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ector, but the decision over buying or selling the stock isn't as
easy as you might think. Investors often buy or sell stocks based on
their relative valuation within their peer group, but with the network
security sector it isn't quite so easy. Why is this so? Furthermore, is
Palo Alto Networks a buy or sell?
You say value, I say growth
It's tricky to
compare valuations in the network security sector, because the leading
players are at different stages of their development, and this makes
them attractive to a different type of investor. For example, a value
investor might look at a mature, highly cash generative, stock like Check Point Software (NASDAQ: CHKP) at conclude that it's the best in class. Meanwhile, growth at reasonable price,or GARP, investor will like the look of Fortinet's (NASDAQ: FTNT)
mix of mid-teens revenue growth and solid free-cash flow generation,
while a growth investor will favor Palo Alto's 30% plus growth rates,
even if its free-cash flow yield is low.
I'm going to graphically introduce some of these ideas for you, and
then get into the numbers. First, a quick look at revenue growth for
these three companies in the last four years and the analyst forecast
for the fifth year, reveals that they really are at different stages of
development.
he information-technology network security sector is unusual in
the sense that its leading companies offer markedly different maturity
levels. If FireEye and Palto Alto Networks (NYSE: PANW) are the new kids on the block, and Fortinet (NASDAQ: FTNT) is the maturing teenager, then Check Point Software (NASDAQ: CHKP)
is very much the mature old uncle. With that said, Fools shouldn't
dismiss the stock as unexciting. On the contrary, there was a lot to
like about Check Point's recent third-quarter earnings, and the numbers
confirm that the company's business strategy is working. Time for a
look.
Check Point Software's third-quarter results
Highlights of its earnings and guidance for the upcoming fourth quarter:
Third-quarter revenue of $370.4 million vs. analyst estimate of $367.1 million
Third-quarter earnings per share of $0.93 vs. analyst estimates of $0.91
Fourth-quarter revenue guidance of $395 million-$430 million vs. analyst estimate of $410.3 million
Fourth-quarter EPS guidance of $0.99-$1.09 vs. analyst estimate of $1.03
In summary, revenue and EPS beat analyst expectations and
guidance was ahead of what the market projected. This is obviously good
news, particularly because Check Point's management is known for giving
conservative guidance.
The IT security market has always been highly competitive and the
competitive dynamics in the industry are constantly changing. If Check Point Software Technologies is the established pure play in the sector, and Palo Alto Networks is the up and coming competitor, then
sits somewhere in the middle. With that said, how is it best to look
at the investment proposition with Fortinet? In addition, what do its
recent, and well received, results really mean to the company?
Check Point Software, Fortinet and Palo Alto Networks, getting to know you When
looking at the three together, I can't help feeling that they could
almost be the same company, just at different stages of their
development. Indeed, there are some close relationships between them.
Palo Alto Networks founder and CTO, Nir Zuk, used to be principal
engineer at Check Point, but there is little love lost between the self
appointed "Check Point Killer" and the company these days. In addition,
Fortinet's VP of services, Michael Anderson, was formerly at Check
Point, as was Michelle Spolver, Fortinet's VP of corporate
communications.
These links -- although not uncommon in a niche IT industry -- serve
to highlight the competitive nature of the industry. It's no secret that
Palo Alto Network's is growing revenue in the 30%-40% range by trying
to displace incumbents like Check Point, Cisco, and
Juniper in the firewall market. But what is less understood is how Check
Point and Fortinet are generating growth by competing in smaller and
larger deal sizes respectively. They are increasingly encroaching on
each others markets.
The IT security market has always been highly competitive and the
competitive dynamics in the industry are constantly changing. If Check Point Software Technologies is the established pure play in the sector, and Palo Alto Networks is the up and coming competitor, then Fortinet
sits somewhere in the middle. With that said, how is it best to look
at the investment proposition with Fortinet? In addition, what do its
recent, and well received, results really mean to the company?
Check Point Software, Fortinet and Palo Alto Networks, getting to know you When
looking at the three together, I can't help feeling that they could
almost be the same company, just at different stages of their
development. Indeed, there are some close relationships between them.
Palo Alto Networks founder and CTO, Nir Zuk, used to be principal
engineer at Check Point, but there is little love lost between the self
appointed "Check Point Killer" and the company these days. In addition,
Fortinet's VP of services, Michael Anderson, was formerly at Check
Point, as was Michelle Spolver, Fortinet's VP of corporate
communications.
These links -- although not uncommon in a niche IT industry -- serve
to highlight the competitive nature of the industry. It's no secret that
Palo Alto Network's is growing revenue in the 30%-40% range by trying
to displace incumbents like Check Point, Cisco, and
Juniper in the firewall market. But what is less understood is how Check
Point and Fortinet are generating growth by competing in smaller and
larger deal sizes respectively. They are increasingly encroaching on
each others markets.
Analyzing the network security sector sometimes
gives you the feeling that you are researching the only one company,
just at different stages in its development. Most companies tend to
evolve in a similar fashion, from high-growth start up to mature GDP
growth type cash cow. Check Point and Cisco's security division would definitely represent the later stage of this hypothetical company's development. Palo Alto Networks is at the high-growth end of the spectrum and Fortinet lies somewhere in the middle.The question is which company has the best risk/reward profile?
Network security rebounds It's been a varied year for the sector. After a weak first quarter, where companies like Fortinet, Palo Alto and F5 Networks disappointed with results, the last two quarters have been relatively good.
It's hard to pinpoint exactly what happened back
then, but sequestration appears to have had an effect on confidence.
Furthermore, some unexpected weakness in telco provider spending also
hit the market. No matter, the sector has reported some pretty good
results since then.
The mature companies Check Point finally managed to get product sales growing positively again.
In addition, its new low-end product range is making inroads in the
small and medium size business market. Meanwhile, it continues to
generate huge amounts of free-cash flow. By my calculations free-cash
flow was $925 million over the last year, representing around 8.6% of
its current enterprise value. However, it's only forecast to grow
earnings in the mid-single digit range for next few years. It's
attractive if you favor low growth value plays.
Meanwhile, Cisco Systems has revamped its security
offering with its acquisition of Sourcefire. Although, Cisco is not a
pure-play security company, the way that is able to buy growth by an
acquisition is typical of a mature late stage company. Cisco's main
strength is the ability to bundle solutions to the other equipment that
it sells to Governments and enterprises. Indeed, listening to Palo
Alto's management on its conference call, the Sourcefire acquisition
actually created a positive opportunity:
We've also seen confusion in the market from the
Sourcefire customers about what that deal means... ...We've been able to
develop hundreds and hundreds of leads from dissatisfied or confused
Sourcefire customers... ... it's been a positive
Fortinet matures, unusually Fortinet
also beat estimates in its last quarter. Revenue came in at $154.7
million, beating the high-end of its guidance range by 1.6%. In common,
with Check Point, Fortinet's guidance for the fourth quarter looks a bit
conservative. Check Point has averaged 13.7% in fourth quarter
sequential revenue growth over the last five years, while this year's
guidance implies sequential growth of just 10.4% Meanwhile,despite
beating estimates in its third quarter, Fortinet kept its full year
revenue and EPS guidance constant. Here is how its full-year guidance
has changed this year.
Source: Company presentations
Eagle-eyed
readers will note that its free-cash forecasts have been progressively
lowered throughout the year. Frankly, this is a cause for concern in an
otherwise attractively valued company. Fortinet has had to lower its
inventory turns, and therefore use up more cash in holding inventory on
its books. It's not a major issue, provided it stabilizes as expected.
However, it's something for Foolish investors to look out for. Companies
usually start converting more income into cash flow when they mature,
not the other way around.
Why Palo Alto Networks is the pick It
seems odd to talk about Palo Alto as the best value in the sector, but
on a risk/reward basis the argument stacks up for three reasons.
First, Palo Alto's revenue for the full year is
forecast to be around $559 million , a figure noticeably smaller than
Check Point's estimate of around $1.4 billion or Cisco's trailing year
security revenue of a similar amount. In other words, even if all four
of these companies share the market equally, Palo Alto will see the most
growth.
Second, Palo Alto is doing a pretty good job of converting revenue into free-cash flow.
source: Company accounts, author's analysis
If Palo Alto converts 22% of its forecast revenues
of $559 million and $734 million then investors can expect around $123
million and $161 million in free cash flow in the next two years. That's
not bad for a company that has a current enterprise value of $2.83
billion.
Third, Palo Alto has a favorable geographic mix of
revenue. The most recent quarter saw 67% of the company's revenue coming
from the Americas, with only 19% from Europe and 14% coming from
the Middle East & Africa and Asia-Pacific. With companies like
Cisco and IBM recently warning that emerging market spending was weakening, it's good for Palo Alto to be focused on the Americas.
All told, Palo Alto may not be the cheapest-looking
stock in the sector right now, but it looks a good value based on its
stage of development. Pure value orientated investors may prefer Check
Point, or even a mix of the two.
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 previouslyguided
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.
IT security company Check Point Software's (NASDAQ: CHKP)
latest results confirmed a return to form, thanks to its product sales
growth finally turning positive after three quarters of declines.
However, they also highlighted how competitive its end markets are. With
its revenue growth having slowed to low-single digits, this company is
now firmly in the mature cash-cow phase of its evolution. Is there a
case to be made for buying the stock?
Check Point maturing in a tough market
The IT
security market has unquestionably gotten tougher over the last few
years. As the incumbent leader in the market, Check Point has had to
deal with encroaching competition from the likes of Palo Alto Networks (NYSE: PANW) and Fortinet (NASDAQ: FTNT)
. Palo Alto, a company founded by an ex-Check Point employee, has
stepped up competition with Check Point in the high-end firewall market.
Meanwhile, Fortinet, a company whose traditional strength lies in the
small and medium-sized business market, has been successful in increasing its deal size as it becomes increasingly relevant to larger corporations.
Consequently, Check Point has been squeezed at both ends, and its
growth has slowed accordingly. The latest third-quarter results saw
revenue growth at just 3.5% and the guidance for fourth-quarter revenues
of $365 million to $395 million implies growth of just 3.1% at the
mid-point.
Source: company accounts
5 reasons to be optimistic
A tech stock with low
revenue growth isn't usually seen as an attractive proposition by the
market. However, in Check Point's case there are four key positives from
its third-quarter report.
Even though Check Point tends to bundle its software blades with its
hardware products (so the hardware/software split is somewhat inexact),
the return to product sales growth is still a good indicator because it
suggests the installed base is increasing. In other words, Check Point
should be able to sell add-on software blades in future to its new
hardware customers.
Second, the company has successfully opened up new markets. Its new
low-end 600 and 1100 series (aimed at the SMB market where Fortinet is
strong) saw sales grow 40%. In addition, its high-end data center based
sales (the 13500 and 21000 series) performed extremely well this quarter
with healthy growth.
Third, its underlying metrics have improved. When Check Point takes a
customer on board it books revenues for the products, and also bills
for the full service contract. The service revenues are then recognized
incrementally as the work is done. Therefore, investors should look at
revenues and the change in deferred revenues to better gauge how it is
performing.
For the first time in a year this metric turned positive.
Source: company accounts, and author's analysis
The final point is that its guidance of $365 million to $395 million
looks a little conservative. At the mid-point it represents just 10.4%
sequential growth when the last five years have averaged 13.7%
sequential growth.
Where next for Check Point Software?
Palo Alto
Networks gave results in September and they also confirmed that the
security market remained healthy by predicting that next quarter's
growth would be 37% to 42% on a yearly basis. Meanwhile, analysts have
Check Point on low to mid-single digit revenue growth rates for the next
few years, with EPS growing around 7.3% next year.
By my calculations Check Point has just generated $925 million in
free cash flow (representing around 9% of its enterprise value) and this
holds the key to its future. With over $1.2 billion in net cash , it
has plenty of options in terms of initiating return cash to shareholders
(dividends or more buybacks) or making growth enhancing acquisitions or
investments. I suspect that with any of these initiatives in place, the
stock will be rerated. However, it's one thing to hope something will
happen, and it's another to see it.
In conclusion, Check Point looks undervalued and its underlying
trading performance has improved, but you get the feeling its management
could do more.
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.
Whether rightly or wrongly, the market always seems to want
technology companies to deliver growth, or they will be punished with
low valuations. Consider the case of low-rated IT security specialist Check Point Software(NASDAQ: CHKP). The
company generates huge cash flows, and holds a significant portion
(over 30%) of its market capitalization in cash. On the other hand, it’s
estimated to only grow earnings in the 6% to 8% range over the next
couple of years. Is now the time to buy the stock?
Great cash flow, low rating
Frankly, the main attraction of Check Point is its cash flow. For
example, by my calculations, the company has just generated around $944
million in free cash flow over the last four quarters. In other words,
that cash flow represents nearly 8.8% of its current market value.
Putting this into context, if the company only did this for
the next 11 years (with no growth) then it would have generated the
equivalent of its market cap in cash. However, the company is still
growing earnings and cash flows, so why is it so low-rated?
One possible explanation is that the market is concerned about its
falling product & license revenues. Check Point has a
razor/razorblade business model, which means its hardware products are
sold into customers in order to generate future software blade sales.
The fear is that falling hardware sales will ultimately lead into
falling software sales.
The following chart (sourced from company accounts) demonstrates how
its product & license growth has turned negative over the last year.
If this isn’t worrying enough, then investors only need look at how competitors like Fortinet(NASDAQ: FTNT) and Palo Alto Networks(NYSE: PANW)
have lowered guidance this year due to a weakening environment.
Fortinet gave a weak set of results for the first quarter, and reduced
its full year revenue guidance by about 5% from its previous forecast.
Moreover, its guidance for the second quarter looked weak, and implied that conditions weren’t improving. A month or so later, Palo Alto disappointed the market by claiming that its end-market conditions remained weak going in to June.
So if Check Point’s hardware sales are falling, and its competitors
are warning, can investors feel comfortable with the company’s
prospects?
Six reasons why Check Point investors can feel secure
Firstly, Check Point’s average selling price (ASP) has been
increasing in recent quarters, and its management stated that the ASP
was back to its level of two years ago. The improvement is partly due to
selling a higher proportion of larger deals.
For example, Check Point disclosed that 68% of its deals were at
$50,000 or above, versus 66% last year. This is clearly part of a
positive trend, because in the last quarter’s results, the same
percentage went up to 67% from 60%.
Second, on previous conference calls, Check Point had spoken of a
trading-down effect due to its product refresh. Essentially, its
customers were holding off purchasing its new higher-end solutions in
favor of buying the new lower-end solutions. The customers’ rationale
was that they were getting the same performance as before, but at a
lower price. However, the rise in the ASP in the current report suggests
that the trading-down effect has come to an end.
Third, the company has long been regarded as offering relatively
expensive solutions that hinder its opportunity to sell into the small-
and medium-size business market. The good news is that Check Point now
has a lower-priced ($400 to $1200) entry-level product with its new 600
series. This is a market segment that Fortinet has traditionally been
strong in, so look out for increased competition here.
Fourth, potential investors always need to remember that Check Point
uses bundling as part of its sales strategy. In other words, it tends to
try and accelerate software sales by bundling them with hardware sales.
As the company is increasing the amount of software solutions that work
on its hardware, it is reasonable to expect that hardware sales will
fall as a percentage of the total bundled amount. Don’t panic too much
over falling hardware sales.
Fifth, the guidance looks conservative. Based on company accounts and
the guidance given on the conference call, I have graphed revenues and
implied assumptions for revenue growth in the next two quarters. It
doesn’t look like an aggressive forecast, and Check Point has a history
of being conservative with guidance.
Finally, Cisco Systems(NASDAQ: CSCO) recently announced its plan to acquire IT security company Sourcefire in a $2.7 billion deal.
Cisco’s security revenues fell 5.2% at its last set of results, and
this deal is clearly an attempt to regain positioning. It’s exactly the
kind of deal that Cisco needs to do in order to counteract slowing
growth in its core switching and routing divisions. The immediate
takeover speculation will focus on fast growing companies like Fortinet
and Palo Alto. However, this sort of deal usually helps to guide
investors a sector, and Check Point can expect to benefit too.
The bottom line
In conclusion, while the recent results didn’t have many
positive things to say about the IT spending environment, Check Point
did report some underlying positives. Moreover, the valuation of the
stock is attractive, and it’s a stock well worth considering for value
investors looking for some tech exposure.
The last thing the tech market needed right now was a disappointing set of earnings from Oracle (NASDAQ: ORCL),
but unfortunately that is exactly what it got. It would be an
understatement to say that it has been a difficult 2013 so far for the
tech industry and these numbers will do little to assuage many fears.
But what do they mean for Oracle and how do they relate to the rest of
the tech world?
Oracle disappoints, again
Looking back atan analysis of the previous quarter’s earnings
Oracle missed its own guidance and this quarter saw some key numbers
coming in at the low end. For example Oracle had forecast 1-4% overall
revenue growth (they came in at 2% in constant currency), new software
license and cloud subscription growth was forecast to come in with 1-11%
growth (the result was 2% growth). The one ‘bright’ spot was that
hardware systems product growth was forecast to be negative 12-22% and
came in at the high end with a negative 12%.
Clearly the numbers came in towards the bottom of the guidance
ranges. All of which is somewhat disappointing given that many investors
have been hoping for a second quarter (2Q) bounce back. Last time
around Oracle blamed some sales execution issues and the timing of the
sequester. However it calmed investors by describing its pipeline as
being up and, claimed that the issue was really about the timing and
execution of deal closure.
Well it was a different story this time around with sales execution
quoted as improving ‘significantly’ and economic weakness cited in a few
areas like Brazil, China and Australia. Moreover, transaction sizes
were described as being smaller (a sign of economic pressure).
The good news from a geographic perspective was that its US and EMEA
performance were as expected with 4% and 5% new license growth
respectively. The problem was with Asia-Pacific down 7%. This is a
worrying sign for the industry because many technology companies are
relying on Asia for growth.
What the industry is saying
As a bellwether Oracle’s results will be closely watched and those of
us hoping for some sort of confirmation of a return to better days
would have been disappointed. In a sense it is a mere continuation of
what we have been seeing elsewhere. For example, Palo Alto Networks(NYSE: PANW) recently reported results. It missed estimates and guided lower than the market consensus
for the next quarter. Although Palo Alto is in a different area (IT
security), I found its results interesting because other companies in
the sector had previously reported weakness in April. Unfortunately Palo
Alto came out and confirmed that conditions in May were only ‘in line’
with the reduced expectations created by a weak April. Another indication of weakness and it appears to be linear.
One interesting aspect of Palo Alto is that its telco service
provider revenues do not make up a significant part of its revenues.
This is in contrast with other tech companies like say F5 Networks and Fortinet.
These companies missed estimates and disappointed with guidance. Both
cited weakness in their service provider verticals and this may well
continue into the current quarter. On the other hand Palo Alto's results
are more indicative of the wider tech spending environment and
investors will need to hear some more positive noises from bellwethers
like IBM and Oracle before feeling very confident with Palo Alto.
Moreover Oracle is facing some operational challenges as
it shifts revenues towards cloud-based solutions. It described its SaaS
(software as a service) based revenues as having a $1 billion run rate.
This is fine but to put it into context its full year revenues are
closer to $37 billion. In addition some cloud-based companies like Rackspace Hosting(NYSE: RAX)
have reported some weakness as enterprises still seem keen to use any
excuse to withhold IT spending. In fact in its last quarter it declared
that its revenue per server declined to $1,308 from $1,310 last year.
This is not a good sign for a company supposed to be in a high growth
phase. In Rackspace’s case it was partly due to customers delaying purchases of legacy systems
while they appraised its new OpenStack public cloud offering. Rackspace
also has increasing competition from the likes of Amazon Web Services
(who has been cutting prices) and I take this to be another sign that
conditions have weakened in technology in 2013.
With regards to Oracle’s direct competitors like IBM(NYSE: IBM) and SAP(NYSE: SAP),
these results are obviously not great news and they got marked down in
sympathy. Moreover Larry Ellison was quite candid on his view that SAP’s
Hana database was ‘virtually never’ seen in the market and even
referenced some large German industrial companies that had bought
Oracle’s rival Exadata database machine in order to run SAP’s
applications. He also suggested that Hana could never successfully
compete with Exadata. Frankly there is no love lost between SAP and
Oracle, even when it comes to yachting,
and this sort of comment has been heard before. Moreover I think SAP’s
investors can take some heart from the fact that EMEA (its core market)
was a bit stronger than expected for Oracle.
As for IBM, Oracle’s report was a bit worrying. It pretty much
reported a similar story to Oracle last time around by blaming things
like sales execution, the sequester, the weather and even the change in
the Chinese Government. Will it do the same this time? It’s hard to tell
but IBM didn’t lower its full-year forecast last time around and
announced it would take some workflow rebalancing in Q2. All of which
will put some pressure on it to deliver in the current quarter. As for
the issue with the Chinese Government, did we see signs of this in the
weak results that Oracle just reported?
Where next for Oracle?
The positives in this report were that the transition to new hardware
product systems is going a bit better than expected and the US and
Europe are doing okay. In a sense it is another story of current macro
weakness amidst ongoing change in Oracle’s business as it shifts to
cloud based solutions and new hardware products.
In the last quarter it made sense to pick up some Oracle stock after
disappointing results and I wouldn’t be surprised if the same applies
this time too. The stock trades on an enterprise value to EBITDA
multiple of just 7.4 and generates huge amounts of cash flow that
currently represent over 10% of its enterprise value. On a value basis
the stock looks cheap and I wouldn't be surprised to see Oracle
increasing its returns to shareholders in future. It looks a good long
term hold but be prepared for volatility as the tech spending
environment still looks a little weak this year.
The most surprising thing about Palo Alto Networks'(NYSE: PANW)
recent results were that the market was surprised by them. In truth it
has been a difficult first quarter for technology companies, and despite
having defensive characteristics (IT security threats are definitely
not going away) its sector hasn’t been oblivious to the difficulties. In
summary Palo Alto missed estimates and guided lower than the market
consensus with the usual concerns over Europe and Government coming to
the fore.
Palo Alto gives little succor
Probably the most interesting aspect of these results was the timing. Its security rivals like Check Point Software (NASDAQ: CHKP) and Fortinet (NASDAQ: FTNT)
had already given weaker than expected results amid talk of customer
hesitancy (partly due to sequestration fears) and a faltering macro
environment. If this was to prove temporary then we might have hoped
that Palo Alto would report better conditions given that it is already
June. Unfortunately it intimated that things got worse in April (the
back end of its quarter), and performance in May was only ‘in line’ with
its adjusted guidance.
Here is a chart of Palo Alto’s performance.
Note that product revenues saw a sequential decline in the quarter,
and while the revenue guidance for Q4 of $106 million to $108 million
implies a near 43% rise in revenues (at the mid-point), it is below the
market estimates of $113.7 million. On such things do tech stocks soar
and crash.
To put this into context, Fortinet had already warned, and as articulated in an article linked here,
it will have to see a bounce back in the second half in order to hit
even the lowered guidance. Palo Alto’s recent statements would not
suggest that underlying conditions have improved much so I would suggest
taking Fortinet’s word (that Q2 would be similar to Q1) at face value.
In addition Fortinet stated that its service provider revenues were weak in the quarter. This is a similar story to what F5 Networks (NASDAQ: FFIV)
outlined over its application delivery controller based revenues too.
The good news for Palo Alto is that, although it did see some ‘softness
on its service provider based revenues, they do not make up a
significant part of its overall revenues.
What caused the miss?
It is really about sequestration effects and Europe, specifically
Southern and Central Europe. Palo Alto saw a $3 million-$4 million
shortfall in sales from this region. Overall EMEA sales declined 4% on a
sequential basis. As for federal work the weakness seen
was largely a consequence of sequestration effects. We can also see
these effects on federal spending in a detailed look at F5 Networks' recent results. With regards to F5 specifically, I note that Citrix Systems
had a pretty good quarter with its rival product, and since F5 is
undergoing a product refresh there may be other factors at play here.
With regards to competition there were a couple of interesting points made in the conference call. Firstly,
Palo Alto’s management doesn’t feel that ‘bundling’ will get the job
done anymore. I suspect this is a reference to competitors like Cisco Systems or Juniper Networks who
may well try to include security solutions as part of their networking
offerings. Indeed, Cisco’s security revenue growth turned negative in
the last quarter.
Second, there were the usual references to beating out Check Point
and others in the presentation. As a young and fast growing company we
should expect Palo Alto to be replacing the installed base of
competitors, but in retrospect Check Point’s recent results were
relatively good, and there are some signs (average selling prices
rising) that it is getting over the hump of convincing its customers to
buy its upgraded products.
Where next?
It’s hard to be overly positive because it would have been useful if
Palo Alto had reported better conditions in April/May but, the fact is
that they did not. With that said the bullish case sees the
sequestration effects as causing some short term reactions, much of
which will be ironed out later in the year. Sequestration has its most
obvious influence on public expenditure, but it will also affect the
private sector because the former uses the latter. However, once the
fear of the unknown recedes then companies like Palo Alto and Fortinet
can hit their revised guidance.
The bearish case argues that these effects will continue to slowdown
the IT market as the knock-on effects ripple through the economy and
guidance will have to be lowered for many of these companies. Meanwhile
the situation in Europe is hardly looking much better with sovereign
debt issues remaining at the forefront of concerns.
Since we have never had sequestration before, it is hard to know
which approach to take! My gut feeling is that things won’t get much
worse. Unemployment is falling in the U.S., and growth is moderate but
constant, while the housing market is picking up. F5 Networks has some
uncertainty about it and Check Point needs to demonstrate it can get
back to product revenue growth. However, if you are going to buy Palo
Alto and Fortinet then this could be a decent time to start thinking
about picking some of these names up.
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.
