Fortinet: Profiting From Protecting the Internet

The cybersecurity industry is big - and growing. That won't surprise anyone who's been online and discovered a multitude of bad actors trying to steal everything from their reputations to their bank accounts.

Fortinet Inc. (NASDAQ:FTNT) is among the companies that benefit from the desire for protection from hackers. It has a market cap of nearly $21 billion and is one of the leaders in the industry. It operates through four segments:

• Network Security: Hardware and software under its FortiGate brand name; components include firewalls, SSL (secure socket layer), virtual private networks and switches.
• Infrastructure Security: Its Forinet Security Fabric is a "broad, automated and integrated security platform that extends beyond the network to cover other attack vectors."
• Cloud Security: Provides the same level of cybersecurity and threat intelligence in cloud environments as in physical networks. Its products can be used on all major cloud platforms, including those of Amazon.com (NASDAQ:AMZN), Microsoft (MSFT) and Google (NASDAQ:GOOG).
• Endpoint Protection, Internet of Things and Operational Technology Security: Protects end-customers from advanced threats against devices and data.

• FTNT 30-Year Financial Data
• The intrinsic value of FTNT
• Peter Lynch Chart of FTNT

Fortinet also faces formidable competition from companies such as Check Point Software Technologies (NASDAQ:CHKP), Cisco Systems (NASDAQ:CSCO), F5 Networks (NASDAQ:FFIV) and Palo Alto Networks (NYSE:PANW).

Still, it is well-positioned to compete, in my view. It has no debt, and at the end of the second quarter, it had cash, cash equivalents and marketable securities of just over $1.5 billion. What's more, its share price has risen dramatically over the past five years, so it has the market's confidence:

For a more complete picture of Fortinet's fundamentals, we will review its financial strength, profitability, valuation and dividend situation.

Financial strength

There's a lot to like and little to dislike on this table. No debt, as we've previously noted, and that helps pave the way to good showings for the Altman Z-Score and Piotroski F-Score.

The only area where we see any red is in the equity-to-asset ratio. It is calculated by dividing shareholders' tangible equity by its total assets. In some industries, this ratio helps investors determine how much debt the company is using. However, Fortinet has no debt. In addition, many companies in technology have little tangible equity, but a lot of intangible equity. That's intangible equity in the sense of proprietary research, patents, or processes. Most tech companies need little in the way of buildings, plants or other physical resources. All things considered, we should simply ignore the equity-to-asset ratio for tech stocks in general.

A final note to take from the financial strength table is that the return on invested capital (ROIC) is 17.43%, which is greater than the weighted average cost of capital (WACC) at 6.73%. This signifies the company is a value creator for shareholders.

Profitability

Again, and as we might expect from a firm with a 9 out of 10 rating for profitability, there is nothing to dislike on this table, except perhaps that its return on capital (based on Joel Greenblatt's calculation) is lower than its own historical average.

Take particular note of the three growth lines at the bottom of the table. Fortinet's revenue grew an average of 19.4% per year over the past three years, but even that achievement is overshadowed by the increases in the average Ebitda and earnings per share without non-recurring items. Profit is growing faster than revenue, which means the company is becoming more efficient.

Valuation

When companies are growing this fast, we generally expect to pay a premium for their shares. Thus, it is no surprise that Fortinet is rated as modestly overvalued by the GuruFocus Value chart. However, the PEG ratio, which values earnings per share in relation to the growth of Ebitda, comes in a 1.15, which is just above the fair value point of 1.0.

The price-earnings ratio itself is sending mixed messages. It is overvalued in comparison with the software industry median of 31.42, but also below its own 10-year median of 69.27.

We might turn to the discounted cash flow (DCF) calculator as a tie-breaker since it is based on a 3.5 out of 5 predictability rating. However, its conclusion doesn't make sense to me given the below assumptions:

Here's the problem: the settings I used for the DCF calculator (10-year growth rate of 9.8% and 4% growth rate at the terminal stage) give Fortinet a fair or intrinsic value rating of $34.95, based on a growth value of $21.55 and a terminal value of $13.39 (rounding accounts for the penny difference). The latter appears low, given the company had cash-per-share of $12.03 at the end of 2019, and it is earning more from its invested capital than it pays and enjoys robust margins. Perhaps the results would match my expectations better using higher growth rates.

The DCF suggests significant overvaluation, the GuruFocus Value calculator finds modest overvaluation, the price-earnings ratio suggests modest overvaluation and the PEG ratio indicates fair value or slight overvaluation. With those assessments in mind, let's look at the five-year price chart again:

We see a share price that is between its recent highs and lows, with a noticeable lean to the high side. Based on that, we might argue it is modestly overvalued. Alternatively, since it is right on the price trendline, perhaps we should argue it is fairly valued. I think I'll stay with modestly overvalued.

Dividend and share buybacks

As the chart above suggests, Fortinet isn't yet ready to share much of its earnings with shareholders, through either dividends or share buybacks. However, investors who pursue capital gains will like it without any extras.

The company has decided to keep focusing on growth instead of paying a dividend, and it has a lot of free cash flow to work with:

Gurus

Until recently, gurus had confidence and were strong net buyers of Fortinet shares:

The three gurus who had the largest holdings all reduced them in the second quarter of this year:

• Jim Simons (Trades, Portfolio) of Renaissance Technologies reduced his stake by 1.5%, leaving him with 5,973,687 shares, representing a 3.69% share of the company's shares outstanding.
• Pioneer Investments (Trades, Portfolio) reduced its share count by 55.76% to 304,827 shares.
• Lee Ainslie (Trades, Portfolio) of Maverick Capital cut his position by even more, 72.19%, to 48,373 shares.

Conclusion

Fortinet Inc. is debt-free, has a rapidly-growing top line and even faster-growing profitability. Why wouldn't all investors rush out and buy it?

I think growth investors could put this stock on their shortlists; it has delivered big capital gains since 2016 and odds are management will continue to generate them.

Value investors might keep this name on their wish lists; if the share price drops enough to provide a reasonable margin of safety, this could be attractive since it has no debt.

Disclosure: I do not own shares in any of the companies named in this article.

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