Network Engines Still Not Revved Up (NENG)

May. 1.06 | About: Network Engines, (NENG)

Last week, Network Engines Inc. (NASDAQ:NENG) reported quarterly results that were basically in line with expectations. Despite the fact that the stock is off about 25% from its high, I still believe that my basic investment thesis outlined in prior posts is intact and the I think the risk/reward is still favorable at current prices. Incidentally, I have bought more shares of NENG during the recent sell-off.

In terms of the earnings report, the obvious negatives are the continued cash burn at the company, the negligible revenue growth, and the declining gross margins. Sounds terrible, but that's why I'm still interested in this as an investment. Since there are such low expectations for the company, when Network Engines does in fact deliver strong cash-flow growth (which I expect will happen in six to nine months), the stock can appreciate dramatically. As is generally the case, restructurings and turnarounds take much longer than expected, but at the same time they offer compelling investment "gambles", especially when evidence exists that business conditions are already improving.

So why do I still believe that the company will report improving results over the next twelve months? Well for one, by reading the press releases and listening to the conference calls it is obvious that the new CEO Greg Shortell appears to have a solid plan in place to attack the appliance server market, and with time (he has only been on the job for a mere 3 months or so, but has years of experience in this industry), I believe that the new strategy will bear fruit via new partnerships and sales channels.

Distribution and partnerships deals take a long time to close, but ultimately these deals will lead to significant revenue growth and profits for years to come. Incidentally, I have heard from industry sources that the company initiatives in Europe are slowly gaining traction.

Interestingly, the company is already predicting slight revenue growth quarter over quarter for the June quarter, which is an indication that sales are in fact picking up slightly. With an operating expense base that will basically stay flat, it appears to me that a slight uptick in higher margin revenues can easily put the company in the black. I expect that to happen in the Q3 of 2006.

Additionally, in another positive development, the company, as I expected is slowly diversifying away from EMC (NYSE:EMC), with non-EMC revenues hitting a record $5 million this quarter. I fully expect continued revenue gains from non-EMC customers in the coming year, which would support a higher valuation for the company´s profitable OEM business.

As noted in the past, the way to look at NENG is to just view this company as a former "subsidiary" of EMC, that has been struggling to diversify its business away from EMC via new customer wins and new proprietary product lines. With a strong balance sheet, a decent product line, and a new talented CEO, time is on the side of NENG, and the odds favor a growing and higher-margin non-EMC business over the coming years.

The risk is low here, since there is still little expectation that Network Engines will in fact deliver sustainable cash-flow growth. I would also note that the company's recently hired CTO, received options with a $3 strike price, so buying here gives you the opportunity to get in at a discount to his option grants, which I'm sure were set with a view towards new business deals and opportunities in the year ahead. Until next quarter...

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.