All an investor in high-multiple stories can ask for is a continuation of a strong growth story, complimented with beat-and-raise quarters. Luckily, Fortinet (Nasdaq:FTNT) provided that in the fourth quarter. While there's still a lot of growth potential in security appliances, investors may want to ask themselves just how much success is already built into this stock.
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Nothing Really Amiss in the Fourth Quarter
Fortinet's growth story continued apace in the fourth quarter. Reported revenue rose 29% this quarter (and 4% from the third quarter), as product led the way (up 40 and 8%) over services (up 27 and 6%). Just as important is deferred revenue that rose 17%, while billings were up 27% - accelerating from the 25 and 23% growth seen in the third and second quarter, respectively.
Margin performance wasn't bad, but maybe not as good as longs might hope. Generally accepted accounting principles (GAAP) gross margin eroded a bit on a sequential and annual comparison, but was only down one point from last year. Operating income was up 28 and 1%, and operating margin compressed a bit. Keep in mind, though, that Fortinet's business model isn't necessarily well-treated by GAAP accounting rules, so investors should not overreact to what may look like softening margins. (For related reading, see What Are Some Of The Key Differences Between IFRS and U.S. GAAP?)
Growth Keeps Coming
Although companies like Cisco (Nasdaq:CSCO) and Check Point (Nasdaq:CHKP) have been a little uncertain about IT demand in 2012 (especially in Europe), Fortinet seems fairly confident. Although first quarter guidance suggests a 13% sequential drop in product sales, overall revenue is still looking to be up more than 24% on an annual basis and this guidance is higher than the prior analyst estimates.
Is the Appliance Market Getting More Crowded?
One of the things that sets Fortinet apart is that it custom designs ASICs (semiconductors) to meet the demands of its software. This hardware-software convergence has been a constant theme in technology for a while now, but Fortinet has really made it work for its customers - FortiGate is one of the fastest security appliances out there and simultaneously runs firewall, VPN and intrusion detection/prevention functions.
But Fortinet doesn't have it all to itself. Cisco and Juniper (NYSE:JNPR) are both taking the custom ASIC approaches, and Cisco has the advantage of still holding the No. 1 slot in markets like VPN. What's more, Check Point has really started to focus on its device/hardware business and shouldn't be underestimated. And there are smaller up-and-comers like Sourcefire (Nasdaq:FIRE) and privately-held Palo Alto Networks.
A crowded market split between major corporations and smaller players often means that M&A is on the way sooner or later. Even with the high multiples on Fortinet's stock, I could see Check Point or Juniper considering a buy, or even maybe Intel (Nasdaq:INTC) if they want to build on the addressable markets for McAfee. (For related reading, see Biggest Merger and Acquisition Disasters.)
The Bottom Line
I dare say at least some M&A expectation is already built into Fortinet's stock price. Otherwise today's valuation basically means that the Street thinks Fortinet will blow by Check Point and Juniper, and seriously challenge Cisco's market leadership in a few years' time. While Fortinet bulls may be nodding their heads at this point and saying "yep, that's what's going to happen," it seems like an aggressive outlook today.
Far be it from me to suggest ditching a rebounding/rallying tech name with good growth, momentum and potentially vulnerable competitors. That said, the shares are nothing like cheap and new investors are basically making a bet on a "buy high, sell even higher."
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.