Fortinet Stock: Market Overreaction Seems Unwarranted (NASDAQ:FTNT)

Investment Thesis

In one of my previous articles, I made the analogy that the stock market is like a manic depressive friend who is usually high functioning but who occasionally goes off their meds and gets either irrationally exuberant or depressed in their valuations of companies.

The latter of the two scenarios has come to be for the cybersecurity company Fortinet (NASDAQ:FTNT). The recent release of FTNT’s Q1 earnings was met by an almost 10% decline in the share price. While the results of Q1 earnings were mixed, the most immediately available reason for the sharp sell-off is likely the decline in non-GAAP revenue from Q4 2023 ($1.415B) to Q1 ($1.353B), and decline in (GAAP) net income from $310.9M in Q4 2023 to $299.3M in Q1 2024. However, a closer look at the composition and trajectory of the company’s performance reveals several characteristics of a well-positioned, high-growth company that is primed for a quick rebound.

There are many factors which can obscure a company’s underlying performance, and there are several at play here. Namely, stock markets have the tendency to overweight earnings results, where cash flows are often a better measure of business performance. Additionally, while stock markets do tend to be forward-looking, they can be too myopic on quarter to quarter results while eschewing more long-term analysis. The release of FTNT’s Q1 earnings may create the appearance of declining business performance, however a closer look at cash flows, margins, segments, capital allocation, and forward guidance reveals a business that is executing well and even improving.

Company Overview

With new data breaches and hacks being headline news seemingly every week, it is not difficult to identify the secular tailwinds in the cybersecurity industry. Increasingly, corporations of all kinds are seeing sales in their service segments increase, with physical product sales stagnating or even decreasing. An inherent part of being in the services industry is the aggregation, storage, and retrieval of data. Data protection is the core business of FTNT, and the market for their core business has very promising growth prospects.

Fortinet is currently second in cybersecurity market share, behind only Palo Alto Networks (PANW). A potential tailwind for Fortinet here is the consolidation of what has been a very competitive market of late. The increasing frequency and severity of cyberattacks have incentivized corporations to choose only one, unified cybersecurity provider instead of relying on multiple cybersecurity providers which offer different services. From the Q1 earnings call transcript, it is clear that FTNT’s management team has identified this and adopted a consolidation strategy where a differentiated array of cybersecurity products are all available under the FortiOS Operating System.

Secure Networking is clearly the core business of FTNT, with this operating segment checking in at anywhere from 67% – 70% of revenues over the last three quarters. It’s clear that FTNT’s core product is growing, as management reported market share gains in this segment in the earnings call:

A soft spot in the revenue mix was the 18% decline in product revenue. The decline in product revenue was attributed to “backlog fulfillment in the prior year” which can be observed in the decline in inventory on the balance sheet. However, the 18% decline in product revenue was more than made up for by the 24% increase in service revenue. Based on Q4’s revenue mix, service revenue was 65.5% of total revenues and product revenues were 34.5% of total revenues. As FTNT is much more in the services sector than they are a manufacturer of physical products, the more than offsetting increase in service revenue relative to the decline in product revenue should be viewed as another indicator that the underlying business performance is strong and improving. Furthermore, management seemed to indicate that the decline in product revenue was a temporary fluctuation that is likely to normalize in the second half of 2024.

Finally, Q1 is clearly the seasonally weakest quarter when it comes to sales for FTNT, where revenues slowly build quarter to quarter as the year goes on.

After the reaction to the Q1 earnings, FTNT is a strong buy now as the low point of the sales for the year has likely already arrived, coupled with the fact that management has raised their guidance for the rest of 2024.

Business Analysis

As the saying goes, earnings get the headlines, but cash flow pays the bills. Earnings can be bumpy, noisy, and in some cases manipulated in ways that often do not paint an accurate picture of the success of a company’s operations.

Cash flows are a superior method for judging business performance because cash flows are a more certain and straightforward way of judging the quality of management’s execution. Most specifically, cash flow from operations is the best judge of the core performance of a business’s activities. With this in mind, FTNT produced a company record $830 million in cash flow from operations in Q1. This represents a 22.5% increase in cash flow from operations from Q1 2023.

Another key indicator to help assess earnings quality is the (cash flow) accrual ratio, calculated by (net income – free cash flow) / average operating assets. This is done to determine how well earnings are supported by free cash flow. For a growth company like FTNT, it is optimal to see a negative accrual ratio, which would indicate that free cash flow actually exceeds net income. Per the Q1 earnings release, GAAP net income was $299.3M and free cash flow was $609M. With free cash flow more than doubling net income, it is safe to say that FTNT has passed the negative accrual ratio test with flying colors.

FTNT’s C+ Seeking Alpha Growth rating may also be somewhat misleading. FTNT is performing strongly or adequately in all of the indicators except for one: working capital growth (TTM), where it checks in at a D. A closer look at the balance sheet released with the Q1 earnings report actually shows some promising trends for FTNT’s working capital.

The most obvious trend is increased liquidity. Over the past quarter, cash and cash equivalents as a percentage of total current assets increased from 31.57% in Q4 2023 to 42.25% for Q1 2024. Increased liquidity during periods of elevated interest rates is a sign of strong execution and capital allocation as these increased liquid assets not only generate interest income (increased by $12M in the last year, per the income statement), but are also on the ready for strategic deployment in the form of investment into more permanent, revenue generating assets and/or share repurchases.

Secondly, two significant components of working capital have actually declined in the last quarter; accounts receivable and inventory. A decline in any component of current assets will decrease working capital, but a decline in accounts receivable and inventory is a positive sign for cash flows. A $406 million decline in accounts receivable works as a cash inflow, as FTNT must have received payments from clients who previously purchased on credit. A $45.3 million decline in inventory also functions as a cash inflow, as FTNT has sold off finished products. A build-up of inventory is potentially an indicator of either a slowdown in demand or products reaching obsolescence. Clearly, the opposite is occurring with FTNT.

As a service-oriented company in the IT sector, FTNT likely has higher needs for fixed assets with much lighter needs for working capital. As such, a decline in working capital in this case should be viewed as a tailwind for revenue, earnings, and cash flow growth.

Another indicator of strong business execution is rising margins even in the face of a mixed revenue picture. Compared to Q1 of 2023, saw an increase in both non-GAAP gross margin (76.3% to 78.1%) and operating margin (26.5% to 28.5%).

Looking ahead, there are two major reasons to be optimistic about an upward trend for FTNT’s share price. The Q1 earnings release contained two significant updates regarding forward guidance and the share repurchase program.

Typically, if a company has experienced a decline in earnings but within the same earnings call the management team increases forward guidance, the share price will respond positively as markets are forward-looking. However, again an atypical pattern has emerged with FTNT as an increase in forward guidance by management was met with a 10% share price decline. Here’s what management had to say about forward guidance and the overall demand environment through 2024:

The second reason to be optimistic about a near-term recovery in the share price is the potential for share repurchases. FTNT’s management has the track record, capital allocation strategy, and ability to execute a substantial share repurchase program. In the Q1 earnings release, the management team made no secret about their satisfaction with the progress of share repurchases:

Despite the fact that share repurchases reduce the denominator of the EPS calculation, share repurchases are not a guaranteed way to increase shareholder wealth. Excess cash flows allocated to share repurchases when the share price exceeds intrinsic value are a flat out waste of capital. Share repurchases may also be outweighed by relatively larger increases in employee stock-based compensation. This has clearly not been the approach of FTNT’s management, as shares outstanding have steadily decreased in recent years and the bulk of the share repurchases occurred in the second half of 2022 when the share price was around or below $50. With almost $2B of cash on the balance sheet, FTNT is well-equipped to max out the remaining $1B budget in the share repurchase program, still comfortably conduct any necessary activities of the business, and/or add to the existing capital expenditure.

Valuation

If we accept that cash flow analysis is a superior way to judge a company’s performance, then it logically follows that cash flow ratios should be used to attempt at least a relative valuation.

Per Seeking Alpha, FTNT’s FWD Price/Cash Flow currently stands at 21.87. An investor in the common equity of FTNT’s main competitor, Palo Alto Networks, would pay a premium of almost 50% for the same cash flows at 31.71.

A company’s FWD P/E is a slightly less reliable measure of valuation between peer companies. However, a comparison of the FWD P/E of FTNT to PANW tells a similar story as the cash flow ratio analysis. Seeking Alpha has FTNT’s FWD P/E at 39.20 and PANW’s FWD P/E at 44.81.

Overall, valuations in any tech-related sector, specifically the IT sector, are likely to be high due to The Magnificent Seven. FTNT and PANW each have multiple customers in The Magnificent Seven, so their valuations are somewhat linked. As a result, the relative valuation story for FTNT is not overly compelling here. While waiting for a wider margin of safety, the value for common equity holders lies in the disconnect between the current trajectory of the share price and the underlying business performance.

Risks

Based on the recent 10% decline in share price, a fiscal year’s worth of rising revenues ahead, and FTNT’s position in an industry with robust total addressable market (TAM) growth ahead, coupled with increasing market shares, I view the risks to FTNT’s common equity as minimal.

Anytime a company sees a sudden decrease in its valuation, there is always the possibility that the share price could decline further. So, it is entirely possible that we have not seen the end of the FTNT sell-off related to its Q1 earnings.

FTNT’s customers are corporations, and if a recession or economic slowdown were to occur, they would almost certainly see declines in revenue. However, cybersecurity spending is no longer discretionary for businesses, and is not an interest-rate sensitive form of spending. It is easy to see a pathway where FTNT holds up very well under either a recessionary or inflationary environment.

There are a lot of other players in the cybersecurity space, some of which are also growing quickly. So, there is some competition risk here. There are significant switching costs associated with the cybersecurity industry, so there is reason to believe in the inelasticity of demand for FTNT’s products due to brand loyalty. This coupled with the healthy and sustained increases in margins is reason to believe FTNT has achieved at least some degree of a competitive moat to reduce this competition risk.

A beta of 1.07 means that a FTNT common equity investor bears slightly higher volatility risk compared to an equal investment into the S&P 500. Based on the bullish forward guidance issued by management after Q1, I view this marginal risk as outweighed by the potential gain of share price appreciation from higher future earnings.

FTNT’s management has accessed the debt markets very sparsely, with long-term debt hovering around over $990 million over the last three years. GuruFocus has FTNT’s debt-to-EBITDA at a very manageable .65, meaning that it would take FTNT less than a year’s worth of EBITDA to completely pay off the long-term debt.

Conclusion

FTNT operates in a rapidly growing market, and occupies a secure and increasingly consolidated position in that market. The recent reaction to the Q1 earnings release appears to be in response to noisy earnings data, and is divorced from more promising information regarding actual business performance.

The rate at which net income is forecasted to grow through 2024 has increased, and further share repurchases are likely. To use the slices of pie analogy, the surface area of the pizza (net income) is going to increase and the slices themselves will also grow in size (i.e. continued decreases in shares outstanding due to repurchases).

FTNT shows many of the traits of a buy-and-hold growth company. With the lofty overall market valuations being what they are at the moment, FTNT’s recent sell-off is both an attractive entry point for new investors and an opportunity for current shareholders to add to their positions.