In the weeks leading up to the holiday season, it is typical for investment banks to crank out IPOs at a break-neck pace in order to get them on the market before year end. Such will be the case next week when a flurry of IPOs hit the market. Among the many are two that clearly stand out from the pack that will likely generate a lot of buzz. The first is yet another popular internet-based company that, like other previous internet IPOs, has achieved astounding revenue growth. But, unlike its predecessors, it is actually profitable, making it a much more fundamentally sound company. The other is a rapidly growing apparel and accessory retailer, founded and led by a renowned fashion designer. Its comparable store sales growth is, by leaps-and-bounds, higher than any other recent retail IPO in recent memory. In short, these two deals will garner plenty of press next week, but the difference from other recent highly anticipated IPOs is that they actually have the fundamentals to back up the hype. 

Overview Of Our Grading System & Our "High Buzz" Icon

Before reviewing the IPOs for the week ahead, we wanted to first provide an overview of the factors we look at and analyze when grading an IPO. Our grades are primarily based on the following criteria: 1). profitability; 2). recent revenue and operating income growth rates; 3). future growth catalysts (micro & macro level); 4). margin levels and trends; 5). balance sheet strength; 6). valuation metrics relative to peers and 7). risk profile. Our grades are not an attempt to predict how a given IPO prices relative to expectations, but rather, is a snapshot view of the strengths and/or weaknesses of a company's fundamentals at the time we write the review.

Also, we wanted to alert readers that we have added a new "High Buzz" icon. Readers may have noticed this in our IPO previews for Groupon (GRPN),  Angie's List (ANGI), and Pandora (P). This icon was added to help our readers distinguish between "highly anticipated" deals that are generating a lot of buzz regardless of fundamental attributes, between those that actually do have strong businesses that are growing both the top and bottom lines. Of course, sometimes IPOs that are highly touted will also have solid fundamentals, but oftentimes, IPOs that are creating many headlines don't have the fundamentals to match the hype.

Stronger Growth Rates Key Catalyst For GNC Holdings (GNC), Shares Just Off Post-IPO Highs (11/18/11)
A Few Recent Oil & Gas IPOs Standing Out (11/15/11)
Similar to Groupon (GRPN), Angie's List Continues to Break Down After Strong IPO Day (Published to InPlay on11/25)
Groupon (GRPN) Prices Above Range, Deal Will Generate Excitement, But There Are Longer Term Fundamental Concerns (11/4)
Spirit Airlines (SAVE): Amid Considerable Weakness For Airliners, SAVE Displays Impressive Relative Strength (10/7)

Co-Managers: BofA Merrill Lynch, Barclays, JP Morgan, Allen

Introduction

Zynga (ZNGA), the maker of popular social network games such as FarmVille and Mafia Wars, is the next well known internet-based IPO following highly-anticipated deals such as Groupon (GRPN), Pandora Media (P), and LinkedIn (LNKD). Generally speaking, the trend for these internet IPOs has been to price and open for trading strongly, but then to pull-back sharply over the following trading days. Therefore, unless an investor was fortunate enough to be involved with the IPO, there is a good chance that many are underwater on these deals so far. In most cases, the fundamentals for these companies had serious flaws which gave us cause for concern, leading to mediocre/poor grades for some of these deals: Pandora (C+), Groupon (C-), ANGI (D+). But, as we discuss in more detail below, ZNGA's fundamentals do appear to be stronger than these previous internet-IPOs.

It's been a bumpy ride for ZNGA leading up to its IPO. After its IPO, the company is expected to have a valuation of around $7 billion, which is less than half of what was expected just a few months ago. Recent reports have shown that large investors that backed ZNGA as a private company -- such as Morgan Stanley Investment Management & Fidelity Investments -- are poised to face losses of 30% or more on their initial investments. Morgan Stanley, for instance, bought $75 million of ZNGA preferred shares at a price of about $14/share. There are a few causes for its substantial drop in valuation.

First, although the IPO market has picked up following the August-October doldrums, new deal activity has still been somewhat slow due to market volatility. In the second half of this year particularly, investors have been burned by quick, sharp losses in IPOs, which has dampened enthusiasm. Taking it a step further, internet IPOs have not performed well following their pricings due to concerns over high valuations, and in some cases, due to concerns about whether their business models can generate consistent profits. But, there are also some company-specific issues that have plagued ZNGA.

There are worries that competition is beginning to take a toll on the company, as evidenced by its drop in daily active users. In fact, since ZNGA first filed for its IPO about five months ago, its daily active users have declined by about 10%. There are also questions regarding whether the company warrants a market cap that is on par with Electronic Arts (ERTS), the maker of the ultra-popular Madden Football franchise and the Sims. Finally, it has been well-documented that ZNGA's CEO has told some employees and executives that he wanted them to give back some of their equity in the company -- a move that hasn't generated positive PR for the company, which is known as a tough workplace environment. Questions have been raised about its ability to attract top talent, and these latest headlines won't help that situation.

There are some attractive attributes for this IPO, though. Its revenue growth has been incredible and it is making promising in-roads in the mobile space (daily users have grown 10-fold since last year). Also,  ZNGA is profitable, which is a significant plus. Unlike GRPN, ANGI, and P, investors won't need to worry about whether ZNGA will ever become a profitable entity. Lastly, the deal itself is more attractive for investors. LNKD and GRPN faced quite a bit of scrutiny for not selling enough shares -- GRPN only sold 5% of itself -- which caused huge pops in their shares on the first day of trading. However, it also led to heightened volatility and the IPOs quickly suffered sharp losses after those initial spikes. ZNGA appears to have learned a lesson, and is offering more than 10% of the outstanding shares, which is more inline with a typical float for a technology company.

IPO Details

ZNGA will be selling 100.0 million shares in an expected range of $8.50-$10.00, which would equate to a deal size of $925 million at the mid-point of the IPO. The lead underwriters on the deal are tier one firms Morgan Stanley and Goldman Sachs. 

Neither the CEO, Mark Pincus, or any other executives will be selling shares in the IPO. However, back in March, Mr. Pincus -- who currently owns ~16% of the company -- sold a portion of his stake back to ZNGA for nearly $110 million. Five private equity firms are selling between 2.2-2.5 million shares each, including KPCB Holdings, Institutional Venture Partners, Union Square Ventures, Foundry Venture Capital, and Avalon Ventures. Also, Google (GOOG), which was an original investor in the company, and Silver Lake Partners will each be offering 1.7 million shares.

Business Recap & Use of Proceeds

Zynga (ZNGA) is the world's largest social game developer with 227 million average monthly active users, throughout 175 countries. Its games are best-known for being played on Facebook, which accounts for over 90% of its revenue. ZNGA has many of the most popular online social games, such as CityVille, FarmVille, Mafia Wars, Words with Friends, and Zynga Poker. According to AppData, it had four of the top five games on Facebook, based on daily average users. The success and immediate popularity of some of its games has been quite staggering. For instance, over its first 100 days, FarmVille grew to 43 million average monthly users and CityVille grew to 61 million users over its first 50 days. Its top three games account for nearly 60% of its total revenue, but this is a far cry from the 93% for its top three games in 2008. Successful new game launches, including Hanging with Friends, have lessened its dependence on its most popular game franchises. 

All of ZNGA's games are free to play as it generates revenue through the sale of in-game virtual goods and services which enhance the game playing experience. The company believes players choose to pay for virtual items because they enjoy the additional playing time or added convenience, the ability to personalize their game boards, and the satisfaction in "leveling up." 

As noted above, ZNGA is highly reliant on generating revenue through Facebook's platform. In May of 2010, the company entered into an addendum to Facebook's standard terms & conditions, requiring ZNGA to transition its payment method to "Facebook Credits" -- its proprietary payment method -- as the primary payment means for its games. Under the new terms, Facebook remits to ZNGA 70% of the face value of Facebook Credits purchased by players. ZNGA began transitioning to this method in July 2010, and by April 2011, it had completed the migration. Previously, ZNGA used third party payment processors and paid these processors service fees that ranged from 2-10% of the purchase price of the virtual goods.

One of the company's main strategies going forward is to diversify away from Facebook and it is doing so through mobile gaming. It has had some success here, as "Words with Friends" and "Hanging with Friends" were the top two games in the word category based on the number of downloads from the Apple App Store for iPhone as of September 30, 2011. However, at 93% of total revenue, Facebook is still its largest source of revenue, which poses a significant risk for the company. Should Facebook demand a higher percentage of the take from gaming revenue, ZNGA's business would be greatly hindered. 

The company is planning on using the proceeds of its IPO for a variety of initiatives. Some of the capital will be used for game development and marketing purposes, as well as for acquisitions and/or investments in complementary businesses. Further, it intends to use $83.6 million to satisfy tax withholding obligations related to vesting of restricted stock units in connection with this offering.

 Financial Review

What clearly stands out about ZNGA's financials is its tremendous revenue growth rates, which, to our knowledge, falls short of only GRPN as far as recent IPOs go. Unlike, GRPN, though, the company is generating an operating income. Looking at its most recent results, its revenue surged 1,063% to $828.9 million. This is despite the fact that the adoption of "Facebook Credits", which began in 3Q10, negatively impacted online game revenue for this period. Of the $427.2 million year/year increase in revenue, $100.8 million came from higher revenue from FarmVille, $118.9 million was attributable to FrontierVille, and $84.9 million was due to higher revenue from CityVille. International revenue as a percentage of the total climbed to 35% from 32% a year earlier.

One somewhat concerning metric is that its daily average users slipped to 58 million from 59 million at September 30, 2010. This indicates that existing players aren't playing games as frequently as they have been. On the encouraging side, average monthly unique users grew nicely, moving to 150 million from 118 million a year ago. A combination of new game launches, increasing marketing spend, and a growing mobile presence are the likely drivers to this. Another positive is that its average booking per user, or ABPU, has steadily climbed indicating that the company is doing a good job monetizing its games.

On the expense side, cost of revenue was up 82% and Sales and Marketing costs were up 61% to $121.9 million. While these are large year/year increases, they still are less than that of other recent internet IPOs. For example, GRPN's marketing spend in 2010 skyrocketed by 5,650%, and LNKD's sales and marketing expenses soared by 120% in FY10. This combination of robust revenue growth, and more "down-to-Earth" increases in marketing spending allowed the company to achieve an operating income of $80.9 million, up 50% year/year.

ZNGA's balance sheet also looks to be in good shape with no long term debt and cash & equivalents of $926.3 million. 

Key Metric Comparison

In the table below, we compare some of ZNGA's key financial and valuation metrics against two of its closest competitors -- Electronics Arts (ERTS) & Activision Blizzard (ATVI) -- as well as against the two largest U.S. internet-based IPOs of 2011.

*Most Recent Year End

Compared to the more "traditional" game-makers, ERTS and ATVI, Zynga's growth rates are on a different level. Also, ERTS wasn't even profitable a year ago while ZNGA swung to an operating profit of more than $127 million. In other words, from a financial performance and growth perspective, ZNGA seems to win in a landslide. On the other hand, investors are going to have to pay a high price for this growth as ZNGA's valuation is vastly higher than ERTS or ATVI. It should also be noted that ZNGA's growth rates will likely tail-off as competition heats up -- Disney is making a push with its Playdom gaming business -- and as it laps strong quarterly figures. 

Another way to gauge ZNGA is to stack it up against the two most highly-anticipated internet IPOs of the year -- LNKD and GRPN. Its topline growth rate exceeds LNKD and its business is generating a higher level of profitability as well. It does fall short of GRPN's revenue growth, but as many realize, GRPN has paid a very hefty price for that growth through its sales & marketing expense. Consequently, GRPN has yet to become profitable on an annual basis. All in all, ZNGA's financials look pretty good when compared against these two companies. As expected, it will be pricey, at around 12x trailing sales, but that does put it roughly inline with GRPN and well below LNKD.

Bottom Line and Fundamental Grade: B

Out of the U.S.-based internet companies to go public this year -- GRPN, ANGI, P, LNKD, RATE -- we feel that ZNGA has the best fundamentals coming out of the gate. Not only are its revenue growth rates better than all but one of these recent IPOs (that would be GRPN), but the company is already comfortably profitable. That gives it a major edge versus the other recent internet IPOs. With the ever-increasingly popularity of social networking sites, new game launches, a push into mobile devices, and possibly future acquisitions, its future growth looks promising. 

There are a couple flaws and concerns, though, that kept us from giving it an ever better grade. Valuation has been a significant concern and headwind for internet-based IPOs, and while ZNGA's valuation will be a bit more palatable than past internet IPOs, it will still carry rich multiples. Investors have been quick to flip out of these IPOs after locking in big gains on the first day of trading, pushing the stocks sharply lower in the following sessions. ZNGA could suffer the same fate, but the hope is, its profitability gives it some protection from that and its much larger float eases the volatility. The other primary concern is that competition will become a more prominent factor in the coming quarters. Its recent decline in daily average users is somewhat alarming, perhaps suggesting that ZNGA's customers may already be spending time on other games. 

All in all, though, we feel that ZNGA is an attractive IPO for growth-oriented investors who have a higher tolerance for risk.

 Co-Managers: Baird, Jefferies, Nomura, Piper Jaffray

Introduction

Zynga's (ZNGA) IPO may steal many of the headlines next week, but there is another IPO that will likely generate plenty of interest. Michael Kors Holdings (KORS), which describes itself as a "rapidly growing luxury lifestyle brand", also figures to make a splash when it goes public on December 15. KORS will be looking to capitalize on the strength of luxury and higher-end brands -- evidenced by the performance of peers Ralph Lauren (RL) and Coach (COH) -- as well as a run of noteworthy moves which have increased the visibility of the company and have bolstered its growth. One of those moves that put the company in the spotlight was Kors becoming a judge on the hit show "Project Runway", which debuted in 2004. Its high-profile has helped it to become a sought after brand for many celebrities which has made its apparel and accessory lines even more desirable to its upper class clientele. 

From an operations and strategy standpoint, KORS has been pushing the right buttons as well. Perhaps its most lucrative decision has been to expand its focus beyond apparel and grow its higher margin accessory business, which includes handbags, eyewear, jewelry, and watches. These product categories have been growth engines for other women's retail outlets, like Vera Bradley (VRA) and Coach, and it has certainly boosted KORS' growth. We discuss its financials in more detail below, but one of the most impressive aspects for KORS is that its comparable same store sales surged by an unheard of 48.2% in its fiscal year 2011. Another key move was to transition from a mostly wholesale business into a retail-oriented business. In fiscal year 2009, retail only accounted for 29% of its business, and today, it accounts for nearly 43% of its business. One reason the company did this was so it would have greater control over its brand, which seems to be working quite well.

It is important to note that the company itself is not raising any capital through this offering since all the shares are being offered by current equity holders. That may sour some investors' sentiment on the IPO, as people typically prefer to see a company go public in order to grow its business, improve its balance sheet, etc. At any rate, Michael Kors is expected to sell more than 5.8 million shares in the offering, reducing his stake in the company to 8.6% from 11.7%. At the high end, Kors could cash out $111 million. Even more eye-popping, though, is the profits that investors Silas Chou and Lawrence Stroll stand to make. Through the private equity firm, Hong-Kong based "Sportswear Holdings", they made an initial investment in KORS back in 2003, paying $85 million for an 85% stake. Today, Chou and Stroll own a combined 51.9% of KORS, which is valued up to $1.86 billion. The pair is expected to sell over 25.9 million shares for as much as $493 million.

The story-lines are intriguing for this IPO, and its high growth rates figure to put it on many traders' and investors' radars. With that said, its rich valuation is also something to be aware of. When it goes public next week, the stock could be trading with a trailing P/S above 4x and a P/E north of 45x. This far exceeds COH's valuation on a P/E basis, currently trading around 21x. But, given its exceptional growth rates, an argument can be made that a premium valuation is warranted for KORS. Another potential risk worth pointing out is that it isn't very geographically diversified, generating ~90% of its retail revenue in the U.S. This has worked in its favor recently, since luxury spending in the U.S. has been relatively strong compared to other developed countries, but a downturn in the economy and stock market would have a more profound effect on its business compared to other more geographically diverse retailers. 

Business Recap

KORS operates its business through three segments: retail (46.5% of revenue), wholesale (44.9%), and licensing (5.2%). The company offers two primary collections, the Michael Kors luxury collection and the MICHAEL Michael Kors accessible luxury collection. The Michael Kors brand is carried in its own retail shops as well as in high-end department stores such as Saks, Neiman Marcus, and Bergdorf Goodman. After realizing the success of its Michael Kors brand, in 2004, the company capitalized on that and launched its MICHAEL collection, which has a lower price point and has a strong focus on accessories, in addition to footwear and apparel. This clothing line is offered at all of its lifestyle stores, as well as leading department stores such as Bloomingdale's, Nordstrom, and Macy's. In total, as of October 1, 2011, its retail segment included 169 North American retail stores and 34 international retail stores. In its wholesale segment, its apparel is offered at total of 1,800 department stores in North America and 549 department stores internationally. 

AA significant driver for its future growth is expected to come from new retail store openings. During its fiscal year 2011, it opened 40 new stores, and it believes that there is a large opportunity to continue expanding its retail store base in North America. More specifically, KORS says that in the long-term, it plans to grow its retail store base to 400 locations in North America alone. As we noted above, KORS is still relatively under-penetrated on an international basis, and it sees considerable room for growth here as well. The company plans to leverage its existing operations overseas (London, Madrid,Tokyo, and others) to expand its retail and department store base. Over time, it believes that it can grow its international store base to approximately 100 locations in Europe and 100 locations in Japan.

Financial Review

On many accounts, KORS' financial performance has been very strong and impressive. Its revenue growth rates and its gross margin are robust and both have been trending higher over the past few years. Its comparable store sales growth is the highest that we can recall for any retail IPO in recent memory. When Vera Bradley (VRA), the women's handbag and accessory maker, went public back in October of 2010, we held a positive bias on that IPO partly because of its strong comparable store sales growth of about 22%. Incredibly, KORS' same store sales growth for its FY11 was more than double that rate. 

Drilling down on its results for the six-months ended October 1, 2011, its revenue jumped by about 60% year/year to $548.7 million. Driving the sharp increase in revenue was the 83% surge in sales from its retail segment, which benefited from a 63 store increase from a year ago to 203 locations. Also, comparable store sales growth for its retail shops were up an astounding 42.3% due primarily to higher sales of its accessories lines and watches. Results from its wholesale segment were not quite as impressive, but were strong nonetheless. Revenue climbed by 45% as it continued to enhance its presence in department stores by converting more doors to "shop-in-shops", and working with existing department stores and retailers to optimize its presence in their stores. Additionally, it expanded its doors in Europe to 549 from 238 a year ago, which helped to double its net sales in its European operations.

Gross margin is another bright spot for KORS, moving higher from 47.5% in fiscal year 2009 to 56.9% for the six-months ended October 1, 2011.  This is about in line with Ralph Lauren (RL), which achieved a gross margin of 58.3% for its fiscal year 2011. The improving margins for KORS is related to its push into retail, and higher sales growth in this segment relative to wholesale. But, margins in its wholesale segment have been improving as well, up 170 basis points year/year due to lower allowances and as it sells fewer off-price products.

Operating expenses have also been increasing at high rates, up 53% to $207.8 million for the first six months of fiscal year 2012. The largest component of operating expenses is SG&A, which was higher by 57% to $190.8 million, driven by salary costs and retail occupancy costs. These escalating salary and occupancy costs are related to the company operating more retail stores. However, despite the sharp increase in operating expenses, KORS' income from operations still surged by 112% to $104.3 million as revenue growth and margin improvement more than offset the higher costs. 

Key Metric Comparison

*Most recent fiscal year end. ** Most recent available period.

As the table above illustrates, KORS recent growth rates are far superior to its closest peers, across the board. On a P/S basis, it's valuation is on the high-end, well above RL, but still about inline with COH. Using a trailing P/E, though, KORS' will likely be far more expensive that its peers. But, given its unparalleled growth rates, a premium valuation seems warranted. The question is, how much higher will investors be willing to push its valuation once it begins trading next week?

Another positive sign for its IPO is the stock performance of RL and COH, which have both outperformed the broader markets this year. Also, VRA, which is probably the closest comparable in terms of recent IPOs, stormed out of the gate when it went public back in October of last year. The stock eventually cooled off, but traders and investors may be looking for KORS to replicate VRA's exceptionally strong start.

Bottom Line & Fundamental Grade: A-

Initially, we weren't expecting to be overly enthusiastic about this IPO -- a high-end apparel designer and retailer in a weak global economy. But, it turns out that the company is thriving and outperforming its peers within a subset of the retail sector that has been strong and resilient. Driven by its expansion and focus on accessories, footwear, and watches, its comparable store sales growth is the strongest we have seen. In combination with improving gross margin, its operating income growth has also been phenomenal. Further, the company has a lot of running room in terms of new store growth. Prior to 2009, the company was generating a large percentage of its revenue from the wholesale side of its business. But, over the past couple of years, it has shifted its strategy to the retail side and has been opening new stores at a fairly rapid pace. As we discuss in the "Business Recap" section above, KORS is planning to be very active in coming years in terms of opening new locations.

The biggest concern we have is its valuation. Once it begins trading, KORS will have a P/E north of 40x, which puts it well above its main peers. But, it can be argued that given its superior growth rates, it deserves much higher multiples. The other primary concern we have is that although high-end retailers have held up remarkably well in this environment, should the stock market and economy take a turn for the worse, KORS' business will inevitably suffer. 

OOverall, though, this is one of the more attractive IPOs that we have seen in some time, as our grade of "A-" would attest. 

Co-Managers: Citigroup, UBS, BMO Capital Markets, Wells Fargo

Jive Software (JIVE) sells a web-based social business software platform that facilitates communication and collaboration both inside and outside the enterprise. Its goal is to increase team and work productivity by making it easy for groups to brainstorm, share ideas and see what everyone is working on. JIVE is focused on unlocking what it refers to as the enterprise social graph, or the extended social network of an enterprise, encompassing relationships among its employees, customers and partners, as well as their interactions with people and content. 

JIVE's flagship platform -- Jive Engage -- is set up as a social network for employees within the enterprise and customers and partners outside the business. Internally, the platform is used as a communications tool and collaborative workspace that supports and enhances knowledge sharing, facilitates communication within and across organizational boundaries, and enables individuals to work together to achieve common business goals. Externally, customers and partners of the business use Engage to connect socially with one another, as well as with the enterprise, in a structured online community that allows users to ask questions, post answers and communicate about a product or particular issue. 

The company believes Engage is intuitive, easy to use, flexible and scalable, and can be implemented on either a public or private cloud environment. The product includes team member blogs, wiki-docs for group editing and discussion tools. Recent versions include video, analytics, and social media monitoring. It also taps into the social web by integrating relevant content and connections across the social networking landscape, enabling enterprises to improve their interactions with customers, leverage feedback to deliver improved products and services, and respond more quickly to market opportunities. 

As of the end of Q3, JIVE Engage had 657 enterprise customers with over 17 million users within those communities. While revenues have ramped higher over the past four years, so have losses. The  company remains unprofitable with the rise in costs outpacing the rise in revenues over the first nine months of 2011. Billings, a leading indicator of future revenues, however have been robust. Over the past couple years, billings growth has accelerated. In the most recent year (2010), billings growth doubled.

From a valuation standpoint, JIVE isn't too pricey for a software company. By annualizing revenues thus far this year, JIVE trades at just under 8x trailing sales.

Terms of the Merger

FusionStorm Global has a bit of an unusual history. The parent company is essentially a shell company that was formed in 2009 to acquire three IT consulting firms: fusionstorm, Global Technology Resources (GTRI) and Red River Computer, each has varying specialties. The proceeds from the IPO offering and the newly created shares are going to be used to acquire these three companies. To date, the parent company has not conducted any operations other than in connection with the proposed acquisitions and with this offering. 

Turning to the subsidiary companies, fusionstorm works with small businesses and large corporations, while Red River sells computer products to government agencies and GTRI is focused on services for corporations and the public sector. The parent company will use the proceeds to buy fusionstorm for $100 million, Red River for $26 million, and GTRI for $12.5 million and to pay off their debt. 

While still being separate companies, the various management teams have taken steps to insure a seamless transition. For example, FSTM has already identified the individuals who will lead its commercial division, its public sector division and its services division. Also, it has developed organizational charts and taken steps to reduce costs etc. Some of these actions have already taken place and others will take place upon the closing of the IPO. For example, GTRI and Red River have entered into an agreement which enables GTRI to sell products under Red River's brand to government customers. In addition, FS and GTRI are collaborating on providing technology products and services to GTRI clients. 

Background 

The combined company is a provider of IT services to domestic and international companies, as well as the public sector, including federal, state and local government entities, and educational institutions. FusionStorm provides end-to-end IT services, including hardware and software, maintenance and support services, pre-sales and technical consulting, professional services and managed services, including hosting and cloud services. The company works with clients in all aspects of their IT infrastructure investment, providing services from the initial needs assessment and design to procurement and implementation to on-going support and hosting. 

As technology needs continue to evolve, its clients are increasingly challenged to modernize and upgrade their existing IT infrastructure. FusionStorm helps its clients keep pace with emerging technologies by offering a range of products and services, including: servers and storage; data center and network optimization; server, desktop and client virtualization; data protection; security and compliance tools; unified communications; and cloud-based services. The company specializes in a diverse range of vendor technologies. With the increasing complexity of various technologies and how they work together, FusionStorm believes that there has been a fundamental shift in the industry whereby companies have moved from buying hardware, software and services from different vendors to buying an integrated service from a single IT provider. 

FusionStorm believes the combination of the three companies will enhance its competitive position relative to the three companies operating alone. Through broader geographical reach and expanded offerings, such as managed services and hosting, the company will be able to provide a broader suite of services to its clients. Also, its increased scale will strengthen relationships with its OEM vendors and international clients. 

Some of its key OEM relationships include Adobe, BlueCoat, CA Technologies, Cisco, Citrix, Dell, Dell Compellent, EMC, F5, Hewlett Packard, Hitachi Data Systems, IBM, Juniper, McAfee, NetApp, Novell, Oracle, RedHat, Sonicwall, Symantec, VMware and Websense. 

Clients include Celera, Cost Plus, the Department of Veterans Affairs, eBay, Equinix, Facebook, the FDA, Fujitsu, Google, PNC Bank, Ross Stores, Safeway, Salesforce.com, Sony, Symantec, the U.S. Air Force, the U.S. Navy, VMware and Wal-Mart.com. Of these clients, Facebook represented more than 5% of its pro forma combined revenues in both 2009 and 2010 and Wal-Mart.com represented more than 5% of combined sales in 2010. 

Financials 

The financial results assume the combination of the three companies. FusionStorm reported a profit for the nine months ended September 30, although just barely with net income of $0.4 million vs. an $(8.4) million loss in the year ago period. Revenue during this time period rose 9.5% YoY to about $550 million. 

One of the things that jumps out to us on FSTM is that this is a thin margin business. For the nine months ended September 30, gross and operating margin was just 17.0% and 0.7%, respectively, vs. 17.4% and (0.0%) in the year ago period. 

Overall, we are not overly impressed with the financials of the combined company. Top line growth of 9.5% is pretty modest. Also, the margins are very thin. In fairness, this is not completely unexpected given  FusionStorm's line of work. Remember that it does not manufacture equipment or anything. Rather it provides services to make sure various equipment from various vendors all work together. The revenue from the OEM equipment runs through FusionStorm's revenue line but there is not much margin associated with that so the low margins are a bit skewed because the equipment can be so expensive. Nevertheless, the growth isn't that great and our fear is that margins could take a further hit as there is a good deal of integration risk when you are combining three companies. 

The good thing is that there appears to be little long term debt on a pro forma basis. However, the combination makes the accounting a bit confusing so it's not entirely clear, but that appears to be the case. 

Conclusion 

The company is organized into two business segments. The Elektron division (51% of 2010 sales) sells specialty materials based on magnesium, zirconium, and rare earths. These include light-weight alloys and components for the aerospace and automotive industries, powders for countermeasure flares for defense customers, photo-engraving sheets used by printers, ceramic sensors for electronics, dental crowns, and industrial chemical catalysts. 

The Gas Cylinders unit (49% of sales) sells advanced high-pressure aluminum and composite gas cylinders used to supply oxygen for the healthcare industry, industrial gases for the electronics industry, carbon dioxide for fire-fighting. Also, this unit sells complex-shaped, sheet-based products used in airplane engine air intakes, automotive body panels, window frames for trains, and non-magnetic equipment casings for healthcare customers. 

As its product lines imply, Luxfer has a diverse list of customers, including 3M, Air Liquide, Aston Martin, BAE Systems, BASF, Bombardier, Honeywell, Tyco, and United Technologies. Further, the company isn't heavily reliant on any one large customers; in 2010 Luxfer's ten largest customers represented 32% of total sales. 

While diversified, Luxfer's business is still highly cyclical due to its aerospace, automotive, and industrial end markets. Also, gross margins are subject to the fluctuations in raw materials prices, particularly aluminum and magnesium, and even moreso in its rare earths inputs. 

While the business took a hit in 2009, the company turned a profit and generated cash during each quarter that year. In 2010 sales and operating profit rebounded sharply, with the 2010 operating margin of 11.1% exceeding its 2008 peak of 8.3%. Comparing the first nine months of 2011 versus that of 2010, sales rose 28% while operating profit rose at an even faster pace of 47%. 

While recent growth has been impressive, the balance sheet is a source of concern. While a 2007 restructuring greatly reduced the company's debt burden, Luxfer still has $138 million of debt as of the end of September. The company also notes that its defined benefit pension plan has significant funding deficits. Yet, the company only has $8 million in cash on hand. The IPO is expected to generate $100 million in proceeds, part of which will go to selling shareholders. As to the remainder, management plans to repay all $48 million of its outstanding term loan, and to contribute approximately $25 million towards the purchase of insurance for its pension plans in order to reduce the volatility of its pension liabilities.

GSE Holding (GSE) is set to price its 9 million share IPO next week in the $13-15 range. Of the 9 million shares, 60% (5.4 million) are being offered by the company and the remaining 40% (3.6 million) are from selling stockholders. Based on the mid-point of the range, GSE is expected to have a market cap of around $238 million and it should raise around $126 million before fees. There are no plans to pay a dividend. 

Background 

GSE is a plastics company that sells a variety of geosynthetic materials used for lining landfills, water treatment ponds, canals, tanks, and in other infrastructure applications. Its products are used in a wide range of infrastructure end markets such as mining, waste management, liquid containment (including water infrastructure, agriculture and aquaculture), coal ash containment and shale oil and gas. Products include
geomembranes, drainage products, geosynthetic clay liners (GCLs), nonwoven geotextiles and specialty products. 

Geosynthetic lining is often mandated by regulatory authorities for the safe containment of materials and groundwater protection. Its products are manufactured primarily from polyethylene resins and proprietary additives. They are engineered to high performance specifications such as relative impermeability, structural integrity and resistance to weathering, ultraviolet degradation and extended chemical exposure. 

GSE believes it generates a pricing premium and margin advantage from its technologically advanced products and its brand name which is well-recognized in the industry. That's important for a product that is often required to last in perpetuity. GSE also sees an advantage in the fact that it's one of the few suppliers that has the product breadth to supply large, complex projects on a global basis. Customers include mining, waste management and power companies; independent installers and dealers; general contractors and government agencies. 

About 42% of revenue comes from north America while 58% of sales are outside North America including emerging and frontier markets in Asia (14%), Latin America (11%), Africa (10%) and the Middle East (3%). It sells its products in over 110 countries and it has seven manufacturing facilities located in the US, Germany, Chile, Egypt and Thailand. 

Industry 

GSE is the largest player in its space with a 24% global geomembrane market share. Within individual end markets, GSE has strong market share positions as well, including 40% in the mining end market, 19% in the waste management end market and 11% market share in the liquid containment end market. 

It's a highly fragmented industry with many small, privately held companies competing on a local or regional basis. GSE is one of the few national/global players and it benefits from having has a much deeper product offering. 

Demand for geosynthetics is influenced by environmental regulations, particularly those involving heap leach mining, landfills and waste ponds for industrial and energy process by-products. For these markets, some type of geosynthetic is typically required to comply with environmental standards for groundwater protection. In the US, one example of applicable legislation is the Resource Conservation and Recovery Act of 1976, which provides legal guidelines for the storage, treatment and disposal of hazardous and nonhazardous solid waste. 

End Markets 

Here is a bit more detail on how GSE's products are used I each of its key end markets: 

• Mining: In the heap leach extraction process (the process by which precious metals are extracted from ore) used in the mining industry, geosynthetic systems: 1) prevent the leakage of the valuable leachate into which the metal is dissolved, 2) protect the ground and soil from contamination and 3) provide drainage. In all other processes, geosynthetics are used as containment for the tailing ponds in which water borne tailings are stored in order to allow the separation of solid particles from water. Its products are especially relevant to mining for copper, gold, silver, uranium and phosphate. 

• Waste Management: Geosynthetics are used as liners to prevent landfill runoff from entering the surrounding environment and as caps to prevent the escape of greenhouse gases, control odors and limit rainwater infiltration. Heightened environmental regulation in Asia and other emerging markets is helping demand. These governments are moving from open dumping and open burning practices towards landfilling and other more environmentally friendly methods of disposal. For example, China expects to spend $28 billion on the urban waste disposal sector between 2011 and 2015. 

• Liquid Containment: Geosynthetic products are used in a wide variety of liquid containment applications in civil engineering and infrastructure end markets such as water infrastructure, agriculture and aquaculture. 

• Coal Ash Containment: Coal-burning power plants produce coal ash, a pollutant that can contaminate soil and groundwater. In December 2008, a coal ash containment failure in Tennessee resulted in the release of 5.4 million cubic yards of coal ash into the Emory River. The clean-up costs are estimated to be in excess of $1 billion. Following this incident, the EPA announced plans to regulate the disposal of coal ash under RCRA. However, the proposed rules may never become enforceable because the US House of Representatives recently passed legislation that proposes national standards which the states, and not the EPA, will enforce. Utilities have already begun capping existing noncompliant disposal facilities and constructing new disposal facilities that meet the requirements of the regulation in advance of it coming into effect. 

• Shale Oil and Gas: Geosynthetic products are used in shale drilling in order to line storage and disposal ponds for the containment of freshwater, fracking chemicals and flowback water. GSE believes that the majority of producing shale wells will ultimately require lined ponds. Shale gas production is expected to account for 47% of total natural gas production by 2035 compared to 16% in 2009. 

Financials 

GSE appears to have only recently turned profitable. For the nine months ended September 30, net income from continuing operations was just $1.8 million vs. $(14.7) million in the year ago period. In fact, GSE reported losses on a full-year basis in each year from 2008-2010. Revenue for the first 9 nine months increased 40% YoY to $353.8 million. 

One of the things that jumps out to us on GSE is that this is a thin margin business. For the nine months ended September 30, gross and operating margin was just 14.9% and 5.7%, respectively, vs. 11.9% and (1.0%) in the year ago period. While that's nice growth from a year ago, it's clear that this is a thin margin business. That seems to make sense as polyethylene is the major raw material for GSE. Essentially, the bulk of its costs goes toward purchasing polyethylene then the company simply processes it further into various products. The prices that GSE can charge probably is closely tied to the spot price for polyethylene then customers allow for some add-on profit for GSE to cover its processing costs. 

With that said, even though this is a thin margin business, it appears to us that even small changes in prices could have a big impact on the EPS line because the share count is so low. Just 17.0 million shares will be outstanding following this offering. As such, this could be a volatile name around earnings season, either good or bad. 

A final note on the financials is that GSE has a lot of long term debt. Its pro forma adjusted LT Debt-to-Cap following the offering is expected to be about 59%, which is down from its current level of 85%, but it will still be highly levered. It appears that some of the IPO proceeds will be used to pay down debt, but the balance sheet will remain very levered even after the inflow of cash. 

Conclusion 

While GSE has some positive attributes, namely its top line growth rates, decent underwriters and it has exposure to some attractive end markets which are under pressure to clean up their act (especially shale formations and coal ash), there are still a lot of negatives here. The company has a lot of debt, it's a thin margin business and we expect earnings reports will be volatile events because so much (80%+) of its cost of goods sold is tied to polyethylene prices and because the company has a low share count. However, if you're confident in the direction of polyethylene prices and are looking for a good way to play that market, GSE is certainly a way to do that.

* Most Recent Year End

Delphi Automotive (DLPH): Encouraging New Car Sales In November Help Boost DLPH Back Towards IPO Price ... Published on December 5.

Delphi Automotive (DLPH) got off to a rough start when its IPO priced at the low end of its expected range ($22 Vs. $22-$24) back on November 17 -- click here to read our pricing review. DLPH opened for trading at $21.25, or 3.4% below its IPO price, and sank quickly thereafter, trading as low as $19.22 by November 23. However, this recent IPO has shown some resilience and has rebounded off of those lows, now trading above its opening price and nearing its IPO price.

The primary driver for the turnaround is likely tied to encouraging new car sales in the month of November. In fact, U.S. car sales rose to the highest level in two years, moving to an annualized rate of 13.6 million (the highest figure since cash-for-clunkers in 8/09). Furthermore, the outlook for new car sales looks decent because the average age of a car in the U.S. is now 10 years, as compared to the "normal" age of 6-7 years. This suggests that many people will need to replace their cars soon, which bodes well for auto OEMs (F, GM) and for auto part makers like DLPH.

DLPH is an IPO that we were somewhat positive on, assigning it a grade of "B-" in our original preview, which can be accessed here. What we liked about DLPH is that the company has executed an impressive turnaround following several difficult years in which it recorded hefty losses. As some may recall, DLPH was a former division of General Motors (GM) that emerged from bankruptcy in 2009. This past March, DLPH bought back its stake from GM, and today, its largest shareholder is Paulson & Company, which disclosed a 15.8% stake in the company last Friday. Since detaching itself from GM, the company has undertaken several initiatives such as cutting its product lines to 33 from 119, decreasing its global headcount by 23% (with ~90% of its workforce now in low-cost countries), closing 70 sites around the world, and cutting ties with the UAW. The net result is, the company has gone from large operating losses in 2007-2009, to growing profits over the past two years. These actions helped the company record an operating income of $940 million in 2010 comapred to the sizable losses over the prior few years.

Our primary concern with DLPH was that its business is highly tied to the health of the global economy. Consequently, its stock would suffer when worrisome global macroeconomic headlines hit the wires. Recently, though, most of the news out of Europe and China have been relatively positive, which has helped fuel the turnaround for DLPH. The new car sales data has also been positive for DLPH. All in all, its turnaround has been impressive and it looks poised to benefit from better auto sales, but we do remain a bit cautious on the stock due to the cyclical nature of its business.

In this section of our weekly column, we provide a rolling list of each IPO to price over the past few months. Additionally, performance measures will be included in the table, as well as our grade or sentiment reading, if applicable.

The Next Big Thing team:

• Lead Analyst: Dennis Hobein
• Contributing Analysts: Jim Busch; Chris Borgmeyer, CFA;  Robert Reid; and Jeff Eckmann