Tuesday, May 14, 2013

Will Fortinet Hit Guidance This Year?

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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