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The Ratings Game: Security-software stocks are suffering from this one gloomy forecast

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As cloud-software valuations have been slashed this year, cybersecurity stocks have been the safest play in the sector, but they have been slammed this week — and Thursday’s decline seemed to stem from just one poor forecast.

Fortinet Inc.
FTNT,
-13.40%

guided for fourth-quarter billings Wednesday afternoon that undershot analysts’ expectations, sending shares plunging by a double-digit percentage in Thursday’s action. In a conference call, executives described a stall in completing deals — especially big ones — as companies take care with spending, a common theme in other software sectors this year but not in cybersecurity, which has largely been seen as a necessity that would escape budget discussions.

“As part of the [fourth-quarter] guidance-setting process, we considered several factors, including the greater macro uncertainty today, and with it, the increased risk of forecasting the timing of certain larger transactions [and] the transition to more normalized customer buying behaviors, which means there is less of an emphasis on ordering to get a place in line,” Fortinet Chief Financial Officer Keith Jensen said on a call.

Fortinet stock plunged as much as 20% in morning trading Thursday before pulling back to losses closer to 12%, and cybersecurity ETFs were headed for their second-worst week of the year as larger cybersecurity companies also took a hit. Shares of Palo Alto Networks Inc.
PANW,
-6.81%

dropped as much as 9.6% and Zscaler Inc.
ZS,
-4.16%

shares fell by more than 6% Thursday as analysts showed concerns about big deals closing. Shares of Cisco Systems Inc.
CSCO,
-1.35%

were down 2% at last check, while shares of CrowdStrike Holdings Inc.
CRWD,
-3.50%

were off 2.5%.

Fortinet is looking to compete with those and other vendors for bigger contracts, and a slowdown on those deals could signal a slowdown for cybersecurity competitors, who will not report earnings for at least a couple of weeks. Cisco reports its earnings Nov. 16, Palo Alto Networks is scheduled to report Nov. 17, CrowdStrike is scheduled for Nov. 29 and Zscaler is expected to report in early December.

“As Fortinet has started to move upmarket, the company is participating in larger deals in the seven- and eight-figure range that are facing additional scrutiny in a challenging macro environment,” wrote William Blair analyst Jonathan Ho, who has an outperform rating on Fortinet.

Mizuho analyst Gregg Moskowitz called the stock reaction “overblown,” noting that the company did not supply formal bookings and backlog figures now that “customers are now returning towards more normalized spending behavior (vs. expedited purchasing decisions that had been driven by supply chain constraints).” Moskowitz has a buy rating on Fortinet.

The problem could also be more about Fortinet than the larger sector, as Wells Fargo analysts pointed out that the company was having an issue with “the productivity of recently hired sales reps,” which caused them to be conservative about the ability to close deals in the holiday quarter.

Executives “said sales reps with less than one year of experience now make up 30% of the total sales force,” the analysts wrote, maintaining an overweight rating and $70 price target. “As such, management is not factoring the normal [fourth-quarter] budget flush this year.”

While this earnings season has been rife with fear that businesses are cutting back on capital spending because of a looming recession, analysts have said companies are unlikely to scale back as much on cybersecurity given the amount of negative exposure generated when a company gets locked out of its own data by ransomware.

So, even while cybersecurity stocks were heading for their worst week in six months, they have been still the least scathed of cloud-software stocks on the year. The ETFMG Prime Cyber Security ETF
HACK,
-2.25%

fell more than 2% Thursday, putting the ETF down 7% for the week and on track for its second-worst week this year, after a 7.6% decline for the week ending May 6. The First Trust Nasdaq Cybersecurity ETF
CIBR,
-2.50%

fell more than 2.5% Thursday, putting it on track for a 7.9% decline, its worst since an 8.2% drop that same week.

In comparison, the iShares Expanded Tech-Software Sector ETF
IGV,
-1.78%
,
which was down 1.4% Thursday, was off 7.7% so far this week, having had just two worse weeks this year. Similarly, the First Trust Cloud Computing ETF
SKYY,
-1.20%
,
which was down 1% Thursday and off 7.4% for the week so far, has had three other 7%-plus down weeks this year.

In fact, year to date, cybersecurity is holding up the best when it comes to software. While the HACK is down 29% and the CIBR is off 27% year to date, the IGV is down 38%, while the SKYY has fallen 43%. That’s compared with a 22% drop on the S&P 500 index
SPX,
-0.46%

and a 33% fall of the tech-heavy Nasdaq Composite Index
COMP,
-1.07%
.

At least 12 of the 31 Fortinet analysts that FactSet tracks trimmed their price targets in reaction to the earnings, leaving the average at $65.85 Thursday, more than 40% higher than the going rate. FactSet reports that 25 of the 31 analysts rate the stock the equivalent of a buy, while the other six rate it a hold.

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