Friday, December 24, 2010

Fortinet A Fast Growing Network Security Play




Fortinet is an interesting stock to research because it is a good way to play the growing computer network security market. There are a few options to investing in stocks focused on network security, but I think Fortinet is one of the best options. Fortinet is the worldwide leader in Unified Threat Management (UTM), which is a grandiose way of saying that their network security solution covers all the core security requirements of an enterprise’s connection to the internet. As such, this encompasses firewalls, virtual private networks, intrusion detection and prevention and, anti malware.

The UTM market is primarily targeted at the small to medium size enterprise (SME) and Fortinet is the leading player in this market. Competitors like Cisco are focused on large enterprise solutions, whilst similarly for Check Point Software their UTM offering is only part of their product range. IBM is a competitor but has recently been seen as a potential purchaser of Fortinet due to their tardiness in establishing market share. Fortinet is attractive to IBM because they possess a proprietary technology. Fortinet do not resell other companies products.


Fortinet's Growth Prospects

 I think Fortinet has good growth prospects and I see their key share price drivers

  • Growth in the economy seeing an expansion in SME market and a willingness to free up IT spending
  • Growth in internet functionality of SME market
  • Benefit of a UTM ‘One-Stop-Shop’ solution for SME’s in securing inbound and outbound traffic through one appliance
  • Growth in cyber crime raising awareness of security needs
  • Growth in Fortinet’s top line leading to operating margins that are closer to, say, Check Point Software
  • Takeover potential. IBM are strongly rumored to be looking at them

I think the first point two points are contingent upon your view of the economy. However, should the economy grow next year I think that SME IT spending has the capacity to expand in excess of GDP growth due to the fact that companies have cash on their balance sheets. Moreover, most of the surveys are indicating a loosening of the purse strings in this regard.

The increasing importance of E-commerce and the utilization of internet portals to increase globalization of trade, should drive SME’s to increase their internet functionality. In addition, there will be more emphasis placed on monitoring internet (internal and external) based threats, given the inexorable rise in cyber crime. Similarly, corporations may seek to reduce energy and personnel cost by adopting a one-stop-shop solution with a UTM system. Whilst, this is not seen as an option for a larger enterprise, an SME will have different priorities.

However, I think the key driver for Fortinet’s share price will be top line growth and its effect on their key margin metrics. If we look at the last three years we see a nice trend developing in Fortinet's numbers. I've included Check Point's metrics to 2009 by way of comparison.

 
Fortinet
2008
2009
Rolling to Q3 2010
CheckPoint
2009
Revenue
211791
252115
301808
791,147
Gross Mgn
71.10%
74.93%
72.87%
85.58%
SG&AMgn
49.27%
45.55%
43.02%
30.00%
R & D Mgn
17.49%
16.74%
15.90%
9.71%
Op Mgin
2.33%
10.05%
13.95%
44.89%
FCF Mgn
16.47%
22.76%
28.14%
59.82%
    
source: fortinet,check point software, earnings view

          
The last column of Fortinet numbers are the rolling four quarters to the third quarter of 2010. The drop in gross margin is explained by the fact that Q4 is normally a large quarter. Indeed, analysts have revenue forecasts of $86.57m for 2010 Q4 vs. $70.71m last year. Gross Margins for Fortinet have increased every quarter this year.

 I would also caution that Q4 2010 included a tax gain of $32m which somewhat flatters the free cash flow margins in the last two Fortinet columns. However, excluding that quarter-by calculating free cash flow margin for first three quarters of 2010- still shows they are translating 30% of revenue into free cash flow.


Fortinet Margin Expansion
Clearly, these numbers indicate that Fortinet has room to expand margins and cash flow generation as they grow their revenue numbers. I have included Check Point Software as a benchmark for Fortinet.

However, I think it worth noting that Check Point is likely to have lower SG&A margins because they sell a lot of their product range into larger enterprises (fewer customers, bigger ticker values). In spite of this, I think there is plenty of potential for Fortinet to grow and for these catalysts to be realized in the share price.


Fortinet Evaluation

Fortinet trades at a price of $31.35 and a market cap of $2.31bn with $290m in net cash. On a back of envolope assumption of 30% FCFMargin and analyst forecasts of $370m in revenue for 2011 I would say that a forward FCFYield of 4.8% is cheap for a business growing revenues, earnings and cash flow at mid teens plus rate. You won't get this kind of growth by buying a 10 year note! I picked some up.