A Telecom-Equipment Provider With a Future

I've been mulling over Network Equipment Technologies(NWK) for a few weeks, after seeing a small 5,000 share purchase by CEO Hubert Whyte come across my computer in early April.

Since it was a light filing week, I had more time than usual to investigate this mere $26,850 purchase. I liked that Whyte was averaging up from a larger purchase made in October, and also saw that a director had made a small purchase in November.

It certainly wasn't the strongest-looking insider signal we have seen, but revenue and profit margins at the company were headed in the right direction, and the stock was trading just a little above cash.

In the end, though, I didn't pull the trigger. The relatively small amount of insider buying was one negative, but my larger issue at the time was that the company was still losing money. I wasn't sure investors in this messy market would give any more credit than they already had to a turnaround story that hadn't yet broken back into profitability.

Guess I was wrong. Network Equipment just announced its results for its fourth quarter ended March 29, and the stock gapped up on triple its normal volume. The results showed that the firm's turnaround is for real, which is particularly impressive considering that Network Equipment sells into the telecom industry. And it still looks as if there's some value there. Even after its pop, Network Equipment trades for just 1.4 times cash on hand and below tangible book value.

A Turnaround Story

Bert Whyte took over Network Equipment nearly three years ago to rescue the company after rapid declines in its legacy products left many concluding that the company would eventually go bankrupt. Whyte developed a solid reputation in the telecom industry while working as an executive for Canada's Newbridge Networks, which was eventually sold to Alcatel.

Although you wouldn't know it from Network Equipment's continuing losses, Whyte has done a remarkable job of cutting costs, rescuing and sustaining the legacy business, and developing new products. Of course, that effort has taken time. Even after Whyte's arrival, sales continued to fall. Even the much-celebrated annual top line just reported is less than a third of what the company bagged in fiscal 1997.

The latest quarter was the third in a row to show improving revenue, however. And Whyte's real magic has been worked further down the income statement. Although the latest quarter's revenue was still slightly below that of a year ago, Network Equipment's operating loss was more than halved. Per-share metrics are even more impressive: the company lost 61 cents per share a year ago, 37 cents a share in its third quarter, but just 9 cents in the fourth quarter.

A New Focus

Soon after his arrival, Whyte had concluded that Network Equipment's T1 network products were not very competitive from a technology standpoint. So he told his engineers to redevelop the line while working on newer types of telecom gear.

The legacy T1 products, grouped under the company's Promina division, have finally found some traction. The company expects sales of the Promina products to keep rising sequentially as the U.S. government looks at using more of the gear as part of the new Homeland Defense Security Initiative. New orders have come in from the Marine Corps, the Air Force and other U.S. government agencies

But Whyte isn't guiding investors to look for a strong rebound in the Promina division. Instead, Whyte's hopes are pinned on a pair of new products -- ShoutIP and Scream. ShoutIP is used by telecom carriers to deliver phone calls over the Internet, a technology known as Voice over IP (VoIP). It's a nascent market that has been slow to develop, but firms such as Cisco (CSCO) remain convinced that major enterprises are still planning to eventually embrace VoIP.

But it's the Scream product that has the company most excited. Scream pulls in various data and voice streams in a telecom network, aggregates them and then reroutes them in the most efficient manner. The product is currently in trials with 12 global telecom vendors, and the company expects to start booking initial full-scale orders as soon as this June's SuperComm show.

With tight cost controls, Whyte has positioned the company to hit break-even sooner rather than later. Quarterly operating expenses, which were about $34 million 10 quarters ago, are now about $16 million. Throw in variable expenses, and Network Equipment stands to break even at about $35 million in quarterly revenue. As noted, sales have begun to climb again, and the company is comfortable with estimates that it will hit break-even about four quarters from now.

Although Network Equipment's shares could well pull back because of this messy market or a normal bout of profit-taking, the progress of the company's business and shares over this past (very difficult) year makes it a good bet to perform well over the next 12 months.

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