Network Engines: Dominant Appliance Company? (NENG)

| About: Network Engines, (NENG)

On Wednesday, Network Engines Inc. (NASDAQ:NENG) issued a press release announcing the appointment of a new chief technology officer. While we do our best to not get caught up in the hype of company announcements, we did find some interesting tidbits in this press release.

Below are some quotes from the press release, followed by our comments:

Greg Shortell, CEO of Network Engines (NENG), stated: "I look forward to Kevin's leadership in bringing new appliances to market that combine our heritage in storage management with network and application security for Microsoft-based infrastructures." Shortell said he sees tremendous opportunities created by ever-increasing and diversifying demands for electronic file storage combined with growing regulatory requirements regarding data security.

Citing projections made by the research firm IDC, Shortell said that the market for security appliances is expected to top $5 billion by 2009. "Our ability to help storage and security vendors integrate their capabilities on appliance platforms is unique in the industry," Shortell continued. "As a Microsoft Gold Certified Partner active in the vibrant community of Microsoft-based Independent Software Vendors, we are working on multiple initiatives to address this market, and Kevin's technical leadership will enable us to take our integration capabilities to the next level."

What this tells us is simple: Network Engines is working on closing deals with other software vendors in the Microsoft community, that will either allow for new OEM business and/or new proprietary Network Engines products, ala the NS Series device. Given the company's strong relationships with Microsoft, and proven capabilities in every aspect of the appliance business, we think it is only a matter of time before some new partnership deals are announced. The announcement of any new deals, particularly for the OEM business, would be extremely bullish for Network Engines.

As we noted in our original writeup of the company, Network Engine's OEM business is profitable to the tune of about $10 million a year. However, the profits in the business have been masked by losses in the start-up NS Series business, leading to overall losses at the company. At the same time, Network Engine's OEM business is almost entirely dependent on EMC, to the extent that Network Engine's is somewhat of a "subsidiary" of EMC.This reliance on EMC obviously compels investors to place a low valuation multiple on the OEM business.

However, should Network Engines give any indication that the OEM business is being successfuly diversified, the value discount for the OEM business will rapidly evaporate. Assuming a certain amount of diversification is actually reached, if one gives a 10X multiple to a diversified OEM business (which we think is very fair given the growth opportunities available), that implies a value of $2.50 per share for the OEM business.

Adding in Network Engine's cash of about $0.80 per share, and you get a value for a diversified OEM business of $3.30 per share. That's greater than the current stock price of NENG, and would imply that the company's NS Series business is worthless. We obviously do not think the NS Series has zero value, and as such believe that with the announcement of new OEM deals, Network Engine's stock can easily move up a good 30%+ on a simple re-evaluation of the "hidden" OEM business, coupled with bright prospects for the NS Series line.

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.