Episode 33 | Fortinet and the Cybersecurity Tailwind

In Episode 33 of “Market News with Rodney Lake,” Rodney Lake, Director of the GW Investment Institute, discusses Fortinet, a cybersecurity company performing well, recently hitting a 52-week high. The company has demonstrated consistent growth, with a revenue of $5.9 billion and a market cap of $87 billion. Fortinet enjoys impressive gross margins of 80% and net margins of 26%. Its co-founders, Ken and Michael Xie continue to lead the company, owning a significant stake that aligns them with shareholder interests. Overall, Fortinet is viewed as a high-quality business with growth prospects, solid management, and a strong market position in the cybersecurity sector.

Transcript

Thank you for joining “Market News with Rodney Lake.” This is a regular program for the GW Investment Institute where we talk about timely market topics. I'm Rodney Lake, the director of the GW Investment Institute. Let's get started. Welcome back to “Market News with Rodney Lake.” I'm your host, Rodney Lake. Today's episode is on the company Fortinet. Again, this is a GW Investment Institute program.

This is entertainment purposes only. We are coming to you from the GW School of Business in Foggy Bottom in Duquès Hall. Welcome back. If you've been a viewer and if you're watching on YouTube, thanks very much. And if you're listening on Apple, Spotify, Amazon, welcome back and welcome if it's your first time. Alright. Let's jump into it.

So if you've been following this, the Investment Institute investment framework is what we use to evaluate these companies. Fortinet is a larger holding in one of our portfolios for the Investment Institute. So we're going to talk about it today. And it's been doing well lately. Now it's had some volatility over the past couple of years. But right now it's, we’re in mid-February,

It's hitting a 52-week high. So let's jump into the business. So this is the company Fortinet and the ticker is FTNT. So what is Fortinet? So let’s talk a little bit about what is actually the business. What do they actually do? So if you talk about Fortinet, the company, if you know what it all, you're probably thinking, okay, this is a cybersecurity company.

So they do, network solutions, network cybersecurity, security, you know, software. And so, and they offer this through subscription services, as well. So, let's jump in, to talk about the breakdown here, of where the revenue really it's, services is a little over half, is most of that. And let's say two thirds to three quarters of the revenue and then product is about a quarter of that revenue.

So, when we jump into where does that come from? You know, where in the world about 40% the Americas, about 40% is Europe, Middle East and Africa and 10%, in Asia. So now let's talk about what's the revenue look like for this business. All right. So what's the revenue? Cash and or. Sorry. Excuse me.

Revenue $5.9 billion. And that's grown 12%. We'll get to the balance sheet here in a second. And let's talk about the market cap for the company. Just so get our bearings here. Again, we're at 52-week high, $87 billion market cap. So this is not a small company. This is a quite a large company, and has grown pretty dramatically, over the last five years, which the Institute has been a beneficiary of, of that growth.

So thank you, people who are running Fortinet. And then we'll talk about the management team as well. And so again, 5 billion in revenue, you're talking 12% growth over the last year. But when you look back in 2021, you talked almost 30% growth, ‘22 30% growth, ‘23 20% growth, ‘24 12% growth. And we're projecting another 12% growth approximately for next year.

And then out you're talking, you know, almost, you know, a little more than 12 closing in on 13% growth. So this company, it has done well, is doing well hitting a 52-week high. And you talk about what's the business? And so most of it is services. So you can think okay well probably the margins should be higher right.

Well your guess would be correct. When you look at the gross margins for this business they are 80%. So these are, you know, some of the best margins you're going to get. When you look back at companies or think back to the companies that, if you've been watching the show, this is the category of Visa and Nvidia.

These are super high gross margins, right? When you're talking 80% gross margins, this is in a subclass of its own. You don't have a ton of companies that are going to have 80% gross margins. And then you get down to the net margins. Not quite as outstanding. You're not as good as a Visa, for example, but still very good net margins of 26%.

So very healthy net margins. And they're projected to grow. The the gross margins are projected to stay around the same. The net margins are projected grow a little bit. And so very good gross margins, very healthy net margins at 26%. So this is you know, when you think about this business. So let's step back for a moment and think, you know, is cybersecurity is network security important?

I think it would be hard to find someone to say it's not important. And it would also likely be hard to find someone to say it's not likely to be more important moving forward, right. As everything is more and more digitized, as everything continues to be more online, more sort of digitally based, you're going to need security, right.

And so, companies broadly that operate in this category have a tailwind, very likely if you're thinking, you know, very broadly about, okay, this business, this market, this industry, this, this cybersecurity and security business for software, and digital is going to likely grow and now we don't know. It doesn't mean that Fortinet specifically will benefit. They have to execute but they certainly have a tailwind.

This is not a headwind business. This does not seem like a business or industry that is shrinking. It seems like a business that is growing. And the demand for products and services that people find value and make and work is likely to grow. Right. And you're going to be willing to pay for that security, if it works.

And so again, they have to execute. But the tailwind in their industry is quite strong. And if you look at, you know, people are paying up for this. Right. It's not a negotiable. Certainly if you, you know, any business of any size, you need cybersecurity. You got to make this work. And so people, it's a non-negotiable.

Depending on who you're going to go with. There are other players in the market, and we own some of those, too. But we're talking about Fortinet, and they have done well. And again, those 80% gross margins are are outstanding and net margins of 26 very healthy. So overall, when you talk about the business you're giving this high marks.

Right. The business is growing. And you look at the revenue growth here, you're talking 30% nearly over the last, you know, 28, 30, 20, now 12 and so that has slowed down, but it's become a much bigger company now, your 6 billion in revenue, projected to go to 6.7 billion for 2025 and then 2026, 7.6 growing another 12%.

So good growth, not, you know, not as much as they've had in in the recent past, but good growth in the business and a good good tailwind in the industry. Very high gross margins 80% good healthy net margins at 26%. So the business overall, you're thinking, okay, this is probably in the realm of an eight or a nine type of business.

When we're scoring 1 to 10, ten being the best because, you know, again, the tailwind, the gross margins and the net margins. Very good. So, we'll come back to the business when we when we start talking about everything a little bit and when we’ll weave a few things in. But overall, this is a fantastic business and has been doing quite well.

And so, you know, again, that's why it deserves an 8 or 9 in the business. So now let's move on. To the management. So who is managing the business? The chairman is Ken Xie. And he's been there for 12 years, and he's a co-founder of that business. And he's the, Ken is the chairman, CEO, and co-founder, and the president is Michael, who's the CTO and co-founder of the business.

And so, they have done well founding this business that has they have been great stewards of this company. They're based in Sunnyvale, California. Fortinet is and again, we're hitting a 52-week high. They have been running the business super. Well, and this has been a fabulous business to be in. They have done an excellent job on the execution.

And if you look at, okay, well, you know, are they aligned with us? You know, they still own Ken, still owns 7.8% of the business, and Michael owns 7.42% of the business, and still they still own huge chunks of this business. And so together, you know, a very significant portion, you know, closing in on 15% there of the business are right, right

Around 15% of the business is owned by the pair. And so, again, these are co-founders of the business. And, you know, they're still running the business. Chairman and CEO, Ken and Michael. And so very important, you know, we've talked about in the past, these founder led companies, even when they get to a certain size, you know, these people are not likely now motivated anymore by just money, and maybe they are at some level, who knows, right.

We don't know the specifics. We're not in touch with Ken to Michael specifically, but at certain point, you know, they have plenty of money, right? They want to see their business grow. They want to see, you know, their business flourish. They want to get into possibly new markets. They want to make sure that they're doing an excellent job.

And so they're driven to do a fantastic job because they want to see their business continue to succeed, you know, from where they've started. And that does, you know, help inspire the other parts of the management team and everybody that works at the company. So we like, at the Investment Institute, these founder led companies. So we think, well, of these it's not always the case that they work, but many times they can work. And and in the extreme cases we've talked about these in the past.

You talk about Oracle, Larry Ellison still involved. Steve Jobs, involved in Apple got fired, obviously came back involved in the company until he passed away. Microsoft, led by a long time by Bill Gates. But you look at companies that have achieved, you know, monster success in the in the companies right now that we've talked about more recently that are doing that.

Nvidia, Jensen Huang. You're talking about Tesla and Elon Musk. And so these founders that continue to be involved in these companies after they get very big, have a passion for the business. Keep the management team motivated. And so when you talk about Ken and Michael Xie here, you're talking about co-founders of the business, have helped the company grow over time.

Obviously still believe in the business. And, you know, giving them high marks, for growing this company, staying focused in the in the security business when we talk about capital allocation, really just products and services, offered here. And again, this is technological security services, including firewalls, VPNs, antivirus, intrusion prevention, web web filtering, anti-spam.

So this is the type of business that they're in. And again, a huge tailwind in that business. Security becomes more and more important over time, not less. And so you could say, you know, maybe that changes over time. There's some paradigm shift where it becomes more commoditized. However, right now, there are threats all over.

And so, that business is in general having a tailwind. And so, management team, doing fabulous. And so again, you're talking an 8 or 9 for the business. And I would say the management team is an 8 or 9. You know, I think they're doing great. Co-founders that are involved in the company as a CEO and as president, chairman, CEO, and president, that's Ken and Michael Xie.

So you give them high marks now let's jump into the valuation. Now, you would probably guess, I mentioned that we're hitting a 52-week high here in mid-February. And so you would think well what's the valuation look like? Well and we have 80% gross margins. You're well the valuation is up. It's at 46 times the forward. And that's what we care about.

The price earnings multiple the PE. We care about the forward remember. Because that's where we're looking when we ask our analysts at the Investment Institute to think about where is the business going? Because we can only make decisions today. And and from here we can't go back and say, oh, well, we should have bought here and there. That's very easy to do.

We have to make decisions. Should we hold on to this company? Should we trim this company? Should we buy more of this company if we don't own it, should we own this company? In this case, this is a portfolio position, one of the larger ones, in the Investment Institute portfolio, so Fortinet is an important consideration for us.

What should we be doing with it? 46 times, now that's not outrageous. You wouldn't say, you know, this is a ridiculous valuation when you talk about the S&P 500 at 28 times for the average company right now, you might even say, okay, well that maybe is a high, however, 46 times not something that you're going to go crazy about and think like, oh, this is so overblown.

At 46 times, but not inexpensive. Right? And certainly not a market multiple. And so you are at a premium versus the market. Not a ridiculous premium, but you're at a premium for this company. And so it's something you have to think about, and when you score this, you have to be thinking, okay, well, where are we going to score this company?

Well, at 46 times versus the 28 for the market multiple, and you look at the growth, you look at the gross margin and you look at the net margins. You're going to have to pay up for those 80% gross and 20% net margins. And so, but it doesn't have, you know, the growth is not ridiculous when we talk about the growth. And so you have to factor that in, know 12%, you know, looking compounding for the next few years it's likely on the revenue side. You have to think, okay, well, this is something that, you know, we got to square. So at 46 times, you're probably going to give this a score that is, you know, six, maybe six and a half, you know, somewhere in that neighborhood, maybe seven.

You know, it feels like, you know, at this point that you really have to consider all these factors, and not it feels like, you need to consider all these factors when you're scoring this. When you look at, okay, what are the gross and net margins, what is it going to get rerated higher or are the earnings going to grow or both?

Right now it's hard to say. It's going to get rerated higher unless they can really improve those net margins. It's very challenging to improve their gross margins from here. Right. How would you improve 80%? Well, that's going to be very challenging. Right? You can only get to 100, and that's when you're just collecting checks at 100% gross margins.

And so if you have to deliver anything, right, you got to have something in there. So that 80% gross margin is very challenging to get better than that. But you could make progress on the 20% net margins over time, possibly, if you're steering towards more things that are delivered online and less product, more service, more subscription, you know, that all can help those margins, you know, creep up and maybe you can get to 30% net margins over time.

That would help rerate it. But you're already at 46 times. And so that can be a challenge. And so something to think about there, is that, you know, it's going to be difficult. So let's say, six, seven, you know, six and a half. We go on the valuation price versus valuation. All right. And we're going to pull everything together as we typically do as we wrap up the episode.

But now the next component: business management price valuation we've done. Now let's jump into the balance sheet. So what is the balance sheet look like for Fortinet? Is there any concern about the balance sheet for them? And the quick answer is no. If you look at the balance sheet over time, well, let's look at it right now.

We'll talk about over time. You're talking about cash and cash equivalents of $4 billion, approximately. This is the end of the year, last year, so 20 31 2024. And about a billion in debt, a little bit less than a billion. So you're talking 3 billion, a little bit more than 3 billion in net cash, that this is not something that you're worried about.

Net cash of $3 billion. And then we talked about this before too, when we look at the balance sheet, you know, did they just get to this point? Does it fluctuate dramatically. So let's look at the balance sheet and how this management team, it's been the same management team, has managed the balance sheet over time.

So if you look at 2021, 2.5 billion in cash, a billion in net in debt. So, you know, net cash of a billion and a half, you know, very similar in 22, very similar in 23. And then actually a bump up to 4 billion in cash and a slight reduction, of let's just, less than a billion.

So now you're in a better spot at the end of last year than you have been even over the last few years, when you've had a very strong balance sheet before, the balance sheet is even stronger now. So you'd have to give this balance sheet a nine, possibly even a ten, because the trajectory is actually strength, not weakness. More net cash on the balance sheet. And the other part, obviously, that we always consider here is what's the free cash flow? And the free cash flow in 21 was 1.2 billion. And now free cash flow at the end of 24 1.8 billion. So you have, you know, you can give this a nine and a half if you don't want to give it a ten.

But this is basically a ten balance sheet when you talk about 3 billion in net cash, and strength achieved over the last three years, both in the net cash position going from about a billion and a half to 3 billion a year, basically doubling the net cash position and going from 1.2 billion in free cash flow in 21, up to almost 1.9 billion in free cash flow

At the end of 24. So really, from strength to strength, as they like to say in the business, that is a fantastic balance sheet. Again, if you don't want to give it a ten, fine, give it a nine and a half or a 9.75. But this is a very strong balance sheet. And then again, the balance sheet is managed by the management team.

So you got to give high marks for the management team here, Ken and Michael, thinking about operating this company conservatively making sure that they're never at risk for bankruptcy. And that's something the biggest risk for any business is going bankrupt. Net cash makes you feel good, helps you sleep at night. We're equity shareholders at the GW Investment Institute.

So when we talked to our analysts, we were always reminding them. And that's why the balance sheet is part of this framework is we have to think about the capital structure. We have to think about where do we stack up if there is, you know, some type of bad news, reorganization, bankruptcy, you know, the debt holders are ahead of the equity holders.

And we don't, you know, we're not fixed income investors in these portfolios. We're equity investors. And so we would be behind them. But when you have net cash, that means there are no debt holders ahead of us because we're in a net cash position. Well, there could be some debt holders to be super clear. But there is net cash in the short term to cover that.

If there is an issue and you're generating 1.8 billion in free cash flow. So that's great news. And nine and a half or ten really, on this balance sheet and again, high marks to the management team for doing a great job of managing this balance sheet. And again, important to look at the balance sheet over the last, let's say, 3 to 5 years to think about, okay.

Has there been a dramatic change if they just happened to do a good job in the last year, you don't want them to falter. And maybe they have been volatile with managing that. So looking at the balance sheet over the last few years is a very good idea. It helps us. It says something about the outlook for the management team.

And again, from strength to strength on the balance sheet here. So now let's pull all these together. So the framework business, management, price valuation, and balance sheet. Fortinet today is the company ticker FTNT. They're talking, this is cybersecurity. Network security. These are important. This is an important industry and has a great tailwind to on the business side, 80% gross margins for Fortinet, 26% net margins.

Very good. Improving over time. Hard to get higher than 80% net margins for that business. And so maybe they can do a better job on the, on the on the gross margins, harder do better job net margins possible to do a better job if they mix the products, more towards services, more towards online delivery. We'll see how that evolves over time.

But really fantastic business. You got to give it. You don't have to. You don't have to give it anything. We would give it an 8 or 9. And we had when we asked our analysts, you know, about this business, this is a fantastic business. Management team, Ken and Michael Xie, co-founders of the business. We like the co-founders, still own a huge stake in the company combined 15% about, let's say 7.5% each.

Not exact. But aligned with us. If you look at the capital allocation, have been very focused cybersecurity, haven't really got out of their lane. Let's, you know, we'd have to get really deep dive into each component of the capital allocation over the last, let's say five years, but have pretty much stayed focused, stayed in the network security, stayed in the cybersecurity world, have been delivering, have been doing a good job.

And so you have to give them high marks both on alignment with us. They still have huge stakes in the company founders of the business. Again, we like both co-founders of the business president, president, CEO, chairman, and, excuse me, CEO, chairman, and then president, Ken and Michael, respectively. So this is good news.

So you're giving them high praise. They're 8 or 9 when we then look into the valuation, this is where you're probably going to deduct some points here. 46 times forward. Again, challenge to grow the net gross margins that 80%. Could grow the net margins at 26%. Excuse me, but, you know, that will take some time. And so you're giving them maybe a reduced score here, let's say a six.

And then you move on to the balance sheet again, you know, fortress balance sheet, you know, improved over time. Net cash on the balance sheet, about $3 billion generating 1.8 billion, has gone up from 1.2 over the last three years and really has moved from strength to strength on the balance sheet. No concerns there. So when you pull all those scores together and you weight them, each 25% depending on how you scored each, you're talking that this company is in the 8 or 9 categories.

Right. So this is something that we likely want to hold on to. I think the challenge for our analysts is to think about, you know, should we be trimming this company? You know, what, is there any catalyst that we should be aware of? You know, you can have this significant tailwind in the cybersecurity. They have to specifically execute.

But it is important for our analysts to look at this. We'll have to decide what we do with this. Is it a, are we in a situation that we think it's going to, you know, double in value over the next five years? You know, it's just going to become a much larger company. That's possible. Based on where the market cap is today, at 87 billion.

So all these things we have to consider and we'll ask our analysts to keep looking at this company. But again, good score. Obviously, we're going to be holding on to it with that type of score in the portfolio. But we'll have to decide what to do with it. We'll ask our analysts to do that.

Thank you for watching this episode on Fortinet. We'll see you back next time on “Market News with Rodney Lake.” Thank you.

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