Fortinet A Little Too Hot For Love

By Stephen D. Simpson, CFA | July 26, 2012 AAA

It's hard to imagine a tech world where security isn't an ongoing concern; even sci-fi gives ample time and attention to hackers, slicers and the like. Accordingly, I think companies like Check Point (Nasdaq:CHKP) and Fortinet (Nasdaq:FTNT) are definitely in a market with attractive long-term fundamentals. The real question for investors is value - as far as high-growth tech stocks go, Fortinet doesn't seem too expensive, but it's hard to call this stock cheap.

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Reasonably Good Results
In a market where companies like IBM (NYSE:IBM) have reported iffy hardware and overall IT growth, Fortinet showed some encouraging momentum in sales and billings. Of course, comparing Fortinet to IBM is a little like comparing a speedboat to an oil tanker, so that comparison only goes so far.

Nevertheless, revenue was up 25% from last year and 11% from the first quarter, which was a decent amount of out-performance. Billings were also strong, rising 6% from the first quarter, but 32% from the year-ago level. Interestingly, the company saw the mix shift more to the mid-range and high-end of its product line this quarter.

Margins weren't as good. Gross margin slipped about two points from the first quarter, and operating income was up 12% on both an annual and sequential comparisons. At roughly 16%, Fortinet doesn't have great operating margins, but this could be an area of future growth - if the company can continue to post strong revenue growth, there's a good chance of better leveraging that research and development and SG&A spending to produce stronger income and cash flow growth.

SEE: Understanding The Income Statement

The Need for Speed
Speed is essential to the Fortinet story. While Unified Threat Management (UTM) offers a lot of good things to enterprise IT customers, it comes at a cost - namely, the more security services are activated, the slower the overall performance of the system.

Fortinet and Palo Alto (NYSE:PANW) get around this with a better mousetrap. In the case of Fortinet, it's all about the company's proprietary FortiASIC chips and FortiOS operating system - these basically allow the FortiGate appliances to do what they do with less compromise of performance. This is also where Fortinet (and Palo Alto) try to differentiate themselves from competitors like Check Point and Cisco (Nasdaq:CSCO), where the older technology there can compromise performance.

Does Independence Make Sense?
I do wonder whether Fortinet has much of a future as an independent company. I could see this company's UTM products and technology making sense to a lot of other companies. I would think Cisco would probably prefer to try developing their own ASIC or parallel processing capabilities for UTM, but I could see others contemplating a bid.

Check Point could likely raise the funds if it wanted to, but it would be an unusually bold move. Hewlett-Packard (NYSE:HPQ) arguably already has a lot on its plate, but what about IBM, Oracle (Nasdaq:ORCL) or EMC (NYSE:EMC)? Unfortunately, Fortinet already trades at a pretty significant premium that surpasses many recent deal multiples.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
With the strong positive reaction to earnings, Fortinet is not a cheap stock. On the basis of 15% estimated annual compound free cash flow growth out to 2022, this stock's fair value would seem to be in the mid-$20s. Now that's a fairly aggressive growth assumption, but by the standards of high-growth tech stocks (especially those with differentiated technology in attractive markets), Fortinet isn't as a terribly overpriced as you might first assume.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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