From the Red Herring:
redherring.com
IPO Critic: Network Engines revving up for IPO
By Tom Davey
Redherring.com, July 10, 2000
Network Engines (Nasdaq: NENG) is gearing up to face the challenge inherent in all initial public
offerings: raising funds while satisfying the investment bankers. With its pending IPO scheduled
for next week, the company's bankers are attempting to price the shares low enough to create
strong demand and a healthy aftermarket, while avoiding underpricing, which would leave too
much money on the table.
In the wake of the dot-com fallout over the past few months, investors are understandably
cautious about value. The key question is: How do you value a company that's losing lots of
money now but may be the Dell of 2005?
Some blame market conditions for the fact that recent IPOs have not only sold at or below their
proposed price range, but have also stumbled in the aftermarket. The Nasdaq Composite, a key
barometer of the IPO market, has been crawling out of its slumber and is now up 20 percent
over the past six weeks. Perhaps the recent lackluster IPO showings are more attributable to
bankers overvaluing their clients' companies from the outset.
The financial analysts I talk with say revenue is the answer. Strong double-digit revenue
growth, they insist, combined with decent gross profit margins will lead to bottom-line profits
even when taking into account other costs such as sales, research, and office overhead.
GROWTH ENGINE
With this in mind, Network Engines, which makes specialized Web servers used as plug-and-play
appliances by Internet service providers and Web sites in general, looks like a better prospect
than most of the companies I've recently critiqued. Network Engines hopes to raise $77 million
by offering 5.5 million shares at about $14 a share.
The offering represents a 17 percent equity stake in the company. Network Engines's shares are
expected to be priced on July 12 or 13.
The offering, led by Donaldson Lufkin & Jenrette (NYSE: DLJ), would give Network Engines a
$447 million market value. The proposed offering price is at a slightly lower revenue multiple than
its key competitor, Cobalt Networks (Nasdaq: COBT).
Although this seems like a perfectly logical pricing strategy to generate demand for the stock,
recent IPO pricing trends reflect the opposite -- where shares are priced at much higher
multiples than their publicly held competitors. Those trendsetters also followed with belly flops in
the aftermarket. Many investment bankers seem convinced they can wave a magic wand and
sprinkle fairy dust on an upstart, jump-starting its value and dwarfing the valuations of
comparable public companies. In Network Engines's case, if the stock is priced within its
proposed range, I think it'll trade up.
The company, which has been selling its Web appliance servers for only about a year, lost $8.5
million on $15.4 million in revenue over the past four quarters. Cobalt, the only other significant
pure-play company in the rapidly growing market for comparable devices, lost $21 million on $32
million in revenue over the past four quarters. Network Engines plans to price at 29 times
revenue, which compares with a multiple of 30 times revenue for Cobalt. Although Cobalt is the
market leader with about twice the revenue, its losses are proportionally higher.
COZY NICHE
What's important about both companies, however, is that they're the key players in a hot niche
of a booming market. International Data Corporation predicts the worldwide market for appliance
servers will grow from a $215 million market share last year to $8 billion in 2003, a compound
annual rate of 147 percent. IDC includes other plug-and-play devices in this market, such as
network storage units and email servers.
Network Engines sells about a quarter of its units to IBM (NYSE: IBM), which resells them under
its own brand name. The deal with IBM has recently changed to an agreement where IBM will
license Network Engines's proprietary hardware design and ease-of-use software. This will put a
dent in a key revenue source. But that will be offset by lower costs for manufacturing and
production. Network Engines also sells 18 percent of its units to Microsoft (Nasdaq: MSFT) for
the firm's WebTV operations.
Analysts say it's too early to tell whether Cobalt or Network Engines will be the bigger success.
Unlike most server vendors, both put much of their research into developing software that
enables technicians to upgrade a Web site with new devices in a few minutes and lets them
monitor and maintain equipment from an offsite location. If the market evolves as anticipated,
both should have opportunities to license this software to large computer vendors. Either Cobalt
or Network Engines stands a good chance of being bought out by a large vendor.
Although the storage market is currently the biggest portion of IDC's appliance server category,
IDC analyst Mark Melenovsky says the market for Web servers and other "front-end" specialized
Internet appliances used for caching data and clustering servers should enjoy a faster growth
rate than storage. He notes that many more businesses will turn to such labor-saving devices
because hardware costs are still falling, whereas labor costs are growing.
This implies, of course, the market for products from these two companies will grow even faster
than 147 percent annually through 2003. Even at that rate, Network Engines would have $232
million in revenue for the four quarters ending March 2003 and $573 million a year later. If this
company can maintain that growth level while maintaining its recent 33 percent gross margins,
which are about average in the competitive computer hardware industry, Network Engines is
definitely worth watching. |
