Fortinet's Momentum Challenged

NEW YORK ( TheStreet) -- Every now and then growth investors come to a point when they have to make certain critical decisions about a stock. None is more important than when they realize that the momentum needed to keep a growth story going is starting to evaporate.

One such example is security giant Fortinet ( FTNT). While the company can go a few more quarters producing above-average growth, I worry that too much of its valuation assumes competition will just roll over and concede the market. However, its most recent quarter suggests otherwise.

The Quarter That Was

For the period ending in September, the company reported net income of $17.2 million, or 10 cents a share on revenue of $136.3 million. While revenue rose 17% year over year and in line with consensus estimates, deferred revenue soared to $340 million -- improving by 24% from the same period a year ago. Though profits arrived below estimates, on a non-GAAP basis net income arrived in line with estimates of 14 cents per share -- up from 13 cents year over year.

The company also reported higher sales and marketing expenses, which grew by almost $8 million. Likewise research and development expenses grew by almost $4 million. As a consequence, Fortinet's margins took a slight hit. Gross margins shed 100 basis points year over year, while the company also saw its operating income decline by 1.5%. Nonetheless, that the company produced 17% growth in revenue can offset of lot of uneasiness, especially considering the tough macro climate.

But investors didn't see it this way.

The stock has lost over 20% since announcement. The company's weak guidance might have had a lot to do with investor concerns. For the fourth quarter, the company said it expects revenue to come in the range of $142 million to $146 million -- below analyst's estimates of $146 million. Likewise, net income forecast of 15 cents was shy of consensus by a penny.

For the full fiscal year, management sees profits of 51 cents per share on a revenue range of $524 million to $528 million. Profit expectations were a penny below estimates and similarly, the top of the range of the revenue guidance was $600,000 short of analysts' expectations.

It is possible Fortinet is expecting competition to ramp up or that the company is being overly conservative. I think it's a combination of both.

Moving Forward

As noted in the opening, Fortinet's valuation implies the company is just going to run away with the security market. But management's guidance implies a different thought process.

What's more, with its sales and marketing expenses growing, it seems the company is starting the feel the effects of increased competition from rivals such as market leaders Cisco ( CSCO) and Check Point ( CHKP).

New arrival Palo Alto Networks ( PANW) continues to show more momentum in the market and Fortinet may find it increasingly challenging to overtake the current leaders.

As impressive as Fortinet's growth was during the quarter, it paled in comparison to Palo Alto, which reported a year-over-year increase in revenue of 88%. Likewise, Palo Alto's overall revenue for fiscal 2012 grew 115% to $255.1 million -- exceeding its 2011 mark of $118.6 million.

As a Fortinet investor, it would be hard to see these numbers and not develop some anxiety. Also it doesn't help that Ken Goldman, the company's CFO, has agreed to become the CFO at search giant Yahoo! ( YHOO). While I don't think this somewhat less-than-stellar quarter had anything to do with his departure, conclusions to the contrary will be drawn. Also, anything that introduces uncertainty such as a departing executive does very little to instill investor confidence.

Bottom Line

Understandably, investors showed some concern with Fortinet's earnings results and the guidance that followed. But the numbers were far from horrible. Rather, the uneasiness stemmed from the enormous expectations that have been placed on the company to produce the level of growth its valuation presumes. Though the company did not issue the beat-and-raise quarter investors were looking for, the report did highlight what a good growth story Fortinet continues to be.

The company's challenge is to convince the street that the slight decline in performance is not the beginning of a trend. In the meantime, investors need to ask themselves, how much value is there is the stock that trades at a price-to-earnings ratio close to 50 when rivals Cisco and Checkpoint trades at multiples of 12 and 14 respectively. As a value investor, I would stay away from the stock at currently levels. But should it drop another 10% falling to $17 or below, then I might have to reconsider.

At the time of publication, the author held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Richard Saintvilus is a private investor with an information technology and engineering background and has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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