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In our previous article published last month, we presented an optimistic forecast for Fortinet, Inc. (NASDAQ:FTNT), contending that the company’s growth trajectory is not only impressive but also sustainable. The company’s robust Q1 earnings results have now corroborated our viewpoint, underlining the strength and potential of Fortinet’s growth model. As we dissect the factors contributing to Fortinet’s success, one element stands out prominently – its competitive edge afforded by ASIC technology. This is the topic we will explore today, which underpins our Buy rating on Fortinet, Inc. stock.
Grinding Down The Naysayers
In the wake of Fortinet’s impressive Q1 report, which surpassed expectations and prompted a subsequent upward revision, Bank of America eventually responded by upgrading Fortinet stock to a Buy rating. Although the bank’s response was arguably tardy, it does underscore a broader trend that we’ve been observing: Fortinet is gradually gaining recognition from industry analysts. This evolution in perception could not have come at a more opportune time, as we firmly believe this cybersecurity company’s growth story is just beginning.
Fortinet’s journey over the past four years speaks volumes about its resilience and potential. Rewind to February 2019, a time when only 31% of the 32 analysts tracking the stock had a Buy rating on the stock, a measly figure when compared to competitor Palo Alto Networks, Inc. (PANW), which boasted an 85% Buy rating from 40 analysts. Fortinet’s stock, it seemed, was severely underestimated, as the stock had significantly outperformed Palo Alto over that time period, growing over 300% while Palo Alto returned just half as much.
However, fast forward to today, and the picture is dramatically different. Out of 35 analysts, a remarkable 69% now endorse a Buy rating, with the remaining 31% suggesting a Hold position, according to FactSet data. This shift is no accident, but rather the result of Fortinet’s unwavering commitment to technological leadership and innovation-driven organic growth, a strategy that has clearly borne fruit.
The ASIC Advantage
At the heart of Fortinet’s surge to the forefront of the cybersecurity space is a gem that we believe isn’t getting the recognition it deserves – its proprietary Application-Specific Integrated Circuit (ASIC) chips, or Secure Processing Units ((SPUs)).
These SPUs are not just any technological innovation. They are, in our view, the game-changers in cybersecurity. By incorporating processing power and functionality into Fortinet’s appliances, these chips give the company a formidable competitive edge. While many security appliances are stuck on multi-purpose CPU-based architectures, Fortinet has boldly chosen to create its own security processors, and the results speak for themselves, with accelerated processing of security and networking functions.
Produced in-house and manufactured in Taiwan, these SPUs are the secret sauce in Fortinet’s FortiGate appliances. They supercharge the security processing capabilities of FortiOS by making short work of tasks that require heavy computational power.
The value of computational power in security is beyond dispute, and Fortinet has hit the nail on the head with its SPUs. These chips not only enhance Fortinet’s product functionality but also ensure the network runs more efficiently and with minimal latency – a clear upper hand over competitors lacking similar ASIC compute power.
The variety of SPUs in Fortinet’s arsenal – system-on-chip (SPU SoC), content processor ((SPU CP)), network processor ((SPU NP)), and virtualized security processor (vSPU) – further underlines the company’s commitment to innovation. The deployment of these processors across different products and environments is a testament to Fortinet’s adaptive strategy.
By harnessing its proprietary SPU, Fortinet is able to consistently deliver industry-leading performance, while consolidating network and security functionality with a negligible impact on network throughput performance. What’s more, this approach yields a lower total cost of ownership (TCO) for customers, setting Fortinet apart in a fiercely competitive market.
Additionally, by designing its own ASIC SPU chips, Fortinet has cleverly circumvented industry-wide supply chain constraints. Its forward-looking approach to procurement allows the company to negotiate more favorable rates, a strategy that competitors could learn from.
The unveiling of the fifth-generation security processing unit (FortiSP5) in February 2023 was a bold step forward for Fortinet. Setting new industry benchmarks for performance, cost, and energy efficiency, the FortiSP5 represents Fortinet’s commitment to constant innovation. With the promise of 17x faster firewall performance and 32x faster encryption than leading standard CPUs, all while consuming 88% less power, the FortiSP5 is a game-changer.
In essence, Fortinet’s strategic utilization of ASIC SPU chips is a beacon of innovative prowess in the cybersecurity industry and provides a compelling reason to invest in this underestimated stock. With the game-changing FortiSP5 set to power the next generation of FortiGate firewalls, we confidently anticipate that Fortinet will further solidify its position as a market leader. The future looks bright for this cybersecurity titan.
Risks
Investors eyeing Fortinet, Inc. must grapple with a key concern: the sustainability of its revenue growth. This anxiety is heightened by the potential fallout from worsening macroeconomic conditions. It’s important to remember that during economic downturns, companies may tighten their belts and focus on optimizing their existing cybersecurity spending, similar to their approach with cloud computing costs. While we remain steadfast in our belief that cybersecurity will maintain robust growth for the foreseeable future, driven by the ever-increasing shift from physical to digital economic activity, we must also acknowledge that there have been periods, such as in 2016, when companies temporarily retrenched their cybersecurity spending.
The bear thesis, which suggests Fortinet’s predominant on-premises focus could be disrupted by the ongoing transition to cloud computing, is another risk worth considering. This concern has persisted for several years, despite Fortinet’s sustained outperformance during that period. It’s important to note that Fortinet hasn’t been sitting idly by in the face of this potential threat. The company has significantly bolstered its cloud capabilities and broadened its product portfolio beyond its core firewall offerings. Although we firmly believe this bear thesis is overblown, we maintain a vigilant stance and will keep a close watch for any indications that the shift to cloud computing could pose a significant challenge to Fortinet.
Financials & Valuation
Note: All historical data in this section comes from Fortinet’s 10-Q filings, and all consensus numbers come from FactSet.
Fortinet, Inc. recently reported impressive FY Q1 earnings, which drove the stock up 5.6% on the day after the announcement. The company’s revenue exceeded consensus estimates by 5.1%, growing 32.2% y/y to $1,262 million. Moreover, FTNT’s operating margin improved to 26.5% from 22.0% a year ago, and its EPS for the quarter was $0.34, up 81% y/y, beating consensus by 18.5%. These strong results highlight the company’s solid growth trajectory and increasing operational efficiency.
Over the past three fiscal years, FTNT has demonstrated consistent growth with a 27.0% CAGR in revenue. Sell-side consensus projects revenues to grow by 23.7% this fiscal year, reaching $5.5 billion, and by 18.8% in the following fiscal year, hitting $6.5 billion. The company’s EBIT margin has increased by 2.8% points from 24.5% to 27.3% over the same period. However, the consensus predicts a slight contraction in EBIT margin to 25.7% this fiscal year before expanding to 26.0% in the next fiscal year.
FTNT has effectively managed its stock-based compensation (SBC) and share repurchases over the past three years. The company spent 6.0% of its revenue on SBC and decreased diluted outstanding common shares by 2.8%, indicating that management used share repurchases to offset shareholder dilution. As a result, FTNT’s EPS has grown at a CAGR of 34.1% over the past three fiscal years, outperforming its revenue growth.
Looking ahead, consensus forecasts EPS to increase by 22.9% to $1.46 this fiscal year and by 17.6% to $1.72 in the following fiscal year. FTNT’s return on invested capital is strong at 66.4%, and its robust balance sheet boasts a net cash position of $2,148 million.
While FTNT does not pay a dividend, its stock has outperformed the S&P 500 (SP500) over the past year, generating a 13.5% absolute return, or 12% points more than the S&P 500. Furthermore, the stock is trading 16.7% above its 200-day moving average and 52% above its 52-week low. With a low short interest of 1.8%, market sentiment seems to be bullish on the company.
However, when compared to the S&P 500, FTNT’s valuation appears relatively expensive, trading at a significant premium across multiple metrics such as EV/Sales, EV/EBIT, P/E, and FCF. The company’s FY2 PEG ratio of 2.0 also indicates a premium of 35.2% compared to the S&P 500’s PEG ratio of 1.5.
FTNT’s recent earnings report and growth trajectory make it an attractive investment opportunity. The company’s solid financial performance, strong return on invested capital, and robust balance sheet all point to a bright future. However, investors should be cautious of the stock’s current valuation, as it trades at a significant premium compared to the broader market. All things considered, we continue to like Fortinet stock and believe the upside outweighs the risks.
Conclusion
The impressive strides Fortinet, Inc. has made in the cybersecurity industry, particularly through its proprietary ASIC SPU chips, cement our belief in the company’s innovative prowess and potential for sustainable growth. The recent unveiling of the fifth-generation security processing unit, FortiSP5, is a testament to Fortinet’s commitment to constant innovation and its ability to set new industry benchmarks.
However, like any investment, Fortinet, Inc. is not without its risks. The sustainability of its revenue growth and the potential disruption due to the ongoing transition to cloud computing are valid concerns. Nonetheless, we believe that the company’s consistent growth, solid financial performance, and strategic approach to innovation offer a compelling investment thesis. While its current valuation trades at a premium compared to the broader market, we still view Fortinet, Inc. stock as a promising investment, where the potential upside outweighs the risks. Investors are advised to keep an eye on this cybersecurity titan as it continues to shape the future of the industry.
