Network Engines Reaches Its Inflection Point

Thursday morning Network Engines (NENG) reported its first cash-flow positive quarter in quite some time, generating $1.5 million in cash on increased sales and improved gross margins. Notably, the company is reporting these results ahead of any potential sales increase from several partnerships which will kick into high gear in 2007. At current prices, we still think that NENG has one of the best risk/reward investment ratios we have seen in quite some time, and as we have mentioned in the past, this will be an exciting stock to watch in 2007.

At current prices, considering NENG's cash position of nearly $33 million (NENG has no debt), the company's enterprise value is approximately $43 million. The company's sales are running at $119 million giving NENG a miniscule EV/Sales ratio of 0.36, probably the lowest EV/Sales ratio in the entire hardware market.

What's the catch? NENG relies on EMC Corp. (EMC) for over 80% of sales. And while this obviously effects the potential valuation of the company given the sales concentration, we don't think the EMC business is at all risky. In fact, we believe that NENG may see increased business from EMC in 2007, following EMC's acquisition of Network Intelligence, a big customer of NENG.

But the reason to get excited by NENG is obviously not because of EMC. With the current quarterly results, the company has now proven that it can generate cash-flow on the current low base level of sales. So clearly, if the company can generate additional non-EMC sales growth in 2007, profitability could soar. Moreover, the odds of a significant increase in non-EMC sales throughout 2007 is very high, as the company is working on several exciting revenue-enhancing projects.

The most significant of these projects is a deal with Getronics, a multi-billion dollar international IT services company, to deliver secure managed branch solutions for Microsoft platforms and web-enabled business applications in bank branches around the world. Management estimates conservatively that Getronics, has the potential to sell NENG-based appliances to over 140,000 branches worldwide. These branches are already existing clients of Getronics.

At a conservative average selling price of $3,500 this translates into a nearly $500 million market opportunity. Clearly, the sales potential for a small company like NENG is vast. Initial installations for Getronics are expected at the end of this year with a full sales roll-out, assuming successful tests, expected in 2007.

In evaluating all of the above, it seems to us that on the downside, the worst the can happen to NENG is that it remains an EMC-concentrated business and the stock moves nowhere in 2007. On the upside, however, if several new revenue streams, such as Getronics, begin to develop, the company's top and bottom-line could grow significantly and the share price could rise substantially over the next twelve months.

Even assuming low odds of success for the non-EMC businesses, the stock's expected value is still much higher than the current price suggests. The reason for the low value, is that it generally takes several quarters of good results to convince investors to jump back into "broken" stocks. But this is precisely why a significant amount of money can be made in stocks like NENG. As some investors wait for additional confirmation on what are undeniably positive finanicial results, other investors can purchase stock at levels which provide a significant margin of safety and do not yet reflect the company's improved prospects.

Please Note: We first recommended Network Engines (NENG) at $1.88, and still hold a position in the stock.

NENG 1-yr chart: