Since Facebook's (FB) IPO on May 18, the IPO market has basically been dormant. But, the tide is about turn in a big way next week with a few high-profile IPOs on the docket. Among the set is a popular online travel company that is experiencing solid revenue growth and margin expansion, a next-generation firewall appliance developer that we feel has all the elements of a must-own emerging growth stock, and a retailer that has a similar concept to dollar stores -- one of the hottest spots in the retail sector. 

In short, this is one of the most intriguing lists of upcoming IPOs that we have seen in some time. Given the uncertainties facing the market and economy, and the negative sentiment for IPOs, it makes sense that investment banks would initially go forward with higher-quality IPOs. We would expect these deals to see solid interest, but if the stock market comes under pressure next week -- which is possible with a busy week of earnings on tap -- they may not perform as strongly as expected out of the gate. Consequently, this could open up an opportunity to pick up these IPOs at reasonable prices. 

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.

Introduction

At long last, KYAK will finally go public next week on July 20. The company filed its initial S-1 all the way back in November of 2010, but held off on going public for a variety of possible reasons. Among those reasons for the delay, perhaps the most prominent may have been KYAK's desire to become a more established company and to get its "financial house" in order. In FY11, for instance, the company made a key strategic decision that significantly impacted its financials. The company determined that it would not support two brand names and URLs in the U.S. and that it would migrate all traffic from sidestep.com to KAYAK.com. This created a large write-down of $15 million. KYAK may have preferred for this to be in the rear-view mirror before testing the public markets.

There was another major event that occurred in 2011 that may have dissuaded KYAK from going ahead with its IPO.  Through its $700 million acquisition of ITA Software, Google (GOOG) became a serious competitive threat to KYAK. There was some uncertainty whether the Department of Justice would approve the deal, which also clouded the competitive landscape for KYAK. The DoJ ultimately approved the deal in April 2011, removing that overhang, but KYAK may have wanted to get a better understanding of how this would impact its business before pitching its IPO.

Also, over the past couple of years, the IPO market has suffered through a few different slumps. In particular, several internet related IPOs such as Groupon (GRPN), Pandora (P), Zynga (ZNGA), and most notably, Facebook (FB), have all been busts on varying levels. That doesn't create the most favorable background for KYAK's IPO.

IPO Details

Looking at KYAK's deal, the first thing that stands out is the size -- namely, how few shares are involved. In similar fashion to LinkedIn (LNKD), which only offered 7.8 million shares, KYAK is going ahead with a very small deal, selling only 3.5 million shares. The primary motivation for launching such a small IPO is to create a favorable supply/demand situation. This strategy definitely worked in LNKD's favor, as its deal priced at the high end of expectations and then opened for trading 84% higher. Since then, that stock has built on those initial gains, up 133% versus its IPO price. On the other end of the spectrum is Facebook (FB) and Zynga (ZNGA), both of which had massive deals (421 million & 100 million, respectively). There are, of course, other fundamental issues in play, but, both FB and ZNGA are trading well below their IPO prices. 

KYAK's small deal size could be a positive, but, there is one notable downside worth mentioning. Since the company won't be raising a large amount of money, this does significantly increase the odds of KYAK doing a secondary offering in the near future. This would be dilutive to the stock.

In addition to the IPO, there will also be a $9.2 million concurrent private placement, allowing certain existing stockholders (Oak Investment Partners, General Catalyst Partners, Sequoia Capital) to purchase up to an aggregate 389,643 shares of Class A stock within five business days of the IPO.  

Business Recap & Growth Strategy

Launched in 2004 by co-founders of Expedia (EXPE), Travelocity. and Orbitz (OWW),  Kayak (KYAK) is an online travel company that enable people to easily research and compare a variety of data from hundreds of other travel websites through one, comprehensive, fast, and intuitive platform. It also provides filtering and sorting options, travel management tools such as flight status updates, pricing alerts, and itinerary management. Flights are not purchased directly through KYAK's website, but rather, when a user finds their desired flight, KYAK sends the user to their preferred travel supplier or online travel agent website to complete the purchase. In many cases, users can book hotels directly through KYAK's website or mobile application.

KYAK's services are free for travelers. The company generates its revenue by sending referrals to travel suppliers and online travel agencies (OTA) and from advertising placements on its websites and mobile applications. A significant portion of its revenue comes from a few large customers. Expedia, and its affiliated brands (Hotels.com and Hotwire) accounted for 23% of its total revenue for its first quarter this year. Orbitz and Priceline each accounted for about 10% of total revenues. Of note, its contract with Orbitz expires on December 31, 2013.

Although it is well-known and its services are widely uses, it is actually a small company with only 185 employees. Most of these employees are either software engineers or in another facet of technology. From a geographical standpoint, it has a presence in 15 countries outside of the U.S., including the U.K, Germany, France, Spain, Italy, and Austria.

One way KYAK will look to growth its business is by expanding its direct bookings capabilities. Understandably, most customers would prefer to complete their bookings without having to leave KYAK's website, so bolstering this feature makes sense. In March 2011, it did add the capability for consumers to make hotel reservations through its U.S. website . It has since added this functionality to its mobile applications, and on a limited basis, has introduced this for airline tickets and rental cars. Going forward, it intends to further bolster this capability for flights and rental cars. 

Mobile figures to be another important avenue for growth. Mobile has experienced rapid adoption, with its applications downloaded over 15 million times since being introduced in March 2009. For 1Q12, it had approximately 3 million downloads, equating to year/year growth of 43%.

Lastly, KYAK has a lot of room for international expansion. In 2011, it opened on office in Switzerland, serving as its European headquarters. The company is only in the early innings in terms of growing its business outside the U.S., however, and in 2012 and 2013, it plans to invest in both head count and marketing in these newer markets.

Financial Review

*Excluding impairment charge

KYAK's financials look pretty strong, overall. Revenue growth is solidly in the double-digits, operating margins (albeit not that impressive) are trending in the right direction, and the company is profitable. The company's balance sheet is also in good shape with no long term debt and a decent cash balance. 

Looking at its FY11 results, revenue was up 32% to $224.5 million. The primary driver here was a 42% jump in query volume as it increased its investment in marketing activities, completed its acquisitions of swoodoo and checkfelix, and began its partnership with Bing Travel in March 2011. Offsetting the jump in query volume was a 6% reduction in RPM to $250 from $269 due to an increase in mobile queries in which KYAK earns revenue at a lower rate. Mobile queries were 14.1% of the total as compared to 8.2% in 2010.

KYAK's operating income for FY11 was $14.3 million, down from $16.8 million in FY10. However, this includes a $15 million impairment charge due to its decision to not support two brand names and URLs in the U.S. and to migrate that traffic to Kayak.com. Excluding this charge, its operating income would've been $29.2 million, up 74% year/year. Its operating margin, also excluding this charge, improved meaningfully to 13% from 9.8%. Revenue growth of 39% outpaced overall operating expense increases of 28%, allowing for the margin expansion.

The company also provided some guidance for Q2 and its expected results look good. Revenue growth remained above the 30% range (31-34%) and its operating margin is sharply higher at around 18.5%, using the mid-point of its revenue and operating income guidance. The company states that the higher expected profits are a result of increased revenue, combined with better leverage in cost of revenue, as well as marketing and general and administrative expenses. Consequently, operating income is expected to surge 133-151% year/year for its Q2.

How KYAK Stacks Up

*Most recent quarter  **Most recent year end

When comparing KYAK against some of its closest competitors, it's a bit of a mixed bag. On the positive side, its revenue growth stacks up favorably to just about every peer, with the lone exception being TripAdvisor (TRIP). TRIP is coming off a quarter in which its topline nearly doubled year/year, compared to KYAY's revenue growth of 39%. But, 39% growth is still quite solid, and that easily tops EXPE, TZOO, and GOOG's most recent performance. 

However, KYAK's margins are on the low end of the spectrum at 13% for FY11. This is well below TRIP's astounding operating margin of 42% and slightly below EXPE's 13.9%. It does top TZOO, and KYAK's margins are on the rise, which does offset some of this concern. For instance, the company is guiding for Q2 operating margin of 18.5%, a considerable improvement. 

Its valuation is middle-of-the-road. TRIP has a much higher multiple of sales, but, given its high growth and strong margins, it deserves to trade with a premium valuation. KYAK looks like it will have higher multiples than both EXPE and TZOO, but this also seems warranted considering that it is growing faster than both those companies. So, in conclusion, it seems KYAK's IPO is being fairly valued. Its valuation isn't necessarily a positive catalyst, nor is it a headwind.

Conclusion & Fundamental Grade: B+

From a strictly fundamental perspective -- which is how our grades are determined --  KYAK has a lot going for it. What stands out to us is its steady and solid revenue growth and its expanding operating margins. As the company has grown, it has been benefiting from its scale, finding ways to leverage its business. This certainly bodes well for the company in the future, and if its expected Q2 results are any indication, KYAK's profits are poised for strong growth ahead.

There are a couple concerns, though. There is no shortage of competition in the online travel space. In fact, its prior CFO left KYAK last year to join another online travel start-up called Superfly.com. There are other smaller travel-related internet companies making a name for themselves as well, such as TripIt and Hipmunk. And, of course, KYAK faces competition from the larger, more established companies like TripAdvisor, Expedia, Orbitz, and more recently, Google, with its acquisition of ITA Software. Another concern we have is that its transition to focus more on its mobile applications could hurt its revenue growth. Last year, the company's RPM dipped by 6% due to a higher proportion of mobile queries, in which KYAK earns a lower rate of revenue. In the long-run, mobile figures to be a major driver to its business, so the transition is necessary, but as we have seen with other internet companies, the transition may not always be smooth.

Outside of company-specific fundamentals, the obvious concern is that KYAK is the first internet company to go public since Facebook's (FB) botched IPO. There is certainly a healthy dose of skepticism in the market regarding internet IPOs in particular, so right off the bat, KYAK faces a major hurdle. As a possible antidote to this, the company is going ahead with a very small deal. The very limited supply of stock should be supportive of the price. 

Overall, KYAK is an IPO that we are positive on due to its improving fundamental picture and reasonable valuation. However, the IPO market remains very weak and the broader markets are volatile, so there is no assurance it will perform well out of the gate. Should it stumble out of the blocks, we believe this would represent a compelling opportunity to pick up shares at an attractive valuation.

Fundamental Grade: A-


This is going to be a hot deal, as Palo Alto Networks (PANW) has many of the attributes that investors look for among high-quality emerging growth stocks.

PANW is a security software company that sells next-generation firewalls. This is a large, fast-growing industry that lends itself to a high-margin, recurring revenue model. However, competition is intense and features several big competitors such as Cisco (CSC), Juniper (JNPR), and Checkpoint (CHKP).

PANW has carved out its own niche in the security software space due to its next-generation technology. And their unique approach to firewall technology is resonating with customers, with PANW seeing triple-digit sales growth each of the past 3 years, and rapid increases in the customer count. Importantly, PANW just turned profitable three quarters ago, and has a lot of room for operating margin expansion.

Concerns include the intense level of competition, an ongoing patent lawsuit with JNPR (more on that below), and the generous valuation that the deal will likely price at.

The Business

To generalize, most legacy firewall technology is based on “Stateful Inspection” technology that was created in the 1990s, which analyzes packets at the port, protocol, and IP level. SI firewalls can only allow or deny applications entrance to an enterprise’s network – i.e allow all users access to Twitter, or block all user access to Twitter). While this worked fine during the 1990s and the early 2000’s when enterprises generally only had to worry about basic threats to their email and web browsers, improvements to this technology have not kept pace with the explosion of new applications, web technologies, and new mobile platforms seen in recent years.

PANW’s firewall appliance and related subscription services (first launched in 2007) was designed from scratch to allow granular access control and protection at the application and user level. In other words, enterprises that use PANW’s firewall can allow individual users in the Marketing, Sales, or HR departments safe access to the applications that are relevant to their work – Facebook, Twitter, Salesforce.com, Dropbox, etc – but can block or restrict access to applications that are not relevant or desirable for a particular individual. This is the key differentiator between PANW’s firewall and competitors’ firewalls.

There is a very large market for add-on software and hardware that can allow more flexibility and better threat management to SI firewalls (consisting of myriad stand-alone appliances, Unified Threat Management boxes, blades, etc) but these add significant cost, complexity, and/or latency (the time it takes for users to access an application) since traffic has to pass through and be screened by each box.

PANW's firewall appliances operate on the company's PAN-OS operating system, and utilize their three proprietary identification technologies: App-ID (identifies the application, Content-ID (scans the content for threats), and User-ID (identifies the user). All three processes are done in a single pass of the traffic, which greatly reduces latency.

Interestingly, during their roadshow presentation PANW’s CEO singled out primary competitors CSCO, JNPR, and CHKP, claiming that their security products are all based on legacy technology and that they would have to build entirely new firewall technologies from scratch in order for them to develop a unified, next-generation firewall technology similar to PANW’s. Of course, it’s fair to say that type of competitive bluster from a young upstart in the industry has to be taken with a grain of salt, but it’s also fair to say that PANW really does have a unique firewall technology that is clearly connecting with customers (based on the rapidly growing customer count).

The company sells appliances to a wide range of industry verticals, including education, energy, financial services, healthcare, Internet & media, manufacturing, government, and telecommunications. The customer count has ramped up very fast in recent years, from 1,800 in July 2010 to more than 7,750 as of April 2012. In fact, more than 1,000 customers have been added in each of the past two quarters alone. Encouragingly, the customer base is also well-diversified, with no single customer accounting for more than 10% of total revenue in FY11 (ended July). Geographically, the company has customers in more than 100 countries. For the nine months ended April 30, 2012, 62% of sales came from the Americas; 26% from Europe, the Middle East, and Africa (EMEA); and the remaining 12% from Asia Pacific and Japan.

Finally, to get an idea of the size of the total addressable market, IDC estimates that the security software market currently stands at $10 billion. PANW management believes that its current suite of products can address this entire TAM right now.

Financials

The financials look very good for a Technology company in the relatively early stages of its growth. For the past three fiscal years (ended July), sales grew +328%, +265%, and +143%; during the 9-month periods ended in April of 2011 and 2012, respectively, sales grew 153% and 129%. These are exceptionally strong top-line growth rates. 

For the latest 9 month period ended 2012, product revenues accounted for 70% of total sales, with Service revenue making up the remaining 30%.

Gross margin has been holding steady in the company’s target range of 70-73%. Gross margin is slightly higher for product sales than for service sales, but there’s not a big difference between the two (in FY11 product gross margin was 74% versus 69% for service).

The company just recently turned the corner into profitability on a GAAP basis, beginning with the Oct-11 quarter. So to-date, that’s 3 quarters in a row of net income, although the company has actually been cash flow-positive for the past eight quarters.

PANW’s operating margin currently stands at a relatively meager 6% on a non-GAAP basis. Management has stated that they expect to continue to ramp opex in future quarters in order to fuel growth, which is entirely normal for an early-stage company. While this spending will depress operating margins in the near-term, what this means for longer-term investors is that the company has huge margin expansion potential as it works towards its target non-GAAP operating margin of 22-25%.

Looking at the balance sheet, the company has no long-term debt and currently has a hefty cash balance of $90 million, which does not include the estimated $200+ million from the IPO proceeds.

 


In short, there is the potential here that PANW could possess the “growth stock trifecta” of very fast revenue growth rates, sustained profitability, and room for significant, ongoing operating margin expansion. However, it needs to be stressed that this is all dependent on management proving it can execute. Plenty of companies look great in their S-1 filings, only to stumble once they become a public company. We’ll get our first real clue as to how well PANW management executes and manages Street expectations when they report their first quarter as a public company, likely in the Fall.

Juniper’s Patent Lawsuit

Investors should be aware that in December 2011 JNPR filed a lawsuit against PANW that alleges that PANW's appliances infringe six of JNPR's patents. You can get the details of the lawsuit in PANW's S-1 filing, but here is the gist of it:

Two current PANW employees, Nir Zuk and Yuming Mao, are named inventors on each of the six JNPR patents. Previously, both Zuk and Mao were employed by NetScreen Technologies, which was acquired by JNPR in April 2004. Zuk left JNPR one year later and founded Palo Alto Networks in 2005. Mao joined PANW the year after that, in 2006. Basically, JNPR is asserting that Zuk and Mao used some of the IP that is contained in those six patents owned by JNPR in order to create PANW's competing products. 

Juniper seeks preliminary and permanent injunctions against infringement, treble damages, and attorney’s fees. This suit is in the very early stages, but the risk here is that if it ultimately goes to court and JNPR prevails, PANW could be required to pay substantial damages for past sales, could be forbidden from selling appliances that rely on IP from those patents, and/or could be required to pay substantial ongoing royalties to JNPR. Resolution of this case is a long way out, but it's definitely something that investors should be aware of.

Conclusion and Fundamental Grade: Grade A-

PANW has just about all the characteristics we look for in a high-quality emerging growth stock: a disruptive technology in a large, fast-growing industry; triple-digit top-line growth; a high-margin, recurring revenue model; sustainable profitability; the potential for significant operating margin expansion; and a very small float. Granted, the triple-digit sales growth will inevitably slow down, and it could take several years for the company to hit its 22-25% operating margin target. But the growth potential is still impressive.

This type of growth potential doesn’t come cheap, however, and herein lies the primary risk for PANW investors: In a market where IPO investors have been repeatedly burned by aggressively priced Tech deals, PANW will come public at a valuation in the neighborhood of 11x TTM sales. While not nearly as egregious as Facebook or Groupon, PANW will still be priced at a substantial premium in the midst of a very valuation-sensitive market. Mitigating this to an extent is that PANW’s multiple will look much more palatable once estimates have been published and investors can value the stock based on forward 12-month sales and earnings.

Aside from the ongoing Juniper patent lawsuit, which probably won’t be resolved for years, there aren’t too many blemishes to this story, which makes management’s ability to execute right out of the gate all the more important. 

Guitar maker Fender is set to price its IPO next week. The deal will offer a total of 17 million shares with the company selling 7.1 million shares and PE firm Weston Presidio offering the remaining shares. The IPO is expected to price in a range between $13 and $15 per share.

Business

Fender is perhaps the best-known guitar maker in the world. In fact, the company believes that the Fender brand is closely associated with the birth of rock ‘n roll and has a strong legacy in music and in popular culture. In all, its product portfolio includes fretted instruments (comprised of electric, acoustic and bass guitars, banjos, ukuleles, mandolins and resonator guitars), guitar amplifiers, percussion instruments and accessories.

In addition to the Fender brand, the company has built a portfolio of other music brands.  It owns Squier, Jackson, Guild, Ovation and Latin Percussion, and is the licensee for Gretsch, EVH (Eddie Van Halen) and Takamine. 

In 2011, Fender had the #1 market share by revenue in electric, acoustic and bass guitars and electric and bass guitar amplifiers in the U.S., according to data provided by MI Sales Trak. In addition, since the company’s acquisition of Kaman Music Corporation in 2007, FNDR has been one of the largest independent distributors of musical instrument accessories in America.
FNDR distributes its products in over 85 countries through what the company believes to be one of the largest direct-to-retail sales forces in the musical instruments industry in the U.S., Canada, Europe and Mexico, as well as through a network of distributors in selected international markets.

The company has couple strategies to continue to grow the business.  These include accelerating international expansion, expanding its licensing and co-branding activates, and continuing to explore strategic relationships. More specifically, FNDR management believes that these licensing agreements typically offer low investment costs and attractive margin opportunities without the risk of cannibalizing existing product sales.

Brief History

Its history dates back to the start of its predecessor company in 1946 run by Leo Fender. The company’s popularity quickly grew with the rise of rock n’ roll. Fender is credited with offering the first mass-produced solid-body Spanish-style electric guitar. The company is also well-known for its affiliation with rock legends like Jimi Hendrix, Eric Clapton, and Bob Dylan just to name a few. This influence helped the company rise to prominence in the music industry. 

In 1965, Fender was acquired by CBS. Shortly thereafter, CBS instituted a series of cost-cutting initiatives. This eventually led to a decline in the quality of its instruments, which damaged the company’s reputation. 

Twenty years later, in 1985, Fender employees were given the opportunity to buy back the company from CBS. This exchange of ownership helped restore the quality of the Fender products. Then, in 2002, private equity firm Weston Presidio bought a minority stake in Fender for an undisclosed amount. Three years later, the PE firm, with the help of Goldman Sachs, recapitalized the company’s debt in a $215 million transaction. A decade after Presidio’s investment, the PE firm is ready to take the company public.

Use of Proceeds

At the midpoint of the offering, FNDR will raise a little north of $88 million. The company plans to use the funds to help pay down long-term debt. Upon going public, Weston Presidio’s stake in FNDR will fall to 17.8% from the 42.9% the PE firm holds now.

Financials

Overall, FNDR’s recent financials have been relatively inconsistent. Looking back over the past three fiscal years, the top line grew by less than a percent in FY10 to ~$618 million, but then accelerated last year; FY11 revenues rose 13% year/year to $700.5 million. The company states that the FY11 increase was primarily driven by an increase in overall effective prices and a reduction in discounts, success in new product introductions, continued growth in international markets and overall market conditions, and the resolution of the production problem related to its paint supplier in FY10. The supplier issue was particularly meaningful, as it filled a lot of backlog in the 2H11.

In the company’s most recent quarter (1Q12), however, revenues only grew 2% year/year to ~$174 million. This slow growth rate may be a better indicator of what to expect as opposed to the rebound in sales during FY11. Although this quarter was against inflated comparisons from the year ago quarter when they were filling backlog. In light of the uncertainties in Europe it’s worth noting that FNDR derived roughly 27% of its net sales in FY11, and approximately 25.5% of net sales in 1Q12, from Europe. 

Turing to profitability, the company’s net income fell 63% in FY10 to $11 million, stemming from the aforementioned supplier issue. Profit jumped nearly four-fold the following year to over $43 million. But again, the majority of this spike was the result of filling existing backlog.

Gross margins have been steady near 31% over the past three years. Only during FY10 did margins slip, and that was again due to the supplier issue. 

Given the nature of the company’s PE deal with Presidio, it’s no surprise that FNDR’s balance sheet comes with a significant amount of debt. As of April 1, 2012, the company held just under $14 million in cash and 257 million in debt. The company, of course, does not intend to pay a dividend. 

Conclusion and Fundamental Grade: B-

While Fender is one of the more recognizable brand names we’ve seen come through the IPO pipeline this year, there’s not a whole lot else to get excited about in this deal. Its modest growth prospects and high debt load detract from its otherwise strong market position and iconic brand.

Turning to valuation, FNDR is relatively cheap from a price-to-sales aspect at a ratio of 0.5x FY11 revenues. But given that the company’s high growth days are behind it, we thought a PE ratio may be a better measure for the decades old company.  Based on last year’s sales, FNDR trades at roughly 20x earnings.

In all, we like the business and market position, but don’t see upcoming catalysts that justify and higher of a valuation.

Five Below (FIVE) is set to price its 9.6 million share IPO next week in the $12-14 range. Based on the mid-point of that range, FIVE is expected to have a market cap of around $700 million and it should raise around $125 million before fees. Half of the shares being offered are by the company and the other half are by selling shareholders. FIVE does not expect to pay a dividend for the foreseeable future. Five Below was founded by David Schlessinger, creator and founder of Encore Books and Zany Brainy along with Tom Vellios, former CEO of Zany Brainy.

Five Below Concept – Similar to a Dollar Store

FIVE sees itself as a retailer of trend-right, extreme-value merchandise to the teen and pre-teen market - all for $1 to $5, hence the name Five Below. 

Its assortment of merchandise includes everything from sporting goods, games, fashion accessories and jewelry, to hobbies and collectibles, bath and body, candy and snacks, room decor and storage, stationery and school supplies, video game accessories, books, DVDs, iPhone accessories, novelty and "gag," and seasonal items. 

FIVE believes that its brand concept, merchandising strategy and store ambience work in concert to create a high-energy and vibrant retail experience that is designed to appeal to teens. FIVE monitors trends in the ever-changing teen and pre-teen markets and is able to quickly identify and respond to those that become mainstream. Also, its price points allow teens and pre-teens to shop independently and exercise self-expression, using their own money to make frequent purchases of items geared primarily to them. It’s worth noting that while FIVE focuses on teens and pre-teens, its low prices also attract older customers looking for a deal. 

An attractive feature of targeting teens and pre-teens is that this segment of the population has a significant amount of disposable income because the vast majority of this age group's basic needs are already met so they can spend on aspirational products. 

Early in its Growth Trajectory

Five Below is a pretty new concept. It opened its first store in 2002 and has since been expanding across the eastern half of the US. It has grown from 102 stores a couple of years ago to its current level of about 200 stores across 17 states. It plans to open about 50 stores in 2012 and 60 in 2013. The company believes it has the potential to grow its store base in the US from the current 200 locations to more than 2,000 locations over the next 20 years. Based on its strategy of store densification in existing markets and expanding into adjacent states and markets, FIVE expects most of its near-term growth will occur within in its existing markets.

Its same store sales growth has been impressive. In AprQ, same store sales grew by 10.4%, on top of a 7.6% increase in the year ago period.  Same store sales increased by 12.1% in FY09, 15.6% in FY10, and 7.9% in FY11. 

FIVE has an attractive store model that generates strong cash flow. Each of its stores was profitable on a four-wall basis in 2011 and its new stores have achieved average payback periods of less than one year. 

Financials

Taking a quick look at the financials, there are positives and negatives. 

On the positive side, revenue growth has been strong, in the 40-50% range the past few years. Part of this is due to FIVE’s aggressive store expansion as you can see in the table below. But it’s not just the aggressive store growth, the same store sales growth has been quite strong as well. Since this metric includes only stores that have been open for a full year, this essentially negates the impact of the higher store count. Same store sales growth the past three years is +12.1%, +15.6% and +7.9% last year. While FY11 appears to have declined a bit, it was up against a tough comp in FY10. Also, the +10.4% growth seen in AprQ is quite good. 

Another positive is that FIVE has been profitable every year since FY09. Also, it’s good to see that margins have been steadily rising. 

While the overall growth is good, we do see some negatives. 

Margins have been clearly trending higher which is a good sign, but they are still a bit on the thin side. Operating margin in the low-to-mid single digits is not where we’d like to see them. 

Taking a quick look at the other “dollar stores,” FIVE does come up a bit short in terms of margins. For the most recent quarter, Dollar Tree (DLTR) posted 10.9%, Dollar General (DG) posted 9.9%, Family Dollar (FDO) posted 8.5% while FIVE came in at 5.5%. While the dollar stores are not direct comparisons, they are similar. So in that sense FIVE’s margins are a bit disappointing. However, in FIVE’s defense, they are much smaller so they do not have the revenue base over which it can spread fixed costs. 

Also, we were a bit surprised at just how thin the margins are for the entire dollar store sector. Relative to the more mature dollar names, FIVE’s margins are pretty respectable at this stage of its growth trajectory. On a final note, we would not read too much into AprQ’s margins being lower than FY11. It’s a seasonal business with 40% of sales coming in JanQ, so it’s likely a result of being a seasonally slower quarter.

In terms of the balance sheet, there is a fair amount of debt. The good thing is that in the S-1, the company says that almost all of the money it receives (at least $50 million of the $54 million it’s expected to receive) will go toward paying down debt. Long term debt is expected to fall to $50.3 million after the IPO which is significantly less than the current long term debt of $100.3 million. However, the LT debt-to-cap is still going to be high at 69% even after the IPO.

Conclusion and Fundamental Grade: B+

Think of Five Below as the dollar store for teens, both boys and girls. It’s a pretty interesting take on the dollar store concept. They tweak it a little bit by allowing prices to go up to $5 and they target teens and pre-teens instead of adults. It’s a pretty attractive demographic. Their parents cover their basic needs so whatever money they do make from a job or from allowance, they can spend at Five Below on aspirational goods. It also allows parents to give their kids a sense of independence and a lesson in money management as they can shop on their own and have a lot to choose from.

There are risks. The main one is that perhaps they are growing too quickly – 50-60 stores per year is a ton of stores considering how small the company is now. Recall that Schlessinger and Vellios were running Zany Brainy when it declared bankruptcy in 2001. The 10-year-old company struggled after acquiring rival Noodle Kidoodle for $40 million in May 2000. Rapid growth, including the integration of the 60 Noodle Kidoodle stores and the opening of 27 new Zany Brainy stores was just too much. Hopefully, this management team has learned its lessons but we do have some concerns. Growing this quickly while also having so much debt is a concern. It’s a bit of catch-22. Investors love the rapid store growth but it’s that store growth that’s also the biggest risk.

Overall, we think FIVE will attract a lot of interest when it makes its debut because it has a small float (fewer than 10 million shares), they are growing strongly, they have quality underwriters (Goldman, Barclays, Jefferies, Credit Suisse) and perhaps most importantly the stocks in the dollar store sector have been very strong so we suspect FIVE will get picked up as a secondary play on that trend. We also like that FIVE is early in its store growth trajectory with just around 200 stores so there is a lot of growth on the horizon.

Select Income REIT (SIR): A Niche Commercial REIT With a Solid Yield ... Published on July 11.

Fender (FNDR): An Initial Look at Fender as it Becomes Latest Company to Announce IPO Plans ... Published on July 10.

In a positive development, the IPO pipeline is starting to open up with KAYAK (KYAK), Palo Alto Networks (PANW), Five Below (FIVE), and now Fender (FNDR) announcing plans to go public. The company issued an amended S-1 yesterday, stating that it plans to sell 10.7 million shares within a range of $13-$15, which would give it a market cap of $369 million at the mid-point. The lead underwriters on the deal will be JP Morgan, William Blair, Baird, and Stifel Nicolaus. 

FNDR, of course, is the well-known maker of guitars and musical instruments. Its brand name gained fame in the music industry with music icons such as Jimi Hendrix, Eric Clapton, Buddy Holly, and Kurt Cobain, among others, putting the company in the spotlight. Its strong brand name, which gives investors a unique opportunity to own an iconic brand, could work in its favor. It also owns a portfolio of other brands such as Squier, Jackson, Guild, EVH, and Gretsch.

Taking a quick look at its financials, its revenue was up 13% in FY11 to $700.6 million. Gross margin improved significantly, coming in at 31% for FY11 compared to 27.6% in FY10. Also, it had a good handle on its operating expenses, which were up a modest 10% last year. The sharp increase in gross margin combined with the solid cost containment led to a 276% year/year surge in operating income to $41.8 million. FNDR also provided prelimary results for its Q2, and those figures don't look nearly as impressive, however. Net sales are expected to be $166-$168 million, down 0.4% year/year at the mid-point, and income from operations is projected to be $8.5-$8.9 million, down 14%. FNDR attributes the decline to increased investments in labor expenses due to higher headcount in connection with the establishment of an office in China.

As for its valuation, FNDR would have a trailing P/E of roughly 19x and P/S of 0.53x. On its balance sheet, FNDR has cash & equivalents of $13.8 million and total debt of $257.2 million. It does plan to pay down some of this debt with the IPO proceeds. The company does not plan to initiate a dividend.

Greenway Medical Technologies (GWAY): Greeway Medical Technologies Continues To Display Solid Relative Strength ... Published on July 9.

Greenway Medical Technologies (GWAY) is a recent IPO that we have been keeping a close eye on lately, and today we wanted to put it back on the radar as the stock continues to act very well. With its steady run higher over the past couple of weeks, GWAY is now approaching post-IPO high levels ($17.50 set on 6/19). 

GWAY is a name that may be familiar to subscribers as we highlighted it back on June 1 in our report titled "A Few More Relative Strength Standouts", as well as on June 19 in an Emerging Growth Stocks report titled, "Six Under-The-Radar Growth Storis in Healthcare."

In the above reports, we provide a more detailed look at its business, but here is a quick refresher: GWAY is a cloud-play and a play on the electronic transfer of health care records. It is a provider of software for physician practices. Its Web-based PrimeSUITE software is used to automate practice management, electronic health records (EHR), and managed care functions, as well as to link patient chart records to billing processes. Greenway focuses on ambulatory (outpatient) providers including independent physician practices, group practices, hospital clinics, university health centers, community health centers etc.

Its growth rates have been strong, and impressively, they have been accelerating. Revenue was up 26% in FY09, then 33% in FY10, followed by 39% in FY11. For FY12, analysts are expecting revenue growth to come in at 36%. The company is also comfortably profitable. In FY11, it generated operating income of $3.8 million and for FY12 (ending June 30), analysts are projecting EPS of $0.40, which would represent year/year earnings growth of 82%, assuming GWAY reports an inline Q4 (no confirmed earnings date yet).

In terms of its valuation, GWAY looks expensive with a forward P/E over 42x, based on expected FY12 EPS. However, when factoring in its expected growth and its strong balance sheet, its valuation looks much more palatable. Using its FY12 expected earnings growth, its PEG stands at 0.51x. The company also has $36.4 million in cash, or $1.25/share, and no long-term debt.

LinkedIn (LNKD): Facebook Job Board Seems More Like a Headline Risk Than a Fundamental Concern .... Published on July 9.

Kayak (KYAK): An Initial Look at Kayak's Upcoming IPO ... Published on July 9. 

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

The Next Big Thing column can be found on the Trading Ideas / Fundamental home page.
On In Play, all of our Next Big Thing IPO commentary can be searched for and have alerts generated by the "IPOXX" ticker.