Shares of Fortinet (NASDAQ:FTNT) recently dipped after the company released its third quarter report, even though the cybersecurity firm's numbers easily beat analyst expectations. Fortinet's revenue rose 21% annually to $454 million, beating estimates by about $3 million and marking its strongest growth in seven quarters.

Its non-GAAP net income surged 71% to $86.7 million, or $0.49 per share, which cleared expectations by seven cents. On a GAAP basis, its net income more than doubled to $58.7 million. Fortinet's growth was notably boosted by its acquisitions of Bradford Networks and ZoneFox this year.

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Fortinet's guidance also looked solid. It expects its revenue to rise 18%-20% annually during the fourth quarter and about 20% for the full year. On the bottom line, it expects its non-GAAP earnings to grow 56%-62% for the fourth quarter and 65%-69% for the full year. All of those figures matched analysts' expectations.

Fortinet's stock slightly rebounded after its post-earnings drop, but the stock remains roughly 20% below its 52-week high. Let's dig deeper into Fortinet's third quarter numbers to see if its stock can recover.

Gauging Fortinet's key growth metrics

During the quarter, Fortinet's service revenue rose 22% annually to $289 million, and its product revenue rose 20% to $165 million (or 18% excluding a $2 million benefit from a recent accounting change). Its total billings grew 22% to $528 million as its deferred revenue -- a key indicator of forward demand -- climbed 27% to $1.54 billion. Both figures compare favorably to its growth in previous quarters.

 

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Total billings

15%

15%

20%

22%

Deferred revenue

29%

27%

27%

27%

YOY growth. Source: Fortinet quarterly reports.

Fortinet expects its billings to rise 16%-19% annually during the fourth quarter. It attributes that ongoing growth to the expansion of its Security Fabric Platform, which bundles together several security products (including its flagship next-gen firewall) into a single service.

That platform received a "recommended" rating in nine out of nine NSS Lab categories, which was more than double the number of recommendations for any of its competitors. Gartner also listed Fortinet's Fabric Platform in seven of its Magic Quadrant listings over the past 12 months. That "best in breed" reputation helps Fortinet stand out in the crowded cybersecurity market.

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Expanding margins and steady earnings growth

Fortinet's gross margin rose 50 basis points to 76.5% during the quarter as its expanding service margins offset its declining product margins. Its non-GAAP operating margin rose five percentage points annually to 24%.

Its GAAP operating margin -- which includes its stock-based compensation (SBC) expenses (10% of its revenues) -- also expanded five percentage points to 14%. Fortinet expects its GAAP operating margin to hit 25% by 2022. That margin expansion boosted its free cash flow 13% annually to $159 million during the quarter.

This puts Fortinet on much firmer ground than its next-gen firewall rival Palo Alto Networks (NYSE:PANW), which spent nearly 20% of its revenue on SBC expenses last quarter and remains unprofitable on a GAAP basis.

Analysts expect Fortinet's revenue and non-GAAP earnings to rise 15% and 14% next year (which starts on Jan. 1), respectively, as it laps its acquisitions from 2018. That growth looks less impressive than Palo Alto's forecasts for 22% revenue growth and 26% non-GAAP earnings growth this fiscal year (which started on Aug. 1), but Fortinet arguably has a more stable business model.

But mind the valuation

Fortinet generates steady growth with stable profits, which is rare in an industry filled with companies operating with net losses. However, Fortinet's stock has nearly doubled over the past 12 months, and it isn't cheap at 37 times forward earnings. Therefore I might nibble on Fortinet at these levels, but I'd wait for a pullback before building a bigger position.

Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends Fortinet, Gartner, and Palo Alto Networks. The Motley Fool has a disclosure policy.