Fortinet (Nasdaq:FTNT) is one of the many growth tech stocks that I've damned with the praise of liking the company and the growth story, but finding the valuation to be too demanding and too vulnerable to disappointment. In the case of Fortinet, it looks like that particular bird came home to roost with third quarter results that weren't really that bad, but not nearly strong enough to keep a hope trade going.

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When a Not-Miss Is a Miss
Ostensibly, this quarter was no disaster for Fortinet. Revenue rose 17% and met the average of published analyst estimates; not bad given the softer results at Check Point (Nasdaq:CHKP) and the generally depressing hardware news from bellwether IBM (NYSE:IBM). Unfortunately, this is a company that has consistently reported at the high end of its guidance range (and has generally beaten revenue estimates) for years. Profitability was also a little soft.

Gross margin declined 100 bps from last year, but did improve about 100bps from the prior quarter. Operating income was down 1.5% on a GAAP basis, due largely to a jump in sales and marketing costs, while even the non-GAAP operating income growth of 9% pointed to lower margins. Only about 15% of the jump in marketing costs can be tied to stock comp expense, so I have to wonder if Fortinet is finding itself forced to spend more to hold/gain share against the likes of Palo Alto (NYSE:PANW) or Sourcefire (Nasdaq:FIRE).

New Products Won't Offset the Worries
It's hard for me to panic about a quarter that saw 17% revenue growth, particularly given the weakness in Europe and China. What's more, it's not as though the company is sitting on its hands - a new version of its operating system and a new ASIC should both come out in the first half of next year.

Unfortunately, I doubt that will make anybody feel better today. The company saw its CFO agree to leave the company to become the CFO of Yahoo! (Nasdaq:YHOO) about a month ago, and with this somewhat disappointing quarter I suspect some investors will draw connections that probably shouldn't be drawn. More explicitly, I don't think Mr. Goldman is leaving Fortinet because the company's prospects are dimming, but rather because Yahoo! is a bigger opportunity (and a lucrative one as well).

Competition Isn't Getting Easier
There's little point in pretending that Fortinet doesn't face fierce challengers for market share in the next-gen security market. Not only are newer companies such as sourcefire and Palo Alto offering differentiated mousetraps, but more experienced players such as Cisco (Nasdaq:CSCO) and Check Point are also moving into the appliance space to preserve their businesses.

As if that weren't enough, companies such as F5 (Nasdaq:FFIV) have pointed to security as an attractive market for diversification/expansion. With that sort of competition, it seems like a veritable guarantee that Fortinet must continue to devote substantial resources to both R&D and marketing. On the other hand, the attractiveness of the market also suggests to me that Fortinet could find itself an M&A target before too long.

The Bottom Line
Looking at the recent trend of tech earnings reports (including that of IBM), there are definitely some reasons for concern about the near-term outlook for hardware demand. And while I don't think there's any credible reason to think that long-term demand for enhanced security products is going to decline, stocks like Fortinet are driven significantly (too much, in my opinion) by the near-term outlook. Consequently, for the sin of not beating estimates I expect Fortinet to be put in the penalty box for a while.

Unfortunately, it's not as though these shares are notably cheap even with the big sell-off. Even with low-to-mid teens free cash flow growth, fair value would seem to be in the area of $23 to $24 - higher than today's price, but not by a wide margin. Nevertheless, this is probably as close to what passes for value in growth-tech stocks, so aggressive investors may want to consider taking advantage of this sell-off.

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

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