Fortinet: High-Growth Potential In SD-WAN – Fortinet, Inc. (NASDAQ:FTNT)

Thesis

Fortinet (FTNT) is a high-quality, high-growth company that operates in a growing market. The company also has a significant competitive advantage over its competitors, which creates a nice moat around the business. Finally, high-quality financials make the stock a good candidate for my portfolio.

A high-quality business model

Fortinet is a leading cyber security company that provides broad, integrated and automated cyber security solutions worldwide. Fortinet has more than 400,000 customers all over the world to whom it ships over 4.6 million products and different types of security solutions making it one of the top global providers of network security appliances for carriers, data centers, enterprises, distributed offices, and SMBs.

Fortinet operates under a two-tier model in which it sells its products to a distributor who sells them to enterprise-focused resellers who ultimately sell them to the company’s end customers.

As of 2018, the company has two key reporting segments – Product and Service.

  • Product segment (37% of revenues) – revenue is generated from the sales of the company’s hardware and software products which include products under the FortiGate family (network security appliances) as well as non-FortiGate products who include Fortinet Security Fabric (cloud and email security mostly).
  • Service segment (63% of revenues) – it includes subscription-based services that are complementary to FortiGate products like FortiGuard (real time threat intelligence updates) and FortiCare (technical support).

In 2015 the company has had its sales equally divided between its two segments but since than the revenue mix has been slowly shifting to services as more and more people were subscribing to FortiGate and FortiCare. In 2018 the Service segment is close to 2/3 of revenues and it’s likely to grow even higher. I like this trend as more and more of the service revenues come in the form of deferred revenues which is a good indicator of a growing business pipeline. Also, the service segment operates on a higher gross margin (85.8% in Q1 vs 56.8% for Product).

The company’s revenues are also very diversified geographically at the end of 2018 as 42% come from America, 38% from EMEA and 20% from APAC.

SD-WAN Market potential

This day people expect access to information from anywhere, at any time and from any device. This has been made possible by the adoption of cloud computing and the use of mobile devices. As the adoption of public cloud and SaaS application continues to grow, organizations are quickly discovering that they need to redesign their existing network architectures to deliver a better user experience for their clients and employees. Outdated Wide Area Network (WAN) architecture is no longer useful as it has not been designed for a cloud/SaaS dominant world. This is where the Software Defined Wide Area Network (SD-WAN) steps in as it enables your enterprise to deploy your wide area networks 100 times faster with three times the cost savings.

Based on that trend and its early stage, the SD-WAN market is expected to grow at an 40.4% CAGR from less than 1 billion in 2017 to $4.5 billion in 2020 according to IDC’s latest SD-WAN infrastructure forecast.

The high growth rates in this industry attracted the attention of small and large players alike, making the market extremely competitive. Among the market leaders there are popular names like Cisco (CSCO), VMware (VMW), Fortinet, Silver Peak, Huawei, Nokia (NOK) and others.

As of Q4 2018, Fortinet is the 6-th largest player by revenues in the SD-WAN market but has the most impressive growth rate Q/Q and Y/Y is the second fastest growing company after Huawei.

Source: TEchBlog, HIS

I think that Fortinet will prove to be a disruptor to this industry, due to its competitive advantage, and that it’s a matter of time for Fortinet to find its place among top 3 companies due to its high growth rate and established brand.

FTNT’s competitive advantage in SD-WAN

Fortinet was quick enough to build the SD-WAN functionality into its FortiGate next generation firewalls (NGFW) when the SD-WAN market was still emerging creating a single industry-leading integrated solution. Due to its first mover advantage, up until now Fortinet is the only vendor in the industry to receive a“Recommended” rating in the SD-WAN and NGFW group tests from NSS Labs.

While other vendors require multiples devices to deploy, FTNT’s FortiGate SD-WAN delivers both an effective, low-cost SD-WAN solution and the right security to go with it.

And that is far from all. On April 09, 2019 Fortinet announced the industry’s first SD-WAN ASIC designed to enable security-driven WAN Edge Networking further strengthening its position in SD-WAN. The FortiSOC4 is a custom-designed silicon chip—the first of its kind for an SD-WAN solution. It delivers the fastest application identification and steering in the industry, while providing connectivity and advanced security capabilities 10X faster than the competition giving FTNT a clear competitive edge.

In addition to its new ASIC, FTNT also launched its first appliance to be powered by the new SD-WAN ASIC – FortiGate 100F. The two products combined will provide best in class SD-WAN as well as security capabilities to deliver a 10X faster performance over the competition.

Source: Fortinet.com

Financial analysis and valuation

As of 2018, FTNT has a gross margin of 75% due to its strong Services segment. The high gross margin further highlights the strong competitive advantage the company has over other players in the industry.

Source: SA

The other two things that I find very impressive with Fortinet is the amazing +15% growth rate par year since 2010 and the debt free balance sheet.

Source: SA, author’s visualization

It’s truly outstanding that a high-growth company like FTNT maintains its growth with 0 debt on its balance sheet and at the same time has an ROE of 39.89% due to its high margins and asset turnover.

Source: SA

Risks

I think that few people will doubt the growth potential and the high business quality of FTNT, but some may argue that the majority of that growth is already priced in. When we compare FTNT to its industry and its sector, FTNT indeed looks a bit overvalued.

Source: Reuters.com

However, high valuations are not uncommon for growth stock like FTNT and from my research I can conclude that FTNT clearly deserves some premium over its peers but is the premium over the industry and the sector enough or more multiple expansion is underway is a guessing game. One might want to construct a peer group from SD-WAN vendors and another for cyber security companies to have a clearer picture.

The stock currently trades close to 20% below its all time high, so this must not be disregarded.

Conclusion and recommendation

Fortinet is a company that I have had both of my eyes on for the last two years. I’ve always liked the great business model with the strong operating metrics with the low debt on the balance sheet. The recently introduced products and the SD-WAN market potential go really well with my bullish thesis and I have finally decided to open up a small position. I recommend opening up a small position in FTNT in case the strong rally continues and I will add up to my position if presented with lower prices. I may further investigate the premium over the industry and the sector in another article.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FTNT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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