In general the only  ideas I tend to short are situations where I think there is outright fraud that will likely end in a terminal outcome OR recently minted VC specials, where valuations are absurd and insiders are shedding shares like its jet fuel on a crashing plan, and where we see weakness in the underlying business. Enter Financial Engines which I think falls into the latter category. Not a fraud but not sustainable at these levels

Financial Engines almost seems like a Sand Hill classic. Get a Stanford Nobel Laureate (Bill Sharpe), some good tech guys, put the two together, add some $$$$ and MBAs, simmer, IPO, and then puke the shares on the public markets, rinse repeat.

The business:

Financial Engines operates as a Registered Investment Adviser, and software platform that caters to the needs of the 401K participants ,marketed and is sold through Employer Sponsors of 401K plans. Financial Engines partners with the likes of Fidelity, Vanguard and other folks that run 401K plans (from the administrative perspective), and then go pitch giant employers to offer their services to their participant base.

 It’s been a smart strategy for achieving scale quickly. The product from a regulatory point of view is Investment Advice, something that folks on VIC understand well.

The first step is the company integrates with a 401K administrator, and then when a given employer wants the service they do some integration work and then flip the switch to make the service available as people log into their 401K portals.

A participant signs up and gets and an automated 401K check-up and action plan. For this they charge plan participants 25 bps. Employers pay a platform fee to make the service available to their employees that is generally fixed but recurring.  It’s a very scalable business model with compelling incremental economics.  But we are starting to see the boundaries of that.

 Let’s look at some of the economics.

So why do we think this is a good short candidate:

1. Margins are starting to flatten. Albeit the continued healthy growth in the top line margins are starting to flatten out. It will be hard to really show tons of incremental operating leverage going forward as the numbers show.
2. Employers will push back. When you are a public company and people can see the economics on your product employers will push back hard. They have to as plan fiduciaries or risk getting sued.
3. Competition. This is a big market and one where we have seen the cost going down quickly over time. Charles Schwab now offer an ETF for 4 bps. Vanguard is at 10 bps. And these guys want to charge > 25 bps for automated advice. Morningstar and the 12 other big players in this market are not going to sit by without introducing competing products.
4. Dependence on a few players for channel penetration. My biggest concern is the company is dependent on two relatively powerful players in being able to achieve these economics. The first is plan administrators. The second is the employers themselves. To date they have charged employers a platform fee to be able to offer their services to employees. If I am IBM, for example, and see these economics I would demand that they pay me to get access (or lower fees to my employees), so I think as competition emerges they will either see these platform fees compress or go away all together.
5. 25 bps is not sustainable in a world of single digit index funds. Their business model is very sensitive to these fees. If for instance these got cut in half, they would need to aggregate another 50 B in AUM just to keep the existing economics on the top line. That’s a lot of $$$ anyways you cut it.
6. Levered to the market. The company trades at a rich valuation which I will get into below. But it’s actual revenue stream is also directly tied to the broad market (bps on AUMs). Given that it is priced to perfection I don’t see a lot of upside risk, but if there is a market correction I see two things happening, The first is their AUM, Revenue and profits goes down (and I know operating leverage works both ways). The second double whammy is the market multiple will go down.
7. Litigation Risk. As we know academic theories and things like Var work until they don’t work. Right now the product is positioned to employers as a way to help them mitigate their Fiduciary duty to plan participants. If things go upside down and the market blinks and their 600K members lose money I can see this as a huge class action opportunity that will be pounced upon.
8. Insiders selling every single day. http://finance.yahoo.com/q/it?s=FNGN+Insider+Transactions

 They are shedding this stock as fast as the market will bear.

Valuation:

Share Price: $23.60

Shares Out:   49.93 mm

Net Cash/Debt:  153 mm

Enterprise Value: 1025 mm

Multiples:

2011

EV/Rev = 7.1 X

EV/EBITDA = 25X

2012 Estimates

EV/Rev= 5.95X

EV/EBITDA = 21X

Risk:

Shorts can stay over inflated for a painfully long time.