Make no mistake, cybersecurity is a secular growth trend. As computing technology deepens its roots in the global economy, businesses have new opportunities ahead of them -- but they're simultaneously faced with new dangers too. The pandemic accelerated reliance on digital processes, which has in turn boosted demand for cybersecurity.
But that hasn't equated to shareholder gains. Take Fortinet (FTNT 0.23%), for example. It's the second-largest cybersecurity pure-play stock (as measured by revenue, behind only Palo Alto Networks), and shares are down 30% so far in 2022 as the bear market rages on. Business itself is booming, though. Is this a once-in-a-decade buying opportunity for this long-term growth story?
Q3 was good, but it's all about the guidance
Fortinet's third-quarter revenue increased nearly 33% year over year to $1.15 billion -- driven by a 39% increase in product sales ($469 million) and a 28% increase in services ($681 million). Earnings per share jumped 65% to $0.33, and free cash flow was up 20% to $395 million (for a very healthy free-cash-flow margin of 34%).
Why is the market so down on Fortinet? Just like last quarter, free-cash-flow growth came in a bit light. That's a function of Fortinet's spending this year on research and development, as well as a sizable expansion of its sales and marketing team. The company sees big opportunities ahead of it (more on that in a moment), so it's keeping the foot on the gas to hold onto some of its momentum. With global economic conditions worsening, that's making some investors a bit nervous.
It isn't just the third-quarter free cash flow that's a problem for the market, though. After two years of accelerating growth in Fortinet's hardware sales, CFO Keith Jensen said on the earnings call the company is "seeing early signs of a transition back to more normalized customer buying behaviors."
What does that mean? Well, back in 2019 before the pandemic, revenue for Fortinet's product and services segments increased a respective 17% and 21%. While that's respectable, it's far lower than the full-year 2022 outlook for revenue to increase about 33% from 2021 (at the midpoint of guidance). If customer buying "normalizes" to a pre-pandemic pace, Fortinet is poised for a big deceleration in the next few years.
Buy Fortinet for the long haul
Worries aside, there is still plenty to like about Fortinet at this juncture. The company benefits from a type of cybersecurity flywheel effect. Once Fortinet's security equipment is installed, customers usually begin to pay for ongoing software and services attached to the hard asset. That means Fortinet's rapid rise in product sales this year should lead to a nice tail of service sales growth in the next few years -- even as product sales ease up.
Additionally, Fortinet has been investing heavily into new services in areas like employee endpoint protection (a must-have for remote workers) and providing various network security technologies from a single platform (from mobile 5G network operators to more traditional networks). CEO Ken Xie said this has led to expanding relationships with existing customers, especially as larger organizations look for more simplicity by consolidating the number of security vendors they use.
With that as the backdrop, Fortinet doesn't see a slowing economy -- perhaps even a recession -- as a significant risk to the medium-term guidance it laid out in May 2022. Specifically, management expects to reach $8 billion in revenue by 2025 (which would work out to a 22% average annual growth rate from today), and a 2025 free-cash-flow margin roughly in line with where it is now. Additionally, Fortinet has returned $2.56 billion to shareholders over the last 12-month stretch via share repurchases. Balancing profitable growth with shareholder returns will remain the focus going forward.
Fortinet stock now trades for 43 times expected 2022 adjusted earnings, or 35 times trailing-12-month free cash flow. With growth still going strong and a possible rebound in profitability in store next year as Fortinet's heavy rate of investment spending eases, it isn't an unreasonable price tag. The stock's fall this year doesn't exactly spell once-in-a-decade opportunity. However, if Fortinet achieves its goals, this remains a top buy among cybersecurity stocks in my book.
