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Co-founded by Nobel laureate William F. Sharpe in 1996, investment adviser Financial Engines (NASDAQ:FNGN) is expected to complete its highly anticipated IPO this week. If successful, the company stands to be the first small cap growth IPO to test investors' appetite since early February, when online lead generation firm QuinStreet (NASDAQ:QNST) raised $150 million.

Backed by well-regarded venture firms including Foundation Capital, New Enterprise Associates and Oak Hill, Financial Engines was originated to cater to the retirement needs of less affluent individual investors and hopes to benefit from positive trends in the retirement industry, such as the notable shift toward defined contributions plans, automatic enrollment into 401(k) plans and a changing regulatory backdrop that reduces the fiduciary risk associated with offering investment advice.

Financial Engines expects to raise $109 million by offering 10.9 million shares, with 5 million coming from insiders, at a range of $9-$11. Goldman Sachs (NYSE:GS) and UBS Investment Bank (NYSE:UBS) are the lead underwriters on the deal, which was slated to price Monday night and open for trading on the NASDAQ on Tuesday. At the midpoint of the range, the company will command a market cap of $441 million.

The Business

Financial Engines targets three key constituents in the retirement plan market: (1) plan participants, the individual employees who are enrolled in corporate 401(k) plans, (2) plan sponsors, the employers who offer these plans, and (3) plan providers, separate companies that offer the financial products and administrative services behind these plans.

The technology-enabled investment adviser generates revenue by charging plan members a modest fee (based on assets) for directly managing a participant's overall portfolio or by charging plan sponsors a subscription fee for access to its platform, which offers services such as nondiscretionary online advice and annual retirement risk evaluations. Financial Engines' services are delivered through the platforms of major 401(k) plan providers, including JPMorgan (NYSE:JPM), ING, Vanguard and Fidelity.

Fundamentals

While relatively small in size, Financial Engines has managed to grow its top line and improve its margins throughout the economic downturn by focusing on an underserved market in the financial industry and successfully forging relationships with major plan sponsors. In 2009, revenue grew 19% to $85 million as assets under management (AUM) swelled 65% to $25.6 billion. The company also turned profitable on a cash flow basis for the first time, and the company appears to have hit a tipping point in terms of scaling the business. In 2009, EBITDA margins nearly doubled to 23% while free cash flow topped $11 million compared with a year ago loss.

Despite competition from independent boutiques and traditional asset managers, Financial Engines appears poised to continue to grow, with contracts with 760 plan sponsors covering roughly 7.4 million plan participants and $500 billion in assets as of December 31, 2009. This means the company is less than 10% penetrated on both a member and asset basis.

Key Issues

As noted above, Financial Engines is indeed a relatively small company in comparison with industry peers and only turned profitable last year. Additionally, though assets under management have generally increased in recent years due to strong growth in plan sponsors and members, AUM per member fell over 30% in 2008 due to asset depreciation. In addition, competition remains a key risk going forward as the company may increasingly butt heads with major plan providers who may be less willing to share in the lucrative fees should Financial Engines continue to gain scale.

Valuation

Compared with both investment services and analytics providers as well as more traditional asset managers that offer retirement products, Financial Engines appears to be coming to market at a premium based on P/E. However, we believe the higher price may be justified by the company's promising growth outlook, particularly if its margins continue to scale.

Source: Financial Engines: First Small Cap Growth IPO in 6 Weeks