Fortinet, Inc. (NASDAQ:FTNT) is a cyber security solutions provider specializing in threat detection. They produce firewall and advance threat detection systems. Fortinet recently reported second-quarter results which were better than expected. Revenue was $184 million and EPS was $0.11. EPS beat analysts' estimates by $0.01 and revenue beat by $12.52 million. The second-quarter results are a continuation of the company's solid financial performance. From 2009-2013, revenue grew at a CAGR of 25.0%. The company's double digit growth rate has coincided with solid operating income growth. From 2009-2013, operating income grew at a CAGR of 29.9%. However, operating income has declined in 2014. The decline is the result of a rapid rise in sales and marketing expense. The company increased sales and marketing expenses 34% in 2014 and increased it as a percent of revenue to 40.3%, up from 37.4% in 2013. Management is trying to bolster their sales infrastructure and increase personnel in order to better reach customers. Although, the company has grown double digits their growth has been impacted by a lack of brand recognition. Management has started to address this issue with an increased sales and marketing push in 2014. This very important because the sales force will be vital to their success in a new market segment.
Before going on, there is some confusion in the cyber security industry regarding firewalls. There are two types of firewall systems. They are called Unified Threat Management or UTM and Next Generation Firewall or NGFW. The difference between these two is simply in the name. The two types of firewalls are capable of performing the same tasks. Although they are the same, UTM is used to refer to firewalls for small to midsized organizations and NGFW is used to refer to firewalls for enterprise organizations. These two systems are the same, but the industry uses different terminology depending on the market segment.
Winning Against The Competition
The firewall market is expected to grow at a CAGR of 16.59% until 2015, according to TechNavio. The firewall market has been growing because of the demand for better security tools. Firewalls are an integral part of any cyber security system. Fortinet is considered to have one of the best firewall systems. Gartner placed Fortinet as the leader in the unified threat management firewall market. Additionally, Fortinet has shown the ability to compete against much larger competitors. On the Q2 conference call, Drew Del Matto CFO talked about beating Juniper Networks, Inc. (NYSE:JNPR) "...based on our superior performance advantage intelligent and detailed reporting and overall lower cost of ownership". Fortinet also beat Cisco Systems, Inc. (NASDAQ:CSCO) based on performance and adaptability during the quarter. Lastly, Fortinet was able to beat Palo Alto Networks, Inc. (NYSE:PANW) and Check Point Software Technologies. The win over these two competitors shows Fortinet has a competitive advantage with their firewall solution. This is because Palo Alto and Check Point have top quality firewall solutions. Gartner ranks both Check point and Palo Alto as leaders in the firewall market.
Fortinet's firewall system has driven revenue growth. Fortinet's early success came from targeting small to midsized businesses. Yet, management has increasingly targeted and won enterprise deals. On the Q1 conference call, Drew Del Matto stated, "In particular, we are winning a growing number of large enterprise data center security deals with the number of deals over $500,000 in Q1 increasing 146% year-over-year." Yet, enterprise deals can take much longer to close and require more sales people. Fortinet has been growing well into the double digits, but they are still growing much slower than competitors. Their slower growth is due to a lack of sales and marketing spending. Management has started to address this issue in 2014 and will need to continue their efforts into the future. This will help the company maintain or even speed up their double digit growth.
Increased Sales Push
The firewall market is growing fast and Fortinet has been able to enjoy this growth. On the Q2 conference call, Drew Del Matto talked about market conditions, "...we experienced increased momentum and saw healthy spending within the enterprise. Primarily driven by firewall refresh and network upgrades." Although, Fortinet has been able to achieve double digit revenue growth over the last several years. The company's growth rate has varied significantly. In 2011, revenue grew 33.5% which is the highest annual growth rate during 2009-2013. The lowest annual growth rate is 15.3% which occurred in 2013. Management has a top quality firewall product, but has experienced inconsistent year to year growth. The major reason for this inconsistency is the company's subpar sales and marketing effort.
Palo Alto Networks is a developer of firewall solutions. From 2009-2013, they have grown at a CAGR of 230%. Palo Alto's firewall system is on par with Fortinet's system. Yet, Fortinet has only been able to grow double digits over the last several years. Palo Alto was a much smaller company which explains a large portion of the company's CAGR from 2009-2013, but doesn't account for Palo Alto's 48% growth in 2014. Fortinet is growing slower than Palo Alto because they don't spent enough on sales and marketing. Palo Alto spent as a percentage of revenue 55.7%, 61.2%, and 72.8% on sales and marketing in 2012, 2013, and 2014, respectively. Conversely, Fortinet spent as a percentage of revenue 33.6%, 36.6%, and 40.3% on sales and marketing in 2012, 2013, and 2014, respectively. Palo Alto's rapid revenue growth is due to their top quality firewall solution and their sales and marketing efforts.
In 2013, Palo Alto spent $305 million on sales and marketing but Fortinet only spent $225 million. This disparity occurred even though Palo Alto had half the revenue of Fortinet. Fortinet doesn't need to spend 70% (as a percentage of revenue) on sales and marketing but they need to spend more. Fortinet's customers are even complaining about the company's lack of marketing. On the Q2 conference call, Drew Del Matto talked about customers lacking awareness of their brand "...we've certainly invested more in marketing to get that awareness out there, but we still view there's opportunity there, that would be the feedback that we've seen and we absolutely take that seriously and we will continue to invest." Fortinet has a top quality product which they need to market better in order to take advantage of the industry's double digit growth.
Fortinet has increased their spending on sales and marketing in 2014. On the Q2 conference call, Drew Del Matto stated "... we've grown I think headcount what do we think, 50% over a year ago, with really the bulk of that in sales, really a bulk of that in sales." They spent 40.3% as a percentage of revenue compared to 37.4% in 2013. The increased sales effort helped increase revenue growth to 24.6%. The 24.6% growth is substantially higher than 2013's full year growth rate of 15.3%. The cyber security industry is growing because of the increasing number of threats. A firewall system is a critical part of any cyber security system. Fortinet has positioned themselves well in the firewall market and with an increased sales effort should continue to outperform. Yet, they will need significant help from their sales and marketing team to catch up in the advanced threat detection market.
The global cyber security industry is expected to grow at a CAGR of 11.81% until 2018, according to TechNavio. Yet, several market segments are growing faster. Cyber criminals are getting more sophisticated. They have been able to get past many security systems. The key to limiting the damage of an intrusion is to quickly detect and isolate the threat. This is why there has been a rapid increase in demand for advance threat detection systems. These systems are expensive but can save millions in data breach expenses. Fortinet introduced their own advanced threat detection system in February 2014. Yet, Fortinet is entering the market very late.
Competitors like FireEye, Inc. (NASDAQ:FEYE), Palo Alto, and several other vendors introduced their products years ago which gives them a significant head start on Fortinet. Management was originally suppose to launch their advance threat detection appliance FortiSandBox in 2013. However, they delayed the release because they were working on a licensing agreement with Microsoft. A sandbox can run several different version of Windows which can violate the licensing agreement if the company doesn't have a license for each version. Although saving time and money in the future, this delay has given FireEye, Palo Alto, and other competitors a massive head start. This delay will require a significant market push to help them establish a market presents.
The massive head start has allowed many competitors to grow into formidable opponents. From 2009-2013, FireEye has grown at a CAGR of 215%. FireEye is expected to have revenue of $423 million by the end of 2014. FireEye and Palo Alto have both spent significantly on sales and marketing. They have both established a significant presence in the advanced threat detection market. Fortinet has a top quality firewall solution which they can bundle with their new advanced threat detection system. This should help them establish a market position. Yet due to their late start, they will need to have a significant marketing push to even start to catch up to competitors. This market is growing rapidly and won't require significant market share gains in order to generate meaningful revenue. Yet, Fortinet's competitors aren't going to make it easy especially since they are already outspending them. Fortinet's sales efforts will be key to their success in the advance threat detection market.
Fortinet's management has been able to grow revenue above a CAGR of 20% and has still remained profitable. Currently, Fortinet is the only company producing a net income in the below peer group. This makes a P/E valuation comparison impossible. Although, a forward P/E comparison can be made. Fortinet would be considered relatively undervalued based on a Forward P/E. What about based on revenue multiples?
|Valuation Metric||P/E||Forward P/E||P/S||EV/Revenue|
|Barracuda Networks, Inc. (CUDA)||N/A||99.4||5.1||4.5|
Data: Yahoo Finance- Key Statistics
Fortinet has grown at a CAGR of 25% from 2009-2013. In 2014, they grew 24.6% which makes them the third fastest growing company in the subgroup. Barracuda, Palo Alto, and FireEye are growing at 19.9%, 48.0%, and 173.3%, respectively. All companies are trading as expected based on revenue multiples. Barracuda is trading at the lowest P/S and EV/Revenue which is expected due to its slow growth rate. FireEye has the highest valuation because it's the fastest growing company. Palo Alto is trading at a higher valuation than Fortinet but Palo Alto is growing much faster. Fortinet is trading at a discount to peers based on earnings multiples. Although, Fortinet is trading at fairer value based on revenue multiples. Combining the two types of valuation metrics, Fortinet could be considered fairly valued or at best slightly undervalued compared to peers. This means an investor wouldn't be paying an unreasonable price for the industry.
Sales And Marketing Effort Needs To Continue
The cyber security industry is growing rapidly. The sophistication and number of threats are increasing by the day. Firewalls represent a critical layer in a cyber security system. As a result, the demand for top quality firewalls will continue to grow. Fortinet is well positioned with their current product offering to continue to take advantage of this increasing demand. However, the company has to do a better job of marketing their products. Management has grown sales to double digits over the last several years. Yet, smaller competitors have grown significantly due to their focus on sales and marketing spending. These competitors are now outspending Fortinet. Fortinet will need to increase their sales infrastructure and personal in order to stay competitive.
Especially since they entered the advanced threat detection market after many rivals. Fortinet delayed the launch of their advance threat detection system due to licensing issues. The delay has resulted in several competitors growing into formidable opponents. Fortinet has shown the ability to produce a top quality product. Additionally, the combination of their firewall and advance threat detection system will help gain a foothold in the market. Yet, the company is facing a difficult battle due to their late start. Additionally, several competitors are spending more on sales and marketing. Fortinet will need a significant sales push in order to help establish a significant market presents.
If management can continue their sales push, the company is well positioned in the firewall market. They have ways to go in the advance threat detection market. However, they have entered a rapidly growing market which doesn't require significant market share gains to produce meaningful revenue. Fortinet's stock is fairly or slightly undervalued compared to peers. This means the stock is trading at a reasonable price for the industry. Fortinet is a top quality cyber security company which should continue to outperform over the next several years.
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