Fortinet Stock: Maintaining A Buy Despite Near Term Headwinds (NASDAQ:FTNT)

Investment thesis:

I last wrote on Fortinet (NASDAQ:FTNT) a day before 2Q24 earnings, August 5th, initiating the stock with a buy. Fortinet stock surged 38.5% since I called the bottom, as seen below, and I believe my outperform thesis on the stock remains at play. This is not for bragging purposes, but when the market was bearish on the stock after the 1Q24 pullback, I saw Fortinet’s potential driven by its “unique position in network security, particularly firewall spend” and expected their “UnifedSASE and SecOps offers (both of which are new) to support more cross-selling opportunities to existing customers and support outperformance to the S&P 500.” Consistent with my forecast, Unified SASE and SecOps saw strong pipeline growth this quarter at 45% and 18%, respectively, and gained “significant momentum,” with over 90% of billings coming from existing customers during the quarter. Pre-earnings, I also watched product revenue “religiously” as it was a point of concern. This quarter, product revenue did drop by 4%, but that was far less than management expected, and product sales were up 14 basis points quarter over quarter and year over year, excluding backlog impact, again coming in better than feared.

I am maintaining my buy on Fortinet into the second half of FY24 as I expect a refresh cycle and better firewall growth in 2025 and believe Fortinet’s recent acquisitions and position within AI situate it for more upside surprise in FY26. 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 considering that it is balancing growth and profitability, with plans to reach the rule of 40 in the near future.

The quarter in numbers blurb: balance in growth and profitability

Fortinet came in with strong results this quarter, achieving a record operating margin of 35% with an 820 basis points increase. This was mainly due to cost efficiencies and a reflection of the record gross margin, which increased 360 basis points and came in at a quarterly record of 81.5%. The company exceeded 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 mainly driven by solid service revenue growth, up 20% year over year at $982 million. Service revenue comprised 68.5% of total revenue, led by a 36% increase in SecOps and a 27% increase 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 mentioned, product revenue declined 4.4% year over year and came in at $451.9 million due to tough comparison, following the trend of the last few quarters. This is looming over my head less now as product gross margin of 66% was up 259 basis points from a year ago quarter, backed by increased 1. software mix and 2. lower indirect costs. On a quarterly basis, the product gross margin was up from 56%, mainly due to increased hardware demand and inventory levels normalizing, and it is now edging closer to the historical norms pre-COVID. Software license revenues were up 26% year over year and made up nearly 5 points in the software mix year over year, making up a high percentage of product revenue in the teens. Revenue from both software licenses and software services was up 32% year over year, significantly higher than a year ago quarter at 23%; this increased annual revenue to reach a run rate of more than $800 million.

Why I care about the AcqWINsitions?

Right before earnings, Fortinet closed the acquisitions of Lacework and Next DLP. I’ll get into the long-term attractiveness of these in a second, but first, I’d like to discuss these investments in Q3 and full-year guidance. According to management, the acquisitions increased billings “Q3 by approximately 0.5 point and the full year by approximately 1/3 point. Total revenue increased Q3 and full-year growth by 1 point and 1.5 points, respectively. For gross margin, they decreased Q3 and full-year margins by less than 0.5 point for each period. For operating margin, they decreased Q3 and full-year margins by 3 points and 1.5 points, respectively.”

I believe the company’s guidance for the next quarter and the full year is excusable, considering the size of investments. But I think in this case, these investments will kick in going into 2025, when the firewall market is witnessing a recovery as corporations 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 it with the recent acquisitions, which are expected to generate over 900 customers. Here’s an overview of each of the acquisitions:

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

Lacework acquisition: The company closed the acquisition a few days before earnings and believes that Lacework’s organically developed “AI-driven 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 longer duration contract versus the one-point solution vendor.

Valuation

Fortinet has a market cap of $56.98 billion, and its enterprise value is $53.71 billion. The stock price has risen over 17.31% in the last 52 weeks, and the stock’s beta is at 1.0, making its price volatility similar to the market average. For CY2024, the price/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 believe investors are fully pricing in Fortinet’s future growth opportunities, and the enterprise spending headwinds amidst the current economic uncertainty remain a point of fear. The EV/Sales ratio is 9.5, slightly above the peer group average of 8.2. The last price surge in the stock confirms the numbers; I believe that when the refresh cycle comes around and firewall growth recovery takes off, Fortinet will be better positioned for outperformance. Management doesn’t expect the latter to happen before 2025, and I share the sentiment. Fortinet is balancing growth and profitability by simultaneously generating revenue and a record gross margin, reflecting continued investments in their SASE solutions and cost efficiencies within the business. I continue to believe that Fortinet is a “value pick in the cybersecurity peer group” and see green shoots into 2025.

What’s Next?

The company has many investment ideas that fit into its 3Q24 and full-year guidance. Management wants to invest further in sales and marketing to gain market share, and while such investments don’t show positive numbers instantly, I believe the company continues to find a good balance between profitability and growth. Also, one thing I’m watching is larger enterprises, as Fortinet’s largest customer segment is large and mid-enterprises, representing 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 SMB, which seems to be suffering due to current economic headwinds. I believe Fortinet’s customer base gives it an advantage as larger enterprises prove to be more resilient in such times through higher IT budgets and will perform better under more favorable interest rates. More on large enterprises and how it ties to AI; last quarter, I was watching FortiAI, and for good reason. This quarter, AI-driven SecOps increased to make up 10% of total billings. After tuning into the company’s Goldman Sachs Communacopia+ Technology Conference, I am now more looking forward to the “big plans” that large enterprises have for AI security and expect to see them reflected in top-line growth in FY25. I believe Fortinet is well positioned to gain a larger chunk of market share exiting FY24, in spite of potential near-term headwinds from acquisition integration and macro backdrop.