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It’s been a difficult year for investors in IT security company Fortinet(NASDAQ: FTNT).
They have been forced to watch the stock fluctuate wildly, and then
settle at a price similar to which it began the year. On the one hand,
Fortinet's underperformance to the Nasdaq is justified; throughout 2013,
the company has been lowering full-year guidance. On the other hand,
the key to investing is always to look at the pros and cons of investing
in the stock right now. So is Fortinet worth buying now?
The pros
After delivering a nasty warning in the first
quarter, Fortinet returned to form in the second. It beat its own
revenue expectations by $4.4 million, posting $147.4 million. Earnings
were in line with expectations, and it appeared to resolve the larger
part of the issues that caused the shortfall in Q1. There are four key
takeaways from these results that might lead you to be positive on the
stock.
First, in the previous quarter, Fortinet had explained that its billings miss
of around $12 million was a combination of weakness in orders from
telco service providers ($6 million-$9 million), and the Latin American
region ($4 million-$6 million). Moreover, it had an inventory shortfall
that created a $2 million-$4 million shortfall. The good news is that
telco orders came back in second quarter, and Fortinet successfully
rectified the inventory issue. However, Latin America still remains
tough
The second takeaway is there were some positive signs from deal sizes reported in the quarter
Source: company presentations.
The larger deals (above $500,000) came back strongly in the
quarter, and this is probably due to a return to spending by the telcos.
In addition, Fortinet has seen a strong rise in the number of smaller
deals signed in the last three quarters. The last point is a sign that
it’s capturing the growing market for small and medium size business who
want to prioritize cyber security.
The third positive point is that Fortinet’s guidance looks overly cautious.
Source: company accounts.
In fact the second quarter turned out to be consistent –in
terms of sequential growth- with the previous years. However, the
guidance for the third quarter looks historically conservative.
The final takeaway is that Fortinet made some positive
commentary in its conference call. The company expects to take market
share, and declared that it wasn’t seeing any pricing pressures at the
moment. This suggests that even in a weak spending environment, it can
still generate growth.
The cons
There are three reasons to be cautious over the stock.
The first is that competition is going to increase. Cisco Systems’ (NASDAQ: CSCO)
purchase of Sourcefire will surely result in increased investment.
Cisco’s security division’s growth turned negative in its last quarter,
and the Sourcefire acquisition is an attempt to regain traction in the
sector.
This sort of deal is critical to Cisco because its core
switching and routing divisions are generating
very-low-single-digit-growth, it needs to push growth in its peripheral
activities. Moreover, Cisco can bundle security solutions with a whole
range of other technology offerings.
In addition, Check Point Software(NASDAQ: CHKP)
has released some lower priced products aimed at the small and medium
size business market that Fortinet is traditionally strong. Check Point
has long been known for its high-end solutions, but this move will bring
it into more direct competition with Fortinet. Given that Check Point needs to get product sales growing again, it is reasonable to more competition here.
Similarly, Palo Alto Networks(NYSE: PANW)
missed estimates last time around, and it will be under pressure to
keep its growth profile intact. Indeed, in its conference call, Fortinet
referred to the ‘enormous amount of money’ that Palo Alto spends on
marketing.
The second reason for caution is that the correction of
Fortinet's inventory shortage came at a price. Fortinet outlined that it
would be decreasing expectations for inventory turns to two to three,
from above four times. This just means that more working capital will
have to be allocated towards inventory, as it will be turned over at a
lower rate in future. In other words, long-term cash flow expectations
should be reduced.
Indeed, Fortinet lowered full-year free cash flow expectations
to $130 million-$135 million, from $140 million-$150 million
previously. Note that when it started the year, its free cash flow
expectation for 2013 called for $180 million-$190 milllion. That's a
worrying downtrend.
The final negative takeaway is that the company expressed some
lackluster commentary on the macro environment. Latin America continues
to be weak, and Fortinet’s European sales rise of 22% in the current
quarter will surely not be repeated anytime soon. Management expressed
caution over both these regions. In addition, management spoke of sales
cycles lengthening, and customers wanting to buy in smaller deal sizes.
Both are classic signs of a slowing end market demand.
Where next for Fortinet?
In conclusion, there are mixed signals from the recent report.
While the third quarter guidance looks conservative, the increase in
working capital requirements is a concern for the long-term.
As discussed above, the free cash flow guidance for the full year has been reduced by $52.5 million or 28% throughout
the course of the year. Indeed, the $132.5 million midpoint forecast
for free cash flow in 2013 now only represents 4.5% of its enterprise
value. That looks to be pretty fairly valued in my book, and given the
weakness in tech spending, it makes sense to wait for a dip here.
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