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Morningstar | Fortinet Guides for Strong Growth; Raising FVE to $63 per share. See Updated Analyst Note from 01 Aug 2018

No-moat Fortinet fired on all cylinders in second quarter of 2018, producing strong earnings and raising guidance on the back of robust growth, and we are increasing our fair value estimate to $63 per share from $54 previously. Fortinet's top and bottom line results this quarter narrowly surpassed our expectations, with guidance prompting us to increase our long-term outlook. While the results were overwhelmingly positive, we still see the name as fairly valued and would await a wider margin of safety before entering. First, we see lofty expectations baked into the firm's valuation, even with our expeditious growth assumptions, with the firm trading at 37 times adjusted earnings based on our $63 per share fair value. Second, we largely see the cyber security industry as a no-moat sector, as rapidly evolving technology allows upstarts to claim share.

Digging into the financials, Fortinet's product revenue accelerated with 17% growth, with some one-time benefits, thus our fair value hike was largely attributable to greater confidence in expansion in the products segment. We attribute the acceleration to the firm's new E-series offerings, which management said are picking up steam in the mid-enterprise market, as well as Fortinet's compensation structure reorganization, suggesting incentives are in the right place. The product acceleration likely brings to mind the strong growth in 2013-2015, which was driven by notable corporate breach scandals, such as Target and Sony. However, we note that strength today is not being driven by demand from the news flow, but rather a refresh cycle and product integrations, suggesting health demand.

The three prevailing announcements were that Fortinet's security products are now available on the Google Cloud Platform, that management is adding $500 million dollar increase to the share repurchase program, increasing the total repurchase program to $1.5 billion, and lastly, Fortinet's $17 million acquisition of Bradford Networks.

We note that Fortinet has historically been disciplined in its acquisition track record, relative to peers, preferring to build out offerings in-house. We iterate that Fortinet's acquisition of Bradford gives the firm exposure to Internet of Things security offerings, a burgeoning field of security.

Longer term, we see opportunities for Fortinet's expansion into nascent areas such as SD-WAN security, Wi-Fi, and now Internet of Things, through the Bradford acquisition. We see management's 2022 targets of non-GAAP operating margins above 25% as more than achievable. However, it is difficult for us to get excited about the valuation at this point and even with the relative strength in the enterprise business this quarter. Fortinet's bread and butter is still small to medium size business, or SMB. We still see the SMB as more susceptible to churn, with limited upsell opportunities, compared with enterprise competitors.