To The Moon

Summary

• Fortinet's hardware backlog is exhausted, leading to a decline in product revenue growth.

• Service revenue growth is still strong though, particularly for the OT security and SD-WAN businesses.

• Fortinet's stock now looks far more reasonably valued, although there could still be downside risk if product sales continue to disappoint.

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Fortinet's $Fortinet(FTNT)$ second quarter results appear to have caught the market off guard, with the stock correcting violently to the downside. Fortinet's earnings were actually quite strong though, outside of the fact that its hardware backlog is now exhausted and as a result product revenue growth is falling off a cliff. This was always a high probability event though, given that the pandemic likely pulled forward a significant amount of hardware demand, and was a risk I had recently highlighted. The key questions for Fortinet now are how much demand has been pulled forward and what will be the path of product revenue going forward.

While Fortinet's valuation was probably a little stretched, the market reaction to earnings is somewhat baffling. Fortinet has a dominant position in the firewall market (~50% share), which is based on its combined hardware and software expertise. Any weakness here is far more likely to be a market wide issue than anything Fortinet specific.

Fortinet's service revenue was surprisingly strong in the second quarter and forward guidance reasonably robust. In particular, the OT business continues to be an area of strength. Fortinet is a leading OT security vendor, a market that is expected to grow to 33 billion USD by 2030.

From a competitive positioning standpoint, Fortinet's SASE business is the biggest unknown. Fortinet continues to believe that SASE is a large opportunity that it can capitalize on by leveraging its strength in SD-WAN. It should be noted that Zscaler $Zscaler Inc.(ZS)$ insists that an adequate SASE solution requires the right architecture, and that SD-WAN is antithetical to zero-trust.

Microsoft’s entry into the SASE market already appears to be causing some headaches for Fortinet, even if it is just in the form of customer confusion. Fortinet stated on the second quarter earnings call that customers are taking more time to evaluate solutions. Microsoft's distribution capabilities make it a serious threat in this market, particularly for vendors that have a weaker solution from a technical standpoint.

In support of anticipated SASE growth, Fortinet is accelerating its investments in POPs. While this indicates confidence in the business, it will be a drag on cash flows, which likely won't be well received by the market, particularly with growth decelerating.

Financial Analysis

Revenue increased 26% YoY in the second quarter, with strong service growth being offset by weak product sales. Service revenue growth was 30% YoY, with OT and SD-WAN recording 60% and 40% growth respectively. Security subscriptions now represent over 55% of all service revenue and grew 34% YoY in the second quarter. Product revenue only increased by 18% YoY, with product lead times and backlogs now approaching normal levels. Several years of extremely strong product sales now needs to be digested by the market, and this could take an extended period of time, depending on the extent to which demand has been pulled forward.

Fortinet also believes that macro uncertainty has led large enterprises to exercise caution. An unusually large volume of deals that were expected to close in June fell out of the second quarter and contract durations shortened meaningfully.

Somewhat surprisingly, SMBs appear to have been an area of strength in the second quarter, with Fortinet adding a record 6,500 new logos. Government, manufacturing and construction were all strong verticals in the second quarter, while retail was an area of weakness.

Billings are expected to increase by 13% YoY in the third quarter and revenue is expected to grow 17%. For the full year, billings are expected to increase by 17% over 2022 and revenue is expected to grow roughly 22%. The concerning point here is that service revenue growth is expected to remain fairly stable while product revenue growth is expected to drop into the low single digits.

Figure 1: Fortinet Revenue (source: Created by author using data from Fortinet)

Product gross profit margins continue to improve on the back of higher prices and easing supply chain pressures. This was partially offset by certain inventory charges though. Somewhat concerningly, Fortinet pointed to the fact that product margins are strong and that there is room to use incentives to fuel demand. This suggests that product gross profit margins could fall going forward, or at least won't continue to move higher. Gross profit margins are likely to continue trending higher over time though as the relatively high margin service business continues to grow in importance.

Operating profit margins were also fairly strong in the second quarter, particularly given revenue weakness. While Fortinet has cut back on hiring significantly, weaker growth may weigh on operating profit margins going forward as the company has been investing ahead of anticipated growth.

Figure 2: Fortinet Profit Margins (source: Created by author using data from Fortient)

Figure 3: Fortinet Job Openings (source: Revealera.com)

Valuation

Fortinet's valuation has been well above its historical range over the past few years, but investors should keep in mind that this is a rapidly growing, high margin business, with a strong competitive position. Product sales could remain depressed for an extended period going forward, but this is likely a market issue rather than anything Fortinet specific. OT security and SASE remain large growth opportunities which Fortinet is well positioned to capitalize on, although the strength of Fortinet's position in the SASE market isn't really clear yet.

For longer term investors that remain confident in Fortinet's business, this probably represents a fairly attractive entry point. There is still near-term risk involved though. The macro environment remains uncertain, and there still may be further downside to product sales.

Figure 4: Fortinet EV/S Multiple (source: Seeking Alpha)

Source: Seeking Alpha