Fortinet: Compelling Valuation Based On Some Broad Misconceptions

| About: Fortinet, Inc. (FTNT)

Summary

Fortinet shares remain mired at low prices, still suffering from investor unhappiness with Q3 margin results.

Fortinet growth is actually continuing at high levels, and margins and cash flow growth are continuing to improve.

The company has fully competitive products with its peers according to most industry surveys.

The change in the company's sales leadership is essentially old news and seems fully accounted for by its very conservative guidance.

The company is returning some of the improved margins and cash flow to investors in the form of share buybacks which were recently enlarged and extended.

Why the interest in Fortinet now?

Simple answer - Fortinet (NASDAQ:FTNT) shares got cheaper after what appear to me to be spurious after the release of its 3rd fiscal quarter on October 23rd and it has never recovered. At least in the security space and in the software space, its valuation is an anomaly. It has what most investors want in a name - growth, lots of cash flow, a good competitive position in a hot space and an experienced management at a valuation that will neither shock nor offend. That is why Fortinet shares are worth a look at this point.

To an extent, the Fortinet chart looks like that of many other tech names. The shares dropped by 23% from the start of this year through until the February 11 low and have since recovered. But beneath that summary lie some other significant variables. The shares actually reached their high for the year back in August at more than $48/share. They currently sell for 42% less than that. If you scanned the earnings press releases for the prior quarters they all showed consistent growth and have not led to any significant estimate changes.

While I recently wrote a report on Fortinet in conjunction with a discussion of Palo Alto (NYSE:PANW), I focused much more on the space as a whole and on Palo Alto. The fact is that FTNT is not the absolute growth leader nor is the most profitable company in the space. Fortinet is not likely to grow at the same rates at PANW, either now or any time in the foreseeable future. But the shares are no longer priced in the momentum growth category either. At the end of the day, 20%-25% growth at a reasonable valuation is not easy to find, and thus I felt it relevant to review Fortinet's investment case and its recent history in a bit more detail.

Sometimes reasonable analysts attempt to disaggregate numbers in order to draw conclusions. It is a common enough practice but it can often lead to really inappropriate and disproportionate share price reaction. The reaction to Fortinet's Q3 2015 results was something like that. This company is a subscription revenue company. I have written several times in the past that the appropriate way of assessing the health of companies that sell their products on a subscription revenue basis is to look at their bookings and weight that performance far more than revenues.

The actual results of Fortinet's Q3 were, in fact, quite strong. Just to recapitulate, Fortinet's bookings increased by 41% which was a significant beat, non-GAAP EPS was a beat, non-GAAP operating margins were somewhat greater than forecast. But revenues were not enough of a beat for some folks and operating expenditures were said to be too high.

It usually helps to have a pretty fair idea of what a company does and how it does it before making brave pronouncements about the inadequate job management is doing in terms of building the business. Almost everything I am going to discuss can be readily seen in the company's financial presentation.

The company sells what it describes as bundles at higher price points. I will not discuss the details of that contractual arrangement in any detail. But that is what it is - a contractual arrangement. Because of the higher price point, less revenue from a dollar of bookings is recognized upfront than would otherwise be the case. The bundle arrangement doesn't affect cash, and over time increases total revenues. The difference between recognized revenue and actual revenue shows up on the deferred revenue line which increased 41% year on year to $700 million.

So, why all this concern about a quarter that was reported 5 months ago? Primarily because the earnings release led to a massive selloff in FTNT shares from which they have never recovered. The shares fell by 21% on the day following the earnings release and have fallen another 18% net since that time even after recovering from the February lows. So, they are 35% below the levels they were in late October.

Another earnings release has come and gone. There was a continuation of the mismatch between billings growth which was 35% and product revenue growth which was 31%. The fact is that both billings and revenue growth were above previous guidance. The mismatch was smaller in Q4 than it was in Q3. As a result of the mismatch, the deferred revenue balance continued to increase and was up by 42% year on year. Actually deferred revenue growth of $84 million in Q4 was no less than 12% over the prior sequential quarter which is a remarkable figure for a company of this size.

Renewal rates as well remained consistent. This company sells hardware (security appliances) as opposed to software. Obviously customers will change out hardware far more often than they do software to take advantage of changes in features, functions, footprint and power and heat dissipation. Still, the renewal rate on boxes was in the mid 70% range. The box renewal rate excludes the revenues associated with refresh and upgrades that are inevitably associated with a renewal. Overall, the customer renewal rate is well in excess of 90%. If the company reported renewals that way that most SaaS software companies report the metric, I imagine that renewal rates would be said to exceed 100%. The fact is, that in this environment, no one throws away security solutions and very few people change vendors. The long term opportunities that a subscription model enjoys are essentially the same for this company as they are for any other vendor using a subscription based business model.

Earnings for the period were in-line at $.18/share. With those kinds of results, the company's free cash flow during the quarter was $60 million, more than doubling from year earlier levels. The company spent all of its free cash flow repurchasing shares during the period. I am not too sure that such a strategy is based on optimal capital allocation, but given the valuation of the shares it was perhaps understandable. The company seems likely to repurchase even more shares in the current year based on its new share repurchase plan which calls for an authorization of $200 million to be spent over a two year span. Despite what seemed to be an emollient release considering prior concerns, the shares, after initially spiking after-hours, closed about flat in the following day's trading. That may have had to do with overall market conditions at that time more than any specific reaction to the earnings or the 2016 guidance.

While the guidance was certainly in line with prior estimates and no one changed estimates in the wake of guidance, there were some observers who thought that the guidance was conservative. I think that the basic issue was the reorganization of the sales force that has taken place in the first quarter. A few days ago, it was announced that both the Chief Marketing Officer and the head of Americas Enterprise sales both left the company. While marketing officers clearly have an impact at companies on a longer term basis, in the short term that departure is really not going to be of great importance. The departure of the head of the Americas enterprise sales SVP was almost certainly a result of the earlier announced sales force reorganization in which his organization was essentially disbanded and merged into other groups.

Overall, guidance, particularly for Q1, was very cautious and was cautious because of the potential disruptions caused by the sales force reorganization. The expected growth in revenues, bookings and EPS was quite muted for the period - and that is probably as it should be. Still conservatism has its limits. The company is forecasting 25% revenue growth this year coupled with a 35% growth in EPS. The company has talked about significant operating margin leverage both this year and in the future and estimates reflect that kind of expectation.

So, why consider Fortinet now? Its EV/S at less than 3.2X is quite low for what is, after all, still a quite successful momentum growth story. Operating cash flow for the year rose more than 40% to $282 million. About 1/3rd of operating cash flow came from stock based comp. Stock based comp at around 10% of revenues is lower than the ratios for many other companies who used subscription based revenue models. The other constituents of operating cash flow were basically all at the lower end of normal ranges - except for the massive increase in deferred revenues which was up 73% year on year.

Forecasting cash flows is tricky because of the balance sheet items that usually impact the calculation coupled with minimal visibility in terms of forecasting deferred revenues and stock based comp. Some companies provide estimates for those two metrics. So far that hasn't been the case for Fortinet. With all of that in mind, I expect that operating cash flow will increase a bit faster than earnings to around $390 million which would represent a cash flow margin of above 30%. If that works out, then I would expect free cash flow to be in the range of $340 million for the year which represents a free cash flow yield of more than 8%. Strong growth, rising margins, a good space and reasonable valuations. What more could one want as the basis for an investment.

Well if Fortinet is so good, why is it so cheap? What are we missing, and is what we are missing real or in the minds of investors soon to be enlightened?

It ought to be obvious to most readers at this point that the issue here is that most analysts and portfolio managers don't believe the guidance and are waiting for the other shoe to drop so to speak. Is there any objective basis other than the share price performance of the recent past that justifies the fears and suspicions about this company?

Fortinet was founded in 2000 and is the 3rd largest vendor of network security appliances behind Cisco (NASDAQ:CSCO) and Check Point (NASDAQ:CHKP). It was founded by the brothers Ken and Michael Xie who were amongst the founders of the network security industry in the US. Ken Xie remains CEO of the company.

The company was one of the original developers of what is called Unified Threat Management (UTM) which as its name implies is supposed to provide end to end protection including firewalls, intrusion prevention, gateway anti-virus and anti-span filtering and load balancing. UTM has some obvious advantages such as simplifying complexity and ease of management and some disadvantages particularly including single point of compromise and potential impact on latency and bandwidth.

To a certain extent, the disadvantages of UTM make it better suited for the SMB market space rather than the enterprise space. Fortinet's strategy until fairly recently was to sell its products through the channel primarily to the SMB space. It actually has 20,000 channel partners. In recent years, Fortinet has offered what it calls UTM bundles. From the perspective of an investor, the thing to understand about a bundle is that it costs more than a single product and typically is sold on relatively long-term contracts. That probably doesn't sound like such a big deal and it shouldn't be, but it does answer one of the reasons as to why investors are suspicious of Fortinet. The bundles have the impact of reducing current revenue recognition and adding to the deferred revenue balance.

Now many people wouldn't necessarily think that have a long term stream of visible contracted revenues is a bad thing…but the impact on the shares of selling the bundles has been noteworthy to say the least. A few years ago Fortinet decided to take on the large enterprise market. Again, that seems to be a pretty reasonable evolution for a company like this. The issue really isn't product as I will discuss in a few lines, it is cost. If a company that primarily distributes through channel partners wants to sell to the high end of the enterprise space, it is inevitable that it will have to build out some kind of dedicated enterprise sales force. The biggest issue with that is that it costs money, lots of money and it can, as was the case in Q3, put pressure on margins. Not really lots of pressure - remember EPS came in above expectations but some pressure.

Some investors weren't convinced that Q3 represented the apogee of the bad news and wanted a greater sense of transparency regarding how the company proposed to take advantage of all of its opportunities including those it sees overseas which had an exceptionally strong year in 2015, the midsized enterprise and in its internal marketing programs to raise Fortinet's visibility in the security space amongst prospective customers. Very few companies provide details about their spending to such a granular level and I am not sure that if they did it would prove to be of value to investors, either professional or retail, in making sound investment decisions.

As I mentioned above, I sometimes see analysts become delusional en masse. So far as I can see, Fortinet saw a significant opportunity for its solution set in the enterprise market and spent some resources to attempt to capture that opportunity. The strategy seems to have worked splendidly in that growth in 2015 was the fastest it had been since the company became public back in 2009 and really by a meaningful amount. I would also comment that the experience of this company is that its customers spend 5X their initial purchase over their first 5 years as a Fortinet customer.

I think the trade of a couple of hundred basis points of operating margin in return for markedly faster growth coupled with a far larger base of very visible subscription revenues ought to be one that almost any rational investor would want to see taken. That is really particularly true in the tech space where the biggest trend is always change and obsolescence. I would be far more concerned that as a result of a sagging share price if management abandoned its more aggressive marketing strategy in an effort to raise short-term operating margins. Indeed, I see a little of that in the company's forecast for the current year although I think "only 25% growth" isn't all that terrible for a company of this size. It is far less than the growth of Palo Alto, for example but greater than growth rates at most other vendors in the market. These days, 25% growth is probably double the rate at which the overall market is growing.

The other potential issue that almost inevitably develops with specialized, high end sales forces is that they create jealousy and conflict within the organization. Obviously, the mass of salesman who aren't in the top tier become unhappy that they weren't selected and are even less pleased when they lose the best potential targets in their geographic territory. It may be possible to build a sales force around vertical capabilities without creating conflict, but it is not possible to do so when splitting a sales force into major account specialists and all the rest.

And apparently, the inevitable has come to pass and the experiment in a specialized enterprise sales force has come to an end, and the executive who used to head it has headed to F5 (NASDAQ:FFIV), not quite a competitor but a company that is in adjacent spaces. I really do not think that it is going to be such a Herculean task to get the sales force management right if the solution set is competitive and if the market for security appliances continues to be hot.

I don't want to spend an excessive amount of time trying to evaluate Fortinet's solution vis-a vis the competition. There are loads of competitors in the space and an equal amount of hype. Given that cybercrime is rampant - one study says that it is running at something like a trillion dollar run rate or so and growing at 20% a year, spending a $20 billion/year to at least try to control the problem is a pretty obvious solution. And of course the costs of cybercrime are greater than just monetary losses. Issues of primacy and trust abound. Companies like Target (NYSE:TGT), which suffered a massive and well-publicized breach last year, can spend years attempting to rebuild their reputation and to lure back customers. Of course the cybersecurity market is large and growing and has attracted loads of competitors.

One of the issues with running applications in AWS or other public cloud alternatives is the reasonable fear that the cloud magnifies the chances that data will be hacked and stolen. Gartner claims in one of its innumerable pieces that "Fortinet can enable cloud security to grow with your business through dynamic application security that automatically scales in conjunction with cloud computing resources." Aside from the sentence being a mouthful, Gartner basically says that if you want to implement a security application at scale in the public cloud, Fortinet is one of your better choices.

There is another service called the UTM Mighty Guide. The service doesn't offer conclusions per se, but it reaffirms that the proposition that Fortinet has a technology that ticks all of its boxes in comparison to solutions from Check Point, Dell, Cisco and Sophos (Sophos is a relatively large network security company that is domiciled in Britain and whose shares trade on the London Stock Exchange.). Gartner's latest survey on firewalls rates Palo Alto and Check Point as # 1 and 2 in the space with Fortinet a reasonably close 3rd. On the other hand, Gartner rates Fortinet the #1 vendor in UTM.

I obviously won't even think of trying to evaluate Fortinet as better or worse than its major competitors based on any one particular survey or the other. The only point I think that bears repetition is that Fortinet is either a leader or a close challenger in the product categories in which it competes. If solution capabilities were the only criteria for share valuation, Fortinet shares would not be selling where they are. Of course, the same might be said about Check Point as well, but in that case the issue is clearly one of not enough sales and marketing spend to get its products in front of potential customers.

To answer the question posed at the start of this section, it is my contention that there is nothing "wrong" with Fortinet in either growth, product, business model or expense transparency. There is simply a significant disconnect between Fortinet's valuation vis-à-vis its peers and its current share price.

OK then - Let's see the relevant valuation metrics for the competitors so we can compare Fortinet on that basis.

Palo Alto has an enterprise value of $13 billion at the present time. Its EV/S is just short of 10X and its growth rate over the coming year is thought to be around 40%. PANW has a fee cash flow margin of 40%. Stock based comp. is currently running at 16% of revenues.

On the same basis, Fortinet has an EV/S of 3.2X and its free cash flow margin is 27%. Its growth rate is thought to be about 25% for this current year. Stock based comp is about 10% of revenues.

Checkpoint in some ways is a very cheap name with extraordinary profitability. It has an enterprise value of a bit over $13 billion and an EV/S of 2.9X. Its free cash flow margin will probably be in the range of no less than 55%. Stock based comp was just over 4% of revenues. Growth rate estimates are in the range of 8%.

Symantec's (NASDAQ:SYMC) numbers are still in somewhat of a state of flux in the wake of the recent divestiture of Veritas. It has an enterprise value of $11.6 billion yielding an EV/S of 2.6X. It has an estimated free cash flow margin of just a few percent for 2016 that is not quite comparable to the margins of the other companies in this analysis. Its growth rate is nil and stock based comp is 13% of revenues.

I think it is relatively straightforward that on a relative valuation basis to its peers, Fortinet's valuation appears to be anomalous. Anomalous valuations do not tend to last indefinitely.

Some final thoughts

The share price performance of Fortinet appears to be a product of extreme fear and doubt relative to the company's forecast for the current year. While the company is not growing as fast as industry leader PANW, it is no growth sluggard either with conservative growth estimates for this year estimated at around 25% with some margin improvement. The company's growth in cash flow and free cash flow is quite impressive as an increasing proportion of bookings have turned into deferred revenues because of what is called a bundling strategy.

For reasons not totally clear, investors were said to be very perturbed by the company's Q3 margin performance. Self-evidently, the margin performance did not impact overall earnings which were a beat of forward guidance either. Although both Q4 performance and 2016 guidance was more or less in line, with the exception of cash flow which continues its strong growth trajectory, the shares have never recovered from their late October swoon. There are, I suppose, lots of washed out tech names these days - but most of them have spots on their performance. This really is one of those anomalies that has persisted beyond a reasonable time period. I think it deserves a better valuation and a careful look.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.