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.

Forex Broker Guide: Using the right broker is essential when competing in today's forex marketplace.

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.

Related Articles
  1. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  2. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  3. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  4. Investing

    Has Apple Finally Hit the Wall With the iPhone?

    We look at how the iPhone has sold over its brief existence and what that means for the future of the smartphone market.
  5. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  6. Investing

    The Top Businesses Nurtured By Y Combinator

    We look at the top startups that were incubated at Y Combinator, one of the world's most popular business incubator firms.
  7. Investing

    Is It Time To Bet On The iPad Again?

    Apple's focus on iPad has been fairly tepid these past few years. But, the iPad Pro was the centerpiece of the company's latest product announcements. Why?
  8. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  9. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  10. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  1. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  2. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  3. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  4. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  5. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  6. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!