A Solid Showing Shores Up Fortinet

By Stephen D. Simpson, CFA | February 01, 2013 AAA

This has been a feast-or-famine sort of quarter of tech investors, and Check Point Software Technologies Ltd.'s (Nasdaq:CHKP) feeble quarterly results certainly had investors wondering what sort of quarter Fortinet Inc. (Nasdaq:FTNT) was going to report. Apparently they needn't have worried, as this fast-growing security hardware specialist came through. While Fortinet's valuation doesn't scream bargain, aggressive investors could still find opportunity here.

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Coming Back Strong

Suffice it to say, Fortinet freaked out investors with a pretty weak third quarter and the departure of its CEO. That put even more pressure on the company to deliver a good fourth quarter result, and management came through.

Revenue rose 25% as reported, beating expectations. Product revenue rose 24%, and the company saw 24% growth in billings (or 22% excluding a patent sale). Billings were pretty well-balanced across large, mid-range and small enterprise categories.

Margins were also pretty good. Non-GAAP gross margin fell 40 basis points (BPS) from the year-ago level, but analysts were expecting worse. Operating income rose 28% (again, on a non-GAAP basis) and the operating margin expanded half a point from last year's level on restrained G&A and R&D spending.

SEE: How To Decode A Company's Earnings Report

Plenty of Hard Work Left to Do
While Fortinet management may have been a bit conservative with 2013 guidance, there really wasn't anything that struck me as worrisome. Enterprise IT budget priorities are still up in the air, but I'd be surprised if security doesn't remain near the top of the list of priorities. But that's not to say that it's all smooth sailing from here on for Fortinet.

Due diligence with resellers and customers has turned up the nugget that Fortinet has often been willing to compete on price to gain business from Palo Alto Networks Inc. (NYSE:PANW), Check Point, and Juniper Networks Inc. (NYSE:JNPR), even though it is the market share leader in Unified Threat Management and market leaders aren't typically thought of as price competitors. What's more, Fortinet is working hard to go up-market (larger enterprise customers) and while these customers are not insensitive to price, it is just one of several important considerations. That, then, could put some near-term pressure on margins as the company invests more into marketing.

There's also the more prosaic concern of competition. Cisco Corporation (Nasdaq:CSCO), Check Point, and Juniper have all rolled out new products in Fortinet's core market, and Cisco and Check Point in particular are no slouches when it comes to technology quality and product features. Perhaps it's a bit ironic, but those same due diligence calls suggest a potential benefit to Fortinet's prior willingness to compete on price - many customers seem to think Check Point in particular is more expensive than it actually is, and that could help the company compete against these new product platforms.

SEE: The Pros And Cons Of Price Wars

The Bottom Line
I'm a fan of Fortinet, and I do believe the company's proprietary processing chips and operating system do offer a competitive edge. The problem is that Fortinet also has some very serious rivals with strong technology of their own.

Even so, I think Fortinet could produce long-term revenue growth in the low double-digits. I don't see quite as much incremental margin/free cash flow (FCF) conversion potential, however, so my outlook for FCF growth is pretty close to that of revenue. At a 12 to 13% growth rate from 2012 results, fair value for Fortinet would appear to be in the mid-to-high $20s. That, in turn, suggests that the shares may be 5 to 20% undervalued today - not a tremendously compelling margin of safety given the risks and volatility in the tech sector.

On balance, I'm inclined to buy these shares even with the relatively high valuation. While Check Point and Cisco both could do better, Fortinet is actually doing better today, and I think the company's technology makes it a player to watch, whether it stays independent or gets a bid from a larger tech player.

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

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