Fortinet: Something To Watch For With Earnings Around The Corner

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Fortinet (NASDAQ:FTNT) is a leading cybersecurity provider servicing businesses of all sizes and governments worldwide by providing secure networking solutions and other cybersecurity products such as Next Generation Firewalls. The company is segmented into two units, Products and Services, in each of which is housed the company's Core Platform and Security Subscription and Technical Support Services, respectively.

Founded in 2000, the company has enjoyed success, and the market has rewarded the company thus.

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While the company does not pay a dividend, its price appreciation of more than 480% over the past five years easily dwarfs the wider S&P 500 (SPY) total return of 75%.

The nature of the company's business is a testament to the demand for its products. The impact of cybersecurity is enormous--the Harvard Business Review estimated that the average cost of a cybersecurity breach was over $4 million on a global scale, while in America alone the average cost per breach was more than $9 million. Given the financial impact of a failed cybersecurity solution, one can understand why a company offering a leading product would be in demand.

To this end, Fortinet has seen its quarterly sales grow by more than 700% over a ten-year period, with analysts expecting revenues to continue to grow in by low double digits for the foreseeable future (see chart below).

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Fortinet also conducts itself in ways that are unique to technology companies--for example, the company doles out a relatively low amount of stock-based compensation and, according to its most recent 10K, does not capitalize software development costs.

These are important points that we don't simply want to gloss over. A lack of high stock based compensation (Fortinet posted $56 million in stock based comp $1.2 billion in revenues for the first quarter 2023) shows that management isn't eager to overly reward employees at the expense of shareholders. This may also have to do with the fact that Fortinet is still founder-run, with the foundation owned by the co-founders, the Xie brothers, controlling almost 15% of the company's stock, and do not want to see their ownership overly diluted.

The decision to capitalize versus expense software costs is also significant. While most companies would have to expense software, accounting rules dictate that software companies can capitalize development expenses, meaning that instead of paying up front for the cost, they are spread over time. This can mask cash flow issues, especially if software is the principal business. We think that investors should certainly be aware that Fortinet is an outlier in this regard.

Most companies have a checkered past when it comes to meeting analyst expectations. Geopolitical issues, supply chain problems, and inflation can all impact a company's top and bottom line, disrupting forecasts and causing investors to panic in the short term.

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On this front, Fortinet seems have had virtually no issues. As the chart above illustrates, the company has exceeded top-line estimates for every quarter except one for the last ten years. Its track record with EBITDA and EPS estimates is almost as good, with only a miss here and there.

This track record is, frankly, incredible. On the one hand, it could be interpreted as a testament to the demand for Fortinet's business and services. However, there is one metric which we are keeping an eye on that makes us slightly cautious.

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Over the last ten years, Fortinet's days sales outstanding [DSO] has averaged 70.3 days on a quarterly basis. DSO is a ratio between a company's reported revenue and its accounts receivable, and it's important for investors to be aware of because accounts receivable are counted as revenue but have not actually been received. A company that aggressively recognizes revenue may be setting itself up for problems in the future because--if done for too long and in too aggressive a manner--the revenue chickens may eventually come home to roost.

In Fortinet's case, each of the last five quarter's DSO has exceeded the ten-year average, meaning that Fortinet has been taking longer to actually collect the money it has counted in revenue than before. We also remind readers that the 4th quarter, 2022, was the first quarter in ten years where Fortinet missed its top-line analyst estimates.

It is clear to us that Fortinet has a best-in-class business with products that are in high demand. In our view, the principal risks to the company are litigation from clients in the case of a material cybersecurity breach, or the discovery of an existing flaw in Fortinet's products. These risks, however, are inherent in just about every company in the space--in other words, it comes with the territory.

Earnings for the company are set to be announced August 3rd, where analysts are expecting revenue of $1.3 billion, which is a 26% year-over-year change and a 3% sequential quarterly increase. Despite this impressive expected performance, we will be on the fence for now and will wait to see how the company's next few quarters play out, and be watching where the company's DSO levels move to before making any moves. A move downward in Fortinet's DSO would increase our confidence, while an increase would give us further pause.

Fortinet rises as Guggenheim upgrades after full-year guidance cut

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Fortinet (NASDAQ:FTNT) shares rose more than 2% in pre-market trading on Monday as investment firm Guggenheim upgraded the cybersecurity company despite the fact it cut its full-year guidance last week.

"While we recognize Fortinet faces several headwinds heading into the second half of the year, we do not believe the company is structurally impaired, nor do we believe its competitive positioning has deteriorated," analyst Raymond McDonough wrote in an investor note.

McDonough raised his rating on Fortinet (FTNT) shares to buy from neutral and put on a $70 price target.

The analyst noted that with Friday's 25% decline, there is the belief that risk is "at least partially priced in" and growth is likely to reaccelerate into next year.

In addition, McDonough said that there is likely to be a product "digestion" period of about eight quarters, of which the company is likely three quarters into it.

"To us, this does suggest [second-half] consensus Product revenue estimates are at risk, but we do expect this cyclical downturn to be steeper and shorter than the last (we update our model to reflect this after reviewing our 2024 estimates in detail)," McDonough added. "This is not only due to backlog dynamics creating a headwind going forward (and conversely easier comparisons in 2H24), but also the fact that Fortinet’s business is different today than it was in the past."

Fortinet (FTNT) also has a differentiation in its technology that has created a "sustainable moat," as competitors like Palo Alto Networks (PANW), Cisco (CSCO) and new entrants into the secure access service edge market like Microsoft (MSFT) and Zscaler (ZS), McDonough explained.

Analysts are largely bullish on Fortinet (FTNT). It has a HOLD rating from Seeking Alpha authors, while Wall Street analysts rate it a BUY. Conversely, Seeking Alpha's quant system, which consistently beats the market, rates FTNT a HOLD.

Fortinet Inc.

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