2023-04-12 14:11:04 ET
Summary
- Fortinet's unique ASIC chip technology and expansion into new use cases give it a competitive edge in the network security market.
- The company's single-vendor SASE strategy, with a focus on service providers and a wide range of use cases, sets it apart from competitors.
- Fortinet is well-positioned for future growth with a strategic approach to capital allocation and investment in emerging opportunities like OT security and cloud computing.
As we prepare for the upcoming Q1 earnings release, our in-depth analysis of Fortinet's ( FTNT ) growth prospects and the network security market reveals promising indicators for sustained growth. Contrary to concerns about the sustainability of the company's product revenue growth, we believe that the market is poised to grow at a much higher rate than some competitors suggest, between 10% and 20%. This growth is driven by the emergence of new use cases for network security, Fortinet's unique ASIC chip technology, and its ability to cater to previously underserved markets. In this article, we will explore Fortinet's competitive advantages, its strategies in SASE and SD-WAN, and the company's financial outlook.
Sustainability of Growth
Our analysis of Fortinet's growth prospects and the network security market reveals that concerns about the sustainability of the company's product revenue growth might be misplaced. While some competing vendors such as Palo Alto ( PANW ) suggest that market growth rates are in the low to mid-single digits, we believe that the market is poised to grow at a much higher rate, between 10% and 20%.
One reason behind our conviction in the higher growth rate is the emergence of numerous new use cases for network security, which traditional vendors are not adequately covering. We point to solutions such as SD-WAN and OT have contributed to over 25% of Fortinet's business in the past year. These new use cases, along with internal segmentation, cloud infrastructure traffic, and support for remote work, are expanding the overall market and driving demand.
A key advantage that Fortinet has over competitors is its unique ASIC chip technology, which enables the company to offer broader solutions at a lower cost and with better performance. Traditional network security vendors that rely on software solutions running on general-purpose CPUs struggle to cover the same range of use cases, particularly for small and medium-sized businesses and the operational technology (OT) space.
In the US, fewer than 20% of SMBs have any kind of network security coverage. Fortinet's solutions can cater to this underserved market segment, which is difficult for competitors relying on software solutions to penetrate. Similarly, the company's products can also provide comprehensive coverage for OT devices, which often face challenges when using software-based security solutions.
Given these factors, we believe that Fortinet's product revenue growth will continue to be robust, within the range of 10% to 20%. The company's innovative technology, ability to address new use cases, and penetration into previously underserved markets grant it a significant advantage over competitors. As a result, we remain confident in the growth prospects of both the network security market and Fortinet as a leading player in the space.
SASE
Our analysis of Fortinet's single vendor SASE (Secure Access Service Edge) strategy reveals that the company envisions SASE as a convergence of security and networking, with a broader and more distributed approach than its competitors. Fortinet's concept of "universal SASE" aims to cover a wide range of enterprises, SMBs, and verticals such as healthcare and manufacturing, making service providers and telecom companies important partners in delivering these services.
We believe a significant aspect of Fortinet's strategy is the integration of numerous SASE functions into a single operating system (FortiOS) and appliance, increasing efficiency, especially for service providers. This is in contrast to other SASE solutions that utilize multiple machines and functions in their PoPs (Points of Presence). Fortinet's approach is also more cost-effective when compared to cloud-based solutions and on-premise alternatives.
We believe Fortinet's strategy relies on partnerships with service providers and leveraging their infrastructure, as well as having its own PoPs. The company currently has a considerable number of PoPs, and this number is expected to increase as they continue to collaborate with more telecom and cloud providers. This approach reduces costs and makes the business more profitable and efficient.
As of now, Fortinet's SASE business is substantial, with over $1 billion in revenue from SD-WAN (Software-Defined Wide Area Network) alone in the last 3-4 quarters. This places them in a strong position in the SASE market. However, we sees greater growth potential in offering SASE through service providers and a broader range of use cases and hope management will actively develop in this direction.
SD-WAN
Our analysis of the SD-WAN market suggests that it is poised for significant growth and has the potential to replace a large portion of the current MPLS market. With an estimated value of $4 billion to $5 billion last year and a growth rate of nearly 30% year-over-year, the SD-WAN market has garnered the attention of top vendors in the space such as Cisco ( CSCO ), VMware ( VMW ), Palo Alto, HP ( HPE ), and Fortinet.
One of the key differentiators for Fortinet in this space is their internal development of SD-WAN technology, which allows them to integrate it with their security solutions and use ASIC to accelerate performance. This has resulted in a significant return on investment for their customers, with studies showing an 8-month payback period and a 2-year ROI of around 300%. Fortinet's CEO, Ken Xie, has expressed confidence to investors that they will become the number one vendor in the SD-WAN space within the next couple of years.
SD-WAN technology is seen as a potential replacement for most of the MPLS market and even the majority of the routing business. The only exception is core routing, which will still require the use of routers. This is because SD-WAN offers a more efficient and cost-effective way to deliver traffic-based applications. It is the first protocol that can route traffic based on different applications, providing a more efficient and cost-saving solution for enterprises.
The market's evolution is also marked by new use cases and increased customer creativity in deploying SD-WAN technology. Initially, it was primarily seen as a way to save on MPLS costs in the retail vertical. However, as more features are added and its role in the Secure Access Service Edge (SASE) model becomes more prominent, SD-WAN is starting to evolve into something more than just a branch savings opportunity, in our view.
Interestingly, while there has been a significant focus on the SASE market recently, our analysis suggests that the SD-WAN market is actually larger and addresses a wider range of networking issues. Many SD-WAN customers come from different sectors and use cases compared to traditional enterprise security, indicating that the market for SD-WAN technology is broader and more diverse.
Financials, Capital Allocation, Outlook
In our comprehensive analysis of Fortinet's strategic approach to growth and their outlook for the future, we can discern the company's focus on maintaining a balance between market share and margins, capital allocation, and investment in new opportunities such as OT security and cloud computing. The company has consistently maintained a 25% operating margin target, but there is potential for higher margins due to its scale and increased services revenue mix.
Fortinet's emphasis on investment in growth is clear from their plans to cover new use cases in network security and expand their product offerings. With a highly competitive product in a fragmented market, the company is looking to capitalize on its strong position by investing in sales capacity and boosting productivity.
Regarding capital allocation, we believe Fortinet has been strategic in their approach, with a focus on smaller tuck-in acquisitions to maintain their single operating system strategy. Under the direction of its CEO, the company also invests in real estate through ownership of its office buildings, which aligns with their long-term investor perspective. Additionally, Fortinet is committed to returning capital to shareholders, with a preference for an opportunistic buyback strategy.
The company sees significant potential in the OT security market, especially as the number of connected devices is expected to increase exponentially with the advent of 5G technology. Network security will play a crucial role in securing the limited computing power and varied operating systems of OT devices, making this market a promising growth opportunity for Fortinet.
Fortinet's guidance for 2023 reflects a cautious yet optimistic outlook , considering the sales capacity, pipeline, and close rates. The company is well-positioned to capitalize on its diverse customer base, geography, and use cases, with continued strong performance in SD-WAN and OT security, among other growth areas.
Lastly, Fortinet's partnership with AWS and the integration of its technology with the AWS Graviton CPU presents an opportunity for the company to explore the secure cloud computing market. This collaboration supports their long-term growth and expansion plans while also strengthening their position as a key player in the network security space.
Valuation
Our analysis of Fortinet reveals strong growth prospects in the coming years, supported by consensus estimates from FactSet. Sales are projected to grow by 23% to $5.4 billion in 2023 and then by 19% to $6.5 billion in 2024. While these figures represent robust growth, it is worth noting that they indicate a deceleration from 2022's impressive 32% growth rate. However, we believe these expectations are achievable for Fortinet, given the company's long history of outperforming expectations.
In terms of earnings per share, the company is expected to achieve a 19% compound annual growth rate in 2023 and 2024, reaching $1.67. Investors should be aware that this level of growth comes at a premium, as the company currently trades at 45x forward 12-month EPS estimates. This valuation places FTNT at the midpoint of its 5-year range. When compared to the S&P 500, Fortinet is trading at a 150% premium, which also falls in the middle of its 5-year range.
Considering the rarity of Fortinet's assets, the high quality of its business, and its significant growth potential, we believe that FTNT is currently trading at a fair valuation. Based on our research and analysis, we maintain a positive outlook for the company, as it continues to demonstrate an ability to outperform expectations and capitalize on growth opportunities. Investors looking to gain exposure to a high-growth cybersecurity firm should consider Fortinet as a viable option, despite the premium valuation.
Risks
Our primary concern is the sustainability of its revenue growth, which may be impacted by deteriorating macroeconomic conditions. Additionally, we will address the bear thesis arguing that Fortinet's on-premises focus could be disrupted by the ongoing shift to cloud computing.
Revenue growth sustainability is a crucial factor for investors to consider, as it can be indicative of a company's long-term prospects. While we have previously addressed this concern, it is worth reiterating that if macroeconomic conditions deteriorate further, companies may choose to optimize their existing cybersecurity spending, much like their current approach to cloud computing expenditure. Although we firmly believe that cybersecurity will remain a strong growth theme for decades to come, driven by the shift of economic activity from physical to digital, there have been instances where companies temporarily pulled back from increasing their cybersecurity spending, such as in 2016.
The second risk that investors should be aware of is the argument that Fortinet's primarily on-premises business model may be disrupted by the transition to cloud computing. This bear thesis has been around for at least five years, during which Fortinet has demonstrated significant outperformance. In response to this argument, it is essential to note that the company has made significant investments in its cloud capabilities and diversified its offerings beyond its core firewall products.
While we believe this bear thesis is overstated, as a responsible investor, we will continue to closely monitor any signs that Fortinet may be negatively impacted by the shift to cloud computing.
Conclusion
In light of our analysis, Fortinet's growth prospects remain robust, supported by its innovative technology, ability to address new use cases, and penetration into previously underserved markets. The company's strategies in SASE and SD-WAN, along with its focus on investment and strategic capital allocation, are expected to drive continued strong performance. Despite trading at a premium valuation, we maintain a positive outlook for Fortinet as it continues to outperform expectations and capitalize on growth opportunities in the network security space. Investors seeking exposure to a high-growth cybersecurity firm should consider Fortinet as a compelling option.
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Fortinet: Poised For Sustainable Growth Amid Expanding Network Security Market