Fortinet's Secret Recipe to Try and Beat the Market in 2023

The cybersecurity market has reached a new level of importance the last few years. Secular trends were already pushing many organizations into cloud computing, but the pandemic lit a real fire under those that have been slow to adopt the next-gen IT infrastructure. Cloud services, and the mobile computing they help power, are booming. All of this necessitates a new type of cybersecurity service. 

In spite of all this growth, it would appear cybersecurity businesses had a terrible year. They didn't, but share prices tumbled anyway thanks to the bear market of 2022. Fortinet (FTNT 0.28%) was no exception.

However, the second-largest security software company (behind Palo Alto Networks) remains a market-trouncing stock since its 2009 IPO, and management has plans in place that could keep that trend going in 2023 and beyond.

Fortinet's secret recipe for cybersecurity industry success

In a recent investor presentation, Fortinet outlined the strengths of its business model it has been building in recent years. Fortinet is not a new player in cybersecurity. It was born in an era that predates the cloud, when simply securing a physical location with a device called a firewall was sufficient.

Fortinet still designs firewalls. In fact, it custom-designs its own chips for these firewalls and other security appliances, which it calls Security Processors (SPUs). These SPUs are best-in-class chips that greatly outperform others in the industry in processing speed and energy consumption.

But why would chips custom-designed for security be a differentiator? It has given Fortinet the ability to carve out a niche for itself in the security industry, focusing on various network operators (data centers used for the cloud, on-premises networks for businesses, mobile operators) with its hardware that converges actual data network hardware with security. This makes for a more holistic cybersecurity approach, where a company building a network can embed the security directly into the mix, versus bolting on a security appliance after the fact.

From there, Fortinet has been building a variety of security software services atop its hardware. This software suite is called FortiOS, a type of security "operating system" that can be used for a variety of purposes and to protect a network from all sorts of attack vectors (from an attack on the network hardware itself to an attack on end users accessing a system from their personal device). Fortinet's combined SPUs and FortiOS are frequently ranked as leaders in the cybersecurity industry by tech researchers like Gartner and Forrester Research.

Fortinet's system equates to financial excellence

All of Fortinet's security tech is well and good, but how will it equate to market-beating returns? Well, it has been working out well so far. Since 2009, Fortinet has been averaging well over 20% revenue growth each year, with adjusted operating profit margins in the mid-20% range. The result has been a near-3,000% stock price return since Fortinet became a public company.

Management believes it can continue this stellar financial performance for the next few years. With the pandemic accelerating the move to the cloud, Fortinet has enjoyed an acceleration in product sales (its SPU-powered firewalls and other security appliances). Product sales were up nearly 42% year over year through the first nine months of 2022.  

The real beauty of Fortinet's model, though, is that once it lands a product sale and the security hardware is installed, the customer later turns on the software service -- which creates a long tail of recurring service revenue. In other words, a flurry of infrastructure build-out the last couple of years will lead to double-digit software revenue growth, which is highly profitable.

From 2022 through 2025, Fortinet expects to generate an average of 22% revenue growth, all the while maintaining an average adjusted operating margin of over 25%.

Fortinet has been using ample amounts of profit to repurchase stock, which boosts earnings per share and over time can help lift a stock price higher. Through the first nine months of 2022, Fortinet repurchased $1.99 billion worth of its own shares, or about 5% of the current market cap (if you're looking for an equivalent to a dividend yield).

Will strong growth and high profits help Fortinet beat the market in 2023? It didn't work so well in 2022. Shares are down 30% on the year with just a few days to go. It's close to impossible to predict how the market will react in the short term, but if Fortinet can continue to execute on its growth strategy, eventually investors will reap the rewards of this leading cybersecurity company's efforts. Fortinet has been a market-beating stock for a reason, and it still has all the components necessary to keep beating the market going forward.