Fortinet Stock: Maintaining a Buy Despite Short-Term Headwinds (NASDAQ:FTNT)

investment thesis:

Last time I wrote on Fortinet (NASDAQ:FTNT) a day before 2Q24 earnings, Aug. 5, stock initiation with a buy. Fortinet shares are up 38.5% since our bottom call, as seen below, and I think my stock-beating thesis remains in play. This is not to brag, but when the market was bearish after the 1Q24 pullback, I saw Fortinet’s potential driven by its “unique position in network security, particularly firewall spending” and expected “UnifedSASE offerings and SecOps (both of which are new) to support more cross-selling opportunities to existing clients and to support the outperformance of the S&P 500.” In line with my forecast, Unified SASE and SecOps saw strong growth this quarter, up 45% and 18%, respectively, and gained “significant momentum,” with over 90% of billings coming from existing customers during the quarter. Pre-earnings, I also tracked product revenue “religiously” as it was a point of concern. This quarterproduct revenue was down 4%, but that was much less than management expected, and product sales were up 14 basis points quarter-over-quarter and year-over-year, excluding backlog impact, again , better than he feared.

I maintain my buy on Fortinet in the second half of FY24 as I expect a refresh cycle and better firewall growth in 2025 and I think Fortinet’s recent acquisitions and position in AI positions it for a surprise higher in FY 26. I believe Fortinet’s new acquisitions, Lacework and Next DLP, will expand Fortinet’s market share in the GGNAT and DLP markets, respectively. The company has a lot going for it, especially as it balances growth and profitability, with plans to hit the 40 mark in the near future.

The quarter in numbers: growing balance and profitability

Fortinet entered the quarter with strong results, achieving a record operating margin of 35%, an increase of 820 basis points. This was primarily due to cost efficiencies and a reflection of record gross margin, which increased 360 basis points to a quarterly record of 81.5%. The company beat the high end of its guidance with total revenue of $1.43 billion, up 10.9% year over year and above consensus by 2.31%. This was primarily driven by solid growth in services revenue, up 20% year-over-year to $982 million. Services revenue accounted for 68.5% of total revenue, led by 36% growth in SecOps and 27% growth in Unified SASE. Non-GAAP EPS came in at 57 cents per share, up 50% year over year and beating estimates by 39.02%.

Now let’s break this down into segments. As previously noted, product revenue fell 4.4% year-over-year to $451.9 million due to a tough comparison, following the trend of recent quarters. That’s less looming overhead now, as gross product margin of 66% was up 259 basis points from the year-ago quarter, supported by 1. increased software mix and 2. lower overhead costs. On a quarterly basis, product gross margin increased from 56%, primarily due to increased hardware demand and normalizing inventory levels, and is now closer to historical pre-COVID norms. Software license revenue grew 26% year-over-year and accounted for nearly 5 points of the software mix year-over-year, representing a high percentage of product revenue in teens. Revenue from both software licenses and software services grew 32% year-over-year, significantly higher than the year-ago quarter’s 23%; this increased annual revenue to reach a run rate of over $800 million.

Why do I care about AcqWINsitions?

Just prior to earnings, Fortinet completed its acquisitions of Lacework and Next DLP. I’ll get into their long-term appeal in a second, but first, I’d like to discuss these investments in Q3 and guidance for the full year. According to management, the acquisitions increased Q3 billings by about 0.5 points and the full year by about 1/3 point. Total revenue increased 1 point and 1.5 points in the third quarter and the full year, respectively. For gross margin, they decreased Q3 and full-year margins by less than 0.5 points for each period. For operating margin, they decreased Q3 and full-year margins by 3 points and 1.5 points, respectively.”

I think the company’s guidance for the next quarter and full year is excusable given the size of the investments. But I think in this case those investments will start in 2025 when the firewall market is witnessing a recovery as corporates welcome a healthier rate cut environment. Management is guiding conservatively for the next two quarters, but expects to see a full refresh cycle in 2025 and is better positioned to benefit from recent acquisitions, which are expected to add more than 900 customers. Here’s an overview of each of the purchases:

DLP Purchase: Management announced the acquisition ahead of the earnings call. DLP is a next-generation “cloud-native SaaS data protection platform” that expands Fortinet’s reach in the cybersecurity space, particularly in the data loss prevention market. Management is looking for ways to improve their FortiSASE, and Next DLP data loss prevention capabilities will be integrated with the FortiSASE solution. I think this is a full circle moment.

Lace purchase: The company closed the acquisition days before earnings and believes Lacework’s organically developed “AI-based cloud native application protection platform” combined with Fortinet’s security platform will increase its TAM by $10 billion. This acquisition will also strengthen Fortinet’s position in the GGNAT market, which I believe gives Fortinet more momentum as firewall customers tend to have a longer contract term than a single point solution provider.

ASSESSMENT

Fortinet has a market capitalization of $56.98 billion and an enterprise value of $53.71 billion. The stock price has risen over 17.31% in the last 52 weeks and the stock’s beta value is at 1.0, which makes the price volatility similar to the market average. For CY2024, the price-to-earnings ratio is 37.4, significantly lower than the peer group average of 196.9. This tells me that Fortinet is currently undervalued and attractive at current levels. I don’t think investors are fully appreciating Fortinet’s future growth opportunities, and the company’s spending headwinds in the face of current economic uncertainty remain a point of concern. The EV/Sales ratio is 9.5, slightly above the peer group average of 8.2. The latest increase in the share price confirms the numbers; I believe that when the refresh cycle occurs and the firewall growth recovery begins, Fortinet will be better positioned to outperform. Management doesn’t expect the latter to happen before 2025, and they share the sentiment. Fortinet balances growth and profitability while simultaneously generating record revenue and gross margin, reflecting continued investment in their SASE solutions and cost efficiencies across the business. I continue to believe that Fortinet is a “Cybersecurity Peer Value Pick” and see green growth expected in 2025.

What’s next?

The company has many investment ideas that are in line with its guidance for 3Q24 and the full year. Management wants to continue investing in sales and marketing to gain market share, and while such investments don’t show positive numbers instantly, I think the company continues to strike a good balance between profitability and growth. Also, one thing they’re looking at is larger enterprises, as Fortinet’s largest customer segment is large and mid-sized enterprises, accounting for 86% of Unified SASE and 82% of SecOp solutions this quarter. I discussed this in my last article on Okta (OKTA), and one point of concern was Okta’s aggressive exposure to SMBs, which seems to be suffering from the current economic headwinds. I think Fortinet’s customer base gives it an advantage, as larger enterprises prove to be more resilient in such times with larger IT budgets and will perform better with more favorable interest rates. More on large enterprises and how they relate to AI; For the past quarter, I’ve been looking at FortiAI, and for good reason. This quarter, AI-based SecOps grew to account for 10% of total billings. After tuning into the company’s Goldman Sachs Communacopia+ Technology Conference, I’m now looking forward to the “big plans” big enterprises have for AI security and expect to see them reflected in top-line growth in FY25. I think Fortinet is well-positioned to gain more market share as it exits FY24, despite potential near-term headwinds from acquisition integration and the macro context.