Fortinet (FTNT -1.22%) stock is rocking and rolling again after its fourth-quarter 2022 earnings update. This top cybersecurity pure play not only put the icing on a great couple of years, it also added to shareholder optimism that it can achieve the lofty goals it set for itself at an investor event a few months ago. With shares quickly climbing back toward their all-time highs from nearly a year ago, is Fortinet still a buy?  

Where high-performance networking and cybersecurity meet

Fortinet has been handily beating the overall market for years, and longtime shareholders know the secret sauce is the company's custom hardware. As the company pointed out during its investor presentation in December 2022, its proprietary chip technology (the security processing unit, or SPU) is best-in-breed. It's a big reason Fortinet wins business, as it helps its customers embed security solutions directly into their network infrastructure.

This competitive strength was on financial display in Q4 2022. Management reported total revenue increased 33% year over year to $1.28 billion, including a 43% year-over-year increase in product sales (networking hardware featuring those Fortinet chips) to $540 million. It caps off an epic year of growth. Total 2022 revenue was up 32% to $4.42 billion (including $1.78 billion in product, a 42% increase). This builds on what was also a stellar 2021, when total revenue grew 29%.

Fortinet's profitability was even better in the Q4 report card. Its operating margin rallied in the final months of the year to 27.9%, under generally accepted accounting principles (GAAP), bringing the full-year total to 21.9% -- much of that due to the higher pace of hardware sales (more on that momentarily). Resulting free cash flow also rallied in Q4 to $497 million (a hefty margin of 39%), bringing the full-year free-cash-flow total to $1.45 billion.  

Highly profitable services on the way

On to guidance. Fortinet said to expect first-quarter 2023 revenue to be in the range of $1.18 billion to $1.22 billion, a 26% year-over-year increase at the midpoint of the outlook. And for the full-year 2023 period, revenue is expected to be in the range of $5.37 billion to $5.43 billion, a 22% year-over-year increase. Of the total sales estimate, management said to expect services revenue to be around $3.35 billion, up 27% compared to 2022. This is important news, and a significant development that confirms what savvy investors have been expecting from Fortinet.

You see, the journey doesn't end after Fortinet sells its physical products that get embedded into a customer's network. Once up and running, that customer then turns on recurring software and services that are sold as a package with the security hardware. The result is an ongoing stream of service revenue for Fortinet that can generate highly profitable returns (typically far higher profit than the product sale) for the company for years to come.

It also makes for a very sticky relationship. Many cybersecurity upstart companies (most of which address problems with the modern cloud) are software only. There are often low switching costs associated with those types of services. But a company like Fortinet, with products embedded into the very fabric of a customer's IT infrastructure? That's significantly harder to uproot. 

Additionally, Fortinet has done a great job over the years developing new cloud-based services as an add-on to (or integrated with) its hardware-based offerings. With a large installed base in existence, it gives the company the opportunity to go out and cross-sell more services as their customers need -- further enhancing Fortinet's chance to expand profitably. 

With a big and expanding backlog of business, Fortinet's exact report was fantastic news for this cybersecurity leader. Shares now trade for 32 times 2022 free cash flow, a premium price tag. However, if Fortinet meets its goals for double-digit revenue growth, maintains its high profit margin, and continues to repurchase lots of stock (it repurchased $1.99 billion in 2022) over the next few years, it's certainly not an unreasonable price. I remain a buyer here.

© 2023 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

© 2023 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

Investment Thesis

Fortinet (NASDAQ:FTNT) has a less-than-straightforward story. Its business makes the bulk of its revenues from its Product segment. Something that the Street has generally been skeptical of.

But what Fortinet has excelled in, is in delivering high ROI to its customers, through its low cost-for-performance hardware. Consequently, this has allowed Fortinet to print free cash flow.

Indeed, this quarter we saw Fortinet's free cash flow jump 48% y/y. Reminding investors that there's much to like here, so let's get to it.

Fortinet's Near-Term Prospects

Fortinet continues to push forward with its Service segment. Even though the Service segment ever-so-slightly decelerated sequentially from 28% y/y CAGR to 27% y/y CAGR, these figures are quite compelling.

Particularly given that Microsoft's Azure (MSFT) and Amazon's AWS (AMZN) have both had their earnings results and the figures show that cloud enterprise spending is coming down.

However, the big theme for 2023, I suspect, will be around AI. Being a cybersecurity vendor for AI platforms could be a meaningful tailwind for cybersecurity companies.

That being said, the one aspect that has held back Fortinet in the eyes of investors has been the fact that the majority of its revenues come from its Product business. But this may be less bad than it sounds. Here's why.

Given the industry trend towards ''renting'' software services, investors have generally been skeptical of Fortinet's long-term prospects. Given that point of view, Fortinet used their earnings call to highlight that:

[...] a exact Forrester report highlighted that customers deploying Fortinet Secure SD-WAN solutions achieved a 300% return on investment over three years with a payback period of only eight months.

In sum, the story isn't over for Fortinet. Now, let's dig into its financials.

Revenue Growth Rates Are Fair

Fortinet's guidance for the year ahead isn't all that impressive. But what it does show is that there's ''at least'' 22% top line, if we assume that management is lowballing estimates, to leave room to positively impress investors over the coming quarters.

What's more, given that its billings for Q1 2023 are at 26% y/y and higher than the revenue growth rate guidance for Q1 reinforces the overall image that Fortinet's pipeline of future revenues to be ''recognized'' is healthy.

What's more, Fortinet once again reiterated that it believes it can continue to grow its operations to $8 billion in revenues by 2025. This would imply that investors getting involved today would be getting the ''reassurance'' that Fortinet can put out a 22% CAGR over the next two years.

What's more, given that Fortinet has been unwavering in its outlook for some time now, combined with its near-term guidance being compelling, certainly gives credence to its multi-year outlook.

Next, we'll turn our focus to what's arguably the best reason to own Fortinet.

Fortinet's Bull Case Laid Out

Remember 2020? A period when it was ''uncool'' to be profitable? Throughout that period, Fortinet had one of the weakest performances amongst its cybersecurity peers.

Nevertheless, Fortinet continued to plow forward and lay down the work then, to literally ooze free cash flow now.

Accordingly, Fortinet's guidance for 2025 points to somewhere in the ballpark of $3 billion of free cash flow. For a cybersecurity business that's priced at approximately 15x 2-years forward free cash flows, this is really an attractive valuation.

Given the value of its shares, Fortinet has steadily and consistently repurchased its own shares. But here comes the most shocking aspect! Check out the red arrow below.

This is a rare breed of tech companies where repurchasing shares after stock-based compensation actually brings down the total number of shares outstanding.

That being said, it should be noted that looking ahead to 2023, the total number of shares is estimated to trickle higher by approximately 1%, reversing some of the progress of 2022.

The Bottom Line

The message coming out of Fortinet this quarter is about setting the record straight.

What customers actually want in this environment is savings. The time when enterprises were willing to spend beyond the budget to be safe online may be taking a breather after 2020-2021 saw a very strong pull forward in demand.

In sum, paying around 15x Fortinet's 2025 free cash flows is a compelling investment.

Investment Thesis

Fortinet, Inc. (NASDAQ:FTNT) is a U.S.-based cybersecurity company founded by Xie Jing back in 2000. The company has been one of the best compounders in the past decade, with the stock up over 1,000% during the period. The share price has also been holding up well despite the broad market selloff.

Cybersecurity has a massive TAM (total addressable market) and continues to benefit from secular tailwinds. It is one of the most resilient industries that capture non-discretional spending. The company is also expanding its TAM by entering other verticals, which should open up more growth opportunities moving forward. Some investors are skeptical about the company's prospects, as it generates a large portion of revenue from on-premise products, but the segment continues to grow rapidly despite the shift to cloud security. This is reflected in its latest fourth quarter earnings reported yesterday with upbeat product growth and profitability. The current valuation also isn't too expensive on a historical basis, especially when considering the growth it is showing. Therefore I rate Fortinet, Inc. as a buy.

Huge Market Opportunity

Cybersecurity is a massive and fast-growing market. According to Grand View Research, the TAM for the industry is $222.66 billion in 2023 and is forecasted to grow to $500.7 billion in 2030, representing a CAGR (compounded annual growth rate) of 12.3%. Fortinet estimates its own TAM to be $153 billion in 2023, and it should grow at a CAGR of 10% to $199 billion in 2026. While network security often seemed to be overlooked due to the shift to cloud, it actually accounts for $22.5 billion of the TAM. although it is growing at a slower rate. The company's expansion into new markets like cloud security and zero trust also added nearly $40 billion in TAM, and these segments are also growing much faster. Fortinet's current penetration rate is only around 2.4% despite being such a large company.

The industry is growing quickly due to digital transformation and IoT (internet of things). The penetration rate of the internet and cloud has increased significantly in the past few years which also increased the number of cyberattacks. This vastly increased the demand for more sophisticated cybersecurity solutions as the cost of cyberattacks is huge, especially for big firms. While cloud security benefits from workloads shifting to the cloud, network security is also relevant as many companies are adopting a hybrid approach. Companies still need firewalls and the company dominates in this space. The industry is also seeing a consolidation in vendors as customers want to reduce complexity. This benefits larger vendors like Fortinet as it has a broad product portfolio that addresses different areas.

Keith Jensen, CFO, on vendor consolidation:

There's been an explosion of devices that must be connected to the cloud, data center and edge compute. As a result, the infrastructure has expanded to support secure connectivity via distributed firewalls, it is no longer feasible to overlay security on top of networking in the data center. They must be deployed as a converged solution. Firewalls need to work seamlessly with networking and security applications across the company's entire infrastructure. Fortinet is leading the convergence trend with a wide range of technologies, including network firewalls, Secure SD-WAN, 5G and OT security, all embedded in our single operating system delivered as hardware, software, cloud and as a service.

Q4 Earnings

Fortinet just reported Q4 earnings, and I think the results are very strong considering the macro environment, especially product revenue and the bottom line. The company reported revenue of $1.28 billion, up 33.1% YoY (year-over-year) compared to $963.6 million. The growth is mainly driven by product revenue, which increased 42.5% from $378.9 million to $540.1 million, now accounting for 42.2% of total revenue. During the year, it added over 23,000 new customers for its firewall products. Service revenue grew 27.1% YoY from $584.7 million to $742.9 million, driven by the increase in security subscriptions. Billings for the quarter was $1.72 billion, up 31.6% YoY. Gross profit was $985.7 million compared to $735.3 million with the gross margin flat YoY.

Ken Xie, CEO, on FY22 results:

For the full-year, revenue growth accelerated to 33%. We continue to gain market share in the service security industry with customers increasingly recognizing how Fortinet integrate and a single platform approach to security delivers along total cost of ownership and a greater return on investment than competing solutions.

The bottom line is extremely impressive as the company continues to show strong operating leverage. Despite revenue up over 33%, operating expenses only increased by 20.7% to $627.9 million. This is mostly contributed by S&M (sales and marketing) expenses which grew 24% YoY from $367.7 million to $455.9 million. The discipline in operation spending resulted in operating income increasing over 66.5% YoY from $214.9 million to $357.8 million. Operating margins also improved significantly from 28.5% to 32.5%. EPS for the quarter was $0.40 compared to $0.24, or a 67% increase YoY. It guided revenue for FY23 to be $5.37 billion to $5.43 billion vs $5.35B consensus, representing a solid growth of 22% at the midpoint. The company ended the quarter with only $990 million in debt and $1.68 billion in cash, with provide ample financial flexibility for investments or further share repurchases.

Investors Takeaway

Fortinet, Inc.'s Q4 earnings once again demonstrated why it is one of the best cybersecurity companies in the world. Despite investors' pessimistic view of the product segment, Fortinet still managed to grow product revenue by a whopping 42.5% and added over 6,200 new logos during the quarter. Its strong reputation also helps minimize the S&M spending needed, which resulted in an exponential increase in operating income and EPS.

Considering the huge TAM and its low penetration rate, I believe Fortinet, Inc. can continue to put up consistent growth over the long run, not to mention its opportunities in newer and emerging segments. The current valuation is also not really expensive by historical standards. Fortinet is trading at a fwd price-to-FCF ratio of 23.92x which I believe is very fair, considering its strong growth rates. This is slightly lower than its 5-year historical average of 24.17x. As Fortinet, Inc. continues to scale, the ratio should go down pretty quickly, given the strong operating leverage it has. Therefore, I rate Fortinet, Inc. as a buy.