Fortinet, Inc: A cash machine in cybersecurity

You have certainly heard of phishing, ransomware or malware. Cyber attacks are the other side of the coin of the democratization of the Internet since the end of the 90s. In a connected world, many digital threats exist and business leaders or institutions often find themselves helpless against these risks. The cybersecurity actors are there to mitigate these growing phenomena in our societies.

Overview

Fortinet is one of the big names in the industry, just like Cisco Systems, Palo Alto Networks or Checkpoint Software. The industry, largely dominated by America, is following an exponential dynamic, as demand is strong and seems insatiable for the years to come. The addressable cybersecurity market is expected to exceed $200 billion by 2026, and many opportunities for expansion exist today.

Leader in Gartner's Network Firewall and SD-WAN Magic Quadrant

Source: Gartner

The cybersecurity company is the global leader in network firewalls and SD-WANs, which are software-defined wide area networks, touted as the most relevant solution for the next decade. The company delivers a wide range of solutions through its FortiOS everywhere cloud-based platform. Customers pay a subscription fee to access the various IT security services, which ensures a recurring and scalable revenue stream. Indeed, as a customer's business grows, they will need to purchase new options to support their needs.

Convergence of networks and IT security around FortiOS everywhere

Source: Fortinet

Thanks to its dominant position in the sector, alongside Palo Alto Networks, Fortinet benefits from a scale effect that protects it, to a certain extent, from the risk of obsolescence inherent in the technological compartment. If a competitor emerges with a superior solution, the industry leaders will be in a good position to buy them out and stay in the race, whereas a smaller player will be condemned to sudden death if its technology becomes outdated.

Fortinet is preparing for industry consolidation. Many companies are unprofitable and could suffer from the possible recession coming in 2023. This is a boon for Fortinet, which has enough cash to shop the market and consolidate its position as industry leader.

A highly fragmented industry ready to consolidate

Source: Fortinet

However, and this is appreciable enough to point out, Fortinet remains focused on its organic development: since 2017, 90% of its innovation budget is spent on R&D and only 10% on acquisitions. In fact, the company has repurchased 192 million shares for a total of $4.6 billion since 2017, which has increased the return on investment (ROI) to shareholders by decreasing the number of outstanding shares and thus increasing the share price.

Strategic investments and capital allocation

Source: Fortinet

Financial Analysis

Fortinet is growing twice as fast as its market with an annualized growth of 22.6% over the last decade (compared to 11% for the cybersecurity market).

Graph of income statement evolution

Source: MarketScreener

Three-quarters of the company's revenues are generated outside the United States, with a well-diversified client portfolio and a good balance between large multinationals and medium-sized companies. Sales of services (higher margin than product sales) account for two-thirds of revenues and management predicts expansion in the coming years. Related to contracts, renewal rates are satisfactory and average terms are generally 2-3 years (typical of IT consulting). It is important to note that in general, IT consulting is less entrenched than auditing, for example, because the latter sector is completely consolidated between the "Big 4". In IT, the competition is much more fierce and diversified.

Fortinet's advantage over its competitors is its profitability, surely one of the most profitable companies in its sector with an operating margin above 20% on average since 2009. The FCF (Free Cash Flow) margin has averaged over 32% for the last 5 years. Another good news that differentiates it from its competitors is that the number of shares has remained stable over the last decade, from 819 to 836 million, while the number of shares outstanding has quintupled at Palo Alto Networks and Crowdstrike following capital increases and large stock-based executive compensation programs.

Graph showing operating margin versus revenue growth for major competitors over the last year (2021-2022)

Source: Fortinet

We can observe that Fortinet is the most profitable company among its direct competitors.

Let's look at the "rule of 40": the principle that if a company's growth rate plus operating margin in the software industry exceeds 40%, then we are dealing with a high-quality company and there is a good chance that it will deliver performance in the future. Fortinet has performed admirably with a score near or above 40% since 2009.

The Rule of 40 applied to Fortinet

Source: Fortinet

The balance sheet is excellent with little debt and excess cash. It is a low capital-intensive business, which does not require working capital since customers pay in advance on the SaaS (Software as a Service) model.

Balance sheet situation graph

Source: MarketScreener

Shareholding and valuation

The company was founded by Ken Xie and his brother Michael, who between them still hold 16% of the capital. Ken Vie is an American billionaire of Chinese origin known for having sold in 2014 NetScreen, his first company, for a whopping $4 billion to Juniper Networks.

He's also a true "prince" in the aristocratic coterie of Silicon Valley: his daughter Jaime, a model and businesswoman, is a showbiz star (and a fixture on the Netflix show "Bling Empire"). A former equestrian champion, she used to ride alongside Eve Jobs, the daughter of Apple's founder.

Table of the main shareholders

Source : MarketScreener

The main insiders are rather sell since 2022 even if their positions are still very large. That's why you may need to be patient before rushing into the stock. Starting to accumulate shares around $42-43 seems like an interesting entry point, to be confirmed given the Fed's hawkish policy trajectory, a policy that is weighing on the price of high P/E stocks like Fortinet right now (early 2023). The company is currently valued at 42 times its projected 2023 earnings, 7 times its revenue, but offers a very comfortable FCF Yield of 5.34%, quite reasonable given the quality and growth of the company.

Price chart

Source : MarketScreener

Fortinet has the profile of a leader that will remain so for many years to come. The group is preparing for the coming consolidation of the sector. Its track record will surely allow it to consolidate its leadership position and establish its position in the global cyber-economic fabric.