Shares of Network Engines (NASDAQ:NENG) dropped over 30% today to lead the Nasdaq's percentage losers on news that its distribution agreement with data storage and services leader EMC (NYSE:EMC) promises narrower gross margins.
Last December, Network Engines acquired TidalWare. That then-profitable company distributes EMC-approved host bus adapters (HBAs) and many other products to resellers and systems integrators of storage and network security solutions to businesses. Network Engines said in a prepared statement that the new agreement, effective Jan. 1, 2004 to the end of 2005, increases the company's costs relating to the sale of HBAs. In refreshing clarity, the release says that there will be a decline in gross profit and a negative impact on gross profit and operating margins for calendar Q1 2004.
The company further said that it expects gross profit margin from distributing EMC HBAs to be what it makes on distributing other third-party storage trinkets -- 7% to 12% -- and that it hopes to compensate for the loss by controlling other costs.
Network Engines has been GAAP profitable for two quarters, but hasn't yet produced quarterly free cash flow -- though we won't know about the September quarter until it files its 10-K (its fiscal year ends in September). Investors have driven shares up at a 45-degree angle this year from the depths of penny-company land because of 186%, 547%, 559%, and 443% year-over-year revenue gains for the last four quarters, respectively. Using the last two quarters as guides, shares sell for 87 times earnings after today's drop.
That's either cheap if growth continues at close to current rates, or expensive if the EMC change is very bad news. Yet one factor might trump your thinking either way: One customer provided 48% of sales for the June quarter. That's down from 84% the year before, but still a warning of very great risk.
Meanwhile, you can always find plenty of other excellent stock ideas for the year ahead in our Stocks 2004 --available now!
