Small Cap Stocks

About a year ago, we picked Network Engines (NENG) as a potentially solid turnaround candidate in the technology sector. Back then, the stock was trading at $1.88 per share and the company was losing money. Fast forward one year, and the company is now trading at about $2.25 per share, up nearly 20%, and reported $6 million in free cash-flow for the most recent fiscal quarter.

Overall, given the above statistics, we can´t complain much about our investment in the company. In any turnaround situation, stabilization of cash-flow is the first priority, and management has clearly been very successful on that front.

However, renewed revenue growth, the second important aspect of any turnaround, still remains a concern at Network Engines. With 82% of revenue coming from EMC, the company is in dire need of new revenue streams. On that front, even though the company has been successful in attracting new partners, there has yet to be any meaningful financial impact from these deals. Generating new revenue is, of course, far harder to achieve than cutting costs and we therefore plan to have some more patience to wait for top-line growth.

Furthermore, we think that patience makes sense here, because with $39 million in cash, no debt, and no cash burn, the company has plenty of resources and time to establish new revenue streams, especially considering the booming nature of the appliance industry.

Additionally, with about 40 million shares outstanding, the company´s enterprise value is around $50 million, or less than 0.5X EV/TTM Sales. Though this low relative valuation is somewhat warranted given the reliance on EMC, it should be clear that “The Market” is not pricing in any meaningful sales growth potential for Network Engines.

Therefore, as we mentioned over a year ago, in the event that the company is successful is developing new non-EMC business, the shares could appreciate significantly. In the meantime, as mentioned above, we see little downside risk given the strong balance sheet and already depressed valuation.

Disclosure: We hold shares in NENG. This report includes market analysis. 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 or in any particular stock. 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. We maintain no legal responsibility to update this report or his holdings in the stock mentioned in this report

Back in August 2006, we alerted subscribers to the potential of an expanded Network Engines/Microsoft partnership, following Microsoft’s acquisition of Whale Communications. Today, much to our delight, but not surprise, Network Engines (NENG), released an important PR that actually details an expanded business partnership between the two companies.

According to Microsoft:

“Our expanded relationship with Network Engines ensures that our current IAG customer base will have solid support and service as well as a resource for purchasing and upgrading the IAG-based solutions,” said Mike Schutz, group product manager of the security and access products group for Microsoft. “Network Engines has an established track record of providing appliance solutions and support for Microsoft applications, that when coupled with their advanced manufacturing facilities, Network Engines emerges as a strong choice to support current and future IAG customers.”

We view this news as extremely positive for NENG and we hope to get further clarity on the exact financial impact of this deal when NENG announces quarterly earnings on February 1st. Nevertheless, given NENG’s still depressed valuation, we would still expect the stock to react very favorably to this important new strategic partnership with Microsoft, especially since it provides further evidence on how Network Engine’s (NENG) is slowly, but successfully, growing the Non-EMC business. As we have stated in the past, NENG’s stock should receive a valuation in line with industry-wide multiples, once investors feel comfortable that the company has a more diversified revenue stream. We expect that throughout 2007, the company will establish this broader, and profitable, revenue stream.

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.

Network Engine’s (NENG) released its 10-K last evening. The report is an interesting read since it gives an excellent summary of the company’s changes in 2006 and the new strategic direction for the coming year. As we mentioned when we first started coverage of NENG back in February 2006 at $1.88 per share, 2007 should prove to be a pivotal year for the company, as strategic changes from 2006 finally begin to be reflected in the financial results.

This morning Network Engines 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.

For interested investors in NENG, who might be worried about the company´s reliance on Microsoft security products, we think the following articles, regarding Microsoft´s acquisition of Whale Communications and  the expected release of ISA 2006, will be of interest.

Click Here for a press release from Microsoft.

Click Here for an article from InfoWorld.

Click Here for an additional release issued upon the completion of the Whale Purchase.

Click Here to learn about ISA Server 2006, a key component of the NENG Investment Thesis.

Some things to think about: Will NENG make the appliances based on Whale´s software? Don´t some of the statements in the last press release from Microsoft sound very similar to the planned managed branch offering of Getronics and NENG?

And a final quote from Microsoft: "We are also working with our OEM partners to release an updated Whale
and Microsoft ISA Server 2006 appliance, which we plan to bring to
market in early 2007. At the same time, we will be integrating Whale
technologies into the next release of ISA Server itself (after ISA
Server 2006), with the intent to release shortly after Windows Server
codename “Longhorn.” This new release will fall under the new Microsoft
Forefront brand of security and secure-access solutions."

This post summarizes some facts from Network Engine´s (NENG) most recent 10Q for the quarter ended June 30, 2006.

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.