Network Engines (NENG): New Stock Pick

Investment Summary:
I believe that Network Engines (Nasdaq: NENG), at its current price of $1.88, represents a low-risk investment, with substantial upside price potential in the next several years, should NENG’s newly appointed, and highly experienced Chief Executive Officer, execute on some key business initiatives and position the company successfully in the high-growth network server appliance industry.

Background:

The current stats on NENG are as follows:
Current Share Price:  1.88
Shares Out: 39 million fully diluted
Market Cap:  73 million
Net Cash: 32mm
Debt: $0
EV (Enterprise Value or Value of company minus cash + debt):
$41 million

Network Engines (NENG) generates revenue from two distinct business lines, both targeting the server appliance market.

By way of introduction, a server appliance is:  “a specialized server that is designed for ease of installation and maintenance. Server appliances have their hardware and software bundled in the product, so all applications are pre-installed. The appliance is plugged into an existing network and can begin working almost immediately, with little configuration. It is designed to run with little or no support.” (Source: Webopedia.com).

Due to various cost and other factors (i.e. the need to deploy new software applications at remote office locations quickly and without the need for specialized internal IT departments) there has and continues to be significant growth in the server appliance market, particularly for network security and storage systems.

Network Engines participates in the Server Appliance market by:
1.    Developing, manufacturing and testing server appliances for third-party network equipment manufacturers and independent software vendors (ISV’s). This is NENG’s OEM business.
2.    Distributing its own proprietary server appliance, the NS Series, based on Microsoft’s ISA Server, specifically to provide security protection for Microsoft Exchange Users. This is NENG’s distribution business. It is a high-risk, high-reward business, with a need for significant investment.

For the fiscal year ended September 30, 2005, NENG had $93 million in OEM revenues and $5 million in distribution revenue. NENG reported $10 million in operating profit for the OEM segment in 2005 and a $19 million operating loss in the distribution business. Of note is that business with EMC, represents over 80% of the OEM business. So in essence, I would characterize NENG, as a subsidiary of EMC with a research/start-up arm devoted to developing proprietary server appliance products.

Why is the downside risk in the stock low?

As can been seen from NENG’s stats, the stock has low downside risk at the current price because:

• Horrendous Recent Stock Performance

NENG's stock is near an all-time low and way down from it's all time high. There are therefore few potential sellers left in this stock and there is therefore little downside risk should NENG dissappoint in one way or another.

• A Strong Balance Sheet

Roughly 40% of Network Engine’s market cap is in cash.

Interestingly, despite continued accounting losses, the company’s cash position has remained pretty much steady at over $35 million for the last several years. So even with some needed additional investments in the distribution segment, I feel very comfortable that the company’s worst case cash position will be $30 million or so in cash or $0.77  per share. The large cash position provides downside protection in the stock.

• Losses in Start-Up NS Business Mask a Profitable OEM Division

In addition to the company’s strong balance sheet, NENG also has a profitable OEM business, which is being masked by the losses in its Product business. As mentioned above the company’s OEM business had a $10 million operating profit in 2005. The problem of course is that, as mentioned above, EMC is over 80% of the OEM business, representing an extreme customer concentration risk. However, from what I can gather NENG’s relationship with EMC is very strong and in fact business from EMC continues to increase every quarter.  I honestly see no risk of the EMC business drying up anytime soon. In addition, the company can easily leverage the EMC business, by using it as a platform/ case study to attract other third-party ISV customers. Therefore, considering the above and despite the lopsided nature of the OEM business, I do think that the OEM segment has substantial value and to be very conservative, I assign it a value of at 3X 2005 operating earnings or $30 million.

Worst Case Valuation
So overall, adding the cash of $30 million and a $30 million value for the OEM business, I would say that NENG’s worst case value, completely ignoring the potential value of the NS/Distribution business, is about $60 million or about $1.55 per share. That represents a potential downside of about 18%. 

So why should you invest in NENG now and what is the potential upside?

New Chief Executive Officer
I became interested in NENG when the company hired Gregory A. Shortell as CEO in early January 2006. Mr. Shortell was an instrumental member of Nokia's Enterprise Businesses Group, which grew, under his direction, from $14 million in sales in 1997 to more than $1 billion in 2004. Industry sources and more importantly, Google Searches, have verified that Mr. Shortell played a key role in developing the hugely successful Nokia-Checkpoint server appliance product line. It is clear that Mr. Shortell is a very experienced executive who has the ability to significantly grow NENG’s server appliance business, both on the OEM and Distribution side. I fully expect that Mr. Shortell will leverage his extensive industry connections to strike new deals for NENG’s OEM and Proprietary Distribution businesses. I don’t want to speculate on any specific deals, but I highly doubt that Mr. Shortell took the CEO job at NENG without a good knowledge of the potential new business he could create for NENG via industry contacts. Of note, is that Mr. Shortell was granted 1.5 million shares at $1.36 per share, when appointed CEO of NENG. So he has a huge incentive to get the stock moving and liquid enough, so he can eventually sell his shares.

New OEM clients and Greater Traction for the NS Series Product
Throughout 2006, as can already be seen in the NENG’s last several press releases, I expect NENG to sign additional OEM deals, further diversifying its OEM business and reducing its dependence on EMC. In addition, I expect 2006 to be the break out year for the NS Series product, especially with the recent signing of an agreement with Ingram Micro to resell  the entire family of Network Engines NS Series(TM) Security Appliances. While Microsoft’s ISA Server Product is clearly not a focus for Microsoft and while it remains a tiny business for Microsoft, there is still a large enough potential business in the ISA Server market for a company the size of NENG. Of note, is that more than half the world’s email servers are Microsoft Exchange based—according to recent figures from IDC, there are more than 1.6 million active Exchange Servers worldwide, representing a significant addressable market for NENG’s network security appliances that incorporate Microsoft’s ISA 2004.

Upside Valuation
Should Shortell be successful in further diversifying the OEM business and in growing the NS distribution business, I think NENG’s stock can easily double in the next one to two years. That would give the company a market cap of about $150 million, which after stripping out $35 million in cash (would be higher then, in fact), and a $50 million valuation for the diversified OEM business (4X my estimated operating profit for that business), leaves a potential $65 million valuation for company’s distribution business, which may or may not include the NS Series product (I expect Shortell to quickly scrap the NS Series product if it fails to gain traction soon). Is this a reasonable valuation? I would say that it definitely is, given the fact, that start-ups in the server appliance market with little operating experience and without the caliber of management NENG currently has, are given similar valuations based on projected market penetration rates. Even without using a relative valuation, it is easy to envision the NS series doing $20 million a year in sales, which would justify the $65 million valuation.

It is very important to realize that the growth potential of the server appliance market is huge and with Shortell on board, NENG has the right person to help the company leverage its resources, both tangible and intangible, to capture a nice portion of the server appliance market. It is very difficult to quantify what this potential revenue slice will be, but in speaking with people in the industry, it seems clear that there are a host of opportunities. One can never underestimate the potential combination of a proven leader, a nice pile of cash, and a solid team. Time and again, I have seen how the right person, with the right amount of capital, in the right situation, can take a company from $0 to a $100 million and more.

What are the risks here?

• EMC

Clearly, the biggest risk here is that EMC cancels its contract with NENG. That would severely hurt NENG and probably drive it out of business quickly. However, I see absolutely no risk of this happening any time soon. In fact, I expect the EMC business to grow in 2006. This gives NENG plenty of time to diversify the revenue stream away from EMC.

• NS Series Product Fails

It is quite possible that the NS Series product fails to gain any traction. However, I expect
Shortell to quickly drop the NS Series product, in the event that sales do not justify a continuation of the product line. In that case, NENG is left with a profitable OEM business, and/or the company can try its hand at other proprietary products. In fact, I fully expect Shortell to license other software that can be used to develop proprietary appliance server products for NENG.

Catalysts for Stock Price Appreciation

• New OEM Deals

• New Partnership Deals for the Proprietary NS Series