Wednesday, April 17, 2013

Fortinet Starting to Look Interesting

We are very early into earnings season but already two leading tech companies have reported weaker earnings thanks to a reluctance among telco service providers to close deals. F5 Networks $FFIV previously disappointed and now it’s the turn of Fortinet $FTNT to warn over missing estimates.

Fortinet Warns in Q1

The preliminary announcement of results brought with it some disappointing expectations.

  • Total billings expected to be $147-149 million vs. internal guidance of $158-162 million

  • Total revenue expected to be $134-136 million vs. internal guidance of $138-141 million

The billings miss of $12 million (at the mid-points) was blamed on three factors. In the commentary around the results the managements claimed that $6-9 million was due to the service provider segement, Latin America missed by $4-6 million, and there was an inventory shortage due to a product transition, which caused a $2-4 million miss.

The Good News First

Firstly, the inventory shortage issue was forecast to be rectified within a quarter so we can expect some of those billings to come back. Secondly, the geographic performance was mixed. Latin American weakness was put down to some local macroeconomic issues, although there is a new sales management in place there expected to improve performance going forward. Europe was cited as being weaker, but not by much, and a large deal is expected to close soon. Fortinet had has some issues with China previously, but that region was declared ‘back on track,’ and Asia was strong in general with Japan surprisingly good.

Thirdly, the really good bit of news was that US enterprise based spending did well in the quarter. This nicely mirrors what F5 Networks said over this segment of its sales too. This is heartening because it implies that this is not really a US macro issue. I’m glad that Fortinet confirmed this, because the view from F5 is somewhat obscured by the fact that it is undergoing a product refresh right now.

And Now the Bad News

The bad news is that, just as F5 Networks did, Fortinet argued that the telco service providers were determined to prove themselves villains in the quarter. Almost word for word, Fortinet repeated the mantra that F5 had earlier argued. My interpretation of the commentary runs a bit like this: yes there are large deals out there, no they weren’t closed with others due to competition, yes we think we can close them in the future, but no we can’t be sure when the telcos will do this… and I doubt they are both lying!

In the case of F5 it is a bit more obscure because of the product refresh and its dominant market position (50-60%) in its core application delivery controller (ADC) market. Moreover, Cisco Systems $CSCO has pulled out of investing in its ADC, so it is reasonable to expect F5 to be winning some new business there. Similarly, with Fortinet there is the fear that its weakness is being caused by Cisco bundling security solutions with its core networking equipment to the telcos and undercutting other players. However, there was no indication of this from F5 or from Fortinet.

Instead, there appears to be a shift in service provider spending towards more cautious piecemeal spending. Indeed, Fortinet spoke of one large customer that changed from a ‘capex to an opex’ based approach and decided to shift the purchasing over multiple quarters rather than buy with one large deal.

All of this resulted in a nasty sequential drop in Fortinet’s revenues:

And there can be few guarantees that this will recover in time.

Where Next for Fortinet?

It’s a nasty miss, but I think there is some cause for optimism here. Firstly, if we go back to what Fortinet reported last time we can see that it was a strong quarter that involved a significant amount of larger deals being won.

And since the telco deals that missed in Q1 tended to be larger deals, perhaps the Q4 performance is a sign that there was a budget flush in that quarter? Similarly, I note F5 reported a strong quarter from telco in its Q1 only to disappoint in Q2. A royal budget flush? I’m wondering out loud what this might mean for Cisco’s forthcoming results.

If this turns out to be the case then the weakness within the service provider segment may be incrementally graduated into forecasts over the full year as both companies get over the effects of the change in purchasing patterns by the telcos. Furthermore, if US enterprises are still spending then the economy can’t be in that bad shape.

As I write, Fortinet is trading on a current FCF/EV yield of just over 5% and is on track (in a bad quarter) to generate 8% year on year billings growth with revenue up 15% for Q1. That is not bad at all, although cautious investors (like me) will want to listen to what the Tier 1 service providers say about their spending plans in the forthcoming results. Provided their outlooks are okay, I think Fortinet is worth a close look down here.

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