Financial Engines' growth bet

On the threshold of turning the corner financially, Financial Engines Inc. is trying to fuel its growth in the defined contribution arena through an initial public offering.

Going public could be a referendum on the prospects for Financial Engines, Palo, Alto, Calif., and its evolving business model of providing both managed accounts and online advice.

On the one hand, Financial Engines' revenue, number of customers and assets under management are growing. On the other hand, the company must deal with questions about sustained growth because it still relies on a few clients for a large portion of its revenue and because it faces competition from multiples sources — including some of its clients.

Company executives say they want to raise $100 million for “general corporate purposes,” which include working capital and capital expenditures. Underwriters haven't set an offering-price range or IPO target date.

Company officials filed a registration statement with the Securities and Exchange Commission Dec. 9.

The statement disclosed that its largest shareholders include several affiliates of Foundation Capital Leadership Fund LP (17.4%); several affiliates of New Enterprise Associates VII LP (14.4%); and several affiliates of Oak Hill Capital Partners LP (9.3%). Each firm is based in nearby Menlo Park, Calif.

“They are reaching an inflection point” of profitability, said Paul Bard, director of research for Renaissance Capital LLC, a Greenwich, Conn.-based provider of IPO research and investment management services. “They have a track record of growth.”

The company hasn't turned a yearly profit since its May 1996 incorporation. However, for the first three quarters of 2009, Financial Engines earned $1.7 million on revenue of $58.8 million. By contrast, it lost $1.5 million on revenue of $52.3 million for the first nine months of 2008.

The latest revenue results are part of a favorable trend since Financial Engines began evolving from an online provider of investment advice to a managed accounts provider.

William F. Sharpe, the 1990 recipient of the Nobel Memorial Prize in Economic Sciences and now director emeritus, founded the company along with Joseph A. Grundfest, a former SEC commissioner, and the late attorney Craig W. Johnson.

Financial Engines' managed accounts business accounted for 58% of corporate revenue for the first nine months of 2009.

The company also provides online advice and retirement evaluation, explaining to plan participants how to meet retirement-income goals.

The corporate growth strategy includes converting online-only plan participants to the full package of professional management, online services and retirement evaluation.

The strategy was well timed. In its SEC filing, the company says it plans to capitalize not only on an aging population, but also on trends such as the growing shift to defined contribution plans from defined benefit plans and increasing adoption by employers of automatically enrolling employees in 401(k) plans.

For the professional services component, Financial Engines allocates a plan participant's assets according to the participant's objectives and a plan's investment options. The company also benefited from the Pension Protection Act of 2006 and subsequent Department of Labor regulation that designated managed accounts as one of three qualified default investment alternatives for DC plans.

Except for a slight dip in 2008, assets under management have grown steadily since 2004, according to the company's IPO registration statement. Last year the firm had $25.7 billion under management, up 64.7% from a year earlier.

Managed accounts users have increased steadily, reaching 391,200 last year, or 21.5% higher than the 321,900 in 2008.

However, Financial Engines faces several challenges.

“While there are plenty of things to like about the firm ... we believe the company's current cost structure and increased competition from both independent service providers and major plan providers could prove problematic for the longer term,” said a Jan. 11 research note published by Greggory Warren, an analyst for Chicago-based Morningstar Inc.

Mr. Warren's report cited Morningstar as an example of an independent service provider and Fidelity Investments as an example of a plan provider.

“At the end of the day, this is an economies of scale business,” Mr. Warren said in an interview. “The more assets under management that they have, the better it will be.”

In its SEC filing, Financial Engines warns potential investors that it is “highly dependent on a small number” of retirement plan providers, and that contract renegotiations or cancellations “could significantly impact” its business.

“Our relationships and data connections” with these plan providers not only allow Financial Engines to manage participant accounts but also “provide us with an advantage in trying to sign potential plan sponsors,” the company's SEC filing says.

In 2008, three clients — J.P. Morgan, ING and Vanguard — respectively accounted for 18%, 17% and 11% of corporate revenue, according to the SEC document. “We have historically earned and expect to continue to earn on a combined basis, a significant portion of our revenue through these three retirement plan providers,” the document adds.

The SEC document adds that the company may compete directly with big clients, such as Fidelity Investments, in offering “investment guidance, advice and portfolio management services” to plan participants. Financial Engines considers target-date funds from Fidelity, Vanguard and other clients as indirect competition “that could potentially substitute for our portfolio management, investment advisory and retirement planning services.”

The proposed IPO represents a transition into corporate adulthood for a company that contemplated going public in 2008. However, it backed off in November 2008 before filing a registration statement “because of the disruption in the equity capital markets and general adverse economic conditions present at that time,” according to its SEC filing.

Financial Engines is seeking to go public as the IPO market has shown some signs of a revival. Two-thirds of 2009's IPOS were launched during the last four months of the year, according to Renaissance Capital.

But lately, there's been disquieting news. Eleven of 16 companies that went public between Dec. 1, 2009, and Feb. 2, 2010, did so at prices below the ranges initially set by underwriters. Since the beginning of the year, five IPOs have been withdrawn or postponed.

IPO experts say strong fundamentals and good prospects can overcome investor reluctance. “If you have a bad market and a good deal, you can come to market,” said David Menlow, president of IPOfinancial.com, Millburn, N.J. “They will need to educate investors.”