Can Fortinet Keep Beating Estimates?

Having delivered a shocking set of earnings in the first quarter, IT security company Fortinet (NASDAQ: FTNT  ) has gradually made a comeback this year. Moreover, there are signs that the company is now doing its best to underpromise and overdeliver with its guidance. With the third-quarter results coming in ahead of internal estimates, and the fourth-quarter guidance looking conservative, is now the time to buy the stock?

Fortinet reports results in line with the sector
Having previously guided toward third-quarter revenues of $149 million-$152 million, Fortinet pleased investors by delivering revenues of $154.7 million. Moreover, non-GAAP EPS came in $0.01 above the high end of its $0.11-$0.12 guidance.

In general, it's been a pretty good reporting season for the IT security sector with Check Point Software (NASDAQ: CHKP  ) getting back to product sales growth. Meanwhile, Palo Alto Networks (NYSE: PANW  ) reported product sales growth of 32.4% in the quarter, and it gave a bullish forecast for revenue growth of 37%-42% in the next quarter. Juniper Networks (NYSE: JNPR  ) is more of a networking company, but its security product revenue grew 14% sequentially and management declared that it saw "early signs of the business turning around."

Almost in isolation, Juniper reported that revenue from its security-based service providers was strong in the quarter, although this may be due to its ability to bundle security solutions with its core networking and switching solutions. By way of comparison, telco service providers make up around 25% of Fortinet's revenues, and growth remains below the company's average. In fact, a large part of the $12 million shortfall in billings in the first quarter ($6 million-$9 million) was attributed to a demand shortfall from the telcos.

However, one area where all of these companies saw growth was in data-center security. Check Point cited data centers as a key source of growth within its high-end products, and Fortinet, a company usually known for its strength at the lower end, claimed it won a data center deal over Palo Alto.

Fortinet retains guidance
However, despite a good earnings season for the industry and Fortinet beating its guidance for Q3, the full-year guidance was unchanged.

The following table demonstrates how Fortinet has adjusted full-year guidance throughout the year.

source: company presentations

After a disappointing Q1, Fortinet's guidance has been on a pretty even keel. However, guidance for 2013 free cash flow is a cause for concern. It's been lowered by 30% over the last year for two key reasons. Lower earnings expectations have combined with the need to decrease inventory turnover -- it therefore has to hold more inventory on its balance sheet -- in order to decrease cash-flow generation. Previously, Fortinet ran inventory turns at above four times, but the expectation going forward is for two to three times.

All told, the Q4 guidance of $162 million-$167 million looks a bit conservative compared to what Fortinet has sequentially achieved in the past.

source: company presentations, author's research

Where next for Fortinet?
While the Q4 guidance looks achievable, investors should focus on the fact that even if it comes in at the high end, around $167 million, it still implies a yearly rate of growth of 10.4%. Meanwhile, analysts have Fortinet's revenues growing at 13.7% for 2014.

Frankly, it's hard to see where that acceleration will come from in 2014 unless the economy picks up., especially as the market is getting tougher. Check Point is attempting to aggressively move into the small and medium-sized business market -- Fortinet's core strength. Palo Alto is still in a high-growth phase. Juniper is making bullish noises about its own security products, and Cisco's purchase of SourceFire will surely increase competition.

In conclusion, the short-term guidance looks conservative, but Fortinet will have to beat it in order to inspire confidence it can meet expectations for 2014. As attractive as the stock is, there are some concerns here.