My bigger concern today is not whether Fortinet can stay competitive from a technological and market share perspective, but what the cost of doing so will be. Even with a reputation for sometimes competing aggressively on price, Fortinet had established some solid operating and FCF margins only to see those decline over the past couple of years. I'm not convinced that Fortinet can get back to that 30% level given the competition in the industry, but I do think improvement back into the mid-20%'s would be enough. This is going to need to be a top-to-bottom process, though, as Fortinet needs both strong gross margin and good sales/operating efficiency.
I'm looking for Fortinet to outgrow the overall security market growth rate (helped in part by its exposure to the faster-growing UTM segment) and generate long-term revenue growth around 10%. I'm also looking for those mid-20%'s FCF margins to support low-to-mid teens FCF growth.
The Bottom Line
Low teens FCF growth suggests to me that Fortinet shares could see 10% to 14% stock price appreciation, which is well ahead of what you'd normally expect from the broader markets. Factor in the possibility that a large enterprise IT company could see Fortinet as a valuable piece in a larger puzzle, and I think this is a stock still worth buying or owning today.