Fortinet: Adapting To New Dynamics Of Cybersecurity Industry (NASDAQ:FTNT)

After having recouped most of its losses since its August 2023 drop of nearly 20%, Fortinet, Inc. (NASDAQ:FTNT) seems to be at a crossroads. Its share price has been hovering between the $71 and $73 range for some time now with both Wall Street and Quant having Hold ratings as the stock trades at a hefty 220 times forward sales.

At the same time, dynamics are changing in the cybersecurity industry, which is subject to new economic realities. In these circumstances, by assessing the ability of the company to gain market share against the competition, this thesis aims to show that it is more of a Hold.

I start by looking at revenue growth.

Declining Revenue Growth

As shown in the chart below, from above 30% in 2021 and 2022, the YoY revenue growth on a per-quarter basis is down to about 10%.

There are two reasons for this decline.

First, the digital transformation triggered by the COVID-19 pandemic rapidly increased the amount of IT data residing both in the cloud and on-premises (or corporate server rooms). New IT network routes had to be created as more employees working from their homes or remote offices needed to access corporate data, while at the same time requiring protection against malicious actors. As a result, the company managed to sell more routers, firewalls, and other security products, explaining the high revenue growth seen in the 2020-2021 period.

Against this backdrop, considering that equipment replacement cycles normally last around 4 years, the continued growth enjoyed by Fortinet in 2022 seems somewhat abnormal. This is explained again by the effect of Covid, this time on supply chains causing factories in East Asia, notably China to close down for a prolonged period as the pandemic persisted. As an instinctive reaction, both telcos and CSPs built up inventories by ordering more from Fortinet, in turn benefiting sales numbers.

This signifies its topline has benefited more from a distorted market condition than normal demand in 2022, and now that its clients have a lot of inventories to consume, it looks natural for sales to decline.

Second, Fortinet has also been losing market share because of the competition in the cybersecurity industry for a company whose background was initially in networking for internal segmentation of users within the enterprise. It later evolved its routers by adding firewall functionality, initially, all appliance-based. These later evolved to become software-defined as the market for networking and cybersecurity has undergone rapid change, to tackle both the increasing number of threats as well as hackers getting more sophisticated.

In this respect, competitor Palo Alto (PANW), which has also evolved from a networking background to later cater to corporate security needs, has rapidly transformed their products to become more platform-oriented. At the same time, the market also saw the emergence of cloud-based providers like CrowdStrike (CRWD) whose products were already distributed from the cloud since day one.

Making a comparison as per the chart below, both Palo Alto and CrowdStrike have suffered from revenue declines, but not to the same degree as Fortinet. This, in some way, confirms that in addition to a normalization of supply chain conditions, it is the competition factor that accounts for the loss in market share.

Reorienting Products in the Face of Changing Dynamics in the Cybersecurity Industry

Looking further, market dynamics are also changing as, facing high costs of capital, customers no longer have the liberty to choose individual suppliers for each of the functionalities required, like for example end-point protection, network firewalls, or security operations where an enterprise IT infrastructure is monitored on a 24/7 basis. This means that they are more likely to opt for bulk purchases where there are discount opportunities. Along the same lines, as data sourced from end-point or firewall logs gets leveraged to obtain timely insights to avert service disruption, it makes more sense to choose one supplier whose systems are already integrated.

The above two arguments may be the reason why Fortinet’s largest deals in the fourth quarter of 2023 (Q4) included all three of the company’s products, namely Secure Networking, Security Operations, and Universal SASE as pictured below. Thus, instead of choosing one product from three different suppliers, they have chosen all three from Fortinet.

For this purpose, the company has adapted its product to the fast-growing cybersecurity markets based on a refocusing on the three above areas since November last year. The intent was not only to address the increasing number of threats emerging due to the proliferation of AI-based attacks but also to respond to changes in customer consumption patterns as I detailed earlier.

The readaptation also involved aligning its R&D investments with the products most in demand and by focusing on a few key areas, Fortinet has streamlined its research and development (R&D) efforts. This has paid off with the company being named as a challenger for Single-Vendor SASE in Gartner Magic Quadrant for August 2023 as illustrated below.

For investors, SASE aims to improve application performance at the network edge or outskirts (remote offices) while at the same time providing the security controls users normally enjoy in metro data centers.

Now, emerging as a challenger certainly improves its competitive positioning and may help it to gain market share, but for the stock to be rated as a buy, it is also important to go into more detail and check what are the expectations for sales in the next quarter.

Revenue Expectations Lower and Competitive Risks Due to Freemium

To this end, analysts have downgraded revenue expectations 25 times out of 30 during the last three months, as illustrated below. Thus from $1.47 billion, the revenue forecast for the first quarter of 2024 has been slashed to $1.34 billion. This constitutes only an 8.8% YoY growth over the $1.26 billion achieved in Q1-2023. This means single-digit growth, implying the blue revenue chart above could dip further.

This possibility of experiencing single-digit growth also gets some support from Q4’s billings, which increased only by 8.5% YoY. Now, this is certainly better than the 5.7% YoY increase in the previous quarter (Q3), but the estimate for the first quarter of 2024 points to a 5.5% YoY decrease. For investors, billings are the invoices sent to customers for payment which then translates into revenues for the income statement. In this respect, all the above figures being much lower than during 2021-2023 points to sluggish revenue growth.

Furthermore, according to research by Canalys, IT spending should increase by 6% in 2024 with one of the areas being prioritized being cybersecurity, namely SASE due to the need for simplicity in an increasingly complex network security environment as the nature of cyberattacks evolve.

However, these may not necessarily solve Fortinet’s problems as the freemium business model seems to make its comeback in the cybersecurity space with the latest salvo fired by heavyweight Palo Alto. Thus, in a bid to lure more customers to its three platforms one of which is SASE, the company is offering free trial subscriptions to customers who are already using other cybersecurity vendor products.

Thinking aloud, the objective is eventually to sway them away from the competition, and, given its scale with a market value of $90 billion, Palo Alto’s new growth strategy may have an impact on the industry as a whole. On top, it competes directly with Fortinet for SASE, and, as per the Gartner Magic Quadrant shown above, it is the leader.

Fortinet is More of a Hold with ASIC

Consequently, there is a chance that Fortinet’s stock may suffer from a downside in case it experiences a further reduction in the number of billings as a result of some of its customers switching to its competitor. On the other hand, it can fight back and also offer free trials to counter the effect of Palo Alto’s freemium strategy. It could also offer discounts to attract potential clients.

For this purpose, it can rely on its high profit margins (table below) which can largely mitigate the effects of product discounts.

More importantly, the company has a technology differentiator that can help it navigate the market in case there is a price war.

To this end, according to its CEO, it is the only networking company to develop its own ASIC (or application-specific integrated circuit) or customized chips for its security products. The advantage here is that this allows more functions to be integrated into the same operation system, namely FortiOS. In other words, ASIC allows Fortinet to reduce prices in such a way that it will not suffer to the same extent as those who do not have the ASIC technology.

However, Fortinet’s technology differentiator does not help it to counter Palo Alto’s product strength as a leader for SASE, a market that is expected to grow at 25% CAGR from 2023 to 2028. Also, Fortinet has reoriented its product line to new economic realities, but, due to revenue projections being lowered by analysts and the emergence of the freemium business model, market dynamics may change in unexpected ways, which means it is preferable to stay on the sidelines and watch out how it responds to the new threat. Finally, its high valuations show that a lot of expectations seem to have already been baked into the stock price, and in case of any unfavorable news, it could suffer from a high degree of volatility. This is the reason for my Hold position.