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Shares of Violin Memory (NYSE:VMEM) are facing a violent sell-off in the wake of its third quarter earnings report. A soft quarter and a weak guidance combined with mounting losses make investors very nervous, merely two months after the public offering.

Despite the significant correction, with operating assets valued at merely 1.0 times revenues, I remain very cautious. The company has already built up a bad reputation following its public offering. Given the very large current losses, Violin Memory might run into financial troubles as early as the end of next year.

Third Quarter Results

Violin Memory generated third quarter revenues of $28.3 million, up 37.4% on the year before, and up 6.7% on a sequential basis. Revenues missed consensus estimates at $31.7 million.

Net losses widened from $25.4 million to $34.1 million, as losses per share came in at $0.85 per share. Note that net losses in the second quarter totaled $30.6 million.

Non-GAAP losses came in at $25.4 million, or at $0.63 per share. Analysts were looking for smaller losses at $0.45 per share.

CEO Don Basile commented on the third quarter developments, "Enterprise data center storage is in the early stages of a major transformation to an Enterprise Memory based infrastructure, and Violin is at the forefront of accelerating this transformation."

Looking Into The Results...

While total revenue growth looks solid, it is nearly entirely explainable thanks to service revenues. Service revenues more than five-folded to $6.9 million as product sales inched up by 10.8% to $21.4 million. The slower growth in product sales will undoubtedly limit service revenue growth going forward.

Gross margins inched up by 11 percent points to 54.3% of total revenues. The problem is ballooning operating expenses which rose by 41.3%, thereby outpacing revenue growth and totaling $48.4 million.

...And Ahead

Revenues for the fourth quarter are seen between $30 and $32 million. This implies that at the midpoint of the range, revenues are seen to be up 9.5% on a consecutive basis. Revenues are seen to grow 41.4% on an annual basis.

Non-GAAP gross margins are seen at 53-55%, while non-GAAP operating expenses are forecasted at $39-$40 million.

The guidance implies that operating losses are supposed to narrow compared to the third quarter.

Analysts were looking for a much greater acceleration in revenue growth, expected to come in around $43.3 million. The huge discrepancy between the fourth quarter guidance and consensus estimates is a key driver for the sell-off on Monday.

Valuation

Violin Memory ended its third quarter with $134.2 million in cash, equivalents and short-term investments. The company has no debt outstanding for a solid net cash position.

Revenues for the first nine months of the year came in at $79.6 million, up 56.4% on the year before. Losses widened to $93.3 million, indicating the company is burning through its current cash balances in about a year's time. At this pace, annual revenues are seen around $110 million.

Factoring in Friday's massive losses, with shares trading just above the $3 mark, the company values Violin Memory at about $250 million. Excluding the cash position, operating assets are valued at merely $115 million at this point. This values operating assets of the firm at about 1.0 times annual revenues.

Obviously, Violin Memory does not pay a dividend at the moment.

Some Historical Perspective

Back in September, shares of Violin Memory made their public debut. Bankers priced the offering at $9 per share, after which shares fell by more than 20% on their opening day.

Shares continue to fall and trading around $3 per share, shareholders have suffered losses of nearly 70% in merely two months' time.

While the company has grown from hardly reporting revenues in 2009, to an expected $110 million business in 2013, losses have been exploding as well. Losses came in at $109 million last year, to be followed by an equivalent loss this year.

Investment Thesis

Investors are shocked based on the results and outlook which fell short on all metrics.

In Violin's defense, I think the expectations from analysts, notably for fourth quarter revenues, have been too high to start from. At consensus estimates, fourth quarter revenues were set to nearly double, which was too ambitious. That being said, the third quarter revenue and earnings guidance falls a bit short to levels which I believe would be achievable.

Not only slower revenue growth, but higher costs are a big issue as well as losses are mounting. At this pace, the company is rapidly burning through its public offering proceeds. Even though the fourth quarter guidance implies that losses are set to narrow in the coming quarter, Violin might run into financial difficulties next year. At the current pace, the company is burning through its entire cash balances in 12-18 months' time.

Yet investors are not focusing on narrowing losses going forward, as the bad news is dominating on Friday. Comments from CEO Basile about customer additions and a transformation to an Enterprise Memory based infrastructure, are largely ignored.

Back in September, I took a look at Violin Memory's prospects following its public offering. I concluded that a failed public offering could partially be attributed to insane management compensation.

I noted that high losses at a current rate of $140 million per annum, slower growth and very high management compensation were the drivers behind the "failed" public offering. Note that top three executives of the firm were granted a total of $26 million in compensation for this fiscal year on page 105 of Violin's S1-Filing. The path to profitability and restoring trust will be a long road, making it easy for me to skip the offering given the many red flags. As indicated earlier, dilution might be real risk with current losses at an annual basis exceeding the current cash balances.

Today I reiterate my stance. While Friday's price reaction might be a small overreaction, severe dilution or financial stress becomes a real worry at this pace in a year's time.

Source: Violin Memory - Warning Signs Continue As Financial Troubles Might Arise