Why Investors of This Stock Are Feeling Insecure

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There's always a point when investors are forced to realize that the growth momentum needed to support a premium priced stock has disappeared. Panic takes over – especially when the company in question is under-performing its contemporaries. At this crossroad are investors of Fortinet (NASDAQ: FTNT), who are now faced with a tough decision.  

Although there’s plenty of value in Fortinet’s security business, there is an equal to greater amount of unmet expectations. And the competition has not made things easy. While the company can go a few more quarters producing above average growth, it doesn’t justify the premiums investors are paying today for the stock. With Q4 earnings on tap, Fortinet will either affirm its valuation or lower expectations.

Q3 Was Not a Miss, But It Might As Well Have Been

In a market with so many different moving parts, it’s always best to evaluate performances on a relative basis. To that end, I should note that Fortinet’s Q3 report wasn’t terrible. However, when a company carries such enormous expectations as presumed by its P/E of 56, which is 4 times and 3 times that of rivals Cisco (NASDAQ: CSCO) and Check Point (NASDAQ: CHKP), respectively, posting in-line estimates is not enough.

Plus, the valuation portends that the competition is just going to roll over and concede the security market. But Fortinet's recent performances suggests that rivals are in full throttle and have no such plans. The company reported net income of $17.2 million, or 10 cents per share on revenues of $136.3 million. Although revenues rose 17% year over year, as noted, it only arrived in line with consensus estimates.

For a company that has consistently reported at the high end of its guidance range, this was disappointing. And this was also reflected in the stock as shares dropped 10% in the trading sessions that followed. What’s more, profitability was uninspiring with gross margins declining 100 basis points year-over-year. Making matters worse, the company shed 1.5% in operating income while at the same time growing expenses.

This has raised concerns about the Fortinet’s ability to hold off (among others) Palo Alto (NYSE: PANW). Margin pressure has become one significant reason. Since expenses are rising, it’s certainly a worthwhile consideration. Besides, Palo Alto has already proven to be a capable force as evident by the 50% revenue growth in its recent earnings report.

However, for Palo Alto, it’s not just about revenues. The company is also expanding its customer base, which now stands at over 10,000 after adding 1,000 new customers during the quarter. From a fundamental standpoint, Palo Alto ended the quarter with cash and equivalents of $342 million – increasing by $20 million. Better still, the company has no debt.

Palo Alto’s performance was even better than that of Check Point, which is considered the best in the business. In Check Point’s Q3, not only did revenue arrive below estimates of $333 million, it represented growth of only 8% year over year -- after which, the stock immediately sold off 13% as investors were displeased.

Plus, it didn’t help that Check Point then issued guidance that was below analysts’ estimates. The company said it expected revenue to come in the range of $355 million to $387 million. The low end was what scared investors -- analysts projected $382 million. While this does show that Fortinet is gaining ground on Check Point, this was the expectation – it just hasn’t been enough.

What Doe the Future Hold – Will Q4 Provide the Answer?

Although security services have become a huge market, investors are feeling insecure about Fortinet’s prospects. The company’s challenge is to convince the Street that the slight decline in performance is not the beginning of a trend. Plus with "the cloud" not yet fully understood, companies are feeling uncomfortable about sending their "big data" into cyberspace.

For this reason, Fortinet has made considerable investment in this area as evident by its R&D expenses, which have grown to almost $4 million in Q3. Likewise, companies will begin to make investments to expand their portfolios, which will include plenty of M&A activities such as what we’ve seen from Dell's (NASDAQ: DELL) $1.2 billion acquisition of enterprise security giant SonicWall.

Dell understands that its PC business is no longer going to bring in the goods. So as a way to strike first, Dell felt SonicWall was a deal it couldn't pass up. Whether or not it was the right move remains to be seen. But for Dell, it is hard to argue against the justification. I also expect Cisco to become active in this area. If nothing else, Cisco will want to keep these smaller growth names out of the hands of rivals.

Cisco knows that these deals will pay off at some point. To that end, I expect Cisco to make a play for Palo Alto. Cisco can’t continue to ignore Palo Alto’s incredible rate of growth. Plus the company has pioneered what is considered next-generation security along with one of the most innovative platforms in the industry.

What’s more, Palo Alto's recent stock decline now makes it even more attractive to Cisco than before. All of which places a huge mark on Fortinet’s upcoming Q4 report on Wednesday. These questions are certain to be posed. But first Fortinet has to perform. Analysts are looking for revenue growth of 19.3% with 7.1% increase in earnings per share.

Bottom Line

Fortinet has had a couple of challenging quarters. It certainly doesn’t help that Ken Goldman, the company’s CFO, recently agreed to become the CFO at Yahoo. There’s no point in suggesting that Fortinet’s poor performances had anything to do with his departure, nonetheless, high ranking executives rarely leave when things are going great. This has only created more uncertainty. In the meantime, investors need to look in the mirror and feel good about their decision to be long this stock.

Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends Check Point Software Technologies and Cisco Systems. The Motley Fool owns shares of Check Point Software Technologies. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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