The Bull Case for Fortinet Inc. (NASDAQ: FTNT)

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In May, Fortinet reported solid first quarter earnings results. Product revenue was up 35% YoY, service revenue was up 30% YoY, and total revenue was up 32% YoY. Additionally, the business posted strong GAAP operating income of $273.5 million dollars, up 81% YoY, and strong free cash flow figures. With this solid first quarter performance, management guided revenue between $5.425 and $5.485 billion dollars for fiscal year 2023, implying YoY revenue growth of around 23%. With a large installed base of customers, Ken Xie, founder and executive chairman of Fortinet Inc., sees a large opportunity to upsell value-added security services to this customer base.

Fortinet is a global leader in cybersecurity and networking solutions for government organizations, small businesses, organizations, enterprises, security service providers, and communication service providers. The business focuses on secure networking, zero trust access, cloud security, AI-driven security operations, security services, and support and professional services. Their Core Platform product line offers over 35 products that are designed to address security concerns for small to medium-sized businesses, large enterprises, and government organizations around the world, whereas their Enhanced Platform Technology product line is mainly used to expand and integrate security architectures. The Enhanced Platform Technology product line includes the Fortinet Security Fabric (a bundle of 11 products that provides a host of security solutions from identity and access management to network security), email security, cloud security, and endpoint protection. In addition to their product offerings, Fortinet also offers a host of service offerings. Fortinet offers security subscription services (end users often purchase this subscription in advance, with terms of 1-5 years), technical support services, service bundles (consolidated security packages that are catered to different end-users / use cases), professional services, and training services through the company’s training team and authorized training partners.

The market for Fortinet’s products is highly competitive and largely driven by rapid technological change. Management identifies a list of competitive factors that matter within their market. These factors include product security performance, technological expertise and integration of new networking and security features, compliance with industry standards, price of products, brand recognition, customer service, breadth of product line, and sales and distribution capabilities. Additionally, management lists a host of competitors as well, including CrowdStrike Holdings (NASDAQ:CRWD), VMware (NYSE:VMW), Zscaler (NASDAQ:ZS), Cisco Systems (NASDAQ:CSCO), Palo Alto Networks (NASDAQ:PANW), and Arista Networks (NYSE:ANET). Management believes that they compete favorably with these competitors based on a myriad of competitive factors like reliability, security performance, integration of new networking and security features, and technological expertise. They also admit that the industry that they operate in is highly competitive, with a few larger competitors having greater resources, product offerings, and stronger brand name recognition. It is important for investors to understand the risks of investing into such a highly competitive industry.

Management is solid and incentivized well. Capital allocation priorities place shareholders first, evidenced through aggressive share buybacks. In January of 2016, management approved the business’ share repurchase program, which at the time authorized the repurchase of up to $200 million dollars worth of outstanding common stock through December 31st, 2017. From 2016 to 2021, the Board of Directors extended the repurchase program term to February of 2023 and increased the amount authorized for repurchases up to $4.25 billion dollars. This February, the Board of Directors extended the share repurchase program to February of 2024. Since the program’s inception, management has repurchased 211.4 million shares worth of common stock at an aggregate purchase price of $4.72 billion dollars, with $529.6 million dollars left over for future share repurchases as of December 2022. As we can see, management has aggressively bought back shares in the past few years, with plans to continue (management stated that they aren’t considering dividends at the time and probably won’t be for a while), showing management’s dedication to increasing shareholder value and returning excess cash to shareholders.

As for management incentives, the management team is incentivized to return value to shareholders via performance based stock incentives and other long-term incentives based on operating income and revenue based objectives. The pay structure highly incentivizes meeting these targets, and because of this, these targets are usually met, exceeded, or are barely fallen short of. At 90% of the target objective for operating income / revenue, their bonus is paid out 40%, with 6% increases in funding for every additional 1% of performance between 90% and 100%. Additionally, the compensation structure rewards 1% increases in funding for every additional 1% performance increase between 100% – 140% of the target objective. Not only does this incentivize management to meet their target objectives in operating income and revenue, it also incentivizes them to go above and beyond while containing risk-taking measures (bonuses are capped after 140% of the target objective).
Fortinet is a very capital efficient business. The business operates at a LTM ROIC of 100.5% and a WACC of around 12%, leading us to a ROIC to WACC ratio of around 8.5x. This relatively high ROIC to WACC ratio shows the business’ ability to generate returns far greater than its cost of capital. Fortinet is able to reinvest cash back into the business at very high rates of return, rapidly compounding intrinsic value and rewarding shareholders handsomely. Additionally, looking further at efficiency metrics, we can see that Fortinet has been able to handsomely increase ROIC over the last few years. In 2016, Fortinet’s ROIC stood at a measly 5.6%, compared to today where LTM ROIC stands at a whopping 100.5%. This high growth in ROIC acts as a testament to Fortinet’s market position within the cybersecurity sector. Companies that are able to grow and maintain a high ROIC and high ROIC to WACC ratio are thought to have strong competitive advantages in their respective sectors, and we believe that is the case with Fortinet.

Analyzing Fortinet’s income statement, we can see stellar sustained growth in revenue, gross profit, and earnings over the last decade. Since 2013, Fortinet has grown its revenue at a CAGR of 22.6%, growing gross profit at a CAGR of 23.5% over that same time period. The excess increase in gross profit relative to revenue in that time frame can be attributed to incrementally increasing gross margins. The cybersecurity industry operates with very high margins, with Fortinet operating at gross margins of 70.6% in 2013, compared to today where the business operates at LTM gross margins of around 76%. In terms of earnings, Fortinet has grown EBITDA at a CAGR of around 30% since 2013, with EPS growing at a CAGR of 37.75% in that same time period. The growth in EPS can largely be attributed to share buybacks. Since 2019, Fortinet has decreased shares outstanding by around 9%.
Looking at Fortinet’s balance sheet, we can see that the company is in good financial health. Fortinet has around $2.3 billion dollars worth of cash and equivalents on hand, along with $574.9 million dollars worth of short term investments. With around $990 million dollars worth of long-term debt, Fortinet operates at a very healthy cash to long-term debt ratio. Additionally, with an EBIT / Interest Expense (interest coverage ratio) of 58.78x, the business is comfortably able to pay the interest on its outstanding debt.

Looking at Fortinet’s cash flow statement, we can see stellar growth in net income and free cash flow within the last decade, showing the business’ operational efficiency and strong ability to generate cash. Since 2013, net income has grown at a CAGR of 36%, with free cash flow growing at a CAGR of around 30% in that same time frame. The growth in free cash flow can largely be attributed to expanding free cash flow margins. In 2013, free cash flow margins represented 21.7% of revenue, compared to today where LTM free cash flow margins sit at 38.6% of revenue. This relatively large expansion in free cash flow margins over the past few years shows the business’ increasing operational efficiency and ability to generate large amounts of cash from its operations.

After conducting a reverse discounted cash flow (DCF) model analysis, we can see that Fortinet is trading at share prices that imply a 15.50% growth rate in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10%. With free cash flow growing at a CAGR of 30% over the last decade, we believe that Fortinet may be trading at a relatively low / cheap growth rate. While past performance is not indicative of future results, Fortinet operates within the high-growth cybersecurity space, one of the fastest growing sectors in the technology industry. Additionally, with Factset placing a 19.1% long-term growth rate on the company (based on analyst estimates), it can be said that the 15.5% growth rate implied by current share prices is cheap. As mentioned above, Fortinet has expanded its free cash flow margin at an attractive rate over the last decade. Again, while past performance doesn’t indicate future results, the continuation of free cash flow margin expansion can act as a catalyst for increased free cash flow generation over the next 10 years, making this growth rate very attainable.

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This article was originally published on Quiver Quantitative