Network Engines: Like Venture Capital Investing in Public Markets

Network Engines (NENG) remains the biggest loser among our stock picks this year, but after finally listening to the company's latest earnings conference call, I remain bullish on the stock and believe that the shares still offer an attractive risk/reward ratio at current prices.

What's the source of my optimism? There was not one question from analysts on the earnings call. That's a clear signal of extreme pessimism and the type of contrarian indicator that usually makes for a good investment gamble.

Of course, the lack of any Wall Street interest in the company, other than on this blog, might be a signal that I am missing something here and have stumbled onto a real dog that will never recover. However, I'm pretty sure that is not the case, as there is alot to like here.

With an extremely talented new CEO at the helm with proven industry experience, $30 million of net cash on the balance sheet, a profitable OEM business (more on that soon), involvement in a high-growth industry (appliances for security and storage) and exciting new partnerships with strong industry leaders, NENG has everything any venture capitalist could dream of and more.

And that is precisely what NENG is, and should be viewed as: A high-tech venture capital-like investment in the public markets. What makes NENG even more attractive, than the usual venture investment, is the fact that the company can be had for a mere $35 million enterprise valuation, which is probably lower than the valuation afforded to many other start-ups in this industry, many of whom have less operating experience, fewer industry partnerships, and weaker management talent/track records.

At the same time, since NENG is a venture-capital like investment, it still has a high degree of risk and should only make up a very small portion of a diversified portfolio of "junk" stocks, as I like to call these types of investments.

What's the main risk for NENG? As I have mentioned several times in the past, the company is still very much reliant on EMC (EMC) for the profitable OEM business. With the current changes at EMC (e.g. the acquisition of RSA), there is obviously some investor unease with NENG. If NENG should lose EMC as a customer, the company would be in deep trouble, and the stock would crater. However, I suspect that this situation would still not be terminal to NENG, given NENG's strong balance sheet and other favorable business opportunities. Nevertheless, I see no reason to worry about the EMC relationship at this point and I think this is a risk worth taking at the current valuation given the promise of the company's new partnerships and the potential upside once these partnerships gain traction over the next year.

NENG 1-yr Chart

Please Note: We first recommended Network Engines (NENG) at $1.88, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Comments

[jolly singh:]

I have SHORTED it at 12.80 before close. let's see what happens tomorrow morning.

Reports Q2 (Jun) loss of $0.32 per share, $0.14 better than the Reuters Estimates consensus of ($0.46); revenues fell 27.9% year/year to $38.5 mln vs the $30 mln consensus. Cray continues to anticipate annual revenue for 2006 will be higher than 2005 levels. Due to the size of a few large orders and the difficulty in predicting the timing of customer acceptances, there remains a large range of potential revenue results in 2006, ranging from modest to potentially 20% growth. The co expects that 2H06 will be stronger than 1H, with a possibility for 60% of 2006 product revenue being recognized in Q4. Operating expenses will increase in 2H primarily due to higher research and development expenses associated with the Cascade program and sales and marketing costs associated with higher anticipated revenue... In the second quarter of 2006, Cray submitted a proposal to participate in the third phase of the Defense Advanced Research Projects Agency (DARPA) High Productivity Computing Systems initiative. Phase III participants may receive up to $250 mln of research and development co-funding through 2010 with the goal of enabling a breakthrough in the capability of the next generation of supercomputers, providing for sustained petaflops levels of performance on real applications and dramatically improving user productivity. The outcome and timing of this award will affect Cray's operating results in the 2H06, specifically in the form of increased research and development expense associated with the Cascade program -- Q3 research and development expense could now be double Q2 levels, with Q4 levels dependent upon the status of the award. The co expects the outcome to be announced within the next few months and can give no assurance as to whether it will participate in Phase III of the DARPA HPCS program.

2006 Aug 07 07:05 PM