Saturday, September 8, 2012

IT Security Stocks Research

The market seems to be moving into an interesting phase. We seem to have moved from a situation whereby everything was indiscriminately sold off in line with its sector as investors started to price in lower global growth. Estimates have been reduced and many companies have adjusted guidance in line with the reality.

The good news (from a stock pickers perspective) is that stock prices are starting to get back to being correlated with individual earnings and stock specific growth prospects. One sector that I think is capable of generating relatively better growth is internet security, and the latest company in the sector to please the market with its results was Fortinet $FTNT.

In absolute terms, the results and guidance were ok, but in the context of what so many other technology companies are reporting they were nothing less than spectacular. Fortinet handily beat estimates and raised guidance for the next quarter and full year. Check Point Software $CHKP also reported favorable growth recently, and I think it is fair to conclude that IT security is demonstrating that it is a sector that can generate growth in excess of the IT sector.

Fortinet Results and Guidance

In order to see how good these Q2 results are, I have put together a historical chart of the sequential movements in revenues from quarter to quarter.

The Q2 results are pretty much on a level with sequential movements in previous years. Moreover, the guidance was ahead of (already lowered) market estimates. Of course, as we can see from the chart, the mid-point of guidance is not particularly strong in relation to previous years. Now do you see my point about how the market is now rewarding companies beating reduced estimates?

Why Did Fortinet Outperform?

Fortinet’s conference calls (both of them) are always entertaining affairs. One Ken (Goldman) always sounds ebullient and answers questions with a sort of semi-religious fervor. The other (Xie) focuses on the technical aspects of Fortinet’s product range in quite dry language. It is a compelling combination and it is certainly working. Both are keen to point out that Fortinet is taking market share from the likes of Juniper Networks $JNPR, Check Point and Cisco Systems $CSCO.  According to industry analysts, Fortinet is now in fourth place behind these far larger companies.

I suspect that Fortinet is taking market share in the mid-range market. Its traditional strength is in the SMB market, where its Unified Threat Management (UTM) solutions give its customers overall protection, whereas at the higher end customers have usually gone for more sophisticated solutions from the other vendors mentioned above.  In an age of slowing discretionary IT spending, it is possible that the mid-market is deciding to trade down into buying Fortinet’s solutions.

Indeed, the company’s commentary somewhat reflects this. For example, the deals over $100k in the quarter numbered 168 this year versus 127 last year, and the deals over $250k numbered 55 versus 37 last year. Deal size does appear to be getting bigger.

Check Point and Cisco have new products coming out and it will be interesting to see if this enables them to reduce ticket price. In Check Point’s case I doubt it (it has a razor/razorblade model), although it would more likely lead to better product sales than it has reported recently.

New Operating System

An interesting development for Fortinet this year will be the launch of its new operating system and a performance enhancing ASIC. Essentially , Fortinet believes the new operating system is necessary to address the changes in the nature of security threats. The new ‘FortiASIC’ will give it more computing power to address security threats from content and applications.

Management was keen not to guide towards some sort of pick up in end demand following the release of some pent-up demand that had been waiting for the new operating system and ASIC. However, I note that sequential growth is forecast to be relatively better in Q4 than Q3, so perhaps there is an element of this baked in?

The Bottom Line

It is hard to argue that the stock is particularly cheap, but it is performing, and in my experience any stock with sustainable mid teens earnings growth prospects for the next few years trading on a decent cash flow yield usually produces very good performance. In the case of Fortinet, management is forecasting $165-170m in free cash flow this year, which implies a FCF/EV evaluation of around 4.7% with a stock price of $25.09.

This looks cheap but it requires confidence in Fortinet to 'do its numbers.' I think with expectations now lowered, it is more likely that it can hit these targets. Investors will have to watch Check Point and Juniper and see if they start to react to Fortinet encroaching on the mid market. Another possible value 'outer' is a bid, and IBM $IBM has long been mooted as a potential acquirer. IBM does seem to have a gap in its product range for the SMB market.

In terms of its end markets, the usual caveats over global growth need apply. That said, Fortinet remains attractive at this price and for its growth prospects. A good GARP candidate.

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