Cybersecurity pure-play leader Fortinet (FTNT 0.23%) got clobbered again after investors were disappointed with another quarterly financial update. The third quarter of 2023 was solid enough. However, the company's product growth (primarily firewalls for things like data centers and remote branch offices) is facing cyclical decline.
Is it time to buy, or is Fortinet stock now a falling knife too dangerous to try to catch?
Fortinet stepping away from its differentiated product, for now
There were two reasons for Fortinet's most recent stock collapse, which has now erased all gains made in 2023. First, management missed its own guidance for Q3 2023 billings (invoices sent to customers). Billings were $1.49 billion, versus the outlook three months ago for them to be $1.56 billion to $1.62 billion.
And second, at the midpoint of new guidance, billings are expected to close out 2023 down 5% from the $1.7 billion reported in Q4 of 2022.
What's happening? After all, cybersecurity is a booming industry. As more organizations migrate their IT over to the cloud, there is incredible demand for next-gen security that can keep data and apps safe.
Primarily, it's Fortinet's big chunk of business tied to product, again, primarily hardware-based firewalls that monitor traffic for a physical location. Product revenue accounted for 35% of the total in Q3. And unfortunately, sales declined 0.6% year over year. Given a deepening down cycle in data center and cloud infrastructure (many customers are doing belt-tightening this year, and reallocating budgets to AI infrastructure), it's no surprise Fortinet believes this segment will remain in a period of decline through the first half of 2024.
But Fortinet is making a pivot toward a new subscription product (services were the other 65% of revenue in Q3) to make up for the hardware downturn. Specifically, it's the SASE (secure access service edge) offering, which it announced a couple weeks prior to the earnings update that it was expanding, utilizing dozens of Alphabet's Google Cloud data centers to strengthen its "Universal SASE."
Fortinet revealed its SASE subscription already represented 20% of billings in Q3, and the company thinks it can grow this offering quickly in the coming quarters and years given the resilient demand for cloud-based security, despite the firewall hardware pullback.
Is this a buying opportunity?
The billings picture looks ugly, but Fortinet management thinks it can still be a single-digit-percentage revenue-growth business through at least Q2 2024. Beyond that, the top team hopes to be back in a mid- to high-teens percentage growth rate once again. And paired with its highly profitable core business, Fortinet believes it can sustain adjusted operating profit margins north of 25% along the way, which should equate to its prior long-term guidance for free-cash-flow profit margins of over 30%.
Data by YCharts.
Of course, I can understand why an investor might doubt this management confidence, given it just missed its guidance two quarters in a row. However, Fortinet would like to remind everyone it has done an exceptional job of clobbering the market since its initial public offering in 2009. That may count for something.
At any rate, it's now up to the top team at Fortinet to execute on this SASE product bridge while the hardware market stabilizes. I expect more turbulence going forward. However, I'm inclined to believe this is still a great business for those eyeing the potential of the cybersecurity market overall in the decade ahead, not a falling knife (at least not for forever).
Fortinet stock now trades for 35 times trailing-12-month earnings, or just 19 times free cash flow. It could be a reasonable value after the market has doled out some punishment, but tread cautiously.
