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Violin Memory (VMEM) made its public debut on Friday, September 27. Shares of the provider of persistent memory-based storage solutions ended their first day with losses of 22.0% at $7.02 per share.

The sell-off marks a "failed" public offering, which I can completely understand. The rapid losses, long road to profitability, and outright insane management compensation makes it easy to skip this offering. Note that Violin Memory awarded its CEO equivalent to 3% of its current market capitalization over the past year, an insane amount.

The Public Offering

Violin Memory has pioneered a new class of persistent memory-based storage solutions. These solutions align storage performance with high-speed applications, servers and networks.

These solutions are used for high-performance business applications such as Big Data Solutions and cloud offerings. The low latency and consistent performance requirements combined with great reliability, creates value for customers. Customers can realize significant savings on capital expenditure requirements and operational costs.

Violin Memory sold 18 million shares for $9 apiece, thereby raising $162 million in gross proceeds. All shares were sold by the company with no shares being offered by selling shareholders.

Bankers and the firm set an initial price range of $8 to $10 per share. Shares were eventually sold at the midpoint of the range.

Some 22% of the total shares were offered in the public offering. At Friday's closing price of $7.02 per share, the firm is valued at $574 million.

The major banks that brought the company public were JPMorgan (JPM), Baird, Deutsche Bank, Barclays, Bank of America/Merrill Lynch (BAC) and Pacific Crest Securities.

Valuation

Violin Memory has some key services including Flash Memory Arrays, which are designed to optimize flash memory while meeting the high requirements for critical and high-performance applications.

Another offering, the Velocity Peripheral Component Interconnect Express, creates optimal solutions for constant high demand, but low persistent memory access, located on servers.

The need to storage and access large amounts of data provides a new challenge and opportunity within the IT industry, as demand increases in terms of capacity and needs. At the same time, businesses demand world-class reliability.

For the calendar year ended January of this year, Violin generated annual revenues of $73.8 million, up 36.9% on the year before. Net losses more than doubled to $109.1 million.

Sales for the six month period ended July of this year rose by 69.3% to $51.3 million. Net losses widened from $48.3 million to $59.2 million in the meantime.

The company operates with $33.5 million in cash and equivalents and operates with a credit line of $20.2 million. Adding gross proceeds of $162 million from the offering, and Violin should operate with a net cash position of around $150 million. At the current pace, Violin is burning through these amounts within two year's time.

This values operating assets of the firm at $425 million. As such operating assets of the firm are valued around 5.8 times last year's revenues.

Investment Thesis

As noted above, the offering of Violin Memory has been anything but a success. The company priced the offering at the midpoint of the preliminary offering range, after which shares have witnessed a dramatic opening day.

Gross margins fell by 80 basis points to 41.4% in the first half of the year on the back of higher service revenues which carry lower margins. At the same time, Violin Memory has seen significant operating leverage, although not enough. Operating expenses fell from 189.8% of total revenues for the full year of 2012, to 155.5% in the first half of 2013. Obviously, this is still a far from ideal situation.

With every public offering, there are some key risks. For starters, the company has only been founded in 2005, currently employing 445 workers. This includes a heavy customer concentration, while the situation is improving. In 2012 for instance, Hewlett-Packard (HPQ) represented 65% of total revenues. While this has fallen to levels below 10%, the top five customers still generated 37% of total revenues in the fiscal 2013. This percentage dropped to 32% in the first half of the fiscal year of 2014.

Another risk is the great reliance on Toshiba, which is a key shareholder from which Violin buys its flash memory. While Violin states that its technology is superior, the company operates in a highly competitive industry. Some competitors in the traditional storage industry include EMC (EMC), HP and IBM (IBM). Other competitors with server-centric flash solutions include Fusion-io (FU) and Sandisk (SNDK), among others. While the traditional enterprise storage systems market is much greater compared to flash-based systems, the growth in the latter segment is expected to be much higher in the coming years.

Another key risk is product reliance as Violin generates by far the majority of its revenues from the 6000 Series Flash Memory Arrays, launched at the start of 2012.

While all of these risks are somehow manageable, I am shocked when reading the management compensation section, which is a huge red flag to me. CEO Donald Basile took home almost $19 million in total compensation over the past year, an insane amount for such a small company, and especially in the light of the huge losses being reported.

So the market reaction is completely understandable. The revenue multiple is fair enough at 5.8 times last year's revenue, expecting to fall to about 4 times in the calendar year of 2013. Yet Violin Memory's gross margins of 40% are not really impressive. Add to that the significant operating expenses and outright crazy management compensation, and you have to stay out.

As the path to profitability will be a very long road, I completely agree with the market's reaction on Friday, and will skip this offering as I see too many red flags.

Source: Violin Memory - Failed Public Offering On 'Insane' Management Compensation