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Monday, August 14, 2006

Breaking Down Neoware's Earnings

Neoware (NWRE) is a niche oriented company that revolves around the thin client computing for enterprise size clients, and it has suffered of late because of dependence on too few orders. The company had seen its shares butchered and battered after its last earnings warning, and it has been down over 60% from the yearly highs. Its 52-week high is $30.95, and it closed today up over 5% at 12.46. Unfortunately, the shares are down 4% at $11.95 after the earnings report.

What is important here is that the company actually made money and the company doesn't seem like it is prepping the street for a crummy future. When they gave the first guidance, you were at a 6-5 pick'em as to if the quarter was going to show a gain or loss. The company also managed to show a tiny gain in revenues to $22.55 million, up from $23.0 million in the same quarter last year. That is a second sequential decline from last quarter's $27.7 million, so they have to show the street they can grow revenues again. Net income on an EPS basis was $0.09 non-GAAP and $0.02 on a GAAP basis. It also ended the quarter with $114 million cash and short-term securities.

"As previously disclosed, the fourth quarter's results were impacted by the insolvency of one of our German distributors and by the fact that several of our large enterprise customers did not purchase in the quarter,'' commented Michael Kantrowitz, Neoware's Chairman and CEO. He also stated ``What we experienced this quarter is not new for us, and doesn't change our positive outlook for our business and our market. We have consistently communicated that our revenues are subject to quarterly variation -- both positive and negative -- based on the timing of individual orders. In fact, we experienced similar quarterly variation to the positive in the first quarter of fiscal 2006, when our revenues were significantly above the expectations we communicated approximately three weeks before quarter end."

"Because of our confidence in the growth opportunities in our core markets, we are expanding our marketing and sales initiatives in 2007, including increasing our focus on systems integrators, distributors and VARs by increasing our sales headcount and marketing programs aimed at these channels. At the same time, we will also increase our investments in selling and marketing programs aimed at large enterprise customers through partnerships, including those with IBM and Lenovo."

Here is the guidance for Fiscal Year 2007 (June):

-- Revenues for the year are expected to increase by 18% to 20%
compared to fiscal 2006.

-- Gross profit is expected to be in the 40% range, plus or minus a
point or two in individual quarters based upon product mix.

-- Non-GAAP operating expenses, excluding amortization of stock-based
compensation and amortization of acquisition related intangibles,
are projected to increase by approximately $7.0 million for the
year, similar to the increase from fiscal 2005 to 2006.

-- Amortization of stock-based compensation is expected to be
approximately $900,000 per quarter.

-- Amortization of acquisition related intangibles is expected to be
approximately $340,000 charged to cost of sales and $600,000
charged to sales and marketing expense per quarter.

-- The Company's effective tax rate is expected to decline
approximately one to two percent as a result of the positive impact
of tax free investment income.

-- Fully diluted share count is expected to be approximately 20.7
million shares.

Our Take:

The share count is only 0.3 million more, so the company is trying to telegraph that they are not going to sell more shares. It will have to prove if it can grow 18% to 20% even with expended marketing and sales efforts, because that is steep in an environment where the Windows Vista delay has caused pushouts and one where a slowing economy results in lower tech spending. That 40% profit range may be hard to meet with the higher expenses, even with a lower tax rate.

The company is obviously trying to shy away from quarterly guidance here, and the street is probably assuming the 2007 goals may end up being too back-end loaded for a stock that just went through an implosion.

All in all, we are trying to give the company a pass and trying to give them the benefit of the doubt. The company has a long way to go, and it has to be able to prove it can reclaim some growth that it is losing sequentially. It also needs to be able to show less dependence on a small number of orders. This is not a formal member of our BAIT SHOP for takeover candidates in a consolidating corporate environment yet, but it is now going on the watch list for a potential addition. The company has a solid niche, but the street is going to demand that they prove themselves all over again before they endorse management yet.

Neoware, Inc. provides enterprise thin client solutions, and related software and services to the business customers worldwide. Its software products enable enterprises to gain control of their desktops, stream software on-demand, and to integrate mainframe, midrange, UNIX, and Linux applications with Windows environments and the Web. Its market cap as of the close was $246.7 million.

Jon C. Ogg
August 14, 2006

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