[Member] NEI – A Net-Net Stock, Also Undervalued By Earnings

This is a past Premium recommendation and is made available for your reference. For more past trades, refer to our trade history.

After exiting my position in Xyratex, it would have been disappointing if I did not find a way to get my exposure to the storage sector back. With the remarkable growth in the social networks, blogs, and an ongoing migration to cloud computing, storage will continue to be a growth sector for the foreseeable future. However, it is true that the real values are hidden way down in the supply chain. For example, one made a killing buying up the pick and shovel companies in the California gold rush. Investors in the high profile exploration companies that promised the pot of gold – not so much.

Xyratex is one such supplier. They make equipment used to manufacture and test disk drives. However, the value there does not exist anymore as the stock has been marked up by the market since the initial recommendation and purchase. Not so the case with this little company called Network Engines that I am profiling today.

Network Engines Inc – NEI:

Headquartered in Canton, Massachusetts, NEI is a system integrator. NEI designs and manufactures application platforms and appliance solutions on which software applications are applied for both enterprise and telephony information technology ("IT") networks. Application platforms are pre-configured server-based network infrastructure devices, sometimes referred to as appliances, engineered to deliver application-specific functionality, ease deployment challenges, improve integration and manageability, accelerate time to market and increase the security of that software application in an end user’s network. An application platform is also intended to reduce the total cost of ownership associated with the deployment and ongoing maintenance of software applications when applied to a customer’s IT infrastructure. To date, a large portion of their revenues has been derived from the sale of physical application platform solutions to customers serving the data storage, network security and communications markets. They also provide platform management software tools and support services related to solution design, systems integration, application management, global logistics, and support and maintenance programs.

Simply put, they buy hardware such as storage drives, add a box (or appliance) of their own on the top that adds a standard interface between the underlying hardware and any software that is built on the top. A little like an operating system for computers, except the Network Engine operating systems is a combination of hardware and software. Their customers rebrand these appliances under their own name before they are pushed out to the market. Customers include EMC, Tektronix, Symantec, etc.

Why is Network Engines Attractive?

The stock is attractive on two different levels. The primary attraction being that its market value today is just 82% of its NCAV. This means that one can buy the company out at the current valuation, use just the current assets to pay down all its liabilities and still get about 25% in profit left over. Long term assets are a bonus. Buying a Dollar for 80 cents, is always a good deal. Additionally, the stock currently trades a P/E ratio of 8.9. If you take out the non essential cash, which they have quite a bit of, the P/E ratio of its on-going business falls to 6.61. The company delivered a 8.55% return on equity in the 2011 fiscal year.

(If you are following along with data from Yahoo Finance or other online sources, please note that most ratios reported on these sites are wrong and will give you incorrect information. For example, Yahoo Finance reports a P/E ratio of 1.57, which while technically true is not reflective of their 2011 business. You will see below why this is)

The stock currently trades at $1.32/share. The prices are as of market close Jan 24, 2012. This gives the company a market value of $56.05 million.

A Look at the Balance Sheet

The following is a summarized Annual balance sheet for NIE with key data of interest. Please note that the last reported quarter was the end of the fiscal year so the annual balance sheet for 2011 is the most recent.

NEI B.S Annual Balance Sheet
Sep-30-2011 Sep-30-2010 Sep-30-2009 Sep-30-2008
Cash 19.85 15.32 21.04 10
Receivables 43.52 34.38 27.5 28.99
Inventory 24.33 23.16 13.08 21.38
Current Assets 107.59 75.73 66.75 62.43
Long Term Assets (Adj for dep) 23.8 8.38 9.92 15.63
Goodwill/Intangibles 5.24 6.57 8.13 9.88
Total Assets 131.39 84.11 76.67 78.06
Payables 23.36 16.45 14.2 11.74
Short Term Debt 0 0 0 0
Current Liab 35.08 25.96 22.58 21.47
LTD 0 0 0 0
Total Liab 39.17 28.96 25.1 23.71
Equity 92.22 55.15 51.57 54.35

 

The company has $19.85 million in cash, which is 35% of the market value and 18% of its current assets. There is no short term or long term debt, although the company has $10 million available on a line of credit if they need to use it to manage their working capital. The Goodwill/Intangibles line reflects $5.24 million in intangibles in the form of customer relationships acquired as part of an acquisition in 2008. This intangible is amortized and the company does not believe it is impaired.

Its key asset valuation ratios are as follows:

P/B 0.61
P/TBV 0.64
P/NCAV 0.82
Current Ratio 3.07

 

Tangible Book Value and NCAV both discount goodwill and intangibles. The NCAV exceeds the current market value by $12.37 million. Even if you were to assume an impairment of 50% on the inventory (there is no immediate reason to do so), we are still even with the market value. The company has sufficient liquidity with a current ratio above 3.

Using an aggressive assumption to determine the liquidation value of the company, including paying off all the suppliers and other liabilities, I arrived at a liquidation value of $65.7 million, which gives us a 15% margin of safety on the stock. $65.7 million equates to $1.55/share, which is what I would be willing to pay for the assets of the company, if I am indifferent about running the company as an ongoing concern.

Reviewing Profit and Loss

The company has a history of reporting losses, but they are not as bad as they first appear. The reason being that 2011 and 2008 statements included a $0.5 million and $8.7 million in Goodwill impairment, respectively. 2011 statement also includes use of $30.9 million of tax loss benefit which has abnormally inflated their net income and EPS (which is why Yahoo reports a PE of 1.57).

After adjusting for these extraordinary charges and benefits, their income statement can be summarized as the following:

$millions 2011 2010 2009 2008
Sales 272.47 221.62 148.72 197.5
Gross Margin 11.4% 11.5% 15.1% 16.4%
Operating Margin 2.3% 0.7% -2.2% -4.4%
Adjusted Net Income 6.3 1.53 -3.2 0.22
Adjusted EPS 0.14 0.03 (0.07) 0.01

 

Over the last few years, the company has increased sales and seen declining gross margins. This is a result of their over dependence on a few key customers. EMC and Tektronix contribute 59% and 11% of NEI’s sales in 2011. This over dependence resulted from increased business over the years to these two customers. While sales have increased, there have been margin pressures as one can see in the declining Gross Margin.

The company has to its credit focused on its internal operations and improved its operating performance. This has helped them return to profitability in the last 2 years. The continued dependence on EMC and Tektronix is a risk since these are not long term contracts and can be changed by either party at any time.

With the outlook for storage sector growth and NEI’s focus on improving their operating leverage, I am comfortable  in the short term that they will remain profitable and will continue to increase shareholder value. With the risk factors outlined above, I am not willing to make a long term projection for earnings and I am not willing to use earnings power as a basis for my valuation, other than to note that their current PE of 8.9 (6.61 ex-cash) is an added comfort and any positive earnings will be a bonus.

Other Considerations

NEI recently updated their Dec 2011 Quarter guidance upwards, expecting a net income between $1.3 m to $1.6 m. Last comparable quarter net income was $1.35 million so they are expected to come out even or better on the comparable. They report their quarter performance on Jan 26, 2012.

During the three months and year ended September 30, 2011, the Company repurchased 526,342 shares of its common stock at an average cost of $1.19 per share. From the inception of the share repurchase program (Jun, 2008) through September 30, 2011, the Company has repurchased 3,107,888 shares of its common stock at an average cost of $0.90 per share. However the share repurchase program is currently suspended as the company builds up cash for expected increase in working capital requirements that may result from Thailand floods that created a shortage of disk drives.

Bottomline

I recommend purchase of NEI stock at current levels up to $1.55/share with a target sell price of $2.02. Both the buy price and target sell price may be updated in the future if the company continues to create more value.

Comments

  1. Yuan Jiun Lai says

    Thanks Shailesh, got it. The adjusted EPS I get is around $0.005 (0.22/43), is that a round up to $0.01 in your table ?

  2. Yuan Jiun Lai says

    Thanks Shailesh for the clear explanation as always. One more question, I can’t seem to find the $0.5 million and $8.7 million in Goodwill impairment in 2011 and 2008 statements you mentioned. Where should I look ?

    • says

      Assumption is that non essential cash can be distributed as dividends if the company chooses to without affecting their business. Distributing dividends reduces the share price by an equivalent amount which causes the PE to fall.

  3. Yuan Jiun Lai says

    Hi Shailesh, you mentioned the risk is in the concentrated customers in EMC and Tektronix. Would the company be in serious trouble if theses two customers suddenly switch to other suppliers? Who are NEI’s competitors ?

    • says

      Yuan, the company will be in trouble if these two customers switch suppliers. That is why NEI is working hard to ramp up new customers like Symantec. EMC share of revenues this quarter fell from 57% to 50% so there is progress. Another positive in decreasing dependence on EMC is that they are a lower margin customer, just because of their size.

      NEI’s competitors include Avnet (AVT) and to some extent Oracle (Java based appliances), but none of them are pure plays. NEI is focusing now on cloud based storage systems which is a large opportunity.

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