Violin Memory: Will It Always Remain Weak?

The recent IPO of flash-storage provider Violin Memory failed to impress the market due to several persistent issues including an auditors going concern doubt. The IPO process can be very volatile and investors need to look no further than the Facebook IPO to see how a disappointing market reaction can quickly turn around.

The major problem with Violin Memory was the shocking level of losses. The company lost so much money over the last six months that it likely had to raise money. Another factor in the recent pricing weakness has been the horrible market trading of other flash-storage providers Fusion-io and OCZ Technology . Does the recent weakness provide a buying opportunity for patient long-term investors?

Massive operating losses
The most shocking part of the S-1 for Violin Memory was the revelation that the company lost over $100 million last year. On top of that, the company lost nearly $60 million in the first 6 months of the current year. The flash-storage array leader did grow revenue at 60%, but it would take several years of that growth to ratchet up margins enough to cover this level of expenses.

The expense levels provide a mixed bag for investors. Sales and marketing numbers are off-the-chart high for a storage solution provider at 72% of revenues. Considering a consolidation of customers into a few major clients, it appears illogical that it spends that much to court a small customer base. On the flip side, it spent nearly the same level on research and development that is crucial to providing a leading flash-storage solution. Even Fusion-io, at nearly 4 times the revenue base, spends only slightly more on research expenses at just above $25 million per quarter.

Market leader worth something?
Several IT trends are transforming the performance requirements of data centers toward flash storage technology and away from traditional disk-based storage solutions that can't keep up with modern application speed needs.

Gartner recently proclaimed Violin Memory the market leader in the flash-array market segment for 2012. The company only slightly beat out EMC and IBM though an impressive feat considering its relatively small size. At a market share of only 19.4%, the company can justify all that spending by capturing a larger percentage of this sector while it grows even larger.

The company also recently launched a PCIe product for the server-based flash storage market that IDC estimates will surge 32% annually through 2016. That product didn't record any revenues in the reported periods so far providing potential upside going forward.

Doomed sector?
Outside the questionable levels of operating expense, Violin Memory is jumping into a mix of stocks that have failed miserably lately. Fusion-io was a previous IPO success story gone bad and OCZ Tech went from fanatical growth projections to questions of fraud. Both stocks have left the market undoubtedly skeptical of any new issue possibly providing an opportunity in Violin Memory. Gartner lists Fusion-io and OCZ as fourth and sixth in the Solid State Drive (SSD) segment of flash storage. In fact, Fusion-io is second in the enterprise segment.

Fusion-io famously burst onto the markets reporting massive growth, as both Apple and Facebook were major customers for their SSDs. As those two companies maxed out data center growth, Fusion-io has seen a slowdown in growth combined with margins not strong enough to generate much in the way of profits. The company spent over 50% on sales and research expense in fiscal 2013, not providing an encouraging trend for Violin.

OCZ continues to complete a restructuring and is working on filing financials. In early Oct., it reported results for the quarter ending in May and they were nothing to get investors excited about the sector. The shift to enterprise SSD solutions improved gross margins to only 15%. Another concern is that forward guidance continues to be affected by a lack of supply of NAND flash memory.

This brings up another concern with Violin Memory considering it has a partnership with Toshiba and hence reliance with them on supplies of flash memory. Any disruption in supply from Toshiba would have a major negative impact on financials.

Bottom line
Considering price always matters in investing, Violin Memory is naturally more intriguing after a weak IPO pricing and after-market trading. The stock though has several issues it needs to overcome first including insanely high operating expenses that will require substantial growth to justify and an industry that appears to struggle generating profits. Until Violin Memory and Fusion-io can prove the ability to generate strong margins on growth initiatives the stocks aren't attractive, but at some point a leader will emerge in flash-storage that could be extremely attractive to investors.

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