Down Nearly 30% This Year, Is Fortinet Stock a Buy?

Down Nearly 30% This Year, Is Fortinet Stock a Buy?

Fortinet’s stock got clobbered after recent earnings fell short of expectations on one front.

Cybersecurity stocks have been hot this year, with some of them putting up positive returns even as the bear market of 2022 wreaks havoc on investors.

Fortinet ( FTNT 3.64%) was one of these stocks beating the market over the last 12-month stretch — at least, it was up until the second-quarter 2022 earnings report. Revenue growth slowed a bit, and investors were also disappointed with a dip in one particular profitability metric. Share prices of the cybersecurity leader are now down 14% over the last year, and down 28% so far in 2022.

So is Fortinet stock still a buy after the recent sell-off? The convergence of networking and security

Businesses around the world are rapidly migrating their operations to the cloud. With that fundamental change in technology, new security services are needed to keep information and processes connected to a network safe from intrusion. That’s where Fortinet comes in.

Many investors (rightfully) prize cloud companies for their asset-lite business model and high profit margins (or what could one day be a high profit margin, once the high-growth market share-grab phase is over). But at some point, a cloud service needs a hard computing asset to operate it; namely, a data center.

That’s where Fortinet comes in. The company is the leader in security infrastructure. These days, that means hardware that operates security services in data centers, 5G mobile networks, and other networking and computing equipment.

There’s a lot of activity out there right now upgrading data centers, mobile networks, and private networks to accommodate this big migration to the cloud. This has been filling Fortinet’s funnel of activity, and Q2 2022 was no exception.

Total revenue was up 29% year over year to $1.03 billion, near the high end of guidance provided a few months prior. This was driven by a 34% advance in product sales, which represented about 39% of total revenue (the other 61% being service revenue — more on that in a moment).

In spite of these solid results, full-year 2022 revenue guidance was left unchanged, calling for growth of about 31% to 32%. Given the company’s strong financial performance, some investors may have been hoping for an increase in this outlook. But the big drop in the stock price was likely due to free cash flow , a critical profitability metric.

Free cash flow actually fell 28% in Q2 compared to the year prior, coming in at $284 million. This was still a very healthy free cash flow margin of 27.6%, but the big reduction in profitability apparently had some shareholders rethinking Fortinet stock. A small, temporary speed bump for this cybersecurity leader

Free cash flow can be a volatile metric from quarter to quarter, and there were a number of reasons Fortinet registered a dip here even as revenue steadily climbs higher.

First, the company suspended sales in Russia, which it had said earlier this year accounted for about 1.5% of total revenue. Besides a small loss there, macroeconomic uncertainty in the global economy has slowed the pace of deals Fortinet is inking. Organizations are simply taking a closer look at spending, even if it’s a mission-critical service like cybersecurity. Days until payment is received from a customer also lengthened, which also impacted the bottom line.

Another issue for free cash flow was a change in how research and development is accounted for in taxation, which led to an elevated quarter for tax payments. And one other line item was purchases of property and equipment. To support the expansion of cloud-based networking, the company has spent nearly $163 million on property and equipment so far this year, compared to just $75.6 million during the same period last year.

There’s good reason to believe all of these factors will be a temporary drag on profits, though. Bookings (which measures the value of new contracts signed with customers) jumped 42% from a year ago to $1.38 billion in Q2. And Fortinet’s billings (services invoiced and awaiting payment) were up nearly 36% year over year to $1.3 billion. Both of these metrics are a good indicator of where revenue — and ultimately profitability — are headed.

You see, as Fortinet sells security equipment, there is a delay between that sale and when the purchaser turns on the ongoing software service contract (the other 61% of Fortinet’s revenue). Due to various factors explained above, as well as component shortages elsewhere in the supply chain, some of Fortinet’s customers are experiencing delays when installing […]

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