To The Moon

Summary

• Fortinet missed revenue consensus in 2Q and provided weak revenue guidance in FY2023, leading to a 25% selloff and concerns about growth outlook.

• The company's product revenue saw a substantial decline, indicating a normalization from the pandemic-driven surge.

• The management also attributed this growth slowdown to shortened billings duration and the delay of large deals to the next quarter.

• The stock's valuation remains relatively high compared to peers and market indexes, but the adherence to the software's 40-Rule justifies it to some extent.

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Investment Thesis

Fortinet $Fortinet(FTNT)$ not only missed the 2Q FY2023 revenue consensus but also provided a weak FY2023 revenue guidance. This resulted in a 25% selloff following the earnings announcement, fueled by concerns about the company's growth outlook. The management attributed this weakness to shortened billings duration and the delay of large deals to the next quarter. Moreover, the product revenue saw a substantial decline, dropping to the high teens for the first time since 3Q FY2020. Despite a slight improvement in operating margin in 2Q, the company's guidance indicates an expected margin contraction in both 3Q and FY2023.

Currently, the stock is trading at a post-selloff valuation of 38x non-GAAP P/E FY2023E, reflecting a premium multiple. While FTNT is often seen as a high-growth cybersecurity player with a lofty valuation, this rationale becomes less apparent given the 2Q earnings results. As a result, I have initiated a "hold" rating on FTNT, considering that the company's growth slowdown is likely to compress its valuation multiple.

2Q23 Takeaway

The company model

As previously mentioned, FTNT experienced a 25% decline due to a deterioration in top-line growth. Despite reporting better-than-expected non-GAAP EPS, the company's total revenue fell short of the market consensus. Particularly, its product revenue, accounting for 37% of the total revenue in 2Q, exhibited a significant deceleration, growing only 18% YoY. The chart shows that the product segment had undergone a super cycle driven by the pandemic in recent years. However, the 2Q earnings indicated a potential normalization in product revenue, evident from a decline in the product backlog that contributed to weaker overall revenue growth.

On the other hand, we saw a steady growth trajectory of service revenue, which has maintained a robust 30% YoY growth. This growth is primarily fueled by the strong performance of security subscriptions.

The company model

Let's do some billings analysis. By examining the chart, we observe that FTNT's total billings have decelerated at a faster pace than its current billings (normally less than 12 months). This suggests a potential contraction in billings duration due to prevailing macro uncertainties. During the 2Q earnings call, the CFO explained:

"Regarding the second quarter, we believe macro and certainly impacted our billing performance to average contract duration, and in the second half of June, and the elevated level of enterprise deals pushing the future quarters."

If indeed deals were postponed to 2H FY2023, this would imply a recovery in the latter half of the year due to the pushouts from 2Q. However, if this recovery fails to materialize, this could potentially send a negative signal to investors. In this scenario, I believe this could disrupt the company's consistency in revenue recognition over the long term. For investors who don't know how to analyze software companies, understanding the concept of billings could be a bit difficult. Let me explain:

In the software industry, billings are a crucial metric for driving growth. Unlike revenue, which represents the amount of income recognized in a given period, billings reflect the actual cash inflow received by a company. It's important to note that revenue doesn't directly represent the cash received from customers.

Billings are calculated by adding revenue to the positive change in deferred revenue (liability side of balance sheet). Deferred revenue represents cash received in advance from customers, which will be recognized as revenue once the company provides the corresponding services.

2Q23 Presentation

Based on the company's guidance, we can anticipate a further growth slowdown in 3Q FY2023, as the management projected a 13% YoY growth in total billings and a 17% YoY growth for FY2023. These forecasts are not only below the market consensus but also indicate a significant growth slowdown when compared to the +30% YoY achieved over the past two years. This clearly shows that FTNT's growth has returned to a more normalized level after the pandemic. As a result, a weaker top-line growth can be anticipated in the coming quarters.

The company model

Despite seasonality, it's apparent that FTNT's operating margin had expanded consistently over the past three years from 1Q to 4Q. However, a potential downtrend in FY2023 has emerged. I believe this also signifies a return to normalcy following FY2022, during which the company had witnessed above-trend top-line growth and margin expansion. The guidance of a further contraction to 25% in 3Q FY2023 reinforces this perspective. With that being said, in the absence of a clear indication of either an inflection point or a stabilization in the growth and margin outlook, I'm skeptical that the stock can sustain a consistent upward momentum in the near term.

Lastly, let's talk about the company's EPS outlook, it's worth mentioning that in its 2Q presentation, FTNT made a slight upward adjustment to the non-GAAP FY2023 EPS by $0.05, from $1.44 to $1.48, as initially projected in 1Q. However, we observed that FTNT exceeded its 2Q non-GAAP EPS forecast by $0.04. Therefore, when excluding this outperformance, we only see a modest increase of $0.01. Therefore, I believe that the guidance might not be very impressive in terms of supporting the company's current high valuation.

Valuation

Seeking Alpha

FTNT is currently trading at a P/E of 43x based on GAAP TTM. Despite nearing the lowest point over a three-year period, the stock remains relatively expensive when compared to its peers and broader market indexes. If we consider its non-GAAP EPS in FY2023E, the stock's P/E would be 38x. While I admit that its valuation has indeed experienced a substantial contraction following the 25% post-earnings selloff, I'm not convinced that the current multiple indicates a bargain, particularly given the ongoing deceleration in growth.

Despite the forward guidance, FTNT's high valuation can still be justified by its adherence to the "40-Rule." This rule combines the growth rate of revenue and profit margin to evaluate a company's performance. This metric is particularly important for valuing SAAS companies, as it accounts for both top-line growth and profitability. We notice that the company's FY2023 outlook implies a combined value of 44%, which remains above the 40% threshold. Therefore, I don't hold an overly bearish view of the stock either.

Conclusion

In sum, FTNT's recent price action and growth outlook present a mixed picture for investors. The 2Q FY2023 earnings results largely disappointed investors, driven by missed revenue consensus and weaker-than-expected revenue guidance, led to a 25% selloff. This reflects concerns about its weak growth trajectory as the product revenue exhibited a significant deceleration, showing a potential normalization from the pandemic-driven surge. Despite a significant contraction in the stock's valuation, it remains relatively high compared to its peers and broader market indexes. However, I believe the company's premium valuation can be supported by its adherence to the software's 40-Rule, which combines growth rate and profit margin. However, the potential reduction in billings duration and the lack of a clear growth and margin stabilization raise caution in the near term. Therefore, I have assigned a hold rating to the stock, reflecting my cautious view on FTNT's growth outlook.

Source: Seeking Alpha