Network Engines on the Verge of an Inflection Point

This post summarizes some facts from Network Engine's (NENG) most recent 10Q for the quarter ended June 30, 2006. What I found most interesting was that the company's OEM division reported rapid growth both on the top-line and the bottom-line. Specifically, sales in the OEM division were up over 30% year-over-year and about 15% quarter-to-quarter (the March 2006 quarter) to nearly $32 million. More importantly, operating income at the OEM division jumped to $4.2 million, up 48% year-over-year, and up over 30% quarter-to-quarter. Interestingly, though NENG relies on EMC (EMC) for 80% of the OEM business, sales to non-EMC customers this quarter were up nearly 50% year-over-year and 5% quarter-to-quarter.

Overall, on an annualized basis NENG's OEM division is now bringing in nearly $15 million in positive operating income per year. So, how much is this business worth? That's a very interesting and debatable question. On the one hand, the company is still very much reliant on EMC for OEM revenues, but on the other hand, the company is steadily growing the non-EMC OEM business as evidenced by the financials and recent partnership announcements. To be conservative, I would value the OEM business at 3X operating income or $45 million. That implies that the value of the company (excluding the still nascent NS Series business) as a whole should be about $75 million ($45 million + $30 million in cash), or about $1.95 per share, at a minimum. As should be obvious, NENG is potentially extremely undervalued assuming greater diversification of the OEM business and even modest successes with the NS Series product line. The key word, of course, is "assuming."

Moving onto the balance sheet, what is interesting is that the company's use of cash was slightly higher due primarily to working capital items, namely a significantly higher accounts receivable balance which can be traced to large orders received in June. The reason why this is noteworthy is because if one normalizes the receivable and payable balances one is forced to conclude that the cash burn would have been much lower this quarter, despite the fact that the company is investing in the NS Series product line. This speaks highly of the new management's fiscal discipline and the ease in which free cash-flow can be reached assuming only a modest increase in sales. In other words, NENG's inflection point for cash profits is seemingly very close. I have found in the past (IIP and RBAK are good examples of this), that the biggest profits in technology stocks are made at these inflection points, as a chronic underperformer, such as NENG, moves from to profits from losses.