Much anticipated second-quarter earnings -- which include the worst of the economic lockdown to attempt to halt the spread of COVID-19 -- are rolling in at a torrid pace. And early results are, not surprisingly, better for digital-based businesses, as the crisis of the last few months is rendering older operations redundant.
But the pace of tech companies handing in report cards to shareholders will pick up pace in August. Three software stocks I'm watching closely are Fortinet (FTNT 0.43%), Twilio (TWLO 1.61%), and Zoom Video Communications (ZM 1.27%).
A rapidly evolving landscape for work
Cybersecurity is a tough segment of the tech sector to invest in. Plenty of promising stocks have gotten off to a hot start, only to later struggle as technologies evolve and security needs quickly pivot. Where some firms have gone wrong is lack of speed in picking up on new security risks, or lacking the financial flexibility to capitalize on them when they emerge.
But one firm has done exceptionally well. Fortinet has been around since 2000 and became a public stock in 2009, making it a "legacy" security outfit that got its start selling firewalls (traditionally, hardware used to create a perimeter around a piece of real estate from which an organization operates). But Fortinet shares have risen consistently since then, and are up nearly 1,600% since IPO. In spite of massive changes -- including the migration to the cloud that makes traditional firewalls irrelevant, the need for AI and security automation to help strapped IT teams keep up, and, more recently, COVID-19, which has dispersed the global workforce and brought on a new work-from-home movement -- Fortinet has been able to adapt.
In fact, while other legacy firms' growth trajectories have slowed or even begun to contract in recent years at the expense of new cloud-native upstarts, Fortinet's pace has picked up a bit. First-quarter 2020 revenue increased 22%, up from 20% in 2019. The secret is that Fortinet has been disciplined with its spending and maintained positive operating profit margins while investing in new in-house product and service development. That's in stark contrast with other firms that have blown money on expensive sales and marketing campaigns and mega-acquisitions that haven't panned out over the long term.
In the last year, Fortinet has made a handful of very small acquisitions to supplement its efforts, but the emphasis is on the "very small" part of that sentence. It continues to make a graceful transition into the cloud and related security service era. The company finished March with $1.4 billion in cash and equivalents and zero debt, currently has a market cap of $22.5 billion, and trades for 29.8 times trailing 12-month free cash flow (revenue less cash operating and capital expenses). Fortinet reports earnings on Aug. 6, but barring some unforeseen occurrence, this will remain one of my favorite cybersecurity stocks.
Meeting the demands of the 21st-century consumer
Unified digital communications technologist Twilio (TWLO 1.61%) is one hot stock this year. Shares are up a whopping 184% 2020 to-date as of this writing. Stellar first-quarter results are part of the reason. Active customers increased 23% from a year ago and surpassed 190,000, and existing customers spent an average of 35% more with Twilio when excluding the company's takeover of SendGrid in early 2019. As a result, total revenue surged 57% higher, with no less than 33% growth forecast for Q2 (which will be reported on Aug. 4).
But that alone doesn't explain the massive upside the stock has experienced. Twilio's market cap is now over $39 billion, valuing it at more than 20 times expected one-year forward sales -- all for a company that has run at negative $35.5 million free cash flow in the last year. The reason is Twilio's business model. The company operates a cloud-based portfolio of integratable software algorithms that allows developers to integrate digital communications into applications. With much of the world getting locked down at some point in recent months and organizations scrambling to put together continuity plans, digital communications are more important than ever before.
Specifically, Twilio's software can help a company build video, voice, text, email, and chat capabilities into their existing operations, or build entirely new applications from the ground up. The company's customer list is impressive, including Airbnb, Lyft (LYFT 4.73%), and salesforce.com (CRM 1.76%), to name just a few. There is a lot up in the air at the moment given the current state of world affairs, but spending on customer experience management tools could grow an average of 18% a year for the better part of the next decade according to some researchers, surpassing $23 billion in annual spend in 2027.
In the driver's seat of (and largely responsible for starting) this movement, Twilio's opportunity is thus quite large. There was $1.84 billion in cash and equivalents and $464 million in convertible debt on the books at the end of Q1. This is another stock to watch closely leading up to and following the next quarterly update.
Voice is dead, long live video
If you had never heard of Zoom prior to the pandemic, you almost certainly have now. It and other web-based video conferencing tools have been a part of the business world for years, but demand for video communications has boomed in recent months. While the phone certainly isn't going anywhere -- nor will travel once social distancing begins to ease -- video as a means to stay in touch looks poised to stick in a post-COVID-19 world.
Zoom's goal is nothing short of that. In fact, the company's mission is to make "Zoom meetings better than in-person meetings." While that may sound ridiculous if you're anxious to go visit family and friends, it may not be ridiculous for a business, school, or some other organization where meetings with others happen out of necessity rather than for pleasure. It may turn out that in-person meetings and all the travel in cars, trains, and planes to facilitate them may have been excessive -- given that Zoom's technology now exists. With the aim of tightening up the budget or to free up cash for better return on investment projects, Zooming could be part of the new normal.
Of course, this isn't news to anyone, and the stock price's more than 270% return this year alone indicates that more than a few people have caught on to the video software company as an investment. And for good reason. Revenue was up 169% from a year ago in Q1, with as much as 190% growth forecast for the full-year period. Even when factoring for an incredible run in 2020, shares trade for a very hefty 31.6 times expected sales.
But though free cash flow margin of $252 million (good for a margin of 77%!) to kick off the year will certainly moderate, this is a highly profitable enterprise that's well-funded to disrupt the way people meet together. Zoom had $1.1 billion in cash and equivalents on the books at the end of March and zero debt. When the company reports in late August or early September, massive growth is already a given. But seeing where Zoom decides to take its incredible momentum will be an intriguing story to follow.