Is This Top Cybersecurity Stock Now Dead Money?

Shares of Fortinet (FTNT 0.09%) gave up recent gains as investors digested another muted outlook from the cybersecurity company’s management team. After several years of accelerated growth due to pandemic lockdowns and the resulting modernization of enterprise IT infrastructure, Fortinet’s historically hardware-based business is in a cyclical downturn.

Ultimately, this has resulted in stocks performing poorly for three years now. Does this mean Fortinet stock is now dead money? Or is there more to the story?

A good quarter, but investors are worried

Fortinet actually had a decent first quarter of 2024. Revenue came in at $1.35 billion, a modest 7% increase year-over-year and near the high end of guidance provided by management three months earlier. Earnings per share (EPS) based on generally accepted accounting principles (GAAP) increased 26% year over year to $0.39. On an adjusted basis, earnings per share also increased 26% year-over-year to $0.43, above the high end of the adjusted EPS forecast of $0.39.

The company even raised its full-year 2024 outlook. The company now expects revenue in the range of $5.745 billion to $5.845 billion (previously forecast at $5.715 billion to $5.815 billion three months ago), representing growth of slightly means more than 9% over the course of 2023. Adjusted earnings per share guidance was also raised to a range of $1.73 to $1.79 (previously $1.65 to $1.70), implying growth of 8% at the midpoint.

Free cash flow (FCF) fell slightly to $609 million from $647 million a year ago. Interestingly, there were no buybacks this quarter. Is Fortinet preparing for a big move? Or just retooling to launch new products? In any case, on balance there was a big increase in liquidity: cash and short-term investments now amounted to up to $3 billion, compared to long-term debt of just $993 million.

So far, so good, so why the market’s fear? As mentioned last quarter (and the last few quarters before that), Fortinet’s billings are a concern for investors. Billings are invoiced amounts that customers owe. For a technology company, especially one like Fortinet that has been focusing on more software business for several years, billings can be an important indicator of future growth.

For full-year 2024, billing expectations were left unchanged at $6.4 billion to $6.6 billion. Billings totaled $6.4 billion in 2023, so it appears that Fortinet’s long-term trajectory is seriously losing steam.

Retool to meet new cybersecurity requirements

As mentioned at the beginning, Fortinet is historically a hardware-based network security provider. Its expansion has been tied to sales of firewall network security devices, and like any hardware sales, growth can come and go in waves. After a massive growth cycle during the pandemic, Fortinet’s hardware sales are now in a downward cycle. Product sales fell 18% year-over-year to $409 million in the first quarter.

But these days, Fortinet’s recurring services business (fueled by a growing software portfolio) is growing rapidly. This segment increased 24% year over year to $944 million. Most of this software expansion was completely in-house development of services Palo Alto Networks‘ (PANW 0.61%) strong acquisition strategy in recent years.

This unified operating system alone does not solve some problems such as customer data and operational silos that may leave parts of the business unprotected. This is increasingly the case as companies adopt a “hybrid cloud” strategy, where parts of their business remain in more traditional IT (on-premise, like computers and servers in an office) and other parts are migrated to the cloud (either Private). or public data center accessed via a network connection or the Internet).

To solve this problem, newer products like Secure Access Service Edge (SASE) come into play. Palo Alto Networks is considered a leader in SASE, and newer cloud-based companies like it Zscaler (ZS 1.55%) have all developed cloud-based alternatives called SSE (Secure Service Edge, a subset of a full SASE solution). However, co-founder and CEO Ken Xie said on the first-quarter earnings call that Fortinet could have a long-term advantage over competitors, including having the same operating system for its new service as its older ones and the flexibility in how customers use the SASE security service deploy (it can be in the cloud or on-premises) and the ability to cover multiple computing endpoints with a single software deployment.

To put it simply, billings are down for a variety of reasons, all related to Fortinet’s development of this new SASE and other cybersecurity services. That sacrifices some growth this year, but Xie and the top team still expect expansion to accelerate again in the second half of 2024.

Fortinet could be cooking up great things

There’s no denying that Fortinet isn’t a “cheap” stock. Shares currently trade at 38 times trailing 12-month GAAP EPS or 27 times trailing 12-month free cash flow. This premium price is why the stock has been so volatile in recent years.

However, the true value lies not in past financials, but in expectations for the future. If Fortinet comes out of this current downturn and delivers strong returns on its current investments (like the new SASE service) as it has in the past, this could actually be a solid long-term bet.

Data from YCharts.

I already have a full position in the stock, as Fortinet has been a core cybersecurity holding in my portfolio for years (along with Palo Alto Networks). That’s why I’m not buying any more at the moment. But given the track record, I’m also more than happy to hold off and wait for growth to resume.