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A few weeks ago IT security company Fortinet $FTNT
helped kick off a pretty dismal reporting season for technology by
pre-announcing a weak set of results. Since then a plethora of other
companies have reported and given a myriad set of reasons and excuses
for missing. I think it’s fair to conclude that there was a marked
reluctance among business to sign off on large tech deals in the
quarter. Given that this could be temporary, is it now time to start
buying these names? And with Fortinet, what does its new guidance entail for 2013?
Fortinet Updates the Market
Before going into the color I want to outline the full year guidance changes.
The guidance changes are pretty significant but I think that if they
are hit then Fortinet will be higher by the end of the year. As I write
the Enterprise Value of the stock is around $2.4 billion. I’ve followed
this stock for a while and never seen it trading on a forward free cash
flow over enterprise value (FCF/EV) of around (145/2400)=6%. The reason I
highlight this metric is to compare it with very low Government bond
yields.
It is arguably cheap on this basis alone. Furthermore consider the
new guidance was based on a continuation of the weak trends in Q1
continuing in Q2 and most notably coming from U.S. service providers. So
if you think this weakness will prove temporary then there could be
upside to come. On the other hand my concern is that the guidance
appears to imply some pretty optimistic assumptions for the second half.
Is Fortinet’s Guidance Achievable?
Consider that Q2 revenues were guided towards $143 million at the
mid-point with $135.8 million reported already for Q1. This makes $278.8
million for H1 but the full year guidance is for $600 million. In order
to see what this implies I have included the Q2 guidance plus my
guesstimates for what Q3 and Q4 are implied to be.
I’ve assumed that Q4 will contribute 28.3% of revenues as it has done in the last three years. The Q3 and Q4 numbers are my estimates.
As you can see the implication is for a pretty concerted resumption
to growth in the second half and I’m not entirely clear how this can be
accepted categorically given the weakness in H2.
Furthermore here is how these numbers look on a sequential basis.
From this graph it looks like the Q3 and Q4 assumptions are for ‘same
again’ sequential growth. Fortinet may well do this but given that Q1
& Q2 are notably weaker it does seem to imply a return to better
conditions.
Why Was the Q2 Guidance So Weak?
I must confess I was hoping a bit more from Fortinet than it gave in Q2 guidance. If you go back to the analysis of the Q1 results
there were three reasons given for the billings miss of around $12
million. Fortinet attributed $6-9m to service providers, Latin America
missed by $4-6m and there was an inventory shortage (due to product
refresh) which caused a $2 million-4 million miss. The
last two issues were believed to have been able to rectify in the
short/medium term thanks to new management and better execution, with
the service provider issue being more problematic. However
in the latest statement Fortinet basically said that conditions
remained the same in Q2 as Q1. Rather confusingly Fortinet cited
challenges in Europe even though a few weeks ago it said Europe was only
a bit weaker.
With regards the telco service providers, there can be little doubt that they have been reluctant to spend. F5 Networks $FFIV also reported very weak numbers from its key telco vertical . My suspicion with F5 is that its problems are a combination of weak telco spending, the success of Citrix Systems
with its rival Netscaler product and the difficulties in protecting its
dominant market position within the application delivery controller
market. For F5 and Fortinet the following graph of the latter’s deal
breakdown reveals a lot.
I think there is a case for a ‘budget flush’ in Q4 which caused some
overdue optimism and lets recall that the previous quarter contained
worries over the fiscal cliff while Q1 saw a lot of attention over the
sequester. Telco customers tend to do large deals and it wouldn’t
surprise if this boils down to a few deals that didn’t close in Q1. So
will future quarters bounce back?
The Competitive Environment?
Looking back at the recent results in the quarter I thought Check Point Software(NASDAQ: CHKP)reported a mixed set of results.
While Check Point probably needs to generate some product and license
sales growth to truly convince, in the light of what the rest of the
industry has reported its results are starting to look good. The good
news is that yearly comparisons are likely to get easier going forward
even if the company doesn't seem to ready to shake off its 'cash flow
now but investors wont see any of it' image.
Amongst the discussion of the deal commentary it mentioned winning a
seven figure contract with U.S. wire based carrier and replacing Palo Alto Networks(NYSE: PANW) as a consequence. In addition it won a large U.S. deal with a global retailer and beat out Check Point, Palo Alto, Juniper and Cisco
in the process. These sorts of wins (and other large deals cited in the
commentary) are actually quite impressive because Fortinet is coming
from a position as being known as primarily a SMB focused company.
For Palo Alto this sort of thing must be a concern because as a young
and fast growing company (with an evaluation top match) it is not a
good thing to see others replacing it with security solutions.
It has a lot of expectations built into its evaluation. Moreover its
solutions are not known for offering a value proposition so given any
kind of discounting in the industry it could see its margins cut.
F5 only has security as a very small part of its revenues (and only
really in the data center) but many of its customers are in common with
these companies and if CFO's have decided to 'go slow' then it will get
hit accordingly. My only concern with F5 as a recovery play is that it
is undergoing a product refresh which might take a quarter or two to
fully filter in. We shall see.
Is Fortinet Worth Buying Now?
As the charts indicate the guidance assumes somewhat of a bounce back
in the second half and there are some internal opportunities (Latin
American leadership and inventory shortages) which can be rectified but
the key issue will be with telco spending.
The good news is that we can keep an eye elsewhere at what other
companies are seeing. It has been a miserable reporting season for most
companies selling into them and cautious investors might want to wait
until one or two companies with telco exposure start saying better
things.
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