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  Network's double bottom

BENJ GALLANDER and BEN STADELMANN

Thursday, July 13, 2006

When Network Equipment was last mentioned in a column in October 2003, we were feeling pretty good about selling 75 percent of our position at $11.74 (U.S.), a lovely gain over the $3.65 paid less than a year before. As for the remaining 25 percent, we held on, convinced that the upward trajectory would continue.

It did, for a while, but in true "what goes up, must come down" parabolic fashion, it has retraced all the way back — and below — our purchase point. Having missed the opportunity to profitably sell the rump of our holding, is now the time to reload for another spin?

It is fascinating to compare the current company fundamentals with those from four years ago. In December 2002, Network was trading at less than the cash per share on the balance sheet. It now has cash of $3.47 per share, so that's still true. Total liabilities have improved from $56 million in 2002 to $43.8 million this year. Dilution has been modest, with the share count increasing from 22.2 million to the current 24.8 million.

Overall then, the balance sheet is at least as strong today as when we bought the company.

The revenue picture, however, is a study in stark contrasts. In those dark days of the bubble bust of 2002, an annual sales volume of around $150 million, with a sprightly uptick for a couple of quarters, encouraged us. However, in the fiscal year ending March 31, 2006, sales tallied an anaemic $70.5 million.

The past two quarters in particular have been dry as a bone, with the company ringing in only $30.5 million into the till.

A couple of years ago, Network's products really seemed to be striking a chord with the U.S. military. The expansion of NATO was the catalyst for improved sales at excellent margins. At the time, it was reasonable to anticipate that this could lead to bigger and better things, especially as management emphasized the need for various military organizations to use standardized equipment to communicate efficiently amongst themselves.

Last January, CEO Nicholas Keating was vaguely twittering about project and budget delays, as if the U.S. armed forces were short of dough — damn that tightwad, George W. Bush. However in April, Keating was somewhat more specific, commenting that "Agencies have shifted some of their IT priorities and continue to modify their network strategies, in some cases transitioning to other technologies."

That sounds ominously as though they have moved on to other vendors and won't be back.

All this brings to mind an "almost" Contra stock, Kasten Chase Applied Research, which was on our short list in the fall of 2003. This Toronto-based cryptographic security software provider had a nice thing going with the spooks at the National Security Agency for a few years, but for whatever reason, the contract was not renewed.

Without the super-secret seal of approval, nobody seemed to want to buy Kasten's magic decoder rings. Though the balance sheet was clean, plummeting revenues meant cutbacks to product development. That downward spiral can be lethal for a high-tech firm, for a "focus on careful cash management" can only get you so far when competitors are bringing out the next generation of gizmos.

Unable to find a buyer, Kasten closed its doors last month. We're awfully happy that one stayed in the "almost" category.

Network's stock price bounced this week to $3.24 on revised guidance that first-quarter revenues would be in the $17.2 million to $17.7 million range, up from $14 million. Does this mean that the company has re-established the pipeline to the government gravy train? That's a substantial increase, but bear in mind that such comparisons are a lot easier from a beaten-down level.

We would need to see at least another quarter of improvement to be sufficiently confident to repurchase this stock.


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