**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

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**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended September 30, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition period from               to               **

**Commissionfile number: 0-30863**

**NETWORK ENGINES, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                    | ** ** | **04-3064173**                        |
|-------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation) |       | (I.R.S. Employer  Identification No.) |
| **25 Dan Road, Canton, MA**                     |       | **02021**                             |
| (Address of  principal executive offices)       |       | (Zip Code)                            |

 

Registrant’s telephonenumber, including area code **(781) 332-1000**

Securities registeredpursuant to Section 12 (b) of the Act: **None**

Securities registeredpursuant to Section 12 (g) of the Act: **CommonStock, $0.01 par value**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes  o    No  x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes  o    No  x

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period than the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes  x    No  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statement incorporated byreference in part III of this Form 10-K or any amendment to this Form 10-K.x

Indicate by checkmarkwhether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).Yes  x    No  o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act). Yes  o    No  x

The aggregate market valueof the voting Common Stock held by non-affiliates of the registrant on March 31,2005 was approximately $53,463,400.

The number of sharesoutstanding of the registrant’s Common Stock as of December 7, 2005:37,945,833 shares.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of our proxystatement relating to the 2006 Annual Meeting of Shareholders are incorporatedby reference into Part III of this Form 10-K.

 

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**NETWORKENGINES, INC.**ANNUAL REPORT ON FORM 10-KFor the Fiscal Year EndedSeptember 30, 2005

**TABLEOF CONTENTS**

| **PART I**   |
|-------------------|
| ITEM  1.          | BUSINESS | 1 |   |
| ITEM  1A.         | RISK FACTORS | 13 |   |
| ITEM  1B.         | UNRESOLVED STAFF COMMENTS | 30 |   |
| ITEM  2.          | PROPERTIES | 30 |   |
| ITEM  3.          | LEGAL PROCEEDINGS | 30 |   |
| ITEM  4.          | SUBMISSION OF MATTERS TO A VOTE OF  SECURITIES HOLDERS | 32 |   |
| **PART II**  |
| ITEM  5.          | MARKET  FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS    | 34 |   |
| ITEM  6.          | SELECTED FINANCIAL DATA | 35 |   |
| ITEM  7.          | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 36 |   |
| ITEM  7A.         | QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK | 55 |   |
| ITEM  8.          | FINANCIAL STATEMENTS AND  SUPPLEMENTARY DATA | 56 |   |
| ITEM  9.          | CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE | 94 |   |
| ITEM 9A.          | CONTROLS AND PROCEDURES | 94 |   |
| ITEM 9B.          | OTHER INFORMATION | 95 |   |
| **PART III** |
| ITEM  10.         | DIRECTORS AND EXECUTIVE OFFICERS  OF THE REGISTRANT | 96 |   |
| ITEM  11.         | EXECUTIVE COMPENSATION | 96 |   |
| ITEM  12.         | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT        | 96 |   |
| ITEM  13.         | CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS | 96 |   |
| ITEM 14.          | PRINCIPAL ACCOUNTANT FEES AND  SERVICES | 96 |   |
| **PART IV**  |
| ITEM  15.         | EXHIBITS AND FINANCIAL STATEMENT  SCHEDULES | 97 |   |
| **SIGNATURES**    | 98 |   |

 

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*This Form 10-K contains forward-lookingstatements within the meaning of Section 21E of the Securities ExchangeAct of 1934, as amended, that involve risks and uncertainties. All statementsother than statements of historical information provided herein areforward-looking statements and may contain projections relating to financialresults, economic conditions, trends and known uncertainties. Our actualresults could differ materially from those discussed in the forward-lookingstatements as a result of a number of factors, including the factors discussedin Item 1A. Risk Factors and elsewhere in this report and the risks discussedin our other filings with the Securities and Exchange Commission. Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s analysis, judgment, belief or expectation only as ofthe date hereof. We undertake no obligation to publicly reissue theseforward-looking statements to reflect events or circumstances that arise afterthe date hereof.*

**PART I**

**ITEM1. BUSINESS**

**Overview**

Network Engines develops and manufactures serverappliance solutions that deliver data storage and network security applicationson server appliances. Server appliances are pre-configured network infrastructuredevices designed to optimally deliver specific software applicationfunctionality while facilitating ease of deployment, improved manageability andincreased security of that software application in a customer’s network. Aserver appliance deployment is intended to reduce the total cost of ownershipassociated with the deployment and ongoing maintenance of mission criticalsoftware applications within a customer’s IT infrastructure.

During fiscal 2005 we were organized into twooperating segments: OEM Appliance and Distribution.

In our OEM Appliance segment, we develop andmanufacture server appliance solutions that enable network equipment providersand independent software vendors, or ISVs, to deliver their data storage andnetwork security applications in the form of a server appliance. We offer ourserver appliance partners a comprehensive suite of services, includingdevelopment, manufacturing, fulfillment and post-sale support. We produce andfulfill devices branded for our network equipment and ISV partners, and wederive our revenues from the sale of value-added hardware platforms to thesepartners. These partners subsequently sell and support the device under theirown brands to their customer base. Our OEM Appliance customers include, but arenot limited to: Advanced Digital Information Corporation, Borderware, Inc.,Computer Associates Inc., EMC Corporation, Network Intelligence Corporation,and Nortel Networks Inc.

Currently in our Distribution segment, we develop,manufacture, sell, market and support our NS Series Security Appliancesthat are based on Microsoft’s Internet Security and Acceleration (ISA) Server2004. During fiscal 2004 we entered a relationship with Microsoft Corporation (“Microsoft”)to license their ISA Server 2004. We have integrated that software with serverappliance platforms and our proprietary software to sell our NS Series SecurityAppliances primarily to Microsoft-certified or network security experiencedvalue added resellers and system integrators. We introduced our first productin the NS Series line of security appliances, the NS6300, in the beginningof fiscal 2005.

Microsoft’s ISA Server 2004 is a third generationapplication firewall software product that also offers advanced virtual privatenetwork (VPN) and web caching functionality. Unlike most earlier generationnetwork firewall solutions, Microsoft’s ISA Server 2004 provides criticalapplication inspection and firewalling along with web access controlfunctionality required to secure critical business applications, specificallyMicrosoft applications suchas Exchange Server, IIS Web Server and Sharepoint Portal server. OurNS Series Security Appliances also include our own software intellectualproperty, Network Engines Web Server, or NEWSTM technology. NEWSTM is a secure,web-based appliance management sub-system that enables deployment andmaintenance tasks such as provisioning and remote system updates. NEWSTM is ourkey technology differentiator and enabler for all NS Series appliance managementand update tasks.

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Previously in our Distribution segment, we alsodistributed third-party data storage networking connectivity products for theleading Fibre Channel host bus adapter, or HBA, and storage switchmanufacturers in the data storage industry to a customer base of value-addedresellers, or VARs, and systems integrators. In early fiscal 2005, we decidedto discontinue selling third-party data storage networking products after areview of that portion of the business and its future prospects. As a result of an amendment to akey distribution agreement, the commoditization of Fibre Channel HBA technologyand increasing competition in the market, we had experienced declining grossprofits in that portion of the Distribution business. Furthermore, weexpected future net revenues and gross profits in that portion of the businessto deteriorate. Although sales of these third-party data storage networkingproducts ceased by December 31, 2004, substantially all of the revenueduring fiscal 2005 associated with our Distribution operations was derived fromthe sale of third-party data storage networking products.

As a result of the decision to discontinue sellingthird-party data storage networking products, we believe we have transformedthe company into a “pure-play” appliance company, dedicated to deliveringnetwork security and data storage solutions. We believewe are a leading provider of server appliance solutions by virtue of ourability to offer a wide range of engineering, manufacturing, supply-chain andsupport services to network equipment providers and ISVs.

Headquartered in Canton,Massachusetts, we were incorporated in 1989, and began developing custom serverhardware platforms in 1997 for internet-based organizations, contentinfrastructure providers and larger enterprises. In 1999, we achieved animportant milestone by introducing a one-rack unit Intel-based server,representing a server only 1.75 inches in height. At that time, we designedmost of the hardware components that went into our servers and, as a result, weinvested significant resources in the development of our products. In largepart as a result of the success of that product, we completed an initial publicoffering in July 2000. Subsequently, a significant number of companiesentered the one rack unit server marketplace, much of the hardware componentsof server appliances became commoditized and, at the same time, the demand ofinternet-based organizations declined precipitously. As a result, werestructured our operations in fiscal 2001, which among other thingsde-emphasized the use of proprietary components in server hardware platforms. InDecember 2002, we acquired TidalWire, which was a specialty distributor ofthird-party data storage networking products. This acquisition provided us withthe ability to partner with ISVs to develop, manufacture, and distribute theISV’s applications in the form of server appliances. Throughout fiscal years2003 and 2004, we established relationships with several ISV partners,including Microsoft. Today, we are leveraging our hardware engineering andmanufacturing infrastructure to supply server appliances to our OEM partnersand investing in software development and channel sales and marketing focusedon our Network Engines NS Series Security Appliances powered by Microsoft’sISA Server 2004.

**Industry Background**

Traditionally, networking solutions were builtutilizing custom-designed hardware and proprietary operating systems. Vendorsdeveloped custom components and systems in an effort to meet the highperformance demands of their customers, such as increasing networking speeds,packet processing requirements and internal storage capabilities. While thesehighly integrated systems were designed to address the performance demands ofthe customer, they were expensive due to the cost of research and developmentrelated to the requisite customization. Networking solution vendors generallymaintained internal research, development, manufacturing and integrationexpertise in both hardware and software, as both were critical aspects of anetworking solution and viewed as essential to maintaining a competitiveadvantage.

Over time, much of the networking solutions market hasevolved toward the development and manufacture of systems, built using commerciallyavailable standardized components and standardized operating system platforms.The speed and processing power of standard Intel-based processors has 

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reached a level wherethese processors can adequately meet the demands of many networking applications.Operating system platforms, such as Windows and Linux, have also increased incapability and sophistication and can now be used as the ‘embedded’ operatingsystem environment for many of today’s networking applications.

This evolution in the development and manufacturing ofsystems, or server appliances, built with commercially-available, standardizedcomponents has allowed networking equipment vendors to refocus developmentefforts and resources on the application software and system integration aspectsof their solutions. Vendors recognize that custom hardware development in manycases is no longer critical in meeting their customers’ performancerequirements. Competing systems are being integrated and packaged onstandardized hardware platforms and, therefore, hardware alone no longerdifferentiates a system in the marketplace. Based on the fact that serverappliance solutions can be built using standard commodity hardware andoperating systems components, vendors recognize that these aspects of theirsolution do not represent competitive differentiation points and hence, arecandidates for outsourcing. As a result, we believe that many network equipmentproviders have begun outsourcing components of hardware integration, test,manufacturing and logistics to partners that specialize in these skills.

While there are many applications for which a serverappliance may ultimately be used, early adoption of the technology is mostprevalent in the data storage and network security markets. These markets are significantin size and have exhibited robust growth in recent years. The securityapplications that we believe are most likely to benefit from a server appliancesolution include firewalls, authentication, anti-virus, anti-spam, instantmessaging or IM security, web content filtering, intrusion detection andprevention, device relationship management, digital rights management and webservices security management. The storage applications that we believe are mostlikely to benefit from deployment in the form of a server appliance includestorage security, backup and recovery, virtual tape libraries, storage resourcemanagement and data migration and archival systems.

Another significant trend driving the growth of thedata storage and network security markets is the decentralization of storagemanagement applications and network security applications. Enterprises aredeploying applications both in data centers and at departmental and remoteoffice locations. As a result, there is an increased need for applications thatcan be deployed quickly and efficiently without the need for extensive internalIT resources. Furthermore, remote deployment, monitoring and upgrades havebecome a critical aspect of managing the IT network of an enterprise.

Finally, the storage andsecurity needs of small to medium size enterprises continue to grow and, giventhe limited resources of these smaller businesses, we believe vendors mustprovide turnkey solutions that are cost-effective, easy to install and deployand require minimal human maintenance and management resources.

**Network Engines’Solution**

*OEM ApplianceSegment*

We develop and manufacture server appliance solutionsthat enable our network equipment and ISV partners to deliver data storage andnetwork security applications as a server appliance. We focus on developingcost-effective server appliance solutions to meet the performance requirementsof our partners’ software applications in order to address the deployment andcost of ownership needs of their customers. Key elements of our solutioninclude:

*Appliancedevelopment expertise.*   One of our corebusinesses is developing and manufacturing high quality server appliancesolutions in conjunction with our network equipment and ISV partners. We havedeveloped a structured appliance development process, which takes into accountall major aspects of a product’s design, from performance requirements tobranding, packaging and quality assurance. We strive 

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to engage with ourpartners at multiple levels of their organization, including engineering andproduct management, to optimize the product or suite of products by focusing onthe integration of the hardware, operating system, utilities and applicationsoftware. We make use of in-house server platform designs and third-party serverplatforms, depending on the configuration, application and volume requirements.

*Flexible,high-quality manufacturing services.*   We have asophisticated manufacturing facility at our headquarters in Canton,Massachusetts, which is ISO 9001:2000 certified. Our advanced control processesand systems, and comprehensive manufacturing test suites that we develop withour partners, are designed to ensure quality and trace-ability at every keystep of the manufacturing process. We believe our core strengths include ourflexibility and ability to react quickly to accommodate changes in customerdemands, including increasing order volumes, engineering changes to existingproducts and new product introductions. For certain high-volume products, wesupplement our production capacity and make provision to maintain continuity ofsupply through a relationship with a contract manufacturer.

*Customdesign services.*   We believe our expertise indeveloping customized hardware platforms is a significant competitive advantagewith respect to partners with high volume requirements for whom commerciallyavailable platforms are not appropriate solutions. This capability is based onour heritage of designing and optimizing custom server platforms, and isgenerally driven by our customers’ specific requirements for features includingdensity, performance or cost optimization. Our customization skills includehardware, firmware and software integration and packaging. Our team of skilledengineers, augmented by third-party contractors, has significant industryexperience in high-density packaging, server design, testing, quality assuranceand technical documentation.

*Appliance life cyclemanagement.*   We operate in a technologyenvironment in which platforms, operating systems, components and softwareapplications are constantly evolving. We pro-actively analyze thesedevelopments in order to maintain the operation of our partners’ softwareapplications despite changes in the underlying technologies. We also adapt theappliance solutions to meet emerging requirements and capabilities of newversions of our partners’ software applications. We believe our expertise inlife cycle management has become a critical factor in attracting new partnersand retaining our existing partners.

*Distribution Segment*

We develop, manufacture, sell, market and support ourNS Series Security Appliances that are based on Microsoft’s InternetSecurity and Acceleration (ISA) Server 2004. We have integrated ISA Server 2004with server appliance platforms and our proprietary software to sell our NS Series SecurityAppliances primarily to Microsoft-certified or network security value addedresellers and system integrators.

Microsoft’s ISA Server 2004 is a third generationapplication firewall software product that also offers advanced virtual privatenetwork and web caching functionality. Unlike most earlier generation networkfirewall solutions, Microsoft’s ISA Server 2004 provides critical applicationinspection and firewalling along with web access control functionality requiredto secure critical business applications, specifically Microsoft applications such as Exchange Sever, IIS Web Serverand Sharepoint Portal server.

Our NS Series Security Appliances also includeour own software intellectual property, Network Engines Web Server, or NEWSTMtechnology. NEWSTM is a secure, web-based appliance management sub-system thatenables deployment and maintenance tasks such as provisioning and remote systemupdates. NEWSTM is our key technology differentiator and enabler for all NS Series appliancemanagement and update tasks.

We believe there is a growing need for enterprises toaugment the security of their corporate networks as the capabilities ofexisting perimeter firewalls fail to protect a business from many emergingInternet threats. This methodology has been described as ‘defense in depth’.Responding to this security strategy, 

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ISA Server 2004, and henceour NS Series Security Appliances, are designed to be deployed directly infront of the mission critical application servers they are protecting. As aresult, even when an innocent employee among an increasingly mobile workforcebrings a threat into the network, our NS Series Security Appliances aredesigned to block that threat prior to it being connected to the Exchange Serveror other Microsoft application servers it was designed to attack.

Since the middle of our fiscal 2005, we have focusedour sales and marketing efforts primarily to sell the NS Series SecurityAppliances to protect Microsoft Exchange servers. One of the primary reasonsfor focusing on the Microsoft Exchange application is the sheer size of thismarket. More than half the world’s email servers are Microsoft Exchange based—accordingto recent figures from IDC, there are more than 1.6 million active ExchangeServers worldwide, representing a significant addressable market for ournetwork security appliances that incorporate Microsoft’s ISA 2004.

In May 2005, weannounced our Network Engines ISA Cooperative Enforcement (NICETM)program. NICETMis a program for approving and distributingthird-party software that enhances the functionality of the NS Series. Underthe NICETM program, the objective is to establish technology and businessrelationships with key third-party vendors and then test and certify thecompatibility and interoperability of their applications with ISA Server 2004,the Windows operating system, and our NS Series Security Appliances. Currently,Websense is the only network security vendor actively participating in our NICETMprogram.

**Business Strategy**

Our objective is to become a leading global providerof server appliance solutions and services for the data storage and networksecurity markets. The key elements of our strategy include:

*Strengthenexisting relationships and engage with new network equipment and ISV partnersto sell server appliance solutions.*   We believethat our full service supply chain capabilities are a competitive advantage inthe marketplace today. We intend to leverage this advantage to develop additionalbusiness within our existing OEM customer base and to identify and attract newOEM partners. We are targeting partners in the data storage and networksecurity markets, where initial adoption of the server appliance solution hasbeen most prevalent.

*Furtherdevelop and grow our indirect sales channel through which we sell our NS Series SecurityAppliances.*   To date substantially all ourefforts have been focused on engaging and training Microsoft certified ornetwork security resellers and system integrators to sell our NS Series SecurityAppliances, powered by Microsoft’s ISA Server 2004. In Europe, we have engageda single distributor to gain access to certain of its Microsoft certified andnetwork security reseller relationships. With Microsoft’s assistance, webelieve we must also establish a similar relationship with a leadingdistributor in North America. In addition to providing us access tosignificantly more resellers, we believe such a relationship will also provideus access to certain direct marketers. While we will continue to offer trainingand channel marketing programs directly to certain resellers and systemintegrators, we also plan to utilize the various sales and channel marketingprograms offered by distributors to reach their base of resellers, systemintegrators and direct marketers.

*Developand integrate technologies that improve the security, manageability anddeployment of server appliances.*   We intend tocontinue to enhance our proprietary technology that we have developed to maketruly headless, remotely managed server appliances. Our NEWSTM technologyenables end-users to remotely manage the NS Series appliances through asecure web-based management system that enables provisioning and remote systemupgrades. NEWSTM is the cornerstone of one of our key differentiators—ourability to enable complete appliance lifecycle management. Today NEWSTM is onlydeployed with our NS Series Security Appliances. We have filed multiplepatents for our server appliance framework technology, unique security featuresand high availability technologies including our automated update 

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management system, and weare continuing to work on additional technology that we expect to be patentedin the future.

We also plan to continue to integrate third partytechnology that will enhance the value of our product offerings throughsecurity capability for targeted scenarios. An example is our relationship withWebsense, with whom we work to offer Websense web security capabilities as partof our NS Series product line. We believe that partnerships like this willnot only improve our product functionality, but may also give us the ability toleverage the customer base which has been built by the technology partner andenabling joint selling and marketing into our combined customer bases.

*Establish strong brandidentity of Network Engines server appliances.*   NetworkEngines plans to employ a branding strategy that establishes Network Engines asthe server appliance development and manufacturing partner of choice. Thisstrategy is designed to establish company name recognition, product brandequity and identification in the data storage and security networking markets.

**Products andServices**

In our OEM Appliance segment, we develop andmanufacture optimized server appliance solutions that enable our networkequipment and ISV partners to deliver data storage and network securityapplications on a server appliance. We have developed a comprehensive suite ofproducts and services, enabling our network equipment and ISV partners toaccelerate the time to market for their products, to optimize their serverappliance solutions and in some cases enable them to utilize our infrastructurefor fulfillment of those server appliance solutions.

In our Distributionsegment, we have leveraged the development and manufacturing capabilities ofour OEM Appliance segment to offer our NS Series family of securityappliances that are powered by Microsoft ISA Server 2004. Our NS Series SecurityAppliances provide application layer protection for mission critical Microsoftapplications such as Microsoft Exchange. We announced the general availabilityof our first product in our family of NS Series Security Appliances, theNS6300, in October 2004. Our products and services are described below:

***Server appliance development***

We have developed astructured approach to server appliance development. We define the customerengagement and ultimate delivery of the product in stages and identify theresponsibilities for both the partner and for ourselves. This program isdesigned to ensure that the engagement with our application partner is wellmanaged and executed and anticipates and includes all aspects of the solutionrequirements of the customer. The key phases of the process consist of thefollowing:

·       Definition:Network Engines and application partner establish project teams and developproduct requirements.

·       Development:Engineering teams from Network Engines and application partner work together todefine a prototype.

·       Prototype:Engineering teams develop, build and test the prototype.

·       PilotManufacturing: Network Engines engineering releases the product tomanufacturing to build the first (Pilot) units.

·       FirstArticle: Both parties approve the first pilot unit(s) and Network Enginesfinalizes manufacturing, fulfillment, and post-sale support processes.

·       GeneralAvailability: The final product is released to Network Engines manufacturingfor production.

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We have a significantamount of experience in developing server appliance solutions and, as such, we believe that our structured approach provides substantial benefits to ourpartners, including improving the chances for a successful development andspeeding the process of bringing a product to market.

***Custom server design and integration***

Our server appliancehardware design team is well versed in custom server design, generallyutilizing standard off-the-shelf components and sub-systems. The development ofcustomized server appliance hardware requires significant design, packaging,regulatory and thermal profiling skills. Our embedded software design team alsoperforms low-level hardware driver development as well as BIOS modificationsand tuning. We leverage these server development skills in order to delivercustom solutions to certain of our partners.

***Manufacturing and test services***

We provide internalmanufacturing and test services for our server appliance partners. We operateseparate manufacturing lines for high volume and low volume manufacturing. Ourhigh volume manufacturing process involves building the chassis, including theintegration of the main logic board, memory, disk drive and PCI-board into thechassis and testing of the final product. Our low volume process involvesbranding of third-party supplied servers, as well as memory, disk drive and PCIboard integration and testing. We maintain separate low and high volume lines inorder to provide our partners with the appropriate type of manufacturingresources and skill sets to best meet the volume requirements of a particularproduct. In addition, our low volume line allows us to provide customers withrapid manufacturing turn around time, which provides a significant time tomarket advantage for new products. Our partners’ products undergo system testand burn-in prior to final inspection, packaging and shipment.

***Branding, packaging and fulfillment services***

In our OEM Appliancesegment, we brand the server appliance solution for our network equipment orISV partner. Branding is applied to the server appliance itself as well as toall accompanying documentation, including quick set-up guides, manuals,shipping cartons, shipping labels and paperwork. We retain a full time graphicartist who is responsible for production of branding designs and we work withoutside design and production agencies that are highly experienced in equipmentpackaging and branding approaches. We also have full-time mechanical engineerswho build customized bezels, LCD front panels, light-pipes, and otherdistinctive features to provide a custom look and feel for our OEM partners’server appliances. We deliver the final product to either our customer or, attheir request, directly to their end user customers.

***NS Series Security Appliances***

Our NS Series Security Appliances combine thepower of Microsoft’s Internet Security and Acceleration (ISA) Server 2004software application with our server appliance integration expertise and ourinternally developed Network Engines Web Server (NEWSTM). Each NS Series SecurityAppliance is a third-generation application layer firewall, VPN and Web-cachesolution that provides advanced protection against a wide range of new andemerging network security threats, fast and secure Web access and is easy touse. Also, each network security appliance is sold with an annual support andmaintenance program, which includes hardware product warranties and a softwareupdate service.

Our NEWSTM technology and software update servicesallow for fast, reliable and secure software updates on a when and if availablebasis. Our NEWSTM management system differentiates our NS Series productfrom ISA Server 2004 in the form of software loaded onto a general-purposeserver, or ISA Server 2004 “pre-loaded” on a server. NEWSTM provides anXML-based “point and click” environment for 

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configuring, managing anddeploying NS Series Security Appliances. As part of this capability, NEWSTMenables users to apply the latest Microsoft software updates, and forinstalling critical and non-critical software releases.

NEWSTM enables significant features in the NS Series thatenables end users to deploy ISA Server 2004 in a comprehensive set of networksecurity scenarios. We believe these capabilities improve the availability,manageability, and accuracy of defense-in-depth and network securityimplementations which inherently makes these implementations more secure.

NEWSTMmakes use of a variety ofinstallation wizards and interfaces to manage NS Series devices forconfiguration and software updates. Software update management is a keyconsideration in security appliance management, especially in a Microsoftenvironment. As part of the software update process available through NEWSTM,the software updates are carefully reviewed and tested by our engineers beforebeing released to users through the NEWSTM management system. NEWSTM then managesthe flow and installation of these software updates, allowing users to controltheir administration and automatically schedule their implementation in a costand time effective way.

The NICETMprogram isour processfor identifying, approving and integrating third-party software that enhancesthe functionality of the NS Series. Under the NICETM program, our objective isto establish technology and business relationships with key third-party vendorsand then test and certify the compatibility and interoperability of theirapplications with ISA Server 2004, the Windows operating system, and our NS Series SecurityAppliances. Currently, Websense is the only network security vendor in our NICETMprogram.

In November 2005, we announced the availabilityof NEWSTM version 3.0 software for all NS Series Security Appliances aswell as our two newest products in the NS Series family, the NS6250 andthe NS8400. As part of the release of version 3.0, the NS Series appliancescan now be securely monitored and managed through Microsoft’s Operation Manager(MOM) management console. While system administrators will continue to use NEWSTMfor installation and updates, the use of a MOM agent allows them to monitor theISA and Windows 2003 Operating System through MOM. Release 3.0 also providesthe option of integrating Websense Web Security SuiteTM for advanced protectionfor web-based communications.

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Today,our NS Series family of security appliances is currently comprised of theNS6250, NS6300, NS6400 and NS8400, each with the characteristics shown in thefollowing table:

| **Feature**                          | ** ** | ** **                        | ** ** | **NS6250**               | ** ** | **NS6300**                            | ** ** | **NS6400**                   | ** ** | **NS8400** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|---------------------------------------|------------|------------------------------|------------|------------|------------|
| 1:1 Automatic  Failover              |       | X                                 |       | X                        |       | X                                     |       | X                            |       |
| Backup and  Recovery                 |       | X                                 |       | X                        |       | X                                     |       | X                            |       |
| Secure Remote  Management            |       | X                                 |       | X                        |       | X                                     |       | X                            |       |
| Secure Automated  Updates            |       | X                                 |       | X                        |       | X                                     |       | X                            |       |
| Dual Drives                          |       |                              |       |                     |       |                                  |       | X                            |       |
| Dual Power                           |       |                              |       |                     |       |                                  |       | X                            |       |
| Hot-swappable  Drives and Power |       |                              |       |                     |       |                                  |       | X                            |       |
| MOM Integration                      |       | X                                 |       | X                        |       | X                                     |       | X                            |       |
| Secure  Application Manager          |       | X                                 |       | X                        |       | X                                     |       | X                            |       |
| Websense Web  Security Suite         |       |                              |       |                     |       | X                                     |       | X                            |       |
| Exchange Mailbox  Clients            |       | 500                               |       | 500                      |       | 1,000                                 |       | 4,000                        |       |
| Target Market                        |       | Small  Business  or Branch Office |       | Small  to Medium  Office |       | Medium  Business  to Small Enterprise |       | Medium  to Large  Enterprise |       |
| Product Launch                       |       | November 2005                |       | October 2004        |       | February 2005                    |       | November 2005           |       |

 

**Customers andPartners**

Each of our business segments, OEM Appliance andDistribution, target a distinct customer base. Our OEM Appliance businesstargets network equipment vendors and ISVs that wish to sell server appliancesolutions to their customers. During the past fiscal quarter, our OEM Appliancebusiness sold server appliances to 15 customers, including: Advanced DigitalInformation Corporation, Borderware, Inc.,Computer Associates Inc., EMC Corporation, Network Intelligence Corporation andNortel Networks. EMC was our only customer that represented more than10% of our revenues for the years ended September 30, 2005 and 2004,during which our sales to EMC were $77.5 million, or 79% of total net revenuesand $67.4 million, or 49% of total net revenues, respectively.

In ourDistribution segment, we began to sell our NS Series Security Applianceswhen our NS6300 appliance became generally available in October 2004. Ourtarget customers are primarily Microsoft-certified or network securityexperienced resellers and system integrators. We spent considerable efforts infiscal 2005 recruiting and training channel partners in both North America andin Europe. Our European efforts began in February 2005 when we signed anexclusive pan-European distribution agreement with InTechnology to distributeour NS Series Security Appliances.

In North America, we were engaged with approximately70 reseller and system integrator partners at the end of our fiscal 2005. Today, our emphasis is on developing existingchannel partners by providing sales and product training along with ISA Server2004 training. Most recently, our primary goal has been to develop moreproductive resellers, which we define as partners who are trained, activelymarketing the NS Series and actually selling product. Additionally, webelieve we must also establish a two-tiered distribution 

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channelin North America as we have done in Europe. We believe the establishment ofsuch a channel will enable us to leverage a distributor’s existing relationshipswith resellers and direct marketers.

In Europe, we are nowengaged with more than 50 channel partners through our relationship withInTechnology. We have engaged an initial core of partners in the UnitedKingdom, France, Spain and Italy, and plan to initiate development activitiesin Germany and other countries during the first half of fiscal 2006.

**Sales and Marketing**

***Sales***

Our OEM Appliance sales team is focused on developingpartnerships with network equipment providers seeking to integrate a serverappliance into their offerings and with ISVs seeking to offer their applicationsoftware as an appliance solution. Once we have identified and qualified aprospective partner and a project is identified, a regional sales manager meetswith the customer and begins to work on an appropriate strategy. We theninvolve other employees from sales, engineering, and product management toanalyze the prospective customer’s requirements and begin to develop asolution.

Our Distribution salesteam is focused on partnering with resellers and system integrators whospecialize in Microsoft infrastructure or network security products andservices to sell Network Engines NS Series Security Appliances powered byMicrosoft ISA Server 2004. A significant number of these new relationships withMicrosoft certified resellers and system integrators have been cultivatedthrough initial contacts derived from working closely with Microsoft sales andmarketing personnel. As a result, we believe this requires our sales team to furtherdevelop and strengthen our relationship with Microsoft in order to continueleveraging Microsoft’s relationships with resellers of Microsoft products andservices.

***Marketing***

Our marketing organization is aligned by two keyfunctions: product management and marketing programs. Our product managementteam is responsible for managing the technical relationship with our hardwareplatform, operating systems and components suppliers. The product managementteam researches the market to anticipate trends and understand and evaluate newtechnologies that we can leverage in the development and integration of serverappliance solutions. They work closely with our engineering team and ournetwork equipment provider and ISV partners to define product requirements.

Our marketing program teamis responsible for building market awareness and acceptance of Network Enginesand our products and services and generating qualified customer leads. Thisteam is also responsible for defining channel marketing programs for our NSSeries product line in order to attract new channel partners as well asstimulate increased activity from our existing reseller base. These programsare executed in cooperation with our field sales teams in North America andEurope. We expect that asignificant benefit of establishing a two-tiered distribution channel in NorthAmerica will be the ability to leverage and participate in marketing programsoffered by a distributor or any of its direct marketers. As a result, in thefuture we anticipate that our marketing programs will also consist of thesetypes of programs.

**Warranty and postsales support services**

We offer a warranty on certain of the products wesell. The warranty generally provides for us to repair or replace a defectiveproduct within certain timeframes and generally lasts for a period of up to 36months after initial product shipment, depending on the product and ourcontractual relationships with certain customers.

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For our OEM Appliance customers, we offer a range ofpost sales support services, including advanced replacement of defective unitsas well as repair and return service for appliance platforms covered by ourcontractual warranty.

For our NS Series SecurityAppliances, we offer different post sales support service programs, includingcall center support, software subscription service, web registration andsupport, and twenty-four hour domestic advanced replacement of appliances. Oursoftware subscription service enables our NS Series Security Appliancecustomers to easily apply software updates for the NS Series appliance. Softwareupdates may include patches, service packs and feature enhancements, when andif available. Web registration and support allows the customer to register itsNS Series Security Appliance through our website, which also providescustomers with additional product information including technical advice,aforementioned software updates and an online support request form.

**Manufacturing**

We provide manufacturing, test and fulfillmentservices for server appliances through our 22,500 square foot manufacturingfacility located at our headquarters in Canton, Massachusetts. In October 2003,we received our initial ISO 9001:2000 certification and were recertified in November 2005.We operate separate server appliance manufacturing lines for high volume andlow volume manufacturing. We maintain two separate lines in order to provideour partners with the appropriate type of manufacturing resources and skillsets to best meet the volume, cost and quality requirements of a particularproduct. In addition, our low volume line allows us to provide customers withrapid manufacturing turn-around time, which provides a significant time tomarket advantage for new products.

We also supplement ourmanufacturing capacity for certain high-volume products by utilizing athird-party contract manufacturer who has multiple manufacturing locations inthe United States and abroad. We use this partner to handle a portion of ourongoing volume requirements to ensure that they are prepared to handle surgeand/or excess volume requirements and also as a disaster-recovery site in theevent that our Canton facility is shut down for any reason.

**Engineering**

We believe that much of our future success depends onour ability to customize server appliances developed utilizing commerciallyavailable standard components and platforms acquired from third-partysuppliers. This customization includes both hardware and software modificationsand enhancements to the standard platforms. We have assembled a team of highlyskilled engineers, contractors and suppliers with significant industryexperience in high-density packaging, server appliance design, system software,quality assurance, testing and technical documentation.

We are also making aconsiderable investment in Network Engines Web Server, or NEWSTM technology,which is our proprietary software used in our NS Series SecurityAppliances. NEWSTM is a secure, web-based appliance management sub-system thatenables deployment and maintenance tasks such as provisioning and remote systemupdates. As part of our NICETM program, we also believe that we will need tomake a considerable investment in integrating third-party network securityapplications into our NS Series Security Appliances.

**Employees**

As of September 30,2005, we had 144 employees, of whom 36 were engaged in manufacturing, 9 wereengaged in customer support, 36 were engaged in sales and marketing, 40 wereengaged in research and development and 23 were engaged in general andadministrative. We also employ contract labor, predominately in our manufacturingoperations. As of September 30, 2005, we utilized 33 contract employees.

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**Backlog**

Our backlog includesorders confirmed with a purchase order for products scheduled to be shippedwithin 180 days to customers with approved credit status. Certain of our OEMAppliance customers place large orders with us to be delivered over time. Inaddition, we have an inventory consignment agreement with our largest customerwhereby shipments for certain products to this customer are held at thiscustomer’s location until this customer requires the products for theirproduction process. We do not recognize revenues from consignment shipmentsuntil the consigned product is utilized. Also, certain of our OEM Appliancecustomers, including our largest customer, have certain rights under ouragreements with them to change the delivery timing of future shipments to them.In addition, our agreement with our largest customer includes provisions thatallow this customer to cancel orders within certain contractual time periods.As a result of these factors, we do not consider our backlog to be firm nor dowe believe that our backlog, as of any particular date, is necessarilyindicative of actual net revenues for any future period.

**Competition**

Our markets are highly competitive, and we expect thiscompetition to persist and intensify in the future. The principal competitorsof our OEM Appliance business are general-purpose server manufacturers thatprovide solutions for network equipment providers and ISVs and build servers forthe OEM marketplace. These competitors include Dell, Hewlett-Packard, IBM andSun Microsystems. We also compete with major distributor integrators, such asArrow Electronics, Inc. and Avnet, Inc., that offer distribution aswell as customized integration services to their customers. In addition, wecompete with smaller companies that specialize in building server products andproviding some level of integration services, such as SteelCloud, Inc.

Our NS Series SecurityAppliances compete with other technology companies that license Microsoft ISAServer 2004 software, and develop their own security appliances, such as Hewlett-PackardCompany, Celestix Networks, Inc., and Pyramid Computer GmbH. In addition, we compete withtechnology companies in the firewall security industry that sellappliances using technology other than Microsoft ISA Server 2004, includingCisco Systems, Inc., Nokia Corporation, Juniper Networks, Inc, WatchguardTechnologies, Inc. and SonicWALL, Inc.

We believe we can compete favorably on factors that are importantto our target market, most importantly on the strength of Microsoft ISA Server2004 and the protection of Microsoft applications such as Exchange Server, IISWeb Server and SharePoint Portal Server. Additional factors include our proprietaryNEWSTMtechnology, our expertise in integrating software applications into serverappliances, our logistics and support infrastructure, our manufacturingproficiency and our commitment to quality.

**IntellectualProperty**

We claim trademark rights for the use of the NetworkEngines name and the Network Engines logos. We believe these rights provide uswith additional protection over the use of these names and descriptions. Weenter into confidentiality or license agreements with our employees, consultantsand corporate partners, and control access to and distribution of our software,documentation and other proprietary information. We also have seven patentsthat primarily pertain to our historical business and will remain in effectuntil 2020 or later. In addition, we have two patents that relate primarily toour OEM Appliance segment.

We have five patents applied for and in process forour NEWSTM based appliance framework technology, including our automated updatemanagement system, and we are continuing to work on additional technology thatwe expect to be patented in the future.

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Despite our efforts toprotect our proprietary rights, our competitors might independently developsimilar technology and unauthorized parties may attempt to copy or otherwiseobtain and use our technology. Monitoring unauthorized use of our proprietarytechnology is difficult, and we cannot be certain that the steps we have takenwill prevent misappropriation of our technology, particularly in foreigncountries where the laws may not protect our proprietary rights as fully as inthe United States. Due to rapid technological changes in our market, we believethe various legal protections available for our intellectual property are oflimited value. In addition to such intellectual property, we seek to establishand maintain an extensive knowledge of leading technologies and to incorporatethese technologies into our appliance platforms by leveraging the technologicalknowledge and creative skills of our personnel.

**Financial InformationAbout Geographic Areas**

See Note 17 to ourConsolidated Financial Statements, entitled “Segment and Geographic Data”, forfinancial information about geographic areas. The Notes to the Company’sConsolidated Financial Statements are contained herein in Item 8.

**Website Access toSecurities and Exchange Commission Reports**

We maintain an internetwebsite at *www.networkengines.com*. We are notincluding the information contained on our website as part of, or incorporatingit by reference, in this Annual Report on Form 10-K. Our periodicSecurities and Exchange Commission reports (including Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q and Current Reports on Form 8-K)are accessible through our website, free of charge, as soon as reasonably practicableafter these reports are filed electronically with, or furnished to, theSecurities and Exchange Commission. We have posted on our website a copy of ourcode of business conduct and ethics. In addition, we intend to disclose on ourwebsite any amendments to, or waivers from, our code of business conduct andethics that are required to be publicly disclosed pursuant to the rules ofthe Securities and Exchange Commission or NASDAQ National Market.

**ITEM1A. RISK FACTORS**

The risks anduncertainties described below are not the only ones we are faced with.Additional risks and uncertainties not presently known to us, or that arecurrently deemed immaterial, may also impair our business operations. If any ofthe following risks actually occur, our financial condition and operatingresults could be materially adversely affected.

***Risks of dependence on one strategic partner.***

**We derive asignificant portion of our revenues from sales of server appliances directly toEMC through our OEM Appliance segment and our revenues may declinesignificantly if this customer cancels or delays purchases of our products,terminates its relationship with us, or exercises certain of its contractualrights.**

In the years ended September 30, 2005 and 2004,sales directly to EMC, our largest customer, accounted for 79% and 49% of ourtotal net revenues and 83% and 84% of our OEM Appliance revenues, respectively.Primarily all of these sales are attributable to one OEM Appliance productpursuant to a non-exclusive contract. We anticipate that our future operatingresults will continue to depend heavily on sales to, and our relationship with,this customer. Accordingly, the success of our business will depend, in largepart, on this customer’s willingness to continue to utilize our serverappliance solutions in its existing and future products. Further, our financialsuccess is dependent upon the future success of the products we sell to thiscustomer and the continued growth, viability and financial stability of thiscustomer, whose industry has experienced rapid technological change, shortproduct life cycles, consolidation and pricing and margin pressures. Asignificant reduction in sales to this customer, or significant pricing andadditional margin pressures exerted on us by this customer, would have amaterial adverse effect on our results of operations. 

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In addition, if thiscustomer delays or cancels purchases of our products, our operating resultswould be harmed and our ability to accurately predict revenues, profitabilityand cash flows would decrease.

Under the terms of ournon-exclusive contract, this customer has the right to enter into agreementswith third parties for similar products, is not obligated to purchase anyminimum quantity of products from us and may choose to stop purchasing from usat any time, with or without cause. In addition, this customer may terminatethe agreement in the event that we attempt to assign our rights under theagreement to another party without this customer’s prior approval. Furthermore,in the event that we default on certain portions of the agreement, thiscustomer has the right to manufacture certain products in exchange for amutually agreeable royalty fee. If any of these events were to occur, or ifthis customer were to delay or discontinue purchases of our products as aresult of dissatisfaction or otherwise, our revenues and operating resultswould be materially adversely affected and our reputation in the industry mightsuffer and our ability to accurately predict revenues, profitability and cashflows would decrease.

***Risks related to business strategy.***

**If potentialcustomers do not accept our NS Series Security Appliances as a solution tocertain of their network security needs, our business will be adverselyaffected.**

We currently expect that future Distribution segmentrevenues will be primarily generated through sales of our NS Series SecurityAppliances and the related maintenance service, and we will not succeed if themarket does not accept these products and services as a viable solution tocertain network security needs. Our NS Series Security Appliances arepowered by Microsoft’s Internet Server Acceleration (“ISA”) Server 2004software application. If customers don’t perceive this application to betechnically superior to other competitive security products or if customers don’tbelieve that our security appliance will provide increased security forMicrosoft applications, then our revenues and operating results will suffer.The initial member of NS Series line of security appliance products hasbeen available since October 2004. The sales of the NS Series SecurityAppliances did not meet our expectations during fiscal 2005. We also may not besuccessful in marketing and selling these products in the future if we areunable to educate and train channel customers on our product line, or if we areunable to gain market acceptance of these products.

Sales of NS Series SecurityAppliances through our Distribution segment requires a greater selling andmarketing burden than any of our other server appliance products. We may findthe selling and marketing burden to be greater than was originally planned. Wehave invested and plan to continue to invest in a significant level of salesand marketing resources and programs along with engineering resources for thecontinued development of our NS Series Security Appliances. If we areunable to generate sufficient revenues to recover these costs and achieve anappropriate gross profit, our operating results will suffer. To date, we havebeen unable to achieve substantial sales of server appliances through ourDistribution segment and there is no guarantee that we will be able to achievesubstantial amounts of such sales in the future. If we are unable to generatesufficient revenues by leveraging our Distribution operation to increase salesof server appliances in a cost effective and timely manner, our operatingresults may suffer and we may determine that we need to increase our investmentin this business, thereby increasing our costs and increasing our losses, or wemay determine that we must discontinue this component of our business strategy,any of which could negatively affect our business.

**Market acceptanceand demand of Microsoft’s ISA Server 2004 software will depend on Microsoft’sdecision to prioritize and concentrate its marketing efforts for this software.**

Because our NS Series line of security appliancesare powered by Microsoft’s ISA Server 2004, our success will depend on theextent the marketplace perceives this software as superior to other forms ofsecurity protection. We believe, this perception will be determinedsubstantially as a result of marketing 

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efforts undertaken byMicrosoft directly. In order to achieve broad recognition that ISA Server 2004provides necessary protection of specific Microsoft applications better thanother competing products, we will rely to a significant extent on Microsoft’sfinancial and technical resources to educate its channel of certified resellersand, equally as important, the ultimate end-users. If Microsoft does notprioritize these marketing and promotional campaigns, or delays the timing ofsuch programs, then we may not achieve significant sales of our NS Series SecurityAppliances, which may adversely affect our business.

Even if Microsoft’s ISAServer 2004 software is widely accepted as the best protection of Microsoftapplications, customers may choose to purchase ISA Server 2004 in the form ofsoftware instead of a server appliance. Although many network securityapplications are sold in the form of an appliance to allow for betterdeployment, management and security, Microsoft could continue to sell and/orcustomers may elect to purchase ISA Server 2004 in the form of software only ormay choose to purchase appliances from other customers. If Microsoft does notpromote the advantages of ISA Server 2004 in the form of a server appliance,this would have a negative impact on our business.

**If we fail toengage with a significant number of new resellers and systems integratorscapable of selling our NS Series Security Appliances, our revenues andoperating results may be adversely affected.**

In order for our NS Series Security Appliances tobe successful we believe we must establish a network of quality VARs andsystems integrators that are familiar with Microsoft products or the networksecurity market and are committed to sell our security appliances. To date, wehave engaged with approximately 70 resellers in North America and 50 resellersin Europe. Many of the North American reseller relationships were derivedthrough working closely with Microsoft’s sales and marketing team. All of ourEuropean reseller relationships are the result of our distribution agreementwith InTechnology. Microsoft was instrumental in our entering this European distributionagreement. As such, we believe that signing additional resellers will continueto depend on our relationship with Microsoft, and our ability to leverage thatrelationship to gain access to quality VARs and system integrators. Therefore,we will need to further establish and strengthen our relationship withMicrosoft in order to be considered a preferred provider of Microsoft ISAServer 2004 in the form of an appliance. We believe to grow and further developour indirect channel of resellers in the future we must establish a two-tiereddistribution channel in North America. We also believe that we will needMicrosoft’s assistance in establishing such a channel. Additionally, we musteffectively manage this relationship to gain access the distributor’sresellers, direct marketers and marketing programs. If we fail to strengthenour relationship with Microsoft enabling us to enter into partnerships with asignificant number of new resellers and systems integrators, or are unable toestablish a two-tiered distribution channel our revenues and operating resultsmay be adversely affected.

In addition, because our channel of distributors, VARsand system integrators have the ability to sell products and services that arecompetitive with ours, to devote more resources to those competitive productsor to cease selling our products and services altogether, we will need toeducate and train our reseller partners on the benefits of Microsoft ISA Server2004 and the added value of selling this application in the form of our NS Series SecurityAppliances. Additionally, we will need to effectively market to end-users ofour NS Series Security Appliances to educate them on the value ofdeploying ISA Server 2004 in the form of an appliance in order to stimulatedemand in the distribution channel.

If we are not successfulin marketing to resellers and end-users, training our resellers, or if theseresellers are not committed to sell our security appliances, our revenue growthmay be limited and our operating results may be adversely affected. Further, toentice these resellers to sell our security appliances we may be required tooffer certain financial incentives that would result in a reduction of revenuesor an increase in operating expenses, which would adversely affect ouroperating results.

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**A breach ofsecurity could harm public perception of our products and services.**

We will not succeed unlessthe marketplace is confident that we provide effective security applicationprotection. Even applications protected by our appliances using Microsoft’s ISAServer 2004 software may be vulnerable to electronic break-ins and computerviruses. If an actual or perceived breach of security occurs in an end-user’ssystems, regardless of whether the breach is attributable to us, the marketperception of the efficacy of our products and services could be harmed. Thiscould cause us or our reseller partners to lose current and potentialcustomers, or cause us to lose potential resellers. Because the techniques usedby computer hackers to access or sabotage networks change frequently andgenerally are not recognized until launched against a target, we may be unableto anticipate these techniques.

**We may be unable todeliver our products and services if we cannot continue to license or integratethird-party technology that is essential for the functionality of our securityappliances.**

Our success will significantly depend on our continuedability to license or integrate technology that is essential for thefunctionality of our security appliances. A material adverse change in ourrelationship with Microsoft or the functionality of its software would have asignificant adverse result on our Distribution segment operations. We depend onMicrosoft to deliver reliable, high-quality software, develop new software on atimely and cost-effective basis and respond to evolving technology and changesin industry standards. Further, ifMicrosoft does not continue to make ISA Server 2004 available to OEM customerson a favorable basis, our ability to sell our NS Series SecurityAppliances may be substantially reduced.

We believe we also need tolicense or integrate technology from additional third-parties that would beincorporated in our NS Series Security Appliances. Because we do notcurrently know with certainty which of these prospective technologies will bedesired in the marketplace, we may incorrectly invest in development orprioritize our efforts to integrate these technologies in our NS Series SecurityAppliances. Additionally, even if we correctly focus our efforts, there can beno assurance that we will select the preferred provider of these technologies,or that the third-party provider will be committed to the relationship andintegration of their technology. If we are unable to successfully integratethese third-party technologies, our NS Series Security Appliances may beinferior with other competitive products, which may adversely affect theresults of our operations and our ability to grow our Distribution segmentbusiness.

**If we do not expandour international operations and successfully overcome the risks inherent ininternational business activities, the growth of our business may be limited.**

Our ability to growwill depend in part on the expansion of our international sales. We currentlyhave a one-year agreement with a distributor headquartered in the UnitedKingdom for exclusive distribution of our NS Series Security Appliancesthroughout Europe. The failure of our distributor to sell our products acrossEurope, or their de-emphasizing their support of our products would limit ourability to increase our revenues in that region. In addition, our internationalsales are subject to the risks inherent in international business activities,including:

·       costof customizing products for foreign countries;

·       exportand import restrictions, such as those affecting encryption commodities andsoftware or those requiring local content;

·       difficultiesin providing customer support;

·       reducedprotection of intellectual property rights and increased liability exposure;

·       regionaleconomic and political conditions; and

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·       uniqueproduct requirements of certain foreign countries which may limit sales and/orrequire significant additional research and development investments, such asbeing able to comply with European Union directive Restriction of HazardousSubstances (RoHS) which restricts the use of hazardous substances in electricaland electronic equipment, by July 1, 2006.

Our international salescurrently are U.S. dollar-denominated. As a result, any increase in the valueof the U.S. dollar relative to foreign currencies makes our products lesscompetitive in international markets. Because of this our revenues may beadversely affected, or we may be required to denominate our sales in foreigncurrencies at some point in the future to remain competitive. In addition,because certain of our operating expenses related to our international salesare denominated in foreign currency, we may have difficulty controllingexpenses in the event of significant currency fluctuations.

**Our future successis dependent upon our ability to generate significant revenues from serverappliance development relationships in our OEM Appliance segment.**

A major component of our business strategy is to formserver appliance development relationships with network equipment providers andISVs in our OEM Appliance segment. Under this strategy, we work with ourpartners to develop a server appliance, which is branded with the applicablepartner’s name and is sold through our OEM Appliance segment to the partner,who then performs all of the selling and marketing efforts related to furthersales.

There are multiplerisks associated with this strategy including:

·       theexpenditure of significant product development costs, which if not recoveredthrough server appliance sales could negatively affect our operating results;

·       asignificant reliance on our partners’ application software products, whichcould be technologically inferior to competitive products and result inlimitations on our server appliance sales, causing our revenues and operatingresults to suffer;

·       thepossibility that our partners will continue selling their application softwareproducts as separate products in addition to selling it in the form of a serverappliance;

·       ourreliance on our partners to perform all of the selling and marketing effortsassociated with further sales of the server appliance product we develop withthem; and

·       ourability to provide our partners with high quality server appliances atcompetitive prices.

Additionally, our futuresuccess will depend on our ability to expand sales of server appliances to ourexisting partners, as well as establishing relationships with new partners. Ifthese partners are unsuccessful in their marketing and sales efforts, or if weare unable to expand our sales to existing partners and develop relationshipswith new partners, our revenues and operating results could suffer.

**Both our OEMAppliance and Distribution segments could be harmed if we fail to adequatelyintegrate new technologies into our server appliance products or if we investin technologies that do not result in the desired effects on our current and/orfuture product offerings.**

As part of ourstrategy, we review opportunities to incorporate products and technologies thatcould be required in order to add new customers, retain existing customers,expand the breadth of product offerings or enhance our technical capabilities. Investingin new technologies presents numerous risks, including:

·       oursecurity appliances based on Microsoft ISA Server 2004 will require asignificant investment in our Network Engines Web Services (“NEWS”) softwarethat could be expended inefficiently because of our limited history in the typeof software development required for this product.

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·       wemay experience difficulties integrating new technologies into our current orfuture products;

·       ournew products may be delayed because selected new technologies themselves aredelayed or have defects and/or performance limitations;

·       wemay incorporate technologies that do not result in the desired improvements toour current and/or future server appliance products;

·       wemay incorporate new technologies that either may not be desired by ourcustomers or may not be compatible with our customer’s existing technology;

·       newtechnologies are unproven and could contain latent defects, which could resultin high product failures; and

·       wecould find that the new products and/or technologies that we choose toincorporate into our products are technologically inferior to those utilized byour competitors.

If we are unable toadequately integrate new technologies into our server appliance products or ifwe invest in technologies that do not result in the desired effects on ourcurrent and/or future product offerings, our business could be harmed andoperating results could suffer.

**If we fail toretain and attract appropriate levels of qualified employees, we may not beable meet key objectives.**

Our success depends inlarge part on our ability to retain, and attract highly skilled engineering,sales, marketing, customer service, and managerial personnel. If we are unableto attract a sufficient number of qualified personnel, particularly personnelknowledgeable in software engineering and channel sales and marketing,experienced in the network security market, we may not be able to meet keyobjectives such as developing, upgrading, or enhancing our products in a timelymanner, and effectively marketing our products to customers, any of which couldnegatively impact our business and could hinder any future growth.

**Some OEM Appliancepartners may view our NS Series family of security appliances ascompetitive to their applications and could choose not to do business with us.**

As part of our OEMAppliance segment, we partner with network equipment providers and ISVs todeliver network security applications in the form of a server appliance. Someof our existing partners or potential future partners may view our NS Series SecurityAppliances as competitive to their applications and may chose not to dobusiness with us. We believe that we have policies and procedures in place toprotect the proprietary nature of our OEM Appliance partners’ applications andbusiness plans. However, if our NS Series Security Appliances achievegreater acceptance in the market, some of these partners or potential partnersmay elect not to utilize our service appliance services, which would have anegative impact on our business.

***Risks related to financial results.***

**We have a history oflosses and may continue to experience losses in the future, which could causethe market price of our common stock to decline.**

Since our inception, wehave incurred significant net losses and could incur net losses in the futureand at September 30, 2005 our accumulated deficit was $126 million. Webelieve that any future growth will require us to incur significantengineering, selling and marketing and administrative expenses, includingmeeting new regulatory and corporate governance requirements. As a result, wewill need to generate significant revenues to achieve and sustain profitability.If we do not achieve and sustain profitability, the market price for our commonstock may decline.

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**If our estimates or judgments relating to our criticalaccounting policies are based on assumptions that change or prove to beincorrect, our operating results could fall below expectations of securitiesanalysts and investors, resulting in a decline in our stock price.**

Our discussion andanalysis of financial condition and results of operations are based on ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof financial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and accompanyingnotes. On an ongoing basis, we evaluate significant estimates used in preparingour consolidated financial statements, including those related to:

·       revenuerecognition, including sales returns and allowances;

·       provisionfor doubtful accounts;

·       inventorywrite-downs;

·       warrantyreserves; and

·       realizationof deferred tax assets.

We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, as provided in our discussion and analysisof financial condition and results of operations, the results of which form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differfrom these and other estimates if our assumptions change or if actualcircumstances differ from those in our assumptions, which could cause ouroperating results to fall below the expectations of securities analysts andinvestors, resulting in a decline in our stock price.

**Our quarterlyrevenues and operating results may fluctuate seasonally, which could result indecreased revenue from quarter to quarter, which in turn could cause the marketprice of our common stock to decline.**

Seasonal fluctuations in revenues and operatingresults in the data storage industry are common. In particular, this industry typicallyexperiences increased orders and resulting revenues in the quarter ended December 31,and a subsequent decline in orders and resulting revenues during the quarterended March 31. With a substantial amount of our revenues currentlyderived from data storage products, we may experience significantquarter-to-quarter fluctuations in revenues and operating results due tocustomers timing their orders based on their own quarterly financial and/oroperational considerations, which we have no influence over. In addition, tothe extent that revenues in our Distribution segment from international salesbecome significant, we may experience seasonal fluctuations during the quarterended September 30, as a result of European holiday patterns.

Accordingly, we believethat quarter-to-quarter comparisons of results of operations are notnecessarily meaningful and should not be relied upon as an indication of futureperformance. Nonetheless, the market price of our common stock could decline inresponse to these variations.

**Our quarterlyrevenues and operating results may also fluctuate for reasons other thanseasonality, which could cause our operating results to fall below expectationsand thus impact the market price of our common stock.**

In addition toseasonality issues, our quarterly revenues and operating results are difficultto predict and may fluctuate significantly from quarter to quarter. None of ourcustomers are obligated to purchase any quantity of our products in the futurenor are they obligated to meet forecasts of their product needs. 

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Ouroperating expense levels are based in part on expectations of future revenuesand gross profits, which are partially dependent on our customers’ ability toaccurately forecast and communicate their future product needs. If revenues orgross profits in a particular quarter do not meet expectations, operatingresults could suffer and the market price of our common stock could decline.Factors affecting quarterly operating results include:

·       thetiming and size of orders from customers, particularly our largest customers;

·       theproduct mix within our OEM Appliance segment;

·       theloss of key suppliers or customers;

·       theavailability and/or price of products from suppliers;

·       pricecompetition;

·       costsassociated with our introduction of our NS Series Security Appliances andthe market acceptance of those products;

·       thetiming of new product introductions by our OEM Appliance partners;

·       thetiming of expenditures in anticipation of increased revenues;

·       themix of product manufactured internally and by our contract manufacturer;

·       changing global economic orpolitical conditions.

**If the products andservices that we sell become more commoditized and competition in the serverappliance, data storage and network security markets continues to increase,then our gross profit as a percentage of net revenues may decrease and ouroperating results may suffer.**

Products and services in the server appliance, datastorage and network security markets may be subject to further commoditizationas these industries continue to mature and other businesses introduceadditional competing products and services. The gross profit as a percentage ofrevenues of our products may decrease, in response to changes in our productmix, competitive pricing pressures, or new product introductions into theserver appliance and data storage markets. If we are unable to offset decreasesin our gross profits as a percentage of revenues by increasing our salesvolumes, or by decreasing our product costs, operating results will decline.Changes in the mix of sales of our products, including the mix of higher marginsales of products sold in smaller quantities and lower margin sales of productssold in larger quantities, could adversely affect our operating results forfuture quarters. To maintain our gross profits, we also must continue to reducethe manufacturing cost of our server appliance products. Our efforts to producehigher margin server appliance products, continue to improve our serverappliance products and produce new server appliance products may make itdifficult to reduce our manufacturing cost per product. Further, utilization ofa contract manufacturer to produce a portion of our customer requirements forcertain of our server appliance products may not allow us to reduce our costper product. If we fail to respond adequately to pricing pressures, tocompetitive products with improved performance or to developments with respectto the other factors on which we compete, we could lose customers or orders. Ifwe are unable to compete effectively, our business will suffer.

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**When we arerequired to take a compensation expense for the value of stock options or othercompensatory awards that we issue to our employees, our earnings will beharmed.**

We believe that stockoptions are a key element in our ability to attract and retain employees in themarkets in which we operate. In December 2004, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) is arevision of FASB Statement No. 123, “Accounting for Stock-BasedCompensation”. SFAS 123(R) requires us to recognize, as an expense, thefair value of stock option and other stock-based compensation to employeesbeginning in our first quarter of fiscal 2006. Previously, we used theintrinsic value method to measure compensation expense for stock-based awardsto our employees. Under that standard, we generally did not consider stockoption grants issued under our employee stock option plans to be compensationwhen the exercise price of stock options were equal to or greater than the fairmarket value on the date of grant. For fiscal 2006 and thereafter, we will berequired to take a compensation charge as stock options or other stock-basedcompensation awards are issued or as they vest, including the unvested portionof options that were granted prior to fiscal 2006. This compensation chargewill be based on a calculated value of the option or other stock-based awardusing a methodology that may not correlate to the current market price of ourstock. The calculations required under the new accounting rules are verycomplex. This incremental compensation expense will have a negative impact ongross margins and operating expenses compared to historical values and willmaterially reduce earnings.

***Risksrelated to the server appliance, data storage and network security markets.***

**If server appliances are not increasingly adopted as asolution to meet a significant portion of companies’ network security and datastorage application needs, the market for server appliances may not grow, whichcould negatively impact our revenues.**

We expect that a substantial portion of our futurerevenues will come from sales of server appliances. As a result, we aresubstantially dependent on the growing use of server appliances to meetbusinesses’ data storage and network security application needs. Our revenuesmay not grow and the market price of our common stock could decline if theserver appliance market does not grow as rapidly as we expect.

Our expectations for thegrowth of the server appliance market may not be fulfilled if customerscontinue to use general-purpose servers. The role of our products could, forexample, be limited if general-purpose servers out-perform server appliances,provide more capabilities and/or flexibility than server appliances or areoffered at a lower cost. This could force us to lower the prices of our serverappliance products or could result in fewer sales of these products, whichwould negatively impact our revenues and decrease our gross profits.

**The products that we sell are subject to rapidtechnological change and our sales will suffer if these products are renderedobsolete by new technologies.**

The markets we serve are characterized by rapidtechnological change, frequent new product introductions and enhancements,potentially short product life cycles, changes in customer demands and evolvingindustry standards. In the server appliance market, we attempt to mitigatethese risks by utilizing standards-based hardware platforms and by maintainingan adequate knowledge base of available technologies. However, the serverappliance products that we sell could be rendered obsolete if products based onnew technologies are introduced or new industry standards emerge and we are notable to incorporate these technological changes into our products. In addition,we depend on third parties for the base platforms of our server appliances formany of our OEM Appliance segment customers and our NS Series SecurityAppliances, and we are at risk if these third parties do not integrate newtechnologies. Specifically, product development for network security appliancesrequires considerable engineering time 

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and testing. Releasing newproducts and services prematurely may result in quality problems, and delaysmay result in loss of customer confidence and market share. We may be unable todevelop new products and services or achieve and maintain market acceptance ofthem once they have come to market. Furthermore, when we do introduce new orenhanced products and services, we may be unable to manage the transition fromthe older products and services to minimize disruption in customer orderingpatterns, avoid excessive inventories of older products and deliver enough newproducts and services to meet customer demand.

To remain competitive inthe server appliance market, we must successfully identify new productopportunities and partners and develop and bring new products to market in atimely and cost-effective manner. Our failure to select the appropriatepartners and keep pace with rapid industry, technological or market changescould have a material adverse effect on our business, results of operations orfinancial condition.

***Risksrelated to competition.***

**Competition in the server appliance market issignificant and if we fail to compete effectively, our financial results willsuffer.**

In the server appliance market, we face significantcompetition from a number of different types of companies. Our competitorsinclude companies who market general-purpose servers, specific-purpose serversand server appliances as well as companies that sell custom integrationservices utilizing hardware produced by other companies. Many of thesecompanies are larger than we are and have greater financial resources and namerecognition than we do, as well as significant distribution capabilities andlarger, more established service organizations to support their products. Ourlarger competitors may be able to leverage their existing resources, includingtheir extensive distribution capabilities and service organizations, to providea wider offering of products and services and higher levels of support on amore cost-effective basis than we can. We expect competition in the serverappliance market to increase significantly as more companies enter the marketand as our existing competitors continue to improve the performance of theircurrent products and to introduce new products and technologies. Such increasedcompetition could adversely affect sales of our current and future products. Inaddition, competing companies may be able to undertake more extensivepromotional activities, adopt more aggressive pricing policies and offer moreattractive terms to their customers than we can. If our competitors providelower cost products with greater functionality or support than our serverappliance solutions, or if some of their products are comparable to ours andare offered as part of a range of products that is broader than ours, ourserver appliance solutions could become undesirable.

Even if the functionalityof competing products is equivalent to ours, we face a risk that a significantnumber of customers would elect to pay a premium for similar functionality froman established vendor rather than purchase products from a less-establishedvendor. We attempt to differentiate ourselves from our competition by offeringa wide variety of software integration, branding, supply-chain management,engineering, support, logistics and fulfillment services. If we are unable to effectivelydifferentiate ourselves from our competition, we may be forced to offer pricereductions to maintain certain customers. As a result, our revenues may notincrease and may decline, and our gross margins may decline. Furthermore,increased competition could lead to higher selling expenses which wouldnegatively affect our business and future operating results.

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**If we are unable to compete successfully in the highlycompetitive market for network security appliances and services for any reason,such as current or potential competitors gaining competitive advantage throughpartnering or acquisition, our business could be adversely affected.**

The market for network security appliances isintensely competitive and we expect competition to intensify in the future. Anincrease in competitive pressures in our market or our failure to competeeffectively may result in pricing reductions, reduced gross margins and loss ofmarket share. Currently, the primary competitors relating to network securityappliances with Microsoft ISA Server 2004 include Hewlett-Packard Company,Celestix Networks, Inc. and Pyramid Computer GmbH. However, because ouragreement with Microsoft to license ISA Server 2004 is not exclusive, Microsoftmay enter into similar license agreements with additional competitors. Suchcompetitors may be larger and have significantly greater resources andexperience than us, which may negatively affect our business.

Competitors in thesecurity industry with appliances using technology other than Microsoft ISAServer 2004 include Cisco Systems, Inc., Nokia Corporation, JuniperNetworks, Inc, Watchguard Technologies, Inc. and SonicWALL, Inc. Substantiallyall of our competitors have longer operating histories, greater namerecognition, larger customer bases and significantly greater financial,technical, marketing and other resources than we do. Our current and potentialcompetitors may establish cooperative relationships among themselves or withthird parties that may further enhance their resources. In addition, current orpotential competitors may be acquired by third parties with greater availableresources. As a result of such potential acquisitions, our current or potentialcompetitors might be able to adapt more quickly to new technologies and customerneeds, devote greater resources to the promotion or sale of their products andservices, initiate or withstand substantial price competition, take advantageof acquisition or other opportunities more readily or develop and expand theirproduct and service offerings more quickly. In addition, our competitors maybundle products competitive with ours with other products that they may sell toour current or potential customers. These customers may accept these bundledproducts rather than separately purchasing our products.

**Our revenues could be negatively affected if ourlarger competitors consolidate their extensive distribution capabilities withour smaller competitors’ products.**

Large server manufacturersmay not only develop their own server appliance solutions, but they may alsoacquire or establish cooperative relationships with our smaller competitors,developing server appliance products and related technologies. Because largeserver manufacturers have significant financial and organizational resourcesavailable, they may be able to quickly penetrate the server appliance market byleveraging the technology and expertise of smaller companies with their ownextensive distribution channels. We expect that the server industry willexperience further consolidation. It is possible that new competitors oralliances among competitors may emerge and rapidly acquire significant marketshare through consolidation. Consolidation within the server marketplace couldadversely affect our revenues.

***Risksrelated to marketing and sales efforts and customer service.***

**We need to effectively manage our sales and marketingoperations to increase market awareness and sales of our products and topromote our brand recognition. If we fail to do so, our growth will be limited.**

Although we currently have a relatively small salesand marketing organization, we must continue to increase market awareness andsales of our products and promote our brand in the marketplace. In our OEMAppliance segment, we believe that to compete successfully we will need networkequipment providers and ISVs to recognize Network Engines as a top-tierprovider of server appliance platforms and custom integration services.

We must also effectivelymarket to VARs, systems integrators, and their end customers our NS Series SecurityAppliances. This marketing effort requires a significant investment inpersonnel and other 

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areas,and an appropriate level of technical knowledge about the security market,Microsoft applications such as Exchange, and other software applicationsincluded in these server appliance products. It also requires substantialunderstanding of the targeted market into which these products are sold and mayrequire the expenditure of a material amount of managerial and financialresources. We have limited experience marketing and selling security applianceproducts through indirect channels and therefore, may not be successful inthese efforts. If we are unable to design and implement marketing campaignsthat are effective in promoting our network security appliances, or if we failto promote and maintain the Network Engines brand, we may not increase ormaintain sales and our business may be adversely affected. Our business wouldalso suffer if we incur excessive expenses in these marketing campaigns butfail to achieve the expected or desired increase in revenues.

**If we are unable to effectively manage our customerservice and support activities, we may not be able to retain our existingcustomers or attract new customers.**

We need to effectively manage our customer supportoperations to ensure that we maintain good relationships with our customers. Becauseour NS Series Security Appliances provide critical protection for certainapplications, managing software updates to the appliance, when and if they areavailable, will be essential to the performance of the appliance. Managing anysuch updates released by Microsoft will require careful consideration todetermine the sensitivity and impact on the function of our appliance. Additionally,any updates designated as vital to the function of our appliance will requirerapid deployment to ensure the customers’ applications are properly protected. Weexpect that providing this increased customer service for our NS Series SecurityAppliances will require more technically qualified staff either within theCompany or from third parties and if we are unable to provide this higher levelof service we may be unable to successfully sell such security appliances.

Our channel partners in some cases will provide supportfor the end-user customers. We may be unable to provide these channel partnerswith the necessary training and back-up support. Therefore they may be unableto provide end-user customers with the necessary level of support, which may bedetrimental to our reputation and ability to sell our products. Also, some ofour channel partners may choose not to provide this service, which wouldrequire us to hire more support staff to provide the first level support to enduser customers, which would increase our costs and lower our margins.

If our customer supportorganization is unsuccessful in maintaining good customer relationships, we maylose customers to our competitors and our reputation in the market could bedamaged. As a result, we may lose revenues and our business could suffer.Furthermore, the costs of this service could be higher than we expect, whichcould adversely affect our operating results.

***Risksrelated to product manufacturing.***

**Our dependence on sole source and limited sourcesuppliers for key server appliance components makes us susceptible to supplyshortages and potential quality issues that could prevent us from shippingcustomer orders on time, if at all, and could result in lost sales andcustomers.**

We depend upon singlesource and limited source suppliers for our industry-standard processors, mainlogic boards, certain disk drives, hardware platforms and power supplies aswell as certain of our cooling systems, chassis and sheet metal parts. We alsorely upon a single source supplier to provide the hardware platform for our NS Series SecurityAppliances. Additionally, we depend on limited sources to supply certain otherindustry-standard and customized components. We are relying on our suppliers tobe compliant with the European Union directive on RoHS by July 1, 2006 forproducts that we ship into the European Union. We have in the past experienced,and may in the future experience, shortages of or difficulties in acquiringcomponents in the quantities and of the quality needed to produce our serverappliance products. Shortages in supply or quality issues related to these keycomponents for an extended 

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timewould cause delays in the production of our server appliance products, preventus from satisfying our contractual obligations and meeting customerexpectations, and result in lost sales and customers. If we are unable to buycomponents in the quantities and of the quality that we need on a timely basisor at acceptable prices, we will not be able to manufacture and deliver ourserver appliance products on a timely or cost-effective basis to our customers,and our competitive position, reputation, business, financial condition andresults of operations could be seriously harmed.

**If our server appliance products fail to performproperly and conform to specifications, our customers may demand refunds,assert claims for damages or terminate existing relationships with us and ourreputation and operating results may suffer materially.**

Because server appliance solutions are complex, theycould contain errors that can be detected at any point in a product’s lifecycle. If flaws in design, production, assembly or testing of our products (byus or our suppliers) were to occur, we could experience a rate of failure inour products that could result in substantial repair, replacement or servicecosts and potential damage to our reputation. In addition, because oursolutions are combined with products from other vendors, should problems occur,it might be difficult to identify the source of the problem. Continuedimprovement in manufacturing capabilities, control of material andmanufacturing quality and costs, and product testing are critical factors inour future growth. There can be no assurance that our efforts to monitor,develop, modify and implement appropriate test and manufacturing processes forour products will be sufficient to permit us to avoid a rate of failure in ourproducts that results in substantial delays in shipment, significant repair orreplacement costs or potential damage to our reputation, any of which couldhave a material adverse effect on our business, results of operations orfinancial condition.

In the past, wehave discovered errors in some of our server appliance solutions and haveexperienced delays in the shipment of our server appliance products during theperiod required to correct these errors or we have had to replace defectiveproducts that were already shipped. Errors in our server appliance solutionsmay be found in the future and any of these errors could be significant. Significanterrors, including those discussed above, may result in:

·       theloss of or delay in market acceptance and sales of our server applianceproducts;

·       diversionof engineering resources;

·       increasedmanufacturing costs;

·       theloss of new or existing server appliance partners;

·       injuryto our reputation and other customer relations problems; and

·       increasedmaintenance and warranty costs.

Any of these problems could harm our business andfuture operating results. Product errors or delays could be material, includingany product errors or delays associated with the introduction of new productsor versions of existing products. If our server appliance solutions fail toconform to warranted specifications, customers could demand a refund for thepurchase price and assert claims for damages.

Moreover, because ourserver appliance solutions may be used in connection with critical computingsystems services, including providing security to protect valuable information,we may receive significant liability claims if they do not work properly. Whileour agreements with customers typically contain provisions intended to limitour exposure to liability claims, these limitations do not preclude allpotential claims. Liability claims could exceed our insurance coverage andrequire us to spend significant time and money in litigation or to paysignificant damages. Any claims for damages, even if unsuccessful, couldseriously damage our reputation and business.

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**Our future server appliance revenue growth is dependenton our ability to expand production capacity.**

Our existing manufacturing facility is limited in itsproduction capacity. For us to achieve significant server appliance revenuegrowth our server appliance sales volumes must increase significantly and ourproduction capacity must increase to support such sales volumes.

To supplement our current production capacity, toprovide for increased capacity for “production spikes” and to provide disasterbackup capabilities, we currently utilize the services of a contractmanufacturer for certain server appliance products on a limited basis. However,our contract manufacturer is not obligated to supply products to us for anyspecific period, or in any specific quantity, except as may be provided in anaccepted purchase order. Using a contract manufacturer increases our cost ofproducing server appliance products and could decrease our gross profits. Inthe event that we need to change contract manufacturers or requiresignificantly increased production levels, we could experience transitionaldifficulties, including production delays and quality control issues, thatcould prevent us from satisfying our production requirements on a timely basis,cause customer relationships to suffer and result in lost sales. Also, the useof a contract manufacturer does not guarantee us production levels,manufacturing line space or manufacturing prices, the lack of which couldinterrupt our business operations and have a negative effect on operatingresults.

In the past, we expandedour internal production capacity through expansion and reorganization of ourcurrent production facilities. Although we believe that our current facility,along with our use of a contract manufacturer to supplement production, issufficient to support our business for the foreseeable future, we may needadditional production capacity. We believe that we could expand productionlevels in our existing facility, but we are currently utilizing all availablemanufacturing space in our existing facility and we may have difficultiesexpanding this facility any further. Therefore, significant further expansionof the production capacity either in our existing facilities or by expandinginto additional facilities could require substantial investments, which coulddetract from our ability to invest in other areas of our business and may notresult in the desired return on investment, which could negatively affect ouroperating results.

**If we do not accurately forecast our server appliancematerials requirements, our business and operating results could be adverselyaffected.**

We use rolling forecastsbased on anticipated product orders to determine our server appliance componentrequirements. Lead times for materials and components that we order varysignificantly, depending among other things, on specific supplier requirements,contract terms and current market demand for those components. In addition, avariety of factors, including the timing of product releases, potential delaysor cancellations of orders, the timing of large orders, and the unprovenacceptance of new products in the market make it difficult to predict productorders. As a result, our materials requirement forecasts may not be accurate. Ifwe overestimate our materials requirements, we may have excess inventory, whichwould increase costs and negatively impact our cash position. Our agreementswith certain customers provide us with protections related to inventorypurchased in accordance with the terms of these agreements; however, theseprotections may not be sufficient to prevent certain losses as a result ofexcess or obsolete inventory. If we underestimate our materials requirements,we may have inadequate inventory, which could interrupt our manufacturing anddelay delivery of our server appliance products to customers resulting in aloss of sales or customers. Any of these occurrences would negatively impactour business and operating results.

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***Risksrelated to product dependence on intellectual property.***

**Our reliance upon contractual provisions, domesticpatent, copyright and trade secret laws and applied-for patents to protect ourproprietary rights may not be sufficient to protect our intellectual property.**

Certain of our server appliance solutions aredifferentiated from the products of our competitors by our internally developedsoftware and hardware and the manner in which they are integrated into ourserver appliance solutions. If we fail to protect our intellectual property,other vendors could sell products with features similar to ours, which couldreduce demand for our solutions. We have taken what we believe to be thenecessary and appropriate steps to safeguard our intellectual property.However, these steps may afford us only limited protection. Others may developtechnologies that are similar or superior to our technology or design aroundthe patents we own. Despite the precautions we have taken, laws and contractualrestrictions may not be sufficient to prevent misappropriation of ourtechnology or deter others from developing similar technologies. In addition,there can be no guarantee that any of our patent applications will result inpatents, or that any such patents would provide effective protection of ourtechnology.

In addition, the laws ofthe countries in which we may decide to market our services and solutions mayoffer little or no effective protection of our proprietary technology. Reverseengineering, unauthorized copying or other misappropriation of our proprietarytechnology could enable third parties to benefit from our technology withoutpaying us for it, which would significantly harm our business. In addition, ourU.S. patents have no effect in foreign jurisdictions and obtaining patentprotection in foreign countries is expensive and time consuming.

**Our operating results would suffer if we, or our ISVor network equipment provider partners, were subject to an infringement claimthat resulted in protracted litigation, the award of significant damagesagainst us or the payment of substantial ongoing royalties.**

Substantiallitigation regarding intellectual property rights exists in the technologyindustry. We expect that server appliance products may be subject tothird-party infringement claims as the number of competitors in the industrysegment grows and the functionality of products in different industry segmentsoverlap. In the past we have received claims from third parties that our serverappliance products infringed their intellectual property rights. We do notbelieve that our server appliance products employ technology that infringes theproprietary rights of any third parties. We are also not aware of any claimsmade against any of our ISV or network equipment provider partners related totheir infringement of the proprietary rights of other parties in relation toproducts that include our server appliance products. Other parties may makeclaims against us that, with or without merit, could:

·       betime-consuming for us to address;

·       requireus to enter into royalty or licensing agreements;

·       resultin costly litigation, including potential liability for damages;

·       divertour management’s attention and resources; and

·       causeproduct shipment delays.

In addition, other partiesmay make claims against our ISV or network equipment provider partners relatedto products that are incorporated into our server appliance products. Ourbusiness could be adversely affected if such claims resulted in the inabilityof our ISV or network equipment provider partners’ to continue to produce theinfringing product.

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***Otherrisks related to our business.***

**If we fail to maintain an effective system of internalcontrols, we may not be able to accurately report our financial results. As aresult, current and potential stockholders could lose confidence in ourfinancial reporting, which could have a negative market reaction.**

Section 404 of theSarbanes-Oxley Act of 2002 requires our management to report on, and ourindependent registered public accounting firm to attest to, the effectivenessof our internal control over financial reporting. We have an ongoing program toperform the system and process evaluation and testing necessary to comply withthese requirements. This legislation is relatively new and neither companiesnor accounting firms have significant experience in complying with its requirements.As a result, we have incurred increased expense and have devoted additionalmanagement resources to Section 404 compliance. Effective internalcontrols are necessary for us to provide reliable financial reports. If wecannot provide reliable financial reports, our business and operating resultscould be harmed.

**Class action lawsuits have been filed against us,our board of directors, our chairman and certain of our executive officers andother lawsuits may be instituted against us from time to time.**

In December 2001, aclass action lawsuit relating to our initial public offering was filed againstus, our chairman, one of our executive officers and the underwriters of ourinitial public offering. In addition, in January 2003, a purported classaction lawsuit was filed against us and our Board of Directors relating to theacquisition of TidalWire Inc. and on December 16, 2003, a number ofpurported class action lawsuits were filed against us and John H. Curtis, ourPresident and CEO, Douglas G. Bryant, our CFO, Vice President of Finance andAdministration, Treasurer and Secretary, and Lawrence Genovesi, our Chairman ofthe Board relating to the timing of our announcement of the amendment of ourHBA distribution agreement with EMC. For more information on these lawsuits,see “Part II, Item 1—Legal Proceedings.” In December 2003, we settledthe class action lawsuit filed against us relating to the acquisition ofTidalWire Inc. and we are currently attempting to settle the lawsuit filedagainst us related to our initial public offering and the lawsuit related tothe timing of our announcement of the amendment of our HBA distributionagreement with EMC. We are unable to predict the effects on our financialcondition or business of the lawsuit related to our initial public offering,the lawsuit related to our announcement of the amendment of our HBAdistribution agreement with EMC or other lawsuits that may arise from time totime. While we maintain certain insurance coverage, there can be no assurancethat claims against us will not result in substantial monetary damages inexcess of such insurance coverage. These class action lawsuits, or any futurelawsuits, could cause our director and officer insurance premiums to increaseand could affect our ability to obtain director and officer insurance coverage,which would negatively affect our business. In addition, we have expended, andmay in the future expend, significant resources to defend such claims. Theseclass action lawsuits, or other similar lawsuits that may arise from time totime, could negatively impact both our financial condition and the market priceof our common stock and could result in management devoting a substantialportion of their time to these lawsuits, which could adversely affect the operationof our business.

**If the site of our manufacturing operations were toexperience a significant disruption in its operations, it would have a materialadverse effect on our financial condition and results of our operations.**

Our manufacturing facilityand headquarters are concentrated in one location. If the operations in thisfacility were disrupted as a result of a natural disaster, fire, power or otherutility outage, work stoppage or other similar event, our business couldbe seriously harmed as a result of interruptions or delays in ourmanufacturing, engineering, distribution or post-sales support operations.

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**We have discontinued selling third-party data storagenetworking products, and are relying on a third party to fulfill the warrantyobligations related to these products.**

Because we haveoutsourced customer support activities of these third-party data storagenetworking products to a third party, we will continue to depend on this thirdparty to successfully address our former customers’ needs for the remainingoutstanding warranty period. Although we have paid the third party in full forthis service, if it does not fulfill its obligation we may be required to incuradditional costs to satisfy those customers’ needs, which may negatively affectour business.

**If we do not retain our senior management, we may notbe able to successfully execute our business strategy.**

The loss of key members ofour management team could harm us. Our success is substantially dependent onthe ability, experience and performance of our senior management team. Becauseof their ability and experience, we may not be able to successfully execute ourbusiness strategy if we were to lose one or more of these individuals. If weare unable to successfully execute our business strategy, our operating resultswould suffer.

**The market price for our common stock may beparticularly volatile, and our stockholders may be unable to resell theirshares at a profit.**

The market price of our common stock has been subjectto significant fluctuations and may continue to fluctuate or decline. Duringfiscal 2004, the price of our common stock ranged from a low of $1.29 to a highof $11.00 and in the year ended September 30, 2005 from a low of $1.37 toa high of $3.16. The stock markets have experienced significant price andtrading volume fluctuations. The market for technology stocks has beenextremely volatile and frequently reaches levels that bear no relationship tothe past or present operating performance of those companies. General economicconditions, such as recession or interest rate or currency rate fluctuations inthe United States or abroad, could negatively affect the market price of ourcommon stock. In addition, our operating results may be below the expectationsof securities analysts and investors. If this were to occur, the market priceof our common stock may decrease significantly. In the past, following periodsof volatility in the market price of a company’s securities, securities classaction litigation has often been instituted against such companies. Suchlitigation could result in substantial cost and a diversion of management’s attentionand resources.

The market price ofour common stock may fluctuate in response to various factors, some of whichare beyond our control. These factors include, but are not limited to, thefollowing:

·       changesin our relationship or contracts with EMC;

·       changesin our relationship with Microsoft;

·       marketacceptance of our NS Series Security Appliances;

·       actualor anticipated fluctuations in our operating results;

·       changesin financial estimates or investment recommendations by securities analysts whofollow our business;

·       technologicaladvances or introduction of new products by us or our competitors;

·       theloss of key personnel;

·       oursale of common stock or other securities in the future;

·       significantsales of our common stock by existing stockholders, affiliates and insiders;

·       intellectualproperty or litigation developments;

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·       changesin market valuations or earnings of our competitors or other technologycompanies;

·       changesin business or regulatory conditions;

·       thetrading volume of our common stock; and

·       disruptionsin the geopolitical environment, including war in the Middle East or elsewhereor acts of terrorism in the United States or elsewhere.

Any decline in the marketprice of our common stock or negative market conditions could adversely affectour ability to raise additional capital, to complete future acquisitions of orinvestments in other businesses and to attract and retain qualified technicaland sales and marketing personnel.

**We have anti-takeover defenses that could delay orprevent an acquisition and could adversely affect the market price of ourcommon stock.**

Our Board of Directors has the authority to issue upto 5,000,000 shares of preferred stock and, without any further vote or actionon the part of the stockholders, will have the authority to determine theprice, rights, preferences, privileges and restrictions of the preferred stock.This preferred stock, if issued, might have preference over the rights of theholders of common stock and could adversely affect the market price of ourcommon stock. The issuance of this preferred stock may make it more difficultfor a third party to acquire us or to acquire a majority of our outstandingvoting stock. We currently have no plans to issue preferred stock.

In addition, provisions ofour second amended and restated certificate of incorporation and our secondamended and restated by-laws may deter an unsolicited offer to purchase us.These provisions, coupled with the provisions of the Delaware GeneralCorporation Law, may delay or impede a merger, tender offer or proxy contestinvolving us. For example, our Board of Directors is divided into threeclasses, only one of which is elected at each annual meeting. These factors mayfurther delay or prevent a change of control of our business.

**ITEM1B.**       UNRESOLVED STAFF COMMENTS

None.

**ITEM2. PROPERTIES**

Our principal businessoperations are conducted in our corporate headquarters in Canton, Massachusettswhere we lease approximately 52,000 square feet of manufacturing and officespace. We believe that our Canton facility will be adequate to meet ourrequirements for the foreseeable future.

**ITEM3. LEGAL PROCEEDINGS**

*Announcement TimingLawsuit*

On March 17, 2004, the United States DistrictCourt for the District of Massachusetts consolidated a number of purportedclass action lawsuits filed against Network Engines, Inc. and certainindividual Network Engines defendants, collectively the defendants. These suitsgenerally concern the timing of the announcement of an amendment to NetworkEngines’ agreement with EMC Corporation regarding the resale of EMC-approvedFibre Channel HBAs. In its March 17, 2004 order, the court selected WingKam Yu, Blake Kunkel, and Thomas Cunningham as lead plaintiffs and appointedMilberg Weiss Bershad Hynes & Lerach LLP (now Milberg Weiss Bershad &Schulman LLP) as plaintiffs’ lead counsel. The lead plaintiffs filed an amendedconsolidated complaint on June 4, 2004. The defendants on August 13,2004 filed a motion to dismiss the amended consolidated complaint. The plaintiffson October 12, 2004 filed an opposition to the defendants’ motion todismiss and the defendants filed a reply to the plaintiff’s 

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opposition on November 12,2004. The court on November 22, 2004 denied the defendants’ motion todismiss the amended consolidated complaint. On December 9, 2004 thedefendants filed an answer to the amended consolidated complaint. Since thattime the parties have engaged in some informal discovery and, more recently,have exchanged formal discovery requests. Discovery is to conclude on or beforeMarch 31, 2006. The parties are currently actively pursuing settlement. NetworkEngines believes that the plaintiffs’ allegations are without merit, and itintends to pursue a vigorous defense.

We are unable to predictthe outcome of this suit and its ultimate effect, if any, on the Company’sfinancial condition; however, our defense against this suit may result in theexpenditure of significant financial and managerial resources. No amounts havebeen accrued for this matter.

*Initial PublicOffering Lawsuit*

On or about December 3, 2001, a putative classaction lawsuit was filed in the United States District Court for the SouthernDistrict of New York against the Company, Lawrence A. Genovesi (the Company’sChairman and former Chief Executive Officer), Douglas G. Bryant (the Company’sChief Financial Officer and Vice President of Finance and Administration), andthe following underwriters of our initial public offering: FleetBostonRobertson Stephens, Inc., Credit Suisse First Boston Corp., Goldman Sachs &Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. collectively, theunderwriter defendants. An amended class action complaint, captioned In reNetwork Engines, Inc. Initial Public Offering Securities Litigation, 01Civ. 10894 (SAS), was filed on April 20, 2002.

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to ourinitial public offering in July 2000, or IPO, without disclosing toinvestors that the underwriter defendants had solicited and received excessiveand undisclosed commissions from certain investors. The suit also alleges thatthe underwriter defendants entered into agreements with certain customerswhereby the underwriter defendants agreed to allocate to those customers sharesof our common stock in the offering, in exchange for which the customers agreedto purchase additional shares of our common stock in the aftermarket atpre-determined prices. The suit alleges that such tie-in arrangements were designedto and did maintain, distort and/or inflate the price of our common stock inthe aftermarket. The suit further alleges that the underwriter defendantsreceived undisclosed and excessive brokerage commissions and that, as aconsequence, the underwriter defendants successfully increased investorinterest in the manipulated IPO securities and increased the underwriterdefendants’ individual and collective underwritings, compensation and revenues.The suit seeks damages and certification of a plaintiff class consisting of allpersons who acquired shares of our common stock between July 13, 2000 and December 6,2000.

In July 2002, Network Engines, Lawrence A.Genovesi and Douglas G. Bryant joined in an omnibus motion to dismisschallenging the legal sufficiency of plaintiffs’ claims. The motion was filedon behalf of hundreds of issuer and individual defendants named in similarlawsuits. Plaintiffs opposed the motion, and the court heard oral argument onthe motion in November 2002. On February 19, 2003, the court issuedan opinion and order denying the motion as to Network Engines. In addition, in October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice.

On July 9, 2003, a Special Committee of our Boardof Directors authorized Network Engines to negotiate a settlement of thepending claims substantially consistent with a memorandum of understandingnegotiated among class plaintiffs, all issuer defendants and their insurers. Wehave negotiated the settlement, which provides, among other things, for arelease of Network Engines and the individual defendants for the conductalleged in the amended complaint to be wrongful. We would agree to undertakeother responsibilities under the settlement, including agreeing to assign, ornot assert, certain potential claims that we may have against the underwriters.Any direct financial impact of the proposed settlement is expected to be borneby our insurers. The settlement is subject to various contingencies, 

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including approval by theCourt overseeing the litigation. On February 15, 2005, the Court issued anOpinion and Order preliminarily approving the settlement, provided that thedefendants and plaintiffs agree to a modification narrowing the scope of thebar order set forth in the original settlement agreement. The parties agreed toa modification narrowing the scope of the bar order, and on August 31,2005, the Court issued a order preliminarily approving the settlement.

We are unable to predictthe outcome of this suit and its ultimate effect, if any, on our financialcondition; however, our defense against this suit has and may continue toresult in the expenditure of significant financial and managerial resources. Noamounts have been accrued for this matter.

**ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

No matters were submittedto a vote of security holders during the fourth quarter of the fiscal yearended September 30, 2005.

**EXECUTIVE OFFICERS OF THE COMPANY**

| **Name**          | ** ** | ** ** | ** ** | **Age**                                                                                         | ** ** | **Position** |
|-------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------|------------|--------------|
| John H. Curtis    |       | 63         |       | President, Chief Executive Officer and Director                                                 |
| John Amaral       |       | 38         |       | Chief Technology Officer                                                                        |
| Douglas G. Bryant |       | 48         |       | Vice President of  Finance and Administration, Chief Financial Officer, Treasurer and Secretary |
| Richard P. Graber |       | 45         |       | Vice President of  Engineering and Operations                                                   |
| J. Donald Oldham  |       | 63         |       | Vice President of  OEM Appliance Sales                                                          |
| Michael D. Riley  |       | 41         |       | Vice President of  Marketing and Strategy                                                       |

 

John H. Curtis

John H. Curtis joined theCompany in March 2001 as President and Chief Executive Officer. Mr. Curtishas served as a director of the Company since March 2001. Prior to joiningthe Company, he was Vice President of Worldwide Sales at Artel Video Systems, Inc.,from August 1996 to March 2001. Prior to Artel Video Systems, Mr. Curtisserved as Senior Vice President of Worldwide Operations at Banyan Systems, Inc.from July 1995 to May 1996 and was Vice President of Worldwide Salesat Intellution Inc. from September 1992 to May 1995. From 1980 to1992, Mr. Curtis held several senior-level management positions at StratusComputer, Inc., including Chief Operating Officer, Vice President ofFinance and Vice President of International Sales.

John Amaral

John Amaral joined theCompany in June 2004 as Chief Technology Officer. Prior to joining theCompany, he served as Chief Technology officer for Artel Video Systems, aprovider of advanced networking and media processing equipment, from September 1999to February 2004. Prior to Artel, Mr. Amaral was Chief TechnologyOfficer for ITS Corp. from June 1991 to August 1999.

Douglas G. Bryant

Douglas G. Bryant hasserved as Secretary and Vice President of Finance and Administration since March 2000,Treasurer since January 1998 and Chief Financial Officer since September 1997.Prior to joining the Company, Mr. Bryant served as Chief Financial Officerof CrossComm Corporation, a manufacturer of internetworking products, includingrouters and switches, from July 1996 to June 1997, and as CorporateController from September 1989 to June 1996.

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Richard P. Graber

Richard P. Graber joinedthe Company in October 2003 as Vice President of Engineering andOperations. Prior to joining the Company, Mr. Graber was the VicePresident of Engineering and Operations at Jedai Broadband Networks, Inc.,a developer of access technology for broadband providers. Prior to JedaiBroadband Networks, Mr. Graber was Vice President of Engineering forViaGate Technologies, Inc. from November 2000 to August 2001. Priorto joining ViaGate Technologies, Mr. Graber held senior engineeringpositions at Dialogic, an Intel company, from June 1988 to October 2000.

J. Donald Oldham

J. Donald Oldham joinedthe Company in October 2002 as Vice President of OEM Appliance Sales.Prior to joining the Company, Mr. Oldham was Vice President of Sales andProgram Management at Manufacturers Services, Inc., a full-service globalelectronic manufacturing services and supply-chain company, from February 2001to March 2002. From 1985 to 1998, Mr. Oldham held multiple seniormanagement positions with Stratus Computer, including Senior Vice President ofWorldwide Sales from 1994 to 1998. Mr. Oldham also held a variety of salesmanagement positions at International Business Machines Corporation, from 1969to 1985.

Michael D. Riley

Michael D. Riley joined the Company in July 2002as Vice President of Marketing. Prior to joining the Company, Mr. Rileywas the Chief Marketing Officer at Sonexis, Inc., a provider ofcollaboration solutions, from July 2001 to May 2002. Prior toSonexis, Mr. Riley held a variety of senior management positions withArtel Video Systems, Inc. from July 1998 to July 2001, includingSenior Vice President of Marketing and Worldwide Sales and Vice President ofMarketing. Prior to Artel Video Systems, Mr. Riley held senior sales andmarketing positions at Premisys Communications from 1994 to 1997 and NewbridgeNetworks Corporation from 1988 to 1993.

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**PART II**

**ITEM 5. MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

*(a) MarketInformation*

NetworkEngines’ common stock began trading on the NASDAQ National Market on July 13,2000 under the symbol “NENG”. Prior to that time there had been no market forour common stock. The following table sets forth the high and low closing salesprices per share for our common stock on the NASDAQ National Market for theperiod indicated:

| ** **                                | ** ** | **Fiscal 2005** | ** ** | **Fiscal 2004** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------------|------------|
| **Fiscal Year  Ended September 30:** | ** ** | ** **           | ** ** | **High**             | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter                             |       | $                    | 2.80       |                 | $          | 1.63 |   | $ | 11.00 |   | $ | 4.10 |   |
| Second Quarter                            |       | 3.16                 |       | 1.66                 |       | 6.19 |   | 3.53 |   |
| Third Quarter                             |       | 2.14                 |       | 1.61                 |       | 4.36 |   | 2.31 |   |
| Fourth Quarter                            |       | 1.94                 |       | 1.37                 |       | 2.52 |   | 1.29 |   |
|                                           |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

*(b) Holders ofrecord*

As of December 5,2005, there were approximately 230 holders of record of our common stock.Because many of such shares are held by brokers and other institutions onbehalf of stockholders, the Company is unable to estimate the total number ofstockholders represented by these record holders.

*(c) Dividends*

We have never paid ordeclared any cash dividends on our common stock. We currently intend to retainany earnings for future growth and, therefore, do not expect to pay cashdividends in the foreseeable future.

*(d) RecentSales of Unregistered Securities*

During the fourth quarterof fiscal 2005, we did not issue any unregistered shares of our common stock.

*(e) Use ofProceeds*

On July 18, 2000, theCompany sold 7,475,000 shares of common stock in an initial public offering ata price of $17.00 per share pursuant to a Registration Statement on Form S-1(Registration No. 333-34286), which was declared effective by theSecurities and Exchange Commission on July 12, 2000. The aggregateproceeds to us from the offering were approximately $116.9 million reflectinggross proceeds of $127.0 million net of underwriting fees of approximately $8.9million and other offering costs of approximately $1.3 million. During theperiod from the offering through September 30, 2005, we used the proceedsfrom our initial public offering as follows: approximately $59.3 million tofund our operations, approximately $8.7 million for the purchase of propertyand equipment, approximately $4.6 million to repurchase our common stock undera stock repurchase plan and approximately $13.2 million for our acquisition ofTidalWire Inc.

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**ITEM 6. SELECTED FINANCIALDATA**

The following selected financial data are derived fromthe financial statements of Network Engines. The historical results presentedare not necessarily indicative of future results. The consolidated statement ofoperations data for the years ended September 30, 2005, 2004 and 2003 andthe consolidated balance sheet data as of September 30, 2005 and 2004 havebeen derived from our consolidated financial statements included elsewhere inthis Annual Report on Form 10-K. The consolidated statement ofoperations data for the years ended September 30, 2002 and 2001 and theconsolidated balance sheet data as of September 30, 2003, 2002, and 2001are derived from our audited consolidated financial statements not included inthis Annual Report on Form 10-K. The selected consolidated financialdata set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and “FinancialStatements and Supplementary Data” and the related Notes included elsewhere inthis Annual Report on Form 10-K.

On December 27, 2002,we completed our acquisition of TidalWire. As a result, the quarter ended March 31,2003 was the first quarter that included the TidalWire operations in ourconsolidated results for an entire quarter. Our financial results for the yearended September 30, 2003 only include TidalWire financial results for theperiod from December 28, 2002 through September 30, 2003. As such,the presentation of historical financial information and any discussionregarding the comparison of historical financial information to financialinformation for the year ended September 30, 2003, does not include anyfinancial information for TidalWire prior to December 28, 2002, unlessotherwise indicated. As previously mentioned, as a result of ourTidalWire acquisition our Distribution segment primarily distributedthird-party data storage networking connectivity products, predominantly FibreChannel host bus adapters. In early fiscal 2005, we decided todiscontinue selling third-party data storage networking products after a reviewof that portion of the business and its future prospects.

**SelectedFinancial Data(in thousands, except per share data)**

| ** **                                                  | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net revenues                                                |       | $                                           | 98,071     |   | $ | 136,755 |   | $ | 81,243 |   | $ | 14,534 |   | $ | 13,515 |   |
| Gross profit  (loss)                                        |       | 17,061                                      |       | 23,908 |   | 16,737 |   | 2,058 |   | (19,444 | ) |
| Operating  expenses(a)                                      |       | 33,637                                      |       | 25,816 |   | 18,686 |   | 17,775 |   | 55,230 |   |
| Loss from  operations                                       |       | (16,576                                     | )          | (1,908 | ) | (1,949 | ) | (15,717 | ) | (74,674 | ) |
| Net loss                                                    |       | (15,583                                     | )          | (1,619 | ) | (1,385 | ) | (14,125 | ) | (69,523 | ) |
| Net loss per common share—basic and diluted            |       | $                                           | (0.42      | ) | $ | (0.04 | ) | $ | (0.04 | ) | $ | (0.44 | ) | $ | (2.03 | ) |
| Weighted average  shares outstanding—basic and diluted |       | 37,461                                      |       | 36,594 |   | 33,142 |   | 32,270 |   | 34,241 |   |

 

| ** **                                                          | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|
| **Balance Sheet Data:**                                   | ** ** | ** **             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Cash, cash  equivalents, short-term investments and restricted cash |       | $                      | 37,409     |   | $ | 39,635 |   | $ | 36,835 |   | $ | 56,196 |   | $ | 75,934 |   |
| Working capital                                                     |       | $                      | 48,484     |   | $ | 55,108 |   | $ | 50,218 |   | $ | 58,612 |   | $ | 70,873 |   |
| Total assets                                                        |       | $                      | 59,804     |   | $ | 78,021 |   | $ | 81,732 |   | $ | 64,210 |   | $ | 83,004 |   |
| Long-term debt,  less current portion                               |       | $                      | 79         |   | $ | — |   | $ | — |   | $ | — |   | $ | 9 |   |
| Total stockholders’  equity                                    |       | $                      | 49,861     |   | $ | 64,673 |   | $ | 64,224 |   | $ | 60,876 |   | $ | 74,489 |   |
|                                                                     |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(a)           Includes $7.8 millionrelated to an impairment charge for goodwill in 2005, and $4 million related toan impairment charge for intangible assets in 2004

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**ITEM 7. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**Overview**

We develop and manufactureserver appliance solutions that deliver data storage and network securityapplications on server appliances. Server appliances are pre-configured networkinfrastructure devices designed to optimally deliver specific softwareapplication functionality and facilitate ease of deployment and support of asoftware application in a customer’s network. We are organized into tworeportable segments: OEM Appliance and Distribution.

**OEM Appliancesegment**

In our OEM Appliance segment, we develop andmanufacture server appliance solutions that enable network equipment providersand independent software vendors, or ISVs, to deliver their data storage andnetwork security applications in the form of a server appliance. We offer ourserver appliance partners a comprehensive suite of services, includingdevelopment, manufacturing, fulfillment and post-sale support. We produce andfulfill devices branded for our network equipment and ISV partners, and deriveour revenues from the sale of value-added hardware platforms to these partners.These partners subsequently sell and support the device under their own brandsto their customer base. During the years ended September 30, 2005 and2004, sales to EMC represented 83% and 84%, respectively, of our OEM Appliancesegment revenues.

For the years ended September 30,2005 and 2004 our OEM Appliance segment had segment operating income of $10.3million and $8.6 million, respectively. Refer to footnote 17 of ourConsolidated Financial Statements contained in Item 8 of this report forpurposes of determining segment operating income.

**Distributionsegment**

Currently in our Distribution segment, we develop,manufacture, sell, market and support our NS Series SecurityAppliances that are based on Microsoft’s Internet Security and Acceleration(ISA) Server 2004. We license and integrate this software with server applianceplatforms and our proprietary software to sell our own branded serverappliances primarily to Microsoft-certified or network security value addedresellers and system integrators. However sales of these servers did notcommence until fiscal year 2005 and, as a result, sales of these serverappliances have represented a small portion of our Distribution segmentrevenues. In October 2004, we began to sell our NS6300 Security Appliance,and in February 2005, we announced the introduction of the NS6400. Weexpect that the sale of our NS Series Security Appliances will be theprimary source of our future Distribution segment revenues. However, sales ofthese appliances did not meet our expectations during fiscal 2005 and webelieve that it may take several quarters more before revenues from sales ofthese server appliances become significant. Primarily as a result of these lessthan expected sales, in fiscal 2005 we recorded a goodwill impairment charge inour Distribution segment of approximately $7.8 million.

Previously in our Distribution segment we alsodistributed third-party data storage networking connectivity products for theleading Fibre Channel host bus adapter, or HBA, and storage switchmanufacturers in the data storage industry to a customer base of value-addedresellers and systems integrators. To date, substantially all of ourDistribution segment’s revenue has been derived from the sale of third-partydata storage networking components and products, predominantly EMC-approvedFibre Channel HBAs. In December 2003, we amended our distributionagreement with EMC regarding our sales of EMC-approved Fibre Channel HBAs. Thisamendment was effective January 1, 2004 and required that we pay a royaltyto EMC for each EMC-approved Fibre Channel HBA that we sell. As a result of this amendment, there was a decline in our grossprofits related to sales of EMC-approved Fibre Channel 

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HBAs, which in turn had a negative impact on our Distributionsegment gross profits as well as our consolidated gross profits and operatingresults. In addition, as a result of the higher costs per EMC-approved FibreChannel HBA that this amendment imposed upon us, our Distribution segment’sability to compete in large sales transactions involving EMC-approved FibreChannel HBAs was negatively affected. This amendment, thecommoditization of Fibre Channel HBA technology, and the increasing competitionin the market resulted in declining gross profits related to our distributionof HBAs. During the quarter ended December 31, 2004, we discontinued salesof these third-party data storage networking products, as a result of thesefactors and the future prospects of this portion of our segment. During theyears ended September 30, 2005 and 2004, sales of these third-party datastorage networking products represented 90% and 99%, respectively, of ourDistribution segment revenues.

For the years ended September 30,2005 and 2004 our Distribution segment had segment operating losses of $19million and $3.8 million, respectively. Refer to footnote 17 of our ConsolidatedFinancial Statements contained in Item 8 of this report for purposes ofdetermining segment operating loss.

**Critical AccountingPolicies And Estimates**

Our discussion andanalysis of financial condition and results of operations are based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America. In preparingthese financial statements, we have made estimates and judgments in determiningcertain amounts included in the financial statements. We base our estimates andjudgments on historical experience and other various assumptions that webelieve to be reasonable under the circumstances. Actual results may differfrom these estimates under different assumptions or conditions. We believe thefollowing critical accounting policies affect our more significant judgmentsand estimates used in the preparation of our financial statements.

***Revenue recognition***

Revenues from products are generally recognized upondelivery to customers if persuasive evidence of an arrangement exists, the feeis fixed or determinable, collectibility is reasonably assured and title andrisk of loss have passed to the customer. In the event we have unfulfilledfuture obligations, revenue and related costs are deferred until those futureobligations are met. We have an inventory consignment agreement with ourlargest customer related to certain server appliances sold through our OEMAppliance segment. This customer notifies us when it utilizes inventory and werecognize revenues from sales to this customer based upon these notifications.

Maintenance revenues are derived from customer supportagreements generally entered into in connection with the initial serverappliance sales and subsequent renewals. Maintenance fees are typically for oneto three year renewable periods and include the right to unspecified softwareupdates when-and-if-available, hardware repairs, 24-hour customersupport, and advanced replacement of server appliances. Maintenance revenuesare recognized ratably over the term of the maintenance period. Payments formaintenance fees are generally made in advance and are included in deferredrevenue.

Contracts and/or customer purchase orders aregenerally used to determine the existence of an arrangement. Shipping documentsand consignment usage notifications are used to verify shipment or transfer ofownership, as applicable. We assess whether the sales price is fixed ordeterminable based on the payment terms associated with the transaction andwhether the sales price is subject to refund or adjustment. We assesscollectibility based primarily on the creditworthiness of the customer asdetermined by credit checks and analysis, as well as the customer’s paymenthistory.

For revenue arrangements that contain multipleelements, such as the sale of both the product and post-sales support, in whichsoftware is not incidental to the product, such as our sales of serverappliances through our Distribution segment, we determine fair value based uponvendor specific objective evidence, 

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which is typicallyestablished through contractual post-sales support renewal rates whereby theresidual fair value is allocated to the server appliance. For revenuearrangements that contain multiple elements, in which software is not includedor is incidental to the product, such as our sales of server appliances throughour OEM Appliance segment, we determine fair value based on objective andreliable evidence of fair value, which is typically determined throughcontractual refund rates for cancellations, and stand-alone sales of post salessupport, whereby the residual fair value is allocated to the server appliance.

We recognize revenue whenthe revenue recognition criteria for each element of the sale is met. If we arenot able to derive the fair value of the undelivered element of the sale(maintenance), all revenues from the arrangement are deferred and recognizedratably over the period of the support arrangement, which is typically one tothree years.

***Allowances for Doubtful Accounts and Sales Returns***

Our allowance for doubtful accounts is based on ourassessment of the collectibility of customer accounts. We regularly review theallowance by considering factors such as historical experience, credit quality,age of the accounts receivable balances, and current economic conditions thatmay affect a customer’s ability to pay. If a major customer’s creditworthinessdeteriorates, or if actual defaults are higher than our historical experience,or if other circumstances arise, our estimates of the recoverability of amountsdue to us could be overstated, and additional allowances could be required,which could have an adverse impact on our results of operations.

Historically, ourDistribution segment customers were offered a thirty-day right of return on “un-opened”third-party data storage networking products. A reserve for sales returns wasestablished based on historical trends in product return rates. The reserve forsales returns was recorded as a reduction of our revenues and accountsreceivable. All rights of return related to sales of these products expired at December 31,2004.

***Inventories***

We value inventory at thelower of cost or estimated market, and determine cost on a first-in, first-outbasis. We regularly review inventory quantities on hand and record a write-downfor excess or obsolete inventory based primarily on our estimated forecast ofproduct demand and anticipated production requirements in the near future. Anyrapid technological changes and future product development could result in anincrease in the amount of obsolete inventory quantities on hand. Agreementswith certain of our OEM Appliance customers include inventory protectionprovisions, however, these provisions may not provide us with completeprotection from loss due to excess or obsolete inventory.

***Product Warranty Obligations***

We offer a warranty on certain of our products thatgenerally provide for us to repair or replace any defective products for aperiod of up to 36 months after shipment. We reserve for the estimated costs tofulfill customer warranty obligations upon the recognition of the relatedrevenue and record warranty expense as a component of cost of sales.

*OEMServer appliance products—**Costs*included in ourserver appliance product warranty obligation include shipping, materials,internal and external labor, and travel. Significant judgment and estimates areinvolved in estimating our warranty reserve on our OEM server applianceproducts. Although our current OEM server appliance products use morestandards-based technologies than in the past, certain of our server applianceproducts incorporate proprietary technologies, which may increase our risksrelated to product warranty obligations. In the past we have experiencedunexpected component failures in certain of our server appliance products,which have required us to increase our product warranty accruals. At the timeany unexpected component failure arises, we assess the costs to repair anydefects and record what we 

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believe to be anappropriate warranty obligation based on the available information at the time.To the extent we may experience increased warranty claim activity, increasedcosts associated with servicing those claims, or use estimates that prove to bematerially different from actual claims, our product warranty obligations mayneed to be increased, resulting in decreased gross profits.

*NS Series SecurityAppliance products—*Our NS Series SecurityAppliances typically do not include a general warranty, but instead customerstypically are required to purchase an annual maintenance program at the time ofthe appliance purchase. Our NS Series Security Appliances sold in Europeare sold with a thirteen-month hardware warranty.

*HBA products—*Our HBA warranty expense was determined based upon contractual rates with athird-party warranty provider who we paid to perform substantially allactivities related to the fulfillment of our HBA product warranty obligations.As such, the warranty expense that we recognized for past shipments is fixedand is not subject to change.

***Goodwill and long-lived assets***

Goodwill represents the excess purchase price over thefair value of the net tangible and intangible assets acquired. We reviewlong-lived assets at least annually to determine if any adverse conditionsexist that would indicate impairment. Conditions that would trigger a morefrequent impairment assessment include, but are not limited to, a significantadverse change in certain agreements, or business climate that could affect thevalue of an asset. We assess the recoverability of long-lived assets based onthe projected undiscounted future cash flows over the asset’s remaining life.The amount of impairment, if any, is measured based on the excess of thecarrying value over fair value. Fair value is generally calculated as thepresent value of estimated future cash flows using a risk-adjusted discountrate, which requires significant management judgment with respect to revenueand expense growth rates, and the selection and use of an appropriate discountrate.

Goodwill is reviewed eachyear in the fourth quarter for impairment, or more frequently if certainindicators are present. Examples of such indicators that would cause us to testgoodwill for impairment between annual tests include, but are not limited to asignificant adverse change in the business climate, unanticipated competition,or a loss of key personnel. When conducting our impairment evaluation, wecompare the carrying value of the reporting unit, as defined, to the fair valueof the reporting unit. If the carrying amount of the reporting unit exceeds itsfair value, then the carrying value of that reporting unit’s goodwill iscompared to the implied fair value of the goodwill and an impairment loss isrecorded in an amount equal to that excess, if any. Fair value is calculated asthe present value of estimated future cash flows using a risk-adjusted discountrate, and includes significant judgments by management. We believe that themost significant judgments involved in the determination of the fair value ofour goodwill is our expectation of future revenues and gross profits from oursales of server appliances through our Distribution segment. We have a limitedhistory selling server appliances through our Distribution segment.

***Income tax asset valuation***

We record deferred taxassets and liabilities based on the net tax effects of tax credits, operatingloss carryforwards and temporary differences between the carrying amounts ofassets and liabilities for financial reporting purposes and the amounts usedfor income tax purposes. We then assess the likelihood that our deferred taxassets will be recovered from future taxable income and, to the extent webelieve that recovery is not likely, we establish a valuation allowance. Thevaluation allowance is based on our estimate of future taxable income and theperiod over which our deferred tax assets will be recoverable. At September 30,2005, we believe that it is more likely than not that all of our deferred taxassets will not be realized, and, accordingly, we have recorded a valuationallowance against all of our deferred tax assets. If 

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resultsof operations in the future indicate that some or all of the deferred taxassets will be recovered, the reduction of the valuation allowance will berecorded as a tax benefit. To the extent that net operating losses, whenrealized, relate to stock options deductions of approximately $2.4 million, theresulting benefits will be credited to additional paid-in capital.

**Comparability ofFinancial Information**

On December 27, 2002,we completed our acquisition of TidalWire. As a result, the three months ended March 31,2003 was the first quarter that included the TidalWire operations in ourconsolidated results for an entire quarter. Our financial results only includeTidalWire financial results for periods subsequent to December 27, 2002.As such, the presentation of historical financial information and anydiscussion regarding the comparison of historical financial information doesnot include any financial information for TidalWire prior to December 28,2002, unless otherwise indicated.

**Results ofOperations**

Thefollowing data summarizes the results of our operations for the past threefiscal years, in thousands and as a percentage of net revenues.

| ** **             | ** ** | **Fiscal Year Ended September 30,** | ** **    |
|------------------------|------------|---------------------------------------------------------|---------------|
| ** **             | ** ** | **2005**                                                | ** **    | **2004** | ** ** | **2003** | ** ** |
| ** **             | ** ** | **Dollars**                                             | ** **    | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** |
| Net revenues           |       | $                                                       | 98,071   |   |   | 100.0% |   |   | $ | 136,755  |   |   | 100.0% |   |   | $ | 81,243  |   |   | 100.0% |   |   |
| Gross profit           |       | 17,061                                                  |          |   | 17.4% |   |   | 23,908 |   |   | 17.5% |   |   | 16,737 |   |   | 20.6% |   |   |
| Operating  expenses(a) |       | 33,637                                                  |          |   | 34.3% |   |   | 25,816 |   |   | 18.9% |   |   | 18,686 |   |   | 23.0% |   |   |
| Loss from  operations  |       | (16,576                                                 | )             |   | (16.9% | ) |   | (1,908 | ) |   | (1.4% | ) |   | (1,949 | ) |   | (2.4% | ) |   |
| Net loss               |       | $                                                       | (15,583  | ) |   | (15.9% | ) |   | $ | (1,619  | ) |   | (1.2% | ) |   | $ | (1,385  | ) |   | (1.7% | ) |   |

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(a)           Includesapproximately $7.8 million related to an impairment charge for goodwill in2005, and $4 million related to an impairment charge for intangible assets in2004.

**Discussion ofFiscal 2005 and 2004**

***Net Revenues and Gross Profit (Loss)***

Thefollowing table summarizes our net revenues and gross profit (loss) byreportable segment, in thousands and as a percentage of net revenues:

| ** **              | ** ** | **For year ended September 30,** | ** **           |
|-------------------------|------------|------------------------------------------------------|----------------------|
| ** **              | ** ** | **2005**                                             | ** **           | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **              | ** ** | **Dollars**                                          | ** **           | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**      |       |                                                 |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | $                                                    | 92,877          |   |   | 100.0% |   |   | $ | 80,321  |   |   | 100.0% |   |   | $ | 12,556  |   |   | 16% |   |   |
| Gross profit            |       | 17,133                                               |                 |   | 18.4% |   |   | 16,283 |   |   | 20.3% |   |   | 850 |   |   | 5% |   |   |
| **Distribution:**       |       |                                                 |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | 5,194                                                |                 |   | 100.0% |   |   | 56,434 |   |   | 100.0% |   |   | (51,240 | ) |   | (91% | ) |   |
| Gross profit (loss)     |       | (72                                                  | )                    |   | (1% | ) |   | 7,625 |   |   | 13.5% |   |   | (7,697 | ) |   | (101% | ) |   |
| **Total net revenues**  |       | **$**                                                | **98,071**** ** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **136,755**** ** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **(38,684**** ** | **)** | ** ** | **(28%** | **)** |   |
| **Total  gross profit** |       | **$**                                                | **17,061**** ** | ** ** | ** ** | **17.4%** | ** ** | ** ** | **$** | **23,908**** ** | ** ** | ** ** | **17.5%** | ** ** | ** ** | **$** | **(6,847**** ** | **)** | ** ** | **(29%** | **)** |   |

 

40

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***Net revenues***

Our revenues are derivedfrom sales of server appliances primarily to our OEM network equipment and ISVpartners. We also derived revenues from the distribution of third-party datastorage networking products, until we completed our exit from this portion ofour Distribution business during the quarter ended December 31, 2004.

Our OEM Appliance segmentnet revenues increased in fiscal year 2005 from fiscal year 2004 primarily due toan increase in sales volumes to EMC, which represented 83% of OEM Appliance netrevenues for the year ended September 30, 2005 versus 84% for the yearended September 30, 2004. Net revenues to other OEM Appliance partners forthe year ended September 30, 2005 increased to $15.4 million from $12.9million for the year ended September 30, 2004. Approximately $2.1 millionof this increase is the result of net revenue growth among pre-existing OEMAppliance customers and approximately $0.4 million of this increase isattributable to revenues from new OEM Appliance customers added in the pastyear.

Our Distribution segmentnet revenues during fiscal 2005 decreased significantly compared to netrevenues in fiscal 2004. Net revenues for fiscal 2004 were attributable tosales of third-party data storage networking products, which we no longer soldsubsequent to December 31, 2004. During the years ended September 30,2005 and 2004, sales of these third-party data storage networking productsrepresented 90% and 99%, respectively, of our Distribution segment revenues. Weexpect that in the future our Distribution segment revenues will consistprimarily of sales of our NS Series Security Appliances. Our first NS Series SecurityAppliance, the NS6300, became available in October 2004 and our NS6400 wasintroduced during February 2005. We have not experienced significant salesfrom these server appliances during fiscal 2005.

***Gross profit (loss)***

Gross profit (loss)represents net revenues recognized less the cost of revenues. Cost of revenuesincludes cost of materials, warranty costs, inventory obsolescence charges,shipping and handling costs, customer support costs, and manufacturing costs,which are primarily comprised of compensation, contract labor costs and, when applicable,contract manufacturing costs.

Gross profit in our OEMAppliance segment increased for fiscal 2005 compared to fiscal 2004, primarilyas a result of increased sales volumes. Gross profit as a percentage of netrevenues in our OEM Appliance segment decreased for fiscal 2005 compared tofiscal 2004. This is due primarily to changes in product mix, which waspartially offset by higher sales volumes. The decrease in gross profits andgross profits as a percentage of net revenues in our Distribution segment wasattributable to our exit from distributing third-party data storage networkingproducts combined with lower than expected sales of our NS Series SecurityAppliances during fiscal 2005.

Our gross profit isaffected by the product mix within our OEM Appliance business, our OEMAppliance segment product pricing as well as the timing, size and configurationof server appliance orders. OEM Appliance gross profit is also affected by themix of product manufactured internally compared to product manufactured by ourcontract manufacturer, which carries higher manufacturing costs. As volumescontinue to increase for a given OEM partner, we expect gross profits as apercentage of net revenues to decline due to higher discounting. In addition,we expect gross profits to also decline in fiscal 2006 based on anticipatedchanges to the OEM product mix and competitive pricing pressure. Because our NSSeries Security Appliances are still an emerging product, until salesvolumes become significant, our gross profits in our Distribution segment willnot be contributory.

We expect gross profit tocontinue to be affected by these factors in both the OEM Appliance andDistribution segments. We expect that the gross margins as a percentage ofrevenue on our NS Series Security Appliances will continue to besignificantly influenced by promotional activities targeted at achieving marketacceptance of these products.

41

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***Operating Expenses***

Themost significant components of our operating expenses are research anddevelopment, selling and marketing, general and administrative expenses, andimpairment of goodwill. The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:

| ** **                                      | ** ** | **For year ended September 30,** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                      | ** ** | ** **                                           | ** ** | **% of Net ** | ** ** | ** ** | ** ** | **% of Net ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Dollars**                                          | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:                             |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and  development                       |       | $                                                    | 7,504      |   |   | 7.7% |   |   | $ | 6,156 |   |   | 4.5% |   |   | $ | 1,348 |   |   | 22% |   |   |
| Selling and  marketing                          |       | 9,848                                                |       |   | 10.0% |   |   | 8,637 |   |   | 6.3% |   |   | 1,211 |   |   | 14% |   |   |
| General and  administrative                     |       | 7,838                                                |       |   | 8.0% |   |   | 6,430 |   |   | 4.7% |   |   | 1,408 |   |   | 22% |   |   |
| Impairment of  goodwill                         |       | 7,769                                                |       |   | 7.9% |   |   | — |   |   | 0.0% |   |   | 7,769 |   |   | 100% |   |   |
| Stock  compensation                             |       | 14                                                   |       |   | 0.0% |   |   | 390 |   |   | 0.3% |   |   | (376 | ) |   | (96% | ) |   |
| Restructuring and  other charges (credits)      |       | 366                                                  |       |   | 0.4% |   |   | (107 | ) |   | (0.1% | ) |   | 473 |   |   | (442% | ) |   |
| Impairment of  intangible and long-lived assets |       | 298                                                  |       |   | 0.3% |   |   | 4,013 |   |   | 2.9% |   |   | (3,715 | ) |   | (93% | ) |   |
| Amortization of  intangible assets              |       | —                                               |       |   | 0.0% |   |   | 297 |   |   | 0.2% |   |   | (297 | ) |   | (100% | ) |   |
| Total operating  expenses                       |       | $                                                    | 33,637     |   |   | 34.3% |   |   | $ | 25,816 |   |   | 18.9% |   |   | $ | 7,821 |   |   | 30% |   |   |

 

*Research anddevelopment.*

Researchand development expenses consist primarily of salaries and related expenses forpersonnel engaged in research and development, fees paid to consultants andoutside service providers, material costs for prototype and test units andother expenses related to the design, development, testing and enhancements ofour server appliance products. We expense all of our research and developmentcosts as they are incurred. The following table summarizes the most significantcomponents of research and development expense for the periods indicated, inthousands and as a percentage of total research and development expense andprovides the changes in thousands and percentages:

| ** **                        | ** ** | **For year ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        | ** ** | ** **                                           | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                    | 4,643      |   |   | 62% |   |   | $ | 3,267 |   |   | 53% |   |   | $ | 1,376 |   |   | 42% |   |   |
| Prototype                         |       | 855                                                  |       |   | 11% |   |   | 1,071 |   |   | 17% |   |   | (216 | ) |   | (20% | ) |   |
| Consulting and outside services   |       | 1,136                                                |       |   | 15% |   |   | 987 |   |   | 16% |   |   | 149 |   |   | 15% |   |   |
| Other                             |       | 870                                                  |       |   | 12% |   |   | 831 |   |   | 13% |   |   | 39 |   |   | 5% |   |   |
| Total research  and development   |       | $                                                    | 7,504      |   |   | 100% |   |   | $ | 6,156 |   |   | 100% |   |   | $ | 1,348 |   |   | 22% |   |   |

 

Overall, our server appliance development expenseshave increased as a result of an increase in software development activitiesrelated to our NS Series Security Appliances and the development andsustained engineering efforts related to existing, new and prospective ISV andnetwork equipment partners. To support these development activities, we haveincreased our research and development personnel from 32 at September 30,2004 to 40 at September 30, 2005, which has resulted in increasedcompensation costs. We have also increased the number of consultants used tosupplement our research and development personnel levels, primarily in the areaof software development, which has resulted in increased consulting and outsideservice costs. Conversely, our prototype expenses for fiscal 2005 

42

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decreased from fiscal 2004as a result of the timing of certain engineering projects in our OEM Appliancesegment.

Our server appliancedevelopment strategy emphasizes the utilization of standard, off-the-shelfcomponents in our server appliance platforms. However, we expect that in somecases significant development efforts will be required to fulfill our currentand potential ISV and network equipment partners’ needs. In addition, for ourNS Series Security Appliances, we intend to focus our software developmentin areas that improve the ease of server appliance implementation and use,which we believe will enhance our value proposition. We expect that researchand development costs will continue to increase in fiscal 2006 primarily due tocertain development projects for both our OEM Appliance segment and NS Series SecurityAppliances.

*Selling andmarketing.*

Sellingand marketing expenses consist primarily of salaries and commissions forpersonnel engaged in sales and marketing; costs associated with our marketingprograms, which include costs associated with our attendance at trade shows,public relations, product literature costs, web site enhancements and productevaluation costs; consulting and outside services costs and travel. Thefollowing table summarizes the most significant components of selling and marketingexpense for the periods indicated in thousands and as a percentage of totalselling and marketing expense and provides the changes in thousands andpercentages:

| ** **                        | ** ** | **For year ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            | ** ** | ** **                                           | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                    | 5,803      |   |   | 59% |   |   | $ | 6,192 |   |   | 72% |   |   | $ | (389 | ) |   | (6% | ) |   |
| Marketing programs                |       | 1,994                                                |       |   | 20% |   |   | 940 |   |   | 11% |   |   | 1,054 |   |   | 112% |   |   |
| Consulting and outside services   |       | 384                                                  |       |   | 4% |   |   | 176 |   |   | 2% |   |   | 208 |   |   | 118% |   |   |
| Travel                            |       | 828                                                  |       |   | 8% |   |   | 568 |   |   | 7% |   |   | 260 |   |   | 46% |   |   |
| Other                             |       | 839                                                  |       |   | 9% |   |   | 761 |   |   | 9% |   |   | 78 |   |   | 10% |   |   |
| Total selling and  marketing      |       | $                                                    | 9,848      |   |   | 100% |   |   | $ | 8,637 |   |   | 100% |   |   | $ | 1,211 |   |   | 14% |   |   |

 

Our Distribution segment by its nature incurs more ofthe marketing and sales burden of the products that it sells and must engage ina higher level of marketing program activities than our OEM Appliance segment.Sales in our OEM Appliance segment are to our ISV and network equipmentpartners who market and sell their products, which incorporate our serverappliances. As a result, our OEM Appliance segment engages in a limited levelof marketing programs.

As indicated in the table above, the primary componentof the increase in selling and marketing expenses are marketing program costsoffset in part by a decrease in compensation costs. We have increased the levelof marketing programs during fiscal 2005 as a result of the release of our NS Series SecurityAppliances. Our selling and marketing personnel decreased slightly, in theaggregate, from 43 at September 30, 2004 to 42 at September 30, 2005.This net decrease represents decreases from terminations and attrition relatedto our exit from the distribution of third-party data storage networkingproducts, partially offset by increased hiring throughout the year related toour NS Series Security Appliances. As a result, compensation and relatedexpenses decreased in the aggregate during fiscal 2005 as compared to fiscal2004. In addition, our consulting and outside services and travel expenses haveincreased from fiscal 2004 as a result of our continued effort to build ourchannel of resellers and distributors for our NS Series SecurityAppliances. In particular we commenced our European sales operations during thequarter ended June 30, 2005, with our initial focus being in the UnitedKingdom and southern Europe.

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We believe that we mustcontinue our selling and marketing efforts in order to enhance our position asa leading provider of server appliance products and to establish ourselves as aleader in network security appliances. Variable marketing costs, such asmarketing programs, are somewhat dependent on the timing and magnitude of newproduct introductions and will fluctuate depending on the level of thisactivity. We expect selling and marketing expenses to increase in fiscal 2006as we continue invest in developing our channel of resellers and building brandawareness for our NS Series Security Appliances.

*General andadministrative.*

Generaland administrative expenses consist primarily of salaries and other relatedcosts for executive, finance, information technology and human resourcespersonnel; professional services, which include legal, accounting, audit and taxfees, and costs of compliance with the Sarbanes-Oxley Act; director and officerinsurance; and bad debt expenses. The following table summarizes the mostsignificant components of general and administrative expense for the periodsindicated in thousands and as a percentage of total general and administrativeexpense and provides the changes in thousands and percentages:

| ** **                        | ** ** | **For year ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:      | ** ** | ** **                                           | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                    | 2,819      |   |   | 36% |   |   | $ | 2,616 |   |   | 41% |   |   | $ | 203 |   |   | 8% |   |   |
| Professional services             |       | 3,185                                                |       |   | 41% |   |   | 1,950 |   |   | 30% |   |   | 1,235 |   |   | 63% |   |   |
| Director and officer insurance    |       | 952                                                  |       |   | 12% |   |   | 932 |   |   | 14% |   |   | 20 |   |   | 2% |   |   |
| Bad debt expense (recoveries)     |       | (4                                                   | )          |   | (0% | ) |   | 31 |   |   | 0% |   |   | (35 | ) |   | (113% | ) |   |
| Other                             |       | 886                                                  |       |   | 11% |   |   | 901 |   |   | 14% |   |   | (15 | ) |   | (2% | ) |   |
| Total general and  administrative |       | $                                                    | 7,838      |   |   | 100% |   |   | $ | 6,430 |   |   | 100% |   |   | $ | 1,408 |   |   | 22% |   |   |

 

As indicated in the table above, the primary componentof the increase in general and administrative expenses is increased consultingand professional services. The increase in consulting and professional servicesis due primarily to increased costs related to our compliance with theSarbanes-Oxley Act of 2002.

We expect general andadministrative expenses to remain consistent in fiscal 2006, however this willbe dependent on costs associated with ongoing litigation and the relative coststo operate as a public company.

*Impairment ofgoodwill*

We performed our annualimpairment assessment of goodwill during the fourth quarter of fiscal 2005. Thisassessment was performed using an appraisal based primarily on the estimateddiscounted cash flows expected to be generated by our Distribution segment,which now consists only of our NS Series Security Appliances. Thediscounted cash flows used in the appraisal were based on a number of estimatesand assumptions made by us, including the projected future operating results ofour Distribution segment, the discount rate, and the long-term growth rate. Webased our revenue assumptions on estimates of relevant market sizes, expectedmarket growth rates, and actual fiscal 2005 results. Sales of our NS Series SecurityAppliances did not meet our expectations during fiscal 2005 and we believe thatit may take several more quarters before revenues from sales of these serverappliances become significant. These factors were significant contributors indetermining key assumptions used in our appraisal. In addition to thesefactors, we considered the continued expected investments in technologydevelopment and sales and marketing efforts. Our assessment resulted in animplied fair value of the Distribution reporting unit’s goodwill that wassignificantly lower than its carrying value of that goodwill. Consequently, wedetermined that our 

44

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goodwillwas fully impaired resulting in an impairment charge of $7,769,000 for the yearended September 30, 2005.

*Stock compensation.*

Stock compensation relates to the issuance of stockoptions in prior years with exercise prices below the deemed fair value of theCompany’s common stock on the date of issuance. We amortized stock compensationover the vesting period of the related options, which is attributable for approximately$7,000 of stock compensation in fiscal 2005. The decrease in stock compensationin fiscal 2005 compared to fiscal 2004 is due to the completed amortization ofthe deferred stock compensation related to these options as scheduled. Inaddition, approximately $7,000 of stock compensation in fiscal 2005 relates tostock options granted to a non-employee.

Prospectively we expectstock compensation to have a material impact on our results of operations fromour adoption of Statement of Financial Accounting Standard, No. 123(R) “Share-BasedPayment” beginning in fiscal 2006 which requires all share-based payments toemployees to be recognized in our financial statements.

*Restructuring andother charges.*

During fiscal 2005, we recorded a restructuring chargeof approximately $366,000 related to our exit from that portion of the businessrelated to the distribution of third-party data storage networking products. Approximately$283,000 of the charge related to one-time employee benefits associated withterminating certain employees in this portion of the business during the year.We also incurred $83,000 for a fixed payment related to our warrantyfulfillment contract with an external service provider.

During fiscal 2004 wereversed the remaining restructuring accrual balance of $107,000, which relatedto certain modifications we made to our leased facilities.

*Amortization andimpairment of intangible and long-lived assets.*

In connection with our acquisition of TidalWire in December 2002,we recorded a definite-lived intangible asset attributable to TidalWire’sexisting customer relationships. This asset was being amortized on astraight-line basis over its estimated useful life. In December 2003, weamended our agreement with EMC regarding distribution of EMC-approved HBAs. Thisamendment required us to pay a royalty to EMC for each EMC-approved HBA we sold.As a result of the negative effect of this amendment on our gross profits, weconsidered this amendment to be a triggering event requiring assessment for impairment.As a result, during the quarter ended December 31, 2003 we conducted adetailed impairment analysis of our intangible assets. This analysis resultedin the determination that the fair value of our intangible assets was less thanits carrying amount, which resulted in a charge to operations of approximately$3,614,000 in the quarter ended December 31, 2003. We also performed animpairment evaluation of the remaining carrying value of these intangibleassets at September 30, 2004. This analysis resulted in an additionalimpairment charge of $399,000. The effect of the total fiscal 2004 impairmentcharge of $4,013,000 reduced the remaining carrying value of these intangibleassets to zero. As a result of this elimination of the carrying value of theassets during fiscal 2004, there was no amortization expense for fiscal 2005.

In the fourth quarter offiscal 2005,we also assessed the undiscounted cash flows expected to begenerated by our Distribution segment and determined that the carrying value ofcertain equipment attributable to our Distribution segment was not recoverableas determined in accordance with SFAS 144. As a result, we recognized animpairment charge of $313,000 for the year ended September 30, 2005. Approximately,$15,000 of this impairment charge was recorded through cost of revenues.

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***Interest and Other Income (Expense), net***

Interest and other income(expense), net has increased from $333,000 in fiscal 2004 to $993,000 in fiscal2005. This increase was primarily due to higher average interest rates earnedon our cash, cash equivalents, and short-term investments.

**Discussion ofFiscal 2004 and 2003**

***Net Revenues and Gross Profit***

Thefollowing table summarizes our net revenues and gross profit by reportablesegment, in thousands and as a percentage of net revenues:

| ** **              | ** ** | **For year ended September 30,** | ** **  |
|-------------------------|------------|------------------------------------------------------|-------------|
| ** **              | ** ** | **2004**                                             | ** **  | **2003** | ** ** | **Increase (Decrease)** | ** ** |
| ** **              | ** ** | **Dollars**                                          | ** **  | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**      |       |                                                 |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | $                                                    | 80,321      |   |   | 100.0% |   |   | $ | 43,289 |   |   | 100.0% |   |   | $ | 37,032 |   |   | 86% |   |   |
| Gross profit            |       | 16,283                                               |        |   | 20.3% |   |   | 9,241 |   |   | 21.3% |   |   | 7,042 |   |   | 76% |   |   |
| **Distribution:**       |       |                                                 |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | $                                                    | 56,434      |   |   | 100.0% |   |   | $ | 37,954 |   |   | 100.0% |   |   | $ | 18,480 |   |   | 49% |   |   |
| Gross profit            |       | 7,625                                                |        |   | 13.5% |   |   | 7,496 |   |   | 19.8% |   |   | 129 |   |   | 2% |   |   |
| **Total net revenues**  |       | **$**                                                | **136,755** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **81,243** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **55,512** | ** ** | ** ** | **68%** |   |   |
| **Total  gross profit** |       | **$**                                                | **23,908**  | ** ** | ** ** | **17.5%** | ** ** | ** ** | **$** | **16,737** | ** ** | ** ** | **20.6%** | ** ** | ** ** | **$** | **7,171** | ** ** | ** ** | **43%** |   |   |

 

***Net revenues***

The increase in net revenues from fiscal 2003 tofiscal 2004 is due primarily to increased OEM Appliance sales to EMC andincreased Distribution sales as a result of a full year of sales related tothird-party data storage networking products. Our OEM Appliance segment netrevenues increased for fiscal 2004 primarily due to an increase in salesvolumes to EMC, which represented 84% of OEM Appliance net revenues in thefiscal 2004 versus 88% fiscal 2003. Additionally, net revenues to OEM Appliancecustomers other than EMC grew from $5.2 million in fiscal 2003 to $12.9 millionin fiscal 2004. Approximately $6.7 million of the increase is the result of netrevenue growth among pre-existing OEM Appliance customers and approximately $1million of this increase is attributable to revenues from new OEM Appliancecustomers added in the past year.

Sales of third-party datastorage networking products represented 99% of our Distribution segment netrevenues for fiscal 2004 and 2003. The increase in net revenues in 2004 from2003 was the result of an entire year of Distribution sales in fiscal 2004 fromour acquisition of TidalWire on December 27, 2002 compared to only ninemonths of sales in fiscal 2003. Additionally, sales volumes of HBAs werehigher, which were offset in part by a decrease in the average sales prices.

***Gross profit***

The increase in gross profit in our OEM Appliancesegment is due primarily to growth in our OEM Appliance sales volumes. As apercentage of net revenues, gross profit in our OEM Appliance segment hasdeclined due primarily to higher discounting to certain customers as a resultof volume increases and due to higher inventory obsolescence write-downs. Thedecrease in our gross profit as a percentage of OEM Appliance net revenues wasoffset in part by lower manufacturing costs per unit sold due to volumeefficiencies and related manufacturing process improvements and lower warrantycosts.

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The increase in ourDistribution segment gross profit is due primarily to the growth ofDistribution net revenues. As a percentage of net revenues, gross profit in ourDistribution segment has declined primarily due to royalty costs incurred in2004 as a result of our amended agreement with EMC regarding our distributionof EMC-approved Fibre Channel HBAs, which was effective January 1, 2004.To a lesser extent, the decreases in gross profit and gross profit as apercentage of Distribution segment net revenues are due to lower averageselling prices as well as changes to the mix of products sold through ourDistribution segment.

***Operating Expenses***

Thefollowing table presents operating expenses during the periods indicated, inthousands and as a percentage of net revenues:

| ** **                         | ** ** | **For year ended September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                             | ** ** | **2003** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and  development          |       | $                                                    | 6,156      |   |   | 4.5% |   |   | $ | 4,114 |   |   | 5.1% |   |   | $ | 2,042 |   |   | 50% |   |   |
| Selling and  marketing             |       | 8,637                                                |       |   | 6.3% |   |   | 6,519 |   |   | 8.0% |   |   | 2,118 |   |   | 33% |   |   |
| General and  administrative        |       | 6,430                                                |       |   | 4.7% |   |   | 5,856 |   |   | 7.2% |   |   | 574 |   |   | 10% |   |   |
| Stock  compensation                |       | 390                                                  |       |   | 0.3% |   |   | 928 |   |   | 1.1% |   |   | (538 | ) |   | (58% | ) |   |
| Restructuring and  other charges   |       | (107                                                 | )          |   | (0.1% | ) |   | 507 |   |   | 0.6% |   |   | (614 | ) |   | (121% | ) |   |
| Impairment of  intangible assets   |       | 4,013                                                |       |   | 2.9% |   |   | — |   |   | 0.0% |   |   | 4,013 |   |   | 100% |   |   |
| Amortization of  intangible assets |       | 297                                                  |       |   | 0.2% |   |   | 762 |   |   | 0.9% |   |   | (465 | ) |   | (61% | ) |   |
| Total operating  expenses          |       | $                                                    | 25,816     |   |   | 18.9% |   |   | $ | 18,686 |   |   | 23.0% |   |   | $ | 7,130 |   |   | 38% |   |   |

 

*Research anddevelopment.*

Thefollowing table summarizes the most significant components of research anddevelopment expense for the periods indicated, in thousands and as a percentageof total research and development expense and provides the changes in thousandsand percentages:

| ** **                        | ** ** | **For year ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2004**                                             | ** ** | **2003** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        | ** ** | ** **                                           | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                    | 3,267      |   |   | 53% |   |   | $ | 1,971 |   |   | 48% |   |   | $ | 1,296 |   |   | 66% |   |   |
| Prototype                         |       | 1,071                                                |       |   | 17% |   |   | 1,249 |   |   | 30% |   |   | (178 | ) |   | (14% | ) |   |
| Consulting and outside services   |       | 987                                                  |       |   | 16% |   |   | 216 |   |   | 5% |   |   | 771 |   |   | 357% |   |   |
| Other                             |       | 831                                                  |       |   | 13% |   |   | 678 |   |   | 16% |   |   | 153 |   |   | 23% |   |   |
| Total research  and development   |       | $                                                    | 6,156      |   |   | 100% |   |   | $ | 4,114 |   |   | 100% |   |   | $ | 2,042 |   |   | 50% |   |   |

 

During 2004, our serverappliance development expenses increased as a result of an increase in thedevelopment and sustaining engineering efforts related to existing, new andprospective ISV and network equipment partners and increased softwaredevelopment activities related to our NS Series Security Appliances. Inparticular, we incurred substantial development costs during the fourth quarterof 2004 relating to the development of a server appliance hardware platform fora future version EMC’s Centera product. To support these and other developmentactivities related to our NS Series Security Appliances we increased ourresearch and development personnel from 19 at September 30, 2003 to 32 at September 30,2004, which resulted in increased compensation costs. We also increased thenumber of 

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consultantsused to supplement our research and development personnel levels, primarily inthe area of software and to a lesser extent hardware development, whichresulted in increased consulting and outside service costs.

*Selling andmarketing.*

Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated in thousands and as a percentage oftotal selling and marketing expense and provides the changes in thousands andpercentages:

| ** **                        | ** ** | **For year ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2004**                                             | ** ** | **2003** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            | ** ** | ** **                                           | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                    | 6,192      |   |   | 72% |   |   | $ | 4,716 |   |   | 72% |   |   | $ | 1,476 |   |   | 31% |   |   |
| Marketing programs                |       | 940                                                  |       |   | 11% |   |   | 438 |   |   | 7% |   |   | 502 |   |   | 115% |   |   |
| Consulting                        |       | 176                                                  |       |   | 2% |   |   | 147 |   |   | 2% |   |   | 29 |   |   | 20% |   |   |
| Travel                            |       | 568                                                  |       |   | 7% |   |   | 371 |   |   | 6% |   |   | 197 |   |   | 53% |   |   |
| Other                             |       | 761                                                  |       |   | 9% |   |   | 847 |   |   | 13% |   |   | (86 | ) |   | (10% | ) |   |
| Total selling and  marketing      |       | $                                                    | 8,637      |   |   | 100% |   |   | $ | 6,519 |   |   | 100% |   |   | $ | 2,118 |   |   | 32% |   |   |

 

As indicated in the table above, the primarycomponents of the increase in selling and marketing expenses are compensationand marketing program costs. Primarily as a result of our acquisition ofTidalWire on December 27, 2002, our selling and marketing personnelincreased from 12 prior to this acquisition, to 43 at September 30, 2004.The increases in compensation were primarily due to the effect of an entirefiscal year of expenses related to these personnel additions compared toapproximately nine months in fiscal 2003. Similarly, the increase in marketingprogram costs was due to the effect of an entire fiscal year of marketingprogram activities related to our Distribution segment compared to a partialyear in 2003. Additionally, marketing program costs have increased related toactivities related to our NS Series Security Appliances.

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*General andadministrative.*

Thefollowing table summarizes the most significant components of general andadministrative expense for the periods indicated in thousands and as apercentage of total general and administrative expense and provides the changesin thousands and percentages:

| ** **                        | ** ** | **For year ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2004**                                             | ** ** | **2003** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:      | ** ** | ** **                                           | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                    | 2,616      |   |   | 41 | % |   | $ | 2,169 |   |   | 37 | % |   |   | $ | 447 |   |   |   | 21 | % |   |
| Professional services             |       | 1,950                                                |       |   | 30 | % |   | 1,765 |   |   | 30 | % |   |   | 185 |   |   |   | 10 | % |   |
| Director and officer insurance    |       | 932                                                  |       |   | 14 | % |   | 836 |   |   | 14 | % |   |   | 96 |   |   |   | 11 | % |   |
| Bad debt expense                  |       | 31                                                   |       |   | 0 | % |   | 75 |   |   | 1 | % |   |   | (44 | ) |   |   | (59 | %) |   |
| Other                             |       | 901                                                  |       |   | 14 | % |   | 1,011 |   |   | 17 | % |   |   | (110 | ) |   |   | (11 | %) |   |
| Total general and  administrative |       | $                                                    | 6,430      |   |   | 100 | % |   | $ | 5,856 |   |   | 100 | % |   |   | $ | 574 |   |   |   | 10 | % |   |

 

As indicated in the tableabove, the primary components of the increase in general and administrativeexpenses from fiscal 2003 to 2004 were increased compensation and increasedconsulting and professional service costs. At September 30, 2003 we had 20employees in our general and administrative department compared to 26 employeesat September 30, 2004. The increase in professional services was dueprimarily to an increase in legal and accounting costs related to certainnon-recurring projects, increased compliance costs and overall growth. Ourdirector and officer insurance costs, which are related to premiums associatedwith insurance coverage that we provide on behalf of our directors andofficers, increased from 2003 due to enhanced coverage.

*Stock compensation.*

We recorded deferred stockcompensation on our balance sheet of $15.5 million in connection with stockoption and restricted stock grants to our employees and directors that weregranted between February 1, 1999 and June 30, 2000. This amountrepresents the difference between the exercise price and the deemed fair valueof our common stock for financial reporting purposes at the date of grant. Wehave amortized this stock compensation over the vesting period of the relatedoptions. All options granted subsequent to June 30, 2000 have been issuedwith exercise prices equal to the fair market value of our common stock and,accordingly, no additional deferred compensation has been recorded. Through September 30,2004, we amortized $8.4 million to stock compensation expense and $7.1 millionof deferred stock compensation has been reversed due to the cancellation ofoptions for terminated employees. In connection with our acquisition ofTidalWire, we assumed all of TidalWire’s outstanding options, which convertedinto options to purchase 1,035,033 shares of our common stock. We recordedapproximately $304,000 of deferred stock compensation on our balance sheetrelated to unvested options. This amount represents the difference between theexercise prices and the fair market value of our common stock on the optionconversion date. We amortized this deferred stock compensation over theremaining vesting period of the related options. Through September 30,2004, we amortized $233,000 to stock compensation expense and $64,000 ofdeferred stock compensation has been reversed due to the cancellation ofoptions for terminated employees.

*Restructuring andother charges.*

During the first quarterof fiscal 2003, we recorded a charge to operations of $914,000. This charge wascomprised entirely of future lease and lease-related payments and resulted fromthe continued vacancy of certain leased facilities and the expected futurevacancy of certain leased facilities that were occupied by 

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asub-tenant. We determined the amount of this charge through an analysis of thereal estate market in and around these facilities, the likelihood that thesefacilities could be sub-leased during the remainder of the existing leaseterms and the financial condition of the sub-tenant. During the third quarterof fiscal 2003, we received $30,000 of sublease income not previouslyanticipated and, as a result, reversed $30,000 of this charge. This charge waslater revised resulting in a reversal of $377,000 in the fourth quarter offiscal 2003. In May 2004, our landlord authorized us to expand theproduction area of our leased facilities. Subsequently, our management approvedand initiated a plan to utilize leased space that was previously unoccupied. Asa result, we reversed the remaining restructuring accrual balance of $107,000during fiscal 2004.

*Amortization andimpairment of intangible assets.*

In connection with our acquisition of TidalWire in December 2002,we engaged a third-party valuation firm to evaluate the intangible assetsgenerated as a result of the acquisition. As a result of this valuation work,we recorded approximately $5.1 million of intangible assets attributable toTidalWire’s existing customer relationships as of December 27, 2002. Weestimated the useful life of the relationships to be five years and as such, wewere amortizing the related intangible assets on a straight-line basis overfive years.

On December 10, 2003, we amended our agreementwith EMC regarding our distribution of EMC-approved Fibre Channel HBAs,effective January 1, 2004. Because of this amendment, we were required topay a royalty for each EMC-approved Fibre Channel HBA sold by us beginning inthe quarter ended March 31, 2004. As a result, our gross profits fromsales of EMC-approved Fibre Channel HBAs were lower than originally expected.Because of the negative impact of this amendment on our operating results, weconsidered this amendment to be a triggering event requiring an impairmentevaluation of our intangible assets. As a result, we conducted a detailedanalysis of our intangible assets as of December 10, 2003. This analysisresulted in the determination that the fair value of our intangible assets,which is primarily attributable to our distribution agreement with EMCregarding EMC-approved Fibre Channel HBAs, was less than its carrying amount,which resulted in a charge to operations of approximately $3.6 million in thequarter ended December 31, 2003. As a result of this reduction in thecarrying value of the asset, amortization expense decreased from $762,000 infiscal 2003 to $297,000 in fiscal 2004.

We also performed animpairment evaluation of the remaining carrying value of these intangibleassets at September 30, 2004. This analysis resulted in the remainingcarrying value exceeding the fair value and therefore an impairment charge tooperations of $399,000, resulting in a total impairment charge to operationsduring the year ended September 30, 2004 of $4 million.

***Interest and Other Income (Expense), net***

Interest and other income(expense), net decreased from $564,000 in fiscal 2003 to $333,000 in fiscal2004. This decrease was primarily due to lower average interest rates earned onour cash, cash equivalents, and short-term investments.

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**Liquidity andCapital Resources**

Thefollowing table summarizes cash flow activities for the fiscal years ended (inthousands):

| ** **                                       | ** ** | **September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Net loss                                         |       | $                      | (15,583    | ) | $ | (1,619 | ) |
| Non-cash  adjustments to net loss                |       | 9,255                  |       | 5,903 |   |
| Changes in  working capital                      |       | 4,793                  |       | (2,057 | ) |
| Cash (used in) provided by operating activities  |       | (1,535                 | )          | 2,227 |   |
| Cash (used in)  investing activities             |       | (2,680                 | )          | (117 | ) |
| Cash provided by  financing activities           |       | 709                    |       | 1,637 |   |
| Increase (decrease) in cash and cash equivalents |       | (3,506                 | )          | 3,747 |   |
| Cash and cash  equivalents at beginning of year  |       | 12,974                 |       | 9,227 |   |
| Cash and cash  equivalents at end of year        |       | $                      | 9,468      |   | $ | 12,974 |   |

 

Thefollowing table presents our short-term investments as of the year ended September 30(in thousands):

| ** **              | ** ** | **September 30,** | ** ** |
|-------------------------|------------|------------------------|------------|
| ** **              | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Short-term  investments |       | $                      | 27,894     |   | $ | 26,614 |   |
|                         |            |                        |            |  |  |  |  |

 

***Operating Activities***

Cash flows used in operating activities of $1.5million for fiscal 2005 were attributable to a net loss of $15.6 million offsetby non-cash adjustments to net loss of $9.3 million and changes in workingcapital of $4.8 million. Non-cash adjustments to net loss consistedsubstantially of our goodwill impairment charge of $7.8 million anddepreciation expense of $1.2 million. Significant cash flow effects fromchanges in working capital for fiscal 2005 included an increased cash flow of$2.8 million from the collection of accounts receivable, $5.1 million from areduction of inventory, and $763,000 from increased deferred revenue. Theseincreases in cash flow were partially offset by decreased cash flow from adecrease in accounts payable of $3.7 million.

The higher collections ofaccounts receivable, and the associated reduction in inventory and accountspayable are primarily the result of our exit from the distribution ofthird-party storage networking products. In the first quarter of fiscal 2005 wesold our remaining inventory related to this portion of our business, which hasentirely been converted to cash as of September 30, 2005. Our days salesoutstanding was 39 days in fiscal 2005 compared to 35 days in 2004. Our dayssales outstanding could vary significantly due to possible fluctuations in thetiming of shipments to and payments primarily from our large OEM appliancecustomer.

***Investing Activities***

Cash flows used ininvesting activities during fiscal 2005 resulted from net purchases of $1.2million of short-term available for sale investments combined with $1.5 millionof investments in property and equipment. Cash flows used in investingactivities during fiscal 2004 were attributable to $1.1 million of purchasesfor equipment offset by net sales of short-term investments of $1 million.

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***Financing Activities***

Cash flows provided byfinancing activities consisted of cash received as a result of employee stockoption and stock purchase plan activity of $713,000 in fiscal 2005. Cash flowsprovided by financing activities of $1.6 million for fiscal 2004 were primarilyrelated to stock option and stock purchase plan activity, combined with thereceipt of certain legal settlement proceeds of approximately $415,000. Weexpect employee stock option activity to continue in fiscal 2006, however wecannot predict its level given the volatility of our stock price.

***Contractual Obligations and Commitments***

Thefollowing table sets forth certain information concerning our obligations andcommitments to make certain payments (in thousands).

| ** **                | ** ** | **Payments Due by Period** | ** ** |
|---------------------------|------------|-------------------------------------------|------------|
| ** **                | ** ** | **Less than  1 Year**           | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After   5 Years** | ** ** | **Total** | ** ** |
| Operating leases          |       |                                      | $          | 610 |   |   |   | $ | 305 |   |   |   | $ | — |   |   |   | — |   |   | $ | 915 |   |
| Capital lease  obligation |       |                                      | 24         |   |   |   | 72 |   |   |   | 18 |   |   |   | — |   |   | 114 |   |
| Purchase  obligations     |       |                                      | 200        |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 200 |   |
| Total                     |       |                                      | $          | 834 |   |   |   | $ | 377 |   |   |   | $ | 18 |   |   |   | — |   |   | $ | 1,229 |   |

 

Our futureliquidity and capital requirements will depend upon numerous factors,including:

·       thetiming and size of orders from our largest customer;

·       thelevel of investment required for development and sales and marketing related toour NS Series Security Appliances;

·       ourability to enter into partnerships with value added resellers and systemintegrators and their ability to sell our NS Series Security Appliances;

·       ourability to market and sell our NS Series Security Appliances;

·       ourability to form an adequate number of OEM partnerships with network equipmentproviders and ISVs;

·       thelevel of success of our OEM Appliance partners in selling server appliancesolutions that include our server appliance hardware platforms;

·       thecosts and timing of product engineering efforts and the success of theseefforts;

·       theoutcome of pending litigation; and

·       marketdevelopments.

We believe that ouravailable cash resources, including cash, cash equivalents and short terminvestments, and cash that we expect to generate from sales of our productswill be sufficient to meet our operating and capital requirements through atleast the next twelve months. After that, we may need to raise additionalfunds. We may in the future seek to raise additional funds through borrowings,public or private equity financings or from other sources. There can be noassurance that additional financing will be available at all or, if available,will be on terms acceptable to us. If additional financing is needed and is notavailable on acceptable terms, we may need to reduce our operating expenses.

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**Off-Balance SheetArrangements**

We have not created, andare not party to, any special-purpose or off balance sheet entities for thepurpose of raising capital, incurring debt or operating parts of our businessthat are not consolidated into our financial statements. We have not enteredinto any transactions with unconsolidated entities whereby the Company hassubordinated retained interests, derivative instruments or other contingent arrangementsthat expose the Company to material continuing risks, contingent liabilities,or any other obligation under a variable interest in an unconsolidated entitythat provides financing, liquidity, market risk or credit risk support to theCompany.

**Related PartyTransactions**

In January 2001, we deposited $1.1 million ofcash with a bank to guarantee a personal loan of Lawrence A. Genovesi, ourcurrent Chairman and former President, Chief Executive Officer and ChiefTechnology Officer. This guarantee was made in order to avoid significant salesof our stock by Mr. Genovesi as a result of a margin call on a personalloan collateralized by Mr. Genovesi’s holdings of our stock. Inconjunction with our guarantee of this loan, we entered into an agreement wherebyMr. Genovesi agreed to reimburse us for any obligations incurred by usunder the guarantee. On January 6, 2003, the bank applied $968,596 of ourfunds that were on deposit with the bank in satisfaction of all amounts due tothe bank from Mr. Genovesi and refunded $83,254 to us. On January 27,2003, Mr. Genovesi repaid us $974,168 to satisfy his obligations to us infull under the reimbursement agreement. Of that amount, $456,276 was paid incash and $517,892 was paid with the proceeds from the repurchase by us of391,128 shares of our common stock owned by Mr. Genovesi in a privatetransaction.

During fiscal year 2002, we repurchased 328,572 sharesof common stock held by Mr. Genovesi at a cost of $248,000. Of thepurchase price, $203,000 was applied against Mr. Genovesi’s outstandingloans due to us, while the remaining $45,000 was paid in cash to Mr. Genovesi.Mr. Genovesi also repaid $15,000 due to us under his remaining outstandingloans. On January 27, 2003, Mr. Genovesi, repaid to us a recourse notepayable of $22,500 with proceeds from our repurchase of 17,070 shares of ourcommon stock owned by Mr. Genovesi.

In April 2001, we entered into five recourseloans with certain of our officers and employees at that time totalingapproximately $736,000. We entered into these loan agreements to avoidsubstantial sales of our common stock by these individuals as a result of theiralternative minimum tax obligations incurred as a result of their exercise ofcommon stock options. The loans had an interest rate of 4.63% per year and weredue, as amended, in September 2002. These officers and employees pledgedto us all shares of our common stock owned by them, all common stock optionsheld by them and all proceeds received by them on the sale of either our commonstock or common stock options. During fiscal year 2002, we received proceedsfrom loans principal and interest payments of approximately $30,000; werepurchased 260,777 shares of common stock as repayment for principal andinterest for an additional $267,000. In January 2003, the remaining loansof approximately $489,000 were repaid in full, including accrued interest,through our repurchase of 278,600 shares of our common stock.

In connection with our acquisition of TidalWire on December 27,2002, we paid $1,144,615 in cash to Ascent Venture Partners and $2,205,828 incash to HarbourVest Partners, two of our substantial stockholders at that time.At the time of the acquisition, Ascent and HarbourVest owned approximately18.1% and 16.3% of our outstanding common stock, respectively. Ascent andHarbourVest also owned 12.9% and 24.9% of the outstanding common stock ofTidalWire, respectively. Pursuant to the terms of the merger agreement, weissued 480,706 shares and 926,386 shares of our common stock previously held astreasury stock to Ascent and HarbourVest, respectively, and made theaforementioned cash payments to Ascent and HarbourVest in exchange for all ofthe TidalWire common stock held by Ascent and HarbourVest.

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Robert M. Wadsworth, one of our directors, is amanaging director of the limited liability corporation that controlsHarbourVest Partners (and its affiliates), one of our significant stockholders.Mr. Wadsworth is also a director of PSI Holding Group, Inc. (“PSI”),the parent company of Akibia, Inc. (“Akibia”). During the years ended September 30,2005 and 2004, HarbourVest owned greater than 5% of our outstanding stock andgreater than 5% of the outstanding stock of PSI. While we were sellingthird-party data storage networking products we engaged Akibia to providecertain customer support and warranty fulfillment services, primarily relatedto our sales of HBAs. Our agreement with Akibia expired in March 2005 asscheduled. However, the terms of the agreement required Akibia to fulfill thewarranty services for the entire warranty period of the HBAs. Akibia charged usa quarterly fixed fee of $83,000 and a variable fee based upon our sales ofHBAs, which ended in December 2004. For the years ended September 30,2005, 2004 and 2003, we recognized $201,000, $1,070,000, and $972,000,respectively, of expenses related to these warranty fulfillment services. Inconnection with this customer support and warranty fulfillment servicesagreement, we also sold product to Akibia to allow Akibia to fulfill ourwarranty obligations for these products. For the years ended September 30,2005, 2004, and 2003 we recorded revenues of approximately $40,000, $143,000,and $93,000 respectively, from sales of HBAs to Akibia. We also purchasedcertain products sold through our Distribution segment from Akibia to fulfillcustomer orders. For the years ended September 30, 2004, we purchasedapproximately $19,000 of inventory from Akibia for resale to our Distributionsegment customers. No such purchases were made during the year ended September 30,2005. In addition, during the year ended September 30, 2004, we soldapproximately $60,000, respectively, of server appliance products to Akibia forresale. We had no sales of server appliance products to Akibia during the yearended September 30, 2005. In addition, we engaged Akibia to providecertain customer support and warranty fulfillment services to certain of ourserver appliance customers in both our OEM Appliance and Distribution segments.Under the terms of this agreement, we were obligated to pay Akibia certainfixed fees and certain activity-based fees based on actual warranty experience.We no longer engage Akibia for these support services. For the year ended September 30,2004, we recorded expenses totaling approximately $50,500, respectively,related to this agreement. At September 30, 2004, we had amounts payableto Akibia of approximately $143,000 and amounts receivable from Akibia of$51,000. There were no amounts receivable from or payable to Akibia at September 30,2005. In November 2005, Mr. John A. Blaeser, one of our directors,also joined the board of directors of Akibia.

Mr. Wadsworth also serves as a director ofInnoveer Solutions, Inc. (“Innoveer”), formerly Akibia Consulting, andpreviously a subsidiary of Akibia. We previously engaged Innoveer to performcertain professional services related to an upgrade of our customer resourcemanagement (“CRM”) software system that was completed during fiscal year 2004.We incurred approximately $243,000 related to this upgrade project in the yearended September 30, 2004. We also engage Innoveer to provide professionalservices related to modifications of our CRM software system. During the yearended September 30, 2005, we incurred approximately $14,300 related to theseservices. We had no amounts outstanding to Innoveer at September 30, 2005.

Mr. Frank M. Polestra, one of our formerdirectors, was also a managing director of Ascent Venture Partners. Both Mr. Polestraand Mr. Blaeser are limited partners in one of Ascent Venture Partners’funds, which owns more than 5% of the outstanding capital stock of NetworkIntelligence Corporation. Network Intelligence Corporation has a contract withus to purchase certain of our products. For the years ended September 30, 2005, 2004, and 2003, sales toNetwork Intelligence Corporation were approximately $4,040,000, $3,200,000, and$2,670,000, respectively. At September 30, 2005 and 2004, the Company had$871,000 and $474,000, respectively, of receivables from Network IntelligenceCorporation.

During the year ended September 30,2005 we engaged the consulting services of Mapleworks Technologies (“Mapleworks”),a software development services provider. Both Mr. Blaeser and 

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Mr. Wadsworthare investors in Mapleworks and are members of its board of advisors. For theyear ended September 30, 2005 we incurred $18,000 in fees for theseconsulting services.

**Recent AccountingPronouncements**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) is arevision of Statement of Financial Accounting Standard No. 123, “Accountingfor Stock-Based Compensation”, supersedes Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95,“Statement of Cash Flows”. SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options and stock purchasesunder employee stock purchase plans, to be recognized in the financialstatements based on their fair values. In March 2005, the Securities andExchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB107), which provides the Staff’s views regarding interactions between FAS 123(R) andcertain SEC rules and regulations and provides interpretations of thevaluation of share-based payments for public companies. In April 2005, theSEC adopted a new rule amending the compliance dates for SFAS 123(R). Inaccordance with the new rule, the accounting provisions of SFAS 123(R) areeffective for us in our fiscal year beginning October 1, 2005.

We will adopt SFAS 123(R) using the “modified-prospectivemethod,” which is a method in which compensation cost is recognized beginningwith the effective date (a) based on the requirements of SFAS 123(R) forall share-based payments granted after the effective date and (b) based onthe requirements of Statement No. 123 for all awards granted to employeesprior to the effective date of SFAS 123(R) that remain unvested on theeffective date. We expect to apply the Black-Scholes valuation model indetermining the fair value of share-based payments to employees, which willthen be amortized on a straight-line basis. We expect the adoption to have amaterial impact on our consolidated statements of operations and net loss pershare.

In November 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 151, “Inventory Costs, an amendment of ARBNo. 43, Chapter 4” (SFAS 151). SFAS 151 clarifies that abnormal inventorycosts such as costs of idle facilities, excess freight and handling costs, andwasted materials (spoilage) are required to be recognized as current periodcharges. The provisions of SFAS 151 are effective for the fiscal year beginningOctober 1, 2005. Our early adoption of the provisions of SFAS 151 in theyear ended September 30, 2005, did not affect our consolidated financialposition or results of operations.

**ITEM7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

We do not engage in any foreign currency hedgingtransactions and therefore, do not believe we are subject to material exchangerate risk. We are exposed to market risk related to changes in interest rates.We invest excess cash balances in cash equivalents and short-term investments.We believe that the effect, if any, of reasonably possible near-term changes ininterest rates on our financial position, results of operations and cash flowswill not be material.

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**ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                                                                                                      | ** ** | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| REPORT OF INDEPENDENT  REGISTERED PUBLIC ACCOUNTING FIRM                                                                             |       | 57       |
| CONSOLIDATED BALANCE SHEETS AS OF  SEPTEMBER 30, 2005 AND 2004                                                                       |       | 59       |
| CONSOLIDATED  STATEMENTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 2005, 2004 AND  2003                                        |       | 60       |
| CONSOLIDATED  STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS FOR THE YEARS ENDED  SEPTEMBER 30, 2005, 2004  AND 2003 |       | 61       |
| CONSOLIDATED  STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED SEPTEMBER 30, 2005, 2004 AND  2003                                        |       | 63       |
| NOTES TO  CONSOLIDATED FINANCIAL STATEMENTS                                                                                          |       | 64       |

 

56

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholdersof Network Engines, Inc.:

We have completed anintegrated audit of Network Engines, Inc.’s 2005 consolidated financialstatements and of its internal control over financial reporting as of September 30,2005 and audits of its 2004 and 2003 consolidated financial statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Our opinions, based onour audits, are presented below.

*Consolidated financial statements and financial statementschedule*

In our opinion, the consolidated financial statements listed inthe index appearing under Item 15 (a)(1) presentfairly, in all material respects, the financial position of Network Engines, Inc.and its subsidiaries at September 30, 2005 and September 30, 2004,and the results of their operations and their cash flows for each of the threeyears in the period ended September 30, 2005 in conformity with accountingprinciples generally accepted in the United States of America. In addition, in our opinion, the financialstatement schedule listed in the index appearing under Item 15(a)(2) presentsfairly, in all material respects, the information set forth therein when readin conjunction with the related consolidated financial statements. Thesefinancial statements and financial statement schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements and financial statement schedule based on our audits. Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An audit offinancial statements includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Annual Report on Internal Control Over FinancialReporting appearing under Item 9A, that the Company maintained effectiveinternal control over financial reporting as of September 30, 2005 basedon criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of September 30,2005, based on criteria established in *Internal Control—IntegratedFramework* issued by the COSO. The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express opinions on management’s assessmentand on the effectiveness of the Company’s internal control over financialreporting based on our audit. We conducted our audit of internal control overfinancial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

57

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A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.
| /s/ PricewaterhouseCoopers  LLP |   |
|--------------------------------------|--------|
| Boston,  Massachusetts               |   |
| December 14,  2005              |   |

 

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**NETWORK ENGINES,INC.**

**CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share and per share data)**

| ** **                                                                                                                                                                                                   | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                                                                   |       |                   |       |   |   |
| **Current assets:**                                                                                                                                                                                          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Cash and cash equivalents                                                                                                                                                                                    |       | $                      | 9,468      |   | $ | 12,974 |   |
| Short-term investments                                                                                                                                                                                       |       | 27,894                 |       | 26,614 |   |
| Restricted cash                                                                                                                                                                                              |       | 47                     |       | 47 |   |
| Accounts receivable, net of allowances of $76 and  $442 at September 30, 2005 and 2004, respectively                                                                                                    |       | 10,442                 |       | 13,222 |   |
| Inventories                                                                                                                                                                                                  |       | 9,227                  |       | 14,342 |   |
| Prepaid expenses and other current assets                                                                                                                                                                    |       | 905                    |       | 1,257 |   |
| Total current assets                                                                                                                                                                                         |       | 57,983                 |       | 68,456 |   |
| Property and  equipment, net                                                                                                                                                                                 |       | 1,699                  |       | 1,623 |   |
| Goodwill                                                                                                                                                                                                     |       | —                 |       | 7,769 |   |
| Other assets                                                                                                                                                                                                 |       | 122                    |       | 173 |   |
| Total assets                                                                                                                                                                                                 |       | $                      | 59,804     |   | $ | 78,021 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Current liabilities:**                                                                                                                                                                                     | ** ** | ** **             | ** ** | ** ** | ** ** |
| Accounts payable                                                                                                                                                                                             |       | $                      | 5,645      |   | $ | 9,312 |   |
| Accrued compensation and other related benefits                                                                                                                                                              |       | 1,276                  |       | 1,248 |   |
| Other accrued expenses                                                                                                                                                                                       |       | 1,669                  |       | 2,295 |   |
| Current portion of capital lease obligation                                                                                                                                                                  |       | 18                     |       | — |   |
| Deferred revenue                                                                                                                                                                                             |       | 891                    |       | 493 |   |
| Total current liabilities                                                                                                                                                                                    |       | 9,499                  |       | 13,348 |   |
| Long-term portion  of capital lease obligation                                                                                                                                                               |       | 79                     |       | — |   |
| Deferred revenue                                                                                                                                                                                             |       | 365                    |       | — |   |
| Commitments and  contingencies (Note 8 and 13)                                                                                                                                                               |       |                   |       |   |   |
| **Stockholders’  equity:**                                                                                                                                                                              | ** ** | ** **             | ** ** | ** ** | ** ** |
| Preferred stock, $.01 par value, 5,000,000  authorized, and no shares issued and outstanding                                                                                                                 | ** ** | —                 | ** ** | — | ** ** |
| Common stock, $.01 par value, 100,000,000 shares  authorized; 40,341,890 and 39,678,844 shares issued; 37,780,032 and  37,116,986 shares outstanding at September 30, 2005 and 2004,  respectively |       | 403                    |       | 397 |   |
| Additional paid-in capital                                                                                                                                                                                   |       | 178,446                |       | 177,688 |   |
| Accumulated deficit                                                                                                                                                                                          |       | (126,150               | )          | (110,567 | ) |
| Deferred stock compensation                                                                                                                                                                                  |       | —                 |       | (7 | ) |
| Treasury stock, at cost, 2,561,858 shares at  September 30, 2005 and 2004, respectively                                                                                                                 |       | (2,838                 | )          | (2,838 | ) |
| Total stockholders’ equity                                                                                                                                                                              |       | 49,861                 |       | 64,673 |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                             |       | $                      | 59,804     |   | $ | 78,021 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

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**NETWORK ENGINES, INC.CONSOLIDATED STATEMENTSOF OPERATIONS(in thousands, except per share data)**

| ** **                                                                                                                                                 | ** ** | **Year ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                 | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenues                                                                                                                                               |       | $                                           | 98,071     |   | $ | 136,755 |   | $ | 81,243 |   |
| Cost of revenues                                                                                                                                           |       | 81,010                                      |       | 112,847 |   | 64,506 |   |
| Gross profit                                                                                                                                               |       | 17,061                                      |       | 23,908 |   | 16,737 |   |
| Operating expenses:                                                                                                                                        |       |                                        |       |   |   |   |   |
| Research and development (excluding stock  compensation of $0, $18, and $46 for the years ended September 30, 2005,  2004 and 2003, respectively)     |       | 7,504                                       |       | 6,156 |   | 4,114 |   |
| Selling and marketing (excluding stock compensation  of $7, $65, and $151, for the years ended September 30, 2005, 2004 and  2003, respectively)      |       | 9,848                                       |       | 8,637 |   | 6,519 |   |
| General and administrative (excluding stock  compensation of $7, $307, and $731 for the years ended September 30,  2005, 2004 and 2003, respectively) |       | 7,838                                       |       | 6,430 |   | 5,856 |   |
| Stock compensation                                                                                                                                         |       | 14                                          |       | 390 |   | 928 |   |
| Restructuring and other charges (credits)                                                                                                                  |       | 366                                         |       | (107 | ) | 507 |   |
| Impairment of intangible and long-lived assets                                                                                                             |       | 298                                         |       | 4,013 |   | — |   |
| Impairment of goodwill                                                                                                                                     |       | 7,769                                       |       | — |   | — |   |
| Amortization of intangible assets                                                                                                                          |       | —                                      |       | 297 |   | 762 |   |
| Total operating  expenses                                                                                                                                  |       | 33,637                                      |       | 25,816 |   | 18,686 |   |
| Loss from operations                                                                                                                                       |       | (16,576                                     | )          | (1,908 | ) | (1,949 | ) |
| Interest income                                                                                                                                            |       | 993                                         |       | 333 |   | 564 |   |
| Loss  before income taxes                                                                                                                                  |       | (15,583                                     | )          | (1,575 | ) | (1,385 | ) |
| Provision for income taxes                                                                                                                                 |       | —                                      |       | 44 |   | — |   |
| Net loss                                                                                                                                                   |       | $                                           | (15,583    | ) | $ | (1,619 | ) | $ | (1,385 | ) |
| Net loss per  share—basic and diluted                                                                                                                 |       | $                                           | (0.42      | ) | $ | (0.04 | ) | $ | (0.04 | ) |
| Shares used in computing  basic and diluted net loss per share                                                                                             |       | 37,461                                      |       | 36,594 |   | 33,142 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

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**NETWORKENGINES, INC. CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS(in thousands, except share data)**

| ** **                                                                                                                 | ** ** | **Shares of Common  Stock** | ** ** | **Common  Stock**    | ** ** | **Additional  Paid-in**  | ** ** | **Accumulated** | ** ** | **Notes  Receivable  from** | ** ** | **Deferred  Stock** | ** **     | **Treasury**     | ** ** | **Accumulated  Other  Comprehensive** | ** **      | **Total  Stockholders’** | ** ** | **Comprehensive** | ** **                            |
|----------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|----------------------|------------|--------------------------|------------|-----------------|------------|-----------------------------|------------|---------------------|----------------|------------------|------------|---------------------------------------|-----------------|-------------------------------|------------|-------------------|---------------------------------------|
| ** **                                                                                                                 | ** ** | **Issued**                            | ** ** | **In Treasury** | ** ** | ** Par value** | ** ** | **Capital**     | ** ** | **Deficit**                 | ** ** | **Stockholders**    | ** **     | **Compensation** | ** ** | **Stock**                             | ** **      | **Income**                    | ** ** | **Equity**        | ** **                            | **Loss** | ** ** |
| Balance, September 30, 2002                                                                                           |       | 35,679,075                            |       |                 | (4,898,103 | )                        |       |            | $ 357 |                        |       |                | $ 174,252 |             |       |                                  | $ (107,563 | )                             |       |              | $ (281                           | ) |   |   | $ (1,185 | ) |   |   | $ (4,707 | ) |   |   | $ 3 |   |   |   | $ 60,876 |   |   |   |   |   |   |
| Issuance of common stock upon stock option exercises                                                                       |       | 1,345,756                             |       |                 |       |                     |       |            | 13         |                        |       |                | 747            |             |       |                                  |            |                          |       |              |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 760 |   |   |   |   |   |   |
| Issuance of common stock under employee stock  purchase plan                                                               |       | 169,876                               |       |                 |       |                     |       |            | 2          |                        |       |                | 141            |             |       |                                  |            |                          |       |              |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 143 |   |   |   |   |   |   |
| Issuance of common stock upon cashless warrant  exercises                                                                  |       | 988,451                               |       |                 |       |                     |       |            | 10         |                        |       |                | (10            | )                |       |                                  |            |                          |       |              |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Purchase of treasury stock                                                                                                 |       |                                  |       |                 | (308,000   | )                        |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |                                  |   |   |   |   |   |   |   | (312 | ) |   |   |   |   |   |   | (312 | ) |   |   |   |   |   |
| Cash collection of stockholder notes receivable                                                                            |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              | 4                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 4 |   |   |   |   |   |   |
| Conversion of restricted cash into amounts  outstanding under guarantee agreement                                          |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              | (969                                  | ) |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (969 | ) |   |   |   |   |   |
| Collection of amounts outstanding under guarantee  agreement                                                               |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              | 456                                   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 456 |   |   |   |   |   |   |
| Collection of stockholder notes receivable and  amounts outstanding under guarantee agreement in exchange for common stock |       |                                  |       |                 | (686,798   | )                        |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              | 1,031                                 |   |   |   |   |   |   |   | (1,031 | ) |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Interest on notes receivable from stockholders                                                                             |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              | (13                                   | ) |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (13 | ) |   |   |   |   |   |
| Reversal of reserve against notes receivable from  stockholders                                                            |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              | (228                                  | ) |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (228 | ) |   |   |   |   |   |
| Acquisition of TidalWire Inc.                                                                                              |       |                                  |       |                 | 3,331,043  |                     |       |            |       |                        |       |                | 1,003          |             |       |                                  |            |                          |       |              |                                  |   |   |   | (304 | ) |   |   | 3,212 |   |   |   |   |   |   |   | 3,911 |   |   |   |   |   |   |
| Amortization of deferred stock compensation to  expense                                                                    |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |                                  |   |   |   | 984 |   |   |   |   |   |   |   |   |   |   |   | 984 |   |   |   |   |   |   |
| Reversal of deferred compensation related to  cancellation of stock options                                                |       |                                  |       |                 |       |                     |       |            |       |                        |       |                | (72            | )                |       |                                  |            |                          |       |              |                                  |   |   |   | 72 |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Realized gain on short-term investments                                                                                    |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |                                  |   |   |   |   |   |   |   |   |   |   |   | (3 | ) |   |   | (3 | ) |   |   | $       (3 | ) |   |
| Net loss                                                                                                                   |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  | (1,385          | )                             |       |              |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (1,385 | ) |   |   | (1,385 | ) |   |
|                                                                                                                       |       |                                  |       |                 |       |                     |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | $ (1,388 | ) |   |
| Balance,  September 30, 2003                                                                                          |       | 38,183,158                            |       |                 | (2,561,858 | )                        |       |            | $ 382 |                        |       |                | $ 176,061 |             |       |                                  | $ (108,948 | )                             |       |              | $     — |   |   |   | $  (433 | ) |   |   | $ (2,838 | ) |   |   | $ — |   |   |   | $ 64,224 |   |   |   |   |   |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

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**NETWORK ENGINES,INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS—(Continued)(in thousands, except share data)**

| ** **                                                                              | ** ** | **Shares of Common  Stock** | ** ** | **Common  Stock**    | ** ** | **Additional  Paid-in** | ** ** | **Accumulated** | ** ** | **Notes  Receivable  from** | ** ** | **Deferred  Stock** | ** **     | **Treasury**     | ** ** | **Accumulated  Other  Comprehensive** | ** **      | **Total  Stockholders’** | ** ** | **Comprehensive** | ** **    |
|-----------------------------------------------------------------------------------------|------------|---------------------------------------|------------|----------------------|------------|-------------------------|------------|-----------------|------------|-----------------------------|------------|---------------------|----------------|------------------|------------|---------------------------------------|-----------------|-------------------------------|------------|-------------------|---------------|
| ** **                                                                              | ** ** | **Issued**                            | ** ** | **In Treasury** | ** ** | **Par value**      | ** ** | **Capital**     | ** ** | **Deficit**                 | ** ** | **Stockholders**    | ** **     | **Compensation** | ** ** | **Stock**                             | ** **      | **Income**                    | ** ** | **Equity**        | ** **    | **Loss** | ** ** |
| Balance, September 30, 2003                                                        |       | 38,183,158                            |       |                 | (2,561,858 | )                       |       |            | $ 382 |                        |       |                | $ 176,061 |             |       |                                  | $ (108,948 | )                             |       |              | $ — |   |   |   | $ (433 | ) |   |   | $ (2,838 | ) |   |   | $ — |   |   |   | $ 64,224 |   |   |   |   |   |   |
| Issuance of common stock upon stock option exercises                                    |       | 720,991                               |       |                 |       |                    |       |            | 7          |                        |       |                | 701            |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 708 |   |   |   |   |   |   |
| Issuance of common stock under employee stock  purchase plan                            |       | 250,070                               |       |                 |       |                    |       |            | 3          |                        |       |                | 511            |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 514 |   |   |   |   |   |   |
| Issuance of common stock upon cashless warrant  exercises                               |       | 524,625                               |       |                 |       |                    |       |            | 5          |                        |       |                | (5             | )                |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Amortization of deferred stock compensation to  expense                                 |       |                                  |       |                 |       |                    |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |          |   |   |   | 423 |   |   |   |   |   |   |   |   |   |   |   | 423 |   |   |   |   |   |   |
| Stock compensation related to grants of stock options  to non-employee             |       |                                  |       |                 |       |                    |       |            |       |                        |       |                | 8              |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 8 |   |   |   |   |   |   |
| Reversal of deferred compensation related to  cancellation of stock options        |       |                                  |       |                 |       |                    |       |            |       |                        |       |                | (3             | )                |       |                                  |            |                          |       |              |          |   |   |   | 3 |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   |   |   |   |
| Cash received from settlement of litigation                                             |       |                                  |       |                 |       |                    |       |            |       |                        |       |                | 415            |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 415 |   |   |   |   |   |   |
| Net loss                                                                                |       |                                  |       |                 |       |                    |       |            |       |                        |       |                |           |             |       |                                  | (1,619          | )                             |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (1,619 | ) |   |   | (1,619 | ) |   |
|                                                                                    |       |                                  |       |                 |       |                    |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (1,619 | ) |   |
| Balance, September 30, 2004                                                        |       | 39,678,844                            |       |                 | (2,561,858 | )                       |       |            | 397        |                        |       |                | 177,688        |             |       |                                  | (110,567        | )                             |       |              | —        |   |   |   | (7 | ) |   |   | (2,838 | ) |   |   | — |   |   |   | 64,673 |   |   |   |   |   |   |
| Issuance of common stock upon stock option exercises                                    |       | 404,145                               |       |                 |       |                    |       |            | 4          |                        |       |                | 343            |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 347 |   |   |   |   |   |   |
| Issuance of common stock under employee stock  purchase plan                            |       | 258,901                               |       |                 |       |                    |       |            | 2          |                        |       |                | 364            |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 366 |   |   |   |   |   |   |
| Amortization of deferred stock compensation to  expense                                 |       |                                  |       |                 |       |                    |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |          |   |   |   | 7 |   |   |   |   |   |   |   |   |   |   |   | 7 |   |   |   |   |   |   |
| Stock compensation related to grants of stock options  to non-employee             |       |                                  |       |                 |       |                    |       |            |       |                        |       |                | 7              |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 7 |   |   |   |   |   |   |
| Tax  benefit relating to incentive stock option and employee stock purchase  plans |       |                                  |       |                 |       |                    |       |            |       |                        |       |                | 44             |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 44 |   |   |   |   |   |   |
| Net loss                                                                                |       |                                  |       |                 |       |                    |       |            |       |                        |       |                |           |             |       |                                  | (15,583         | )                             |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (15,583 | ) |   |   | $ (15,583 | ) |   |
|                                                                                    |       |                                  |       |                 |       |                    |       |            |       |                        |       |                |           |             |       |                                  |            |                          |       |              |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | $ (15,583 | ) |   |
| Balance,  September 30, 2005                                                       |       | 40,341,890                            |       |                 | (2,561,858 | )                       |       |            | $ 403 |                        |       |                | $ 178,446 |             |       |                                  | $ (126,150 | )                             |       |              | $ — |   |   |   | $   — |   |   |   | $ (2,838 | ) |   |   | $ — |   |   |   | $ 49,861 |   |   |   |   |   |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

62

 

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**NETWORK ENGINES,INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

| ** **                                                                                             | ** ** | **Year Ended September 30,** | ** **    |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|---------------|
| ** **                                                                                             | ** ** | **2005**                                    | ** **    | **2004** | ** ** | **2003** | ** ** |
| Cash flows from operating  activities:                                                                 |       |                                        |          |   |   |   |   |
| Net loss                                                                                               |       | $                                           | (15,583  | ) | $ | (1,619  | ) | $ | (1,385  | ) |
| Adjustments  to reconcile net loss to net cash (used in) provided by operating activities:             |       |                                        |          |   |   |   |   |
| Depreciation and amortization                                                                          |       | 1,163                                       |          | 1,548 |   | 2,379 |   |
| Provision for doubtful accounts                                                                        |       | (4                                          | )             | 31 |   | 166 |   |
| Impairment of intangible and long-lived assets                                                         |       | 313                                         |          | 4,013 |   | — |   |
| Impairment of goodwill                                                                                 |       | 7,769                                       |          | — |   | — |   |
| Accrued income on short-term investments                                                               |       | —                                      |          | (13 | ) | — |   |
| Stock compensation                                                                                     |       | 14                                          |          | 431 |   | 984 |   |
| Non-cash portion of restructuring and other charges  (credits)                                         |       | —                                      |          | (107 | ) | — |   |
| Reversal of reserve for stockholder notes receivable                                                   |       | —                                      |          | — |   | (228 | ) |
| Provision for uncollectible sub-tenant receivables                                                     |       | —                                      |          | — |   | 138 |   |
| Interest on notes receivable from stockholders                                                         |       | —                                      |          | — |   | (13 | ) |
| Changes  in operating assets and liabilities, net of effects of acquisitions:                          |       |                                        |          |   |   |   |   |
| Accounts receivable                                                                                    |       | 2,784                                       |          | 695 |   | (5,325 | ) |
| Inventories                                                                                            |       | 5,115                                       |          | 595 |   | (10,117 | ) |
| Prepaid expenses and other current assets                                                              |       | 352                                         |          | 689 |   | (778 | ) |
| Accounts payable                                                                                       |       | (3,667                                      | )             | (4,552 | ) | 8,103 |   |
| Accrued expenses                                                                                       |       | (554                                        | )             | 626 |   | 178 |   |
| Deferred revenue                                                                                       |       | 763                                         |          | (110 | ) | 548 |   |
| Net cash (used in) provided by operating activities                                                    |       | (1,535                                      | )             | 2,227 |   | (5,350 | ) |
| Cash  flows from investing activities:                                                                 |       |                                        |          |   |   |   |   |
| Purchases of property and equipment                                                                    |       | (1,451                                      | )             | (1,025 | ) | (782 | ) |
| Purchases of short-term investments                                                                    |       | (48,581                                     | )             | (28,290 | ) | (48,032 | ) |
| Sales of short-term investments                                                                        |       | 47,301                                      |          | 29,250 |   | 70,313 |   |
| Changes in other assets                                                                                |       | 51                                          |          | (52 | ) | (64 | ) |
| Refunds and repayments of restricted cash                                                              |       | —                                      |          | — |   | 83 |   |
| Acquisition, net of cash acquired                                                                      |       | —                                      |          | — |   | (11,101 | ) |
| Payments of transaction costs                                                                          |       | —                                      |          | — |   | (2,133 | ) |
| Net cash (used in) provided by investing activities                                                    |       | (2,680                                      | )             | (117 | ) | 8,284 |   |
| Cash  flows from financing activities:                                                                 |       |                                        |          |   |   |   |   |
| Proceeds from issuance of common stock                                                                 |       | 713                                         |          | 1,222 |   | 903 |   |
| Payments on capital lease obligations and notes  payable                                               |       | (4                                          | )             | — |   | (14 | ) |
| Proceeds from settlement of litigation                                                                 |       | —                                      |          | 415 |   | — |   |
| Collection of notes receivable from stockholders and  collections under guarantee agreement            |       | —                                      |          | — |   | 460 |   |
| Acquisition of treasury stock                                                                          |       | —                                      |          | — |   | (312 | ) |
| Net cash provided by financing activities                                                              |       | 709                                         |          | 1,637 |   | 1,037 |   |
| Net increase (decrease) in cash and cash equivalents                                                   |       | (3,506                                      | )             | 3,747 |   | 3,971 |   |
| Cash and cash equivalents, beginning of year                                                           |       | 12,974                                      |          | 9,227 |   | 5,256 |   |
| Cash and cash equivalents, end of year                                                                 |       | $                                           | 9,468    |   | $ | 12,974  |   | $ | 9,227  |   |
| Supplemental  disclosure of non-cash investing or financing activities:                                |       |                                        |          |   |   |   |   |
| Acquisition of equipment under capital lease  obligation                                               |       | $                                           | 101      |   | $ | —  |   | $ | —  |   |
| Repurchase of common stock through cancellation of  notes receivable from stockholders                 |       | $                                           | —   |   | $ | —  |   | $ | 1,031  |   |
| Conversion of restricted cash into amounts owed by  stockholder under guarantee agreement              |       | $                                           | —   |   | $ | —  |   | $ | 969  |   |
| Repurchase of common stock in exchange for amounts  owed by stockholder under guarantee agreement |       | $                                           | —   |   | $ | —  |   | $ | 518  |   |
| Issuance of common stock upon cashless stock warrant  exercises                                        |       | $                                           | —   |   | $ | 202  |   | $ | 346  |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1. NATURE OF BUSINESS**

Network Engines, Inc. (“Network Engines” or the “Company”)develops and manufactures server appliance solutions that deliver data storageand network security applications on server appliances. Server appliances arepre-configured network infrastructure devices designed to optimally deliverspecific software application functionality and facilitate ease of deploymentand support of a software application in a customer’s network. The Company isorganized into two reportable segments: OEM Appliance and Distribution.

In its OEM Appliance segment, the Company develops andmanufactures server appliance solutions that enable network equipment providersand independent software vendors, or ISVs, to deliver their data storage andnetwork security applications in the form of a server appliance. The Companyoffers its server appliance partners a comprehensive suite of services,including development, manufacturing, fulfillment and post-sale support. TheCompany produces and fulfills devices branded for its network equipment and ISVpartners, and derives its revenues from the sale of value-added hardwareplatforms to these partners. These partners subsequently sell and support thedevice under their own brands to their customer base.

Currently in its Distribution segment, the Companydevelops, manufactures, sells and markets server appliances under its own brandthat are based on Microsoft’s Internet Security and Acceleration (ISA) Server2004. The Company licenses and integrates this software with server applianceplatforms and its proprietary software to sell its own branded serverappliances primarily to Microsoft-certified value added resellers and systemintegrators.

Previously in itsDistribution segment the Company also distributed third-party data storagenetworking connectivity products for the leading Fibre Channel host busadapter, or HBA, and storage switch manufacturers in the data storage industryto a customer base of value-added resellers, and systems integrators. In earlyfiscal 2005, the Company decided to discontinue selling third-party datastorage networking products after a review of that portion of the business andits future prospects. Sales of these third-party data storage networkingproducts ceased by December 31, 2004. Substantially all of the revenueduring fiscal 2005 associated with the Company’s Distribution segment wasderived from the sale of third-party data storage networking products.

**2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

*Basis of Presentation*

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All significant intercompany transactions andbalances have been eliminated.

*Use of Estimates*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosures of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during the period. Actualresults could differ from those estimates.

64

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)**

*Reclassifications*

Certainpreviously reported amounts have been reclassified to conform to the currentperiod presentation. The Company reclassified certain auction rate securitiesfrom cash and cash equivalents to short-term investments for prior periods.These reclassifications had no impact on the results of the operations of theCompany. The following table summarizes the balances as previously reported andas reclassified as of the period ending dates (in thousands):

| ** **               | ** ** | **As Reported**                     | ** ** | **As Reclassified**                 | ** ** |
|--------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **               | ** ** | **Cash and Cash  Equivalents** | ** ** | **Cash and Cash  Equivalents** | ** ** | **Short-term  Investments** | ** ** |
| September 30,  2004 |       |                                     | 37,093     |                                     |       |   | 12,974 |   |   |   | 26,614 |   |   |
| September 30, 2003  |       |                                     | 36,788     |                                     |       |   | 9,227 |   |   |   | 27,561 |   |   |

 

*Cash, CashEquivalents, Short-term Investments and Restricted Cash*

Cash equivalents consistsprincipally of money market funds, commercial paper, and other marketablesecurities purchased with an original maturity of three months or less. Theseinvestments are carried at cost, which approximates market value. The Companyalso invests excess cash in auction rate securities. These securities havelong-term underlying maturities, however the market is highly liquid and theinterest rates reset every 7, 28 or 35 days. The Company’s intent is not tohold these securities to maturity, but rather to use the interest rate resetfeature to sell securities to provide liquidity as needed. The Company’sshort-term investments are classified as available for sale and are carried atfair value, with unrealized gains and losses included in other comprehensiveincome or loss, which is a separate component of stockholders’ equity, untilrealized. At September 30, 2005, and 2004 there were no unrealized gainsor losses. At September 30, 2005 and 2004, $47,000 of cash was restrictedand pledged as collateral on the Company’s facilities.

*Concentrations ofRisk*

*Credit.*

Financial instruments thatpotentially subject the Company to concentrations of credit risk consistprincipally of cash, cash equivalents, restricted cash, short-term investmentsand trade receivables. The Company invests primarily in municipal bonds, moneymarket funds of major financial institutions as well as government agencysecurities. There are no significant concentrations in any one issuer ofsecurities. The Company provides credit to customers in the normal course ofbusiness and does not require collateral from its customers, but routinelyassesses their financial strength. The Company maintains reserves for potentialcredit losses and such losses have been within management’s expectations.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

*Customers.*

Thefollowing table summarizes those customers who accounted for greater than 10%of the Company’s net revenues or accounts receivable:

| ** ** | ** ** | **Net Revenues for the year ended  September 30,** | ** ** | **Accounts Receivable at  September 30,** | ** ** |
|------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** ** | ** ** | **   2005    **                               | ** ** | **    2004    ** | ** ** | **    2003    ** | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
| Customer A |       |                                                                             | 79         | %                                                        |       |   | 49 | % |   |   | 47 | % |   |   | 67 | % |   |   | 38 | % |   |
|            |            |                                                                                  |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Fair Value of Financial Instruments*

Financial instruments,including cash, cash equivalents, restricted cash, short-term investments,accounts receivable, and accounts payable, are carried in the financialstatements at amounts that approximate their fair value as of September 30,2005 and 2004.

*Inventories*

Inventories are valued atthe lower of cost or market, with cost determined using the first-in, first-outmethod. The Company regularly reviews inventory quantities on hand and recordsa write-down for excess and obsolete inventory based primarily on our estimatedforecast of product demand and anticipated production requirements in the nearfuture.

*Property andEquipment*

Property and equipment arerecorded at cost and depreciated using the straight-line method over theirestimated useful lives. Leasehold improvements are amortized over the shorterof the useful life of the improvement or the remaining term of the lease. Uponretirement or sale, the cost of the assets disposed of and the relatedaccumulated depreciation are removed from the accounts and any resulting gainor loss is included in the determination of net income or loss. Repairs andmaintenance are charged to expense as incurred.

*Intangible Assetsand Goodwill*

Intangible assets that resulted from the Company’s December 2002acquisition of TidalWire Inc. consisted of customer relationships (see Note 3).During the years ended September 30, 2004 and 2003, these assets wereamortized on a straight-line basis over their estimated useful lives of fiveyears.

Goodwill is the amount bywhich the cost of acquired net assets exceeded the fair value of those netassets on the date of acquisition. In July 2001, the FASB issued Statementof Financial Accounting Standard No. 142, “Goodwill and Other IntangibleAssets” (SFAS 142). As a result, goodwill is no longer amortized but tested forimpairment under a two-step process. Under the first step, an entity’s netassets are broken down into reporting units and compared to their fair value.If the carrying amount of a reporting unit exceeds its fair value, the secondstep of the goodwill impairment test is performed to measure the amount ofimpairment loss, if any. The second step compares the implied fair value of areporting unit’s goodwill with the carrying amount of that goodwill. If thecarrying amount of a reporting unit’s goodwill exceeds the implied fair valueof that goodwill, an impairment loss is recognized in an amount equal to thatexcess. Fair value is calculated as the present value of estimated future cashflows 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

using arisk-adjusted discount rate, which requires significant management judgmentwith respect to revenue and expense growth rates and the selection and use ofan appropriate discount rate. The Company tests goodwill during the fourthquarter of each year for impairment, or more frequently if certain indicatorsare present or changes in circumstances suggest that impairment may exist. Duringthe year ended September 30, 2005, the Company recorded an impairmentcharge of $7,769,000 related to goodwill (see Note 4).

*Impairment of Long-lived Assets*

Statement of FinancialAccounting Standard No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets” (SFAS 144), requires impairment losses to be recorded onlong-lived assets used in operations when indicators of impairment are presentand the undiscounted cash flows estimated to be generated by those assets areless than the assets’ carrying amount. If such asset is considered to beimpaired, the impairment to be recognized is the amount by which the carryingamount of the asset, if any, exceeds its fair value determined using adiscounted cash flow model.

*Revenue Recognition*

Revenues from products are generally recognized upondelivery to customers if persuasive evidence of an arrangement exists, the feeis fixed or determinable, collectibility is reasonably assured and title andrisk of loss have passed to the customer. In the event the Company hasunfulfilled future obligations, revenue and related costs are deferred untilthose future obligations are met. The Company has an inventory consignmentagreement with its largest customer related to certain server appliances soldthrough its OEM Appliance segment. This customer notifies the Company when itutilizes inventory and the Company recognizes revenues from sales to thiscustomer based upon these notifications.

Maintenance revenues are derived from customer supportagreements generally entered into in connection with the initial serverappliance sales and subsequent renewals. Maintenance fees are typically for oneto three year renewable periods and include the right to unspecified softwareupdates when-and-if-available, hardware repairs, 24-hour customersupport, and advanced replacement of server appliances. Maintenance revenuesare recognized ratably over the term of the maintenance period. Payments formaintenance fees are generally made in advance and are included in deferredrevenue.

Contracts and/or customer purchase orders aregenerally used to determine the existence of an arrangement. Shipping documentsand consignment usage notifications are used to verify shipment or transfer ofownership, as applicable. The Company assesses whether the sales price is fixedor determinable based on the payment terms associated with the transaction andwhether the sales price is subject to refund or adjustment. Collectibility isassessed based primarily on the creditworthiness of the customer as determinedby credit checks and analysis, as well as the customer’s payment history.

For revenue arrangements that contain multipleelements, such as the sale of both the product and maintenance, in whichsoftware is not incidental to the product, such as sales of server appliancesthrough the Company’s Distribution segment, fair value of the undeliveredelement is determined based upon vendor specific objective evidence, which istypically established through contractual post-sales support renewal rateswhereby the residual fair value is allocated to the server appliance. Forrevenue arrangements that contain multiple elements, in which software is notincluded or is incidental to the product, such as sales of server appliancesthrough the Company’s OEM Appliance segment, fair value is 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

determined based onobjective and reliable evidence of fair value, which is typically determinedthrough contractual refund rates for cancellations, stand-alone sales ofmaintenance whereby the residual fair value is allocated to the serverappliance.

The Company recognizesrevenue when the revenue recognition criteria for each element of the sale aremet. If the fair value of the element of the sale (maintenance) is unable to bederived, all revenues from the arrangement are deferred and recognized ratablyover the period of the support arrangement, which is typically one to threeyears. The Company includes shipping and handling costs, if any, reimbursed byits customers as net revenues and cost of revenues.

*Product Warranties*

The Company offers awarranty on all products in its OEM Appliance segment, which generally providesfor repair or replacement of any defective products for a period of up to 36months after shipment. Based upon historical experience and expectation offuture conditions, the Company accrues for the estimated costs to fulfillcustomer warranty obligations upon the recognition of the related revenue.

*Advertising Costs*

Advertising costs areexpensed as incurred. Advertising expenses for the year ended September 30,2005 were $965,000, and were not material for the years ended September 30,2004, and 2003.

*Research andDevelopment*

Research and developmentcosts, except for certain software development costs, are expensed as incurred.Related to software to be sold or licensed to customers, software developmentcosts incurred after technological feasibility has been achieved and until theproducts are available for general release are capitalized and upon generalrelease are amortized as the greater of the ratio of current revenues to totalexpected revenues from the product or the straight-line method over theremaining estimated economic life of the product. Costs of internally developedsoftware qualifying for capitalization have not been material to date.

*Accounting forStock-Based Compensation*

Stock options and restricted stock issued to employeesand members of the Company’s board of directors are accounted for in accordancewith Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees,” and related interpretations (“APB 25”). Accordingly,compensation expense is recorded for options and restricted stock awarded toemployees and directors to the extent that the exercise or purchase prices areless than the common stock’s fair market value on the date of grant, where thenumber of shares and exercise or purchase price are fixed. The differencebetween the fair value of the Company’s common stock and the exercise orpurchase price of the stock option or restricted stock award is recorded asdeferred stock compensation.

Deferred stockcompensation is amortized to compensation expense over the vesting period ofthe underlying stock option or restricted stock. Upon cancellation of optionswith residual deferred compensation balances at the date of cancellation, theremaining amount of unrecognized deferred compensation is reversed as anadjustment to additional paid-in capital. The Company follows the 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

disclosure requirements ofStatement of Financial Accounting Standards No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”), as amended by SFAS 148 “Accounting forStock-Based Compensation—Transition and Disclosure”. Stock-based awards tonon-employees are accounted for at their fair value in accordance with SFAS123.

During the yearended September 30, 2000, the Company recorded deferred stock compensationof approximately $13,916,000 for restricted stock and stock options granted atprices deemed to be below fair market value for financial reporting purposes.During the year ended September 30, 2001, the Company recorded deferredstock compensation $6,351,000 associated with the Company’s acquisition of IPPerformance, Inc. During the year ended September 30, 2003, theCompany recorded deferred stock compensation of $304,000 associated with theCompany’s acquisition of TidalWire, Inc. The Company recognized stockcompensation expense of approximately $14,000, $431,000, and $984,000 for theyears ended September 30, 2005, 2004 and 2003, respectively. During theyears ended September 30, 2004 and 2003, the Company reversedapproximately $3,000, and $72,000, respectively, of deferred stock compensationdue to the cancellation of unvested options held by terminated employees.

Thefollowing table illustrates the effect on net loss and net loss per share as ifthe Company had applied the fair value recognition provisions of SFAS 123, tostock-based employee awards:

| ** **                                                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net loss—as  reported                                                |       | $        | (15,583    | )        | $          | (1,619   | )          | $ | (1,385 | ) |
| Add: Stock-based employee compensation expense  included in net loss |       | 7        |       | 423      |       | 984      |       |
| Deduct: Total stock-based employee compensation  expense                  |       | (3,076   | )          | (3,700   | )          | (2,753   | )          |
| Net loss—pro  forma                                                  |       | $        | (18,652    | )        | $          | (4,896   | )          | $ | (3,154 | ) |
| Net loss per share:                                                       |       |     |       |     |       |     |       |
| Basic and diluted—as reported                                        |       | $        | (0.42      | )        | $          | (0.04    | )          | $ | (0.04 | ) |
| Basic and diluted—pro forma                                          |       | $        | (0.50      | )        | $          | (0.13    | )          | $ | (0.10 | ) |
| *Assumptions used in determination of option fair  value:*                |       |     |       |     |       |     |       |
| Expected term:                                                            |       |     |       |     |       |     |       |
| Stock options                                                             |       | 5 years  |       | 5 years  |       | 5 years  |       |
| Employee stock purchase plan                                              |       | 1 year   |       | 1 year   |       | 1 year   |       |
| Risk free  interest rate:                                                 |       |     |       |     |       |     |       |
| Stock options                                                             |       | 3.73     | %          | 3.23     | %          | 2.77     | %          |
| Employee stock purchase plan                                              |       | 3.13     | %          | 1.18     | %          | 1.34     | %          |
| Volatility                                                                |       | 120      | %          | 135      | %          | 141      | %          |
| Dividend rate                                                             |       | 0        | %          | 0        | %          | 0        | %          |

 

All options granted duringthe years ended September 30, 2005, 2004, and 2003 were granted withexercise prices equal to the fair market value of the Company’s common stock onthe grant date and had weighted average fair values of $1.92, $4.47, and $1.07per share, respectively determined using the Black-Scholes option pricingmodel. As of September 30, 2005, 3,794,145 shares were available for futuregrants under the Plans and the Company had reserved 6,701,268 shares of commonstock for the exercise of outstanding stock options.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES (Continued)**

*Income Taxes*

Deferred tax assets andliabilities are determined based on the difference between the financialstatement and the tax bases of assets and liabilities using enacted tax ratesin effect in the years in which the differences are expected to reverse. Avaluation allowance against deferred tax assets is recorded if, based upon theweight of available evidence, it is more likely than not that some or all ofthe deferred tax assets will not be realized.

*ComprehensiveIncome (Loss)*

Comprehensive income(loss) is comprised of two components, net income (loss) and othercomprehensive income (loss). During the years ended September 30, 2005 and2004, the Company had no items qualifying as other comprehensive income (loss).Accordingly, comprehensive loss equaled net loss. During the year ended September 30,2003, other comprehensive income consisted of realization of previouslyunrealized gains on short-term investments as a result of the sales of theseshort-term investments.

*Net Loss per Share*

Basic net loss per share has been computed by dividingnet loss by the weighted average number of common shares outstanding during theyear. Diluted net loss per share is computed using the weighted average numberof common and dilutive common equivalent shares outstanding during the period. Commonequivalent shares consist of stock options, unvested restricted stock andwarrants to purchase common stock. Because the inclusion of these common stockequivalents would be anti-dilutive for all annual periods presented, dilutednet loss per share is the same as basic net loss per share.

Thefollowing table sets forth the potential common stock excluded from thecalculation of net loss per share because their inclusion would beanti-dilutive (in thousands):

| ** **                         | ** ** | **As of September 30,** | ** ** |
|------------------------------------|------------|----------------------------------------|------------|
| ** **                         | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Options to  purchase common stock  |       | 4,444                                  |       | 4,412 |   | 5,539 |   |
| Warrants to  purchase common stock |       | —                                 |       | — |   | 546 |   |
| Unvested  restricted common stock  |       | —                                 |       | — |   | 65 |   |
|                               |       | 4,444                                  |       | 4,412 |   | 6,150 |   |

 

*Recent AccountingPronouncements*

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) isa revision of FASB Statement No. 123, “Accounting for Stock-BasedCompensation”, supersedes Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees”, and amends FASB Statement No. 95, “Statementof Cash Flows”. SFAS 123(R) requires all share-based payments toemployees, including grants of employee stock options and stock purchases underemployee stock purchase plans, to be recognized in the financial statementsbased on their fair values. In March 2005, the Securities and ExchangeCommission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107), whichprovides the Staff’s views regarding interactions between FAS 123(R) andcertain SEC 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

rules and regulationsand provides interpretations of the valuation of share-based payments forpublic companies. In April 2005, the SEC adopted a new rule amendingthe compliance dates for SFAS 123(R).

In accordance with the new rule, the accountingprovisions of SFAS 123(R) will be effective for the Company for the fiscalyear beginning October 1, 2005.

The Company will adopt SFAS 123(R) using the “modified-prospectivemethod,” which is a method in which compensation cost is recognized beginningwith the effective date (a) based on the requirements of SFAS 123(R) forall share-based payments granted after the effective date and (b) based onthe requirements of Statement No. 123 for all awards granted to employeesprior to the effective date of SFAS 123(R) that remain unvested onthe effective date. The Company expects to apply the Black-Scholes valuationmodel in determining the fair value of share-based payments to employees, whichwill then be amortized on a straight-line basis. The Company expects the adoptionto have a material impact on its consolidated statements of operations and netloss per share.

In November 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 151, “Inventory Costs, an amendment of ARBNo. 43, Chapter 4” (SFAS 151). SFAS 151 clarifies that abnormal inventorycosts such as costs of idle facilities, excess freight and handling costs, andwasted materials (spoilage) are required to be recognized as current periodcharges. The provisions of SFAS 151 are effective for the fiscal year beginningOctober 1, 2005. The Company’s early adoption of the provisions of SFAS151 during the year ended September 30, 2005 did not affect the Company’sconsolidated financial position or results of operations.

**3. BUSINESS COMBINATIONS**

*TidalWire Inc.*

On December 27, 2002, the Company acquired all ofthe outstanding capital stock of TidalWire Inc. (“TidalWire”), a privately heldcorporation dedicated to the distribution and support of data storage networkingproducts. The estimated fair values of the acquired assets and assumedliabilities were included in the Company’s financial statements as of theacquisition date, and the results of the operations of TidalWire have beenincluded in the financial statements since that date.

The aggregate purchase price of $17,544,000 included anet cash payment of approximately $9,320,000, representing gross cash paymentsof approximately $9,910,000 less amounts due to TidalWire by a stockholderunder a note of approximately $590,000, and the issuance of 3,331,043 shares ofthe Company’s common stock that were held by the Company as treasury stock(valued at approximately $3,331,000, based on the average market price of theCompany’s common stock over the period three days before and after the terms ofthe acquisition were agreed to and announced). In addition, the Company assumedapproximately $1,878,000 outstanding under TidalWire’s working capital line ofcredit, which the Company repaid and cancelled on December 27, 2002. Aspart of the acquisition, the Company also replaced all outstanding TidalWirecommon stock options with options for the purchase of 1,035,033 shares of theCompany’s common stock with an average exercise price of $0.36.

The value of these options, based on the Black-Scholesvaluation model was $578,000. Related to the unvested portion of the replacedstock options, the Company recorded $304,000 as deferred stock compensationexpense based on the intrinsic value of those employee stock options. TheCompany also incurred fees and expenses of approximately $2,133,000 inconnection with this acquisition. The aggregate 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**3. BUSINESSCOMBINATIONS (Continued)**

purchase price includedcash payments of $3,350,443 and the issuance of 1,407,092 shares of the Company’scommon stock (valued at approximately $1,407,000) to related parties (See Note10).

The Company acquired TidalWire primarily becauseTidalWire had historically been a profitable company with customer management,marketing, logistics and support systems in place to support a growing channelof integrators and resellers. The Company distributed certain of itsIndependent Software Vendor (“ISV”) partners’ server appliances throughTidalWire’s channel of integrators and resellers thereby allowing the Company’scurrent and potential ISV partners to eliminate the cost of sales associatedwith the hardware component of the server appliance sale. The Company alsoutilized TidalWire’s existing infrastructure to diversify its sources ofrevenues beyond the server appliance market.

Asummary of the assets acquired and liabilities assumed in the acquisition andthe fair values recorded for each is as follows (in thousands):

| Cash                                                                      |   | $      | 97     |   |
|---------------------------------------------------------------------------|--------|--------|--------|--------|
| Accounts  receivable                                                      |   | 6,060  |   |
| Inventories                                                               |   | 2,864  |   |
| Other current  assets                                                     |   | 244    |   |
| Property and  equipment and other long-lived assets                       |   | 477    |   |
| Goodwill                                                                  |   | 7,786  |   |
| Customer  relationships (amortized on a straight-line basis over 5 years) |   | 5,071  |   |
| Accounts payable                                                          |   | (4,287 | )      |
| Other liabilities,  excluding debt of $1,878 (repaid on acquisition date) |   | (1,072 | )      |
| Deferred  compensation for unvested employee stock options                |   | 304    |   |
| Net assets acquired                                                       |   | $      | 17,544 |   |

 

All goodwill was assigned to the Company’sDistribution segment and was not deductible for tax purposes. During the fiscalyear ended September 30, 2004, the Company adjusted goodwill by $17,000 asa result of changes in certain income tax liabilities incurred by TidalWireprior to December 27, 2002.

Thefollowing unaudited pro forma results of operations of the Company give effectto the acquisition of TidalWire as if it had occurred at the beginning offiscal 2003 (in thousands, except per share data): 

| ** **                                 | ** ** | **Unaudited Pro forma**                              | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2003**                                                       | ** ** |
| ** **                                 | ** ** | **(in thousands, except  per share data)** | ** ** |
| Net revenues                               |       |                                                           | $          | 92,111 |   |   |
| Net loss                                   |       |                                                           | $          | (1,584 | ) |   |
| Net loss per share—basic  and diluted |       |                                                           | $          | (0.05 | ) |   |

 

These unaudited pro formaresults have been prepared for comparative purposes only and do not purport tobe indicative of the results of operations that actually would have resultedhad the acquisition occurred on the dates indicated and are not necessarilyindicative of future results.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**4. GOODWILL AND INTANGIBLE ASSETS**

The fair value of the Company’s goodwill wasattributable to certain synergies the Company expected to realize from sales ofserver appliances through the distribution infrastructure acquired in itsacquisition of TidalWire. The Company’s intangible assets were primarilyattributable to its acquired distribution agreement with EMC regarding the saleof EMC-approved Fibre Channel HBAs. On December 10, 2003, the Companyamended its agreement with EMC regarding the distribution of these HBAs,effective January 1, 2004. This amendment required the Company to pay aroyalty to EMC for each EMC-approved Fibre Channel HBA sold by the Companybeginning January 1, 2004. As a result of the negative effect of thisamendment on the Company’s gross profits related to sales of EMC-approved FibreChannel HBAs, the Company’s Distribution segment gross profits and the Company’sconsolidated gross profits and operating results, the Company considered thisamendment to be a triggering event requiring evaluation for potentialimpairment of its goodwill and intangible assets, in accordance with SFAS 142and SFAS 144, respectively. As a result, the Company conducted a detailedanalysis of its goodwill and intangible assets as of December 10, 2003.

To assess the fair value of the Company’sdefinite-lived intangible assets under SFAS 144, the Company estimated theundiscounted future cash flows from these assets, based on an internalanalysis. The estimated undiscounted future cash flows from these assets wereless than the assets’ carrying value. As a result, the Company determined thefair value of these assets using a discounted cash flow analysis and anappraisal. This analysis and appraisal were based on a number of estimates andassumptions, including the projected results of the Company’s sales ofEMC-approved Fibre Channel HBAs and the related gross profit. The estimatedfair value of these assets was less than the carrying amount, which resulted inan impairment charge during the quarter ended December 31, 2003 of$3,614,000. In October 2004 the Company decided to cease sellingthird-party data storage networking products. This decision was based on areview of this portion of the business and its prospects. As a result of thecommoditization of the Fibre Channel HBA technology and increasing competitionin the market, the Company experienced declining gross profits from sales ofthese products. In addition, future net revenues and gross profits in thisportion of the business were expected to deteriorate. As a result, the Company’sannual impairment assessment performed in the quarter ended September 30,2004 based on the expected operating results of this portion of the business,resulted in an impairment charge of $399,000. The total impairment charged tooperations during the year ended September 30, 2004 was approximately$4,013,000, which resulted in the carrying value of these intangible assetsbeing reduced to zero at September 30, 2004. During the years ended September 30,2004 and 2003 the Company recorded amortization expense related to theseintangible assets of $297,000, and $762,000, respectively.

In connection with the December 10, 2003triggering event, the Company’s assessed its goodwill for impairment under SFAS142. The Company performed this assessment based on an analysis and appraisalto determine if the fair value of the reporting unit exceeded the carryingvalue. This analysis and appraisal was based on a number of estimates andassumptions made by the Company, including the projected future operatingresults of the Company’s Distribution segment, the discount rate, and thelong-term growth rate. This analysis resulted in the determination that thefair value of the reporting unit, using a discounted cash flow approach,exceeded the carrying value and therefore goodwill was not impaired. TheCompany also performed a similar assessment of the fair value of this reportingunit in the quarter ended September 30, 2004, for purposes of performingits annual impairment evaluation required by SFAS 142.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**4. GOODWILLAND INTANGIBLE ASSETS (Continued)**

This assessment also resulted in the fair value of thereporting unit exceeding the carrying value and accordingly goodwill was notimpaired.

The Company performed itsannual impairment assessment of goodwill as of September 30, 2005 using anappraisal based primarily on the estimated discounted cash flows expected to begenerated by the Distribution segment. The discounted cash flows used in theappraisal were based on a number of estimates and assumptions made by theCompany, including the projected future operating results of the Company’sDistribution segment, the discount rate, and the long-term growth rate. TheCompany based its revenue assumptions on estimates of relevant market sizes,expected market growth rates, and actual fiscal 2005 results. In addition, toarrive at the implied fair value of the reporting unit’s goodwill, the Companyconsidered among other factors, the expected required investments in technologydevelopment and sales and marketing efforts. This assessment resulted in animplied fair value of the reporting unit’s goodwill that was significantlylower than its carrying value. Consequently, the Company determined that itsgoodwill was fully impaired resulting in an impairment charge of $7,769,000 forthe year ended September 30, 2005 (also see Note 7).

**5. CASH, CASH EQUIVALENTS AND INVESTMENTS**

Cash,cash equivalents and investments consist of the following (in thousands):

| ** **                          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2005**               | ** ** | **2004**               | ** ** |
| **Cash  and cash equivalents:**     |       |                   |       |                   |       |   |   |   |   |
| Cash                                |       |                   | $          | 2,722                  |       |   |   | $ | 7,912 |   |   |
| Money market funds                  |       |                   | 5,018      |                   |       |   | 5,062 |   |   |
| Municipal bonds                     |       |                   | 1,728      |                   |       |   | — |   |   |
| **Total cash and cash equivalents** |       |                   | $          | 9,468                  |       |   |   | $ | 12,974 |   |   |
| **Short-term investments:**         |       |                   |       |                   |       |   |   |   |   |
| Commercial paper                    |       |                   | $          | —                 |       |   |   | $ | 2,495 |   |   |
| Municipal auction rate securities   |       |                   | 27,894     |                   |       |   | 24,119 |   |   |
| **Total  short-term investments**   |       |                   | $          | 27,894                 |       |   |   | $ | 26,614 |   |   |

 

**6. INVENTORIES**

Inventoriesconsisted of the following (in thousands):

| ** **      | ** ** | **September 30,** | ** ** |
|-----------------|------------|------------------------|------------|
| ** **      | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Raw materials   |       | $                      | 3,972      |   | $ | 4,909 |   |
| Work in process |       | 302                    |       | 1,579 |   |
| Finished goods  |       | 4,953                  |       | 7,854 |   |
|            |       | $                      | 9,227      |   | $ | 14,342 |   |

 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**7. PROPERTY AND EQUIPMENT**

Propertyand equipment consisted of the following (in thousands):

| ** **                                       | ** ** | ** **                                      | ** ** | **September 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **Useful Life**                            | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Office furniture  and equipment                  |       | 5  years                                        |       | $                      | 836        |   | $ | 876 |   |
| Engineering and  production equipment            |       | 3  years                                        |       | 1,589                  |       | 1,580 |   |
| Computer  equipment and software                 |       | 3  years                                        |       | 3,068                  |       | 4,337 |   |
| Leasehold  improvements                          |       | Shorter  of lease term or  useful life of asset |       | 1,821                  |       | 1,822 |   |
|                                             |       |                                            |       | 7,314                  |       | 8,615 |   |
| Less: accumulated  depreciation and amortization |       |                                            |       | 5,615                  |       | 6,992 |   |
|                                             |       |                                            |       | $                      | 1,699      |   | $ | 1,623 |   |

 

Depreciation and amortization expense, related toproperty and equipment, was approximately $1,163,000, $1,251,000, and$1,617,000 for the years ended September 30, 2005, 2004, and 2003,respectively. During fiscal 2005, the Company disposed of certain equipmentthat had been fully depreciated.

In the fourth quarter offiscal 2005, the Company assessed the undiscounted cash flows expected to begenerated by its Distribution segment, and determined that the carrying valueof certain equipment in its Distribution segment was not recoverable asdetermined in accordance with SFAS 144. As a result, the Company recognized animpairment charge of $313,000 for the year ended September 30, 2005, ofwhich approximately $15,000 has been recorded in cost of revenues.

**8. CAPITAL LEASE AGREEMENT**

During the year ended September 30, 2005, theCompany entered into a lease agreement for certain office equipment that hasbeen accounted for as a capital lease. The Company has assets acquired undercapital lease obligations amounting to $101,000 at September 30, 2005. Accumulatedamortization was not material at September 30, 2005. Amortization of suchequipment is included in depreciation and amortization expense.

At September 30,2005, the minimal annual rental commitments, under this capital lease agreementare as follows (in thousands):

| 2006                                              |   | $   | 24     |   |
|---------------------------------------------------|--------|-----|--------|--------|
| 2007                                              |   | 24  |   |
| 2008                                              |   | 24  |   |
| 2009                                              |   | 24  |   |
| Thereafter                                        |   | 18  |   |
| Total minimum  lease payments                     |   | 114 |   |
| Less amount representing interest                 |   | 17  |   |
| Present value of minimum lease payments           |   | 97  |   |
| Less current portion                              |   | 18  |   |
| Capital lease  obligation, net of current portion |   | $   | 79     |   |

 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**9. STOCKHOLDERS’ EQUITY**

*Preferred Stock*

The Company has authorizedup to 5,000,000 shares of preferred stock, $0.01 par value per share forissuance. The preferred stock will have such rights, preferences, privilegesand restrictions, including voting rights, dividend rights, conversion rights,redemption privileges, and liquidation preferences, as shall be determined bythe board of directors upon its issuance.

*Common Stock*

In November 1999, the Company issued 262,500shares of restricted common stock at $0.24 per share to certain directors ofthe Company. Of these shares, 75,000 shares vested 50% on November 18,2000 and 12.5% per quarter thereafter, and 187,500 shares vested 25% on November 18,2000 and 6.25% per quarter thereafter. As of September 30, 2004, allshares were fully vested. The Company recorded deferred stock compensation ofapproximately $522,000 during the year ended September 30, 2000, whichrepresented the excess of the fair value of the restricted shares at the dateof issue over the purchase price. Compensation expense has been recognizedratably over the vesting period of the restricted stock. For the years ended September 30,2004 and 2003, the Company recognized approximately $23,000, and $93,000respectively, of related stock compensation expense.

In November 1999, the Company issued 375,000shares of restricted common stock to Lawrence A. Genovesi, the Company’s formerChief Executive Officer and current Chairman of the board of directors. Theseshares vested quarterly upon the earlier of the achievement of certainfinancial targets or in December 2004. The Company recorded deferred stockcompensation of approximately $684,000, which represented the excess of thefair value of the restricted shares at the date of issue over the purchaseprice. Compensation expense has been recognized ratably over the vesting periodof the restricted stock. For the years ended September 30, 2004 and 2003,the Company recognized approximately $98,000 of related stock compensationexpense.

In connection with aseverance agreement effective September 30, 2001, the Company agreed toamend this restricted stock agreement and, in November 2001, the Companyrepurchased 93,750 of these shares of restricted common stock at $0.24 pershare, which represented the original issue price, through the cancellation ofan equal amount due under a note receivable from Mr. Genovesi(approximately $23,000). Additionally, for the remaining unvested restrictedcommon stock of 187,500 shares as of September 30, 2001, the Companyamended the agreement to provide for quarterly vesting of that amount through September 30,2004, contingent upon Mr. Genovesi remaining a director of the Company. AtSeptember 30, 2005 and 2004 there were no unvested restricted shares.

*Treasury stock*

On August 14, 2001, the Company announced thatits board of directors had approved the repurchase of up to $5 million of theCompany’s common stock in the open market or in non-solicited privatelynegotiated transactions. During the year ended September 30, 2003, theCompany repurchased approximately 308,000, shares of common stock for cash ofapproximately, $312,000. There were no amounts repurchased during the yearsended September 30, 2005 and 2004.

During the year ended September 30, 2003, theCompany repurchased 686,798 shares of common stock through the cancellation ofapproximately $1,031,000, of outstanding notes receivable from 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**9. STOCKHOLDERS’ EQUITY(Continued)**

stockholders.In December 2002, the Company used 3,331,043 of the repurchased shares tofund a portion of its acquisition of TidalWire Inc.

**10. RELATED PARTY TRANSACTIONS**

In January 2001, the Company entered into aseries of agreements with Lawrence A. Genovesi, currently Chairman of the Boardand formerly President, Chief Executive Officer and Chief Technology Officer ofthe Company. These agreements were entered into to avoid significant sales ofthe Company’s common stock by Mr. Genovesi as a result of a margin call ona personal loan collateralized by Mr. Genovesi’s holdings of the Company’scommon stock. The Company guaranteed a personal loan obtained by Mr. Genovesifrom a financial institution (the “Bank”) through a deposit of $1,051,850 ofthe Company’s cash with the Bank (the “Guarantee”), which was to expire in January 2002.In January 2002, the Company extended the Guarantee period to January 2003.Mr. Genovesi and the Company also entered into an agreement whereby Mr. Genovesiagreed to reimburse the Company for any obligations incurred by the Companyunder the Guarantee (the “Reimbursement Agreement”). Any unpaid balances underthe Reimbursement Agreement bore interest at a rate of 10% per annum. On January 6,2003, pursuant to the Guarantee, the Bank applied $968,596 of the Company’scash deposit to the repayment of Mr. Genovesi’s personal loan and refunded$83,254 to the Company. On January 27, 2003, Mr. Genovesi repaid theCompany $974,168 to satisfy his obligations under the Reimbursement Agreement,including accrued interest. Of that amount, $456,276 was paid in cash and$517,892 was paid with the proceeds from the repurchase by the Company of391,128 shares of the Company’s common stock owned by Mr. Genovesi. Thepurchase price of $1.32 per share was determined based on the average closingprice of the Company’s common stock over the ten trading days prior to andincluding January 17, 2003.

In connection with the Company’s issuance of 375,000shares of restricted common stock to Mr. Genovesi in November 1999,the Company and Mr. Genovesi entered into a recourse note (the “RecourseNote”),  in the principal amount of$90,000, bearing interest at an annual rate of 6.08% and payable upon theearlier of demand by the Company or November 18, 2004. In addition, in January 2001,Mr. Genovesi executed a revolving promissory note of up to $210,000 (the “Note”)with the Company. The Note had an interest rate of 5.9% per annum and was dueand payable in full upon the earlier of January 9, 2002 or 30 daysfollowing the date Mr. Genovesi ceased to be an employee of the Company.In November 2001, the Company repurchased 234,822 shares of the Company’scommon stock from Mr. Genovesi for $225,195 in a private transaction. Thepurchase price was determined based on the average closing price of the Company’scommon stock over the ten trading days prior to the purchase date. Mr. Genovesiused the proceeds to repay all amounts outstanding under the Note of $140,343,to pay $39,813, including accrued interest, of the Recourse Note and to paytaxes incurred in connection with the Company’s repurchase of its common stockfrom Mr. Genovesi. Also in November 2001, the Company repurchased93,750 shares of the Company’s common stock held by Mr. Genovesi asrestricted stock for $22,500. The purchase price was equal to the price atwhich these shares were sold to Mr. Genovesi in November 1999. Theproceeds were used to pay down $22,500 of the Recourse Note. On January 27,2003 Mr. Genovesi repaid, $22,600 that remained outstanding under theRecourse Note, with the proceeds from the repurchase by the Company of 17,070shares of the Company’s common stock owned by Mr. Genovesi. The purchaseprice was determined based on the average closing price of the Company’s commonstock over the ten trading days prior to and including January 17, 2003.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**10. RELATEDPARTY TRANSACTIONS (Continued)**

In conjunction with the Guarantee, the ReimbursementAgreement and the Note, the Company and Mr. Genovesi entered into a pledgeagreement whereby Mr. Genovesi pledged to the Company all shares of theCompany’s common stock owned by Mr. Genovesi as of the date of theagreement or subsequently acquired, and all options and other rights to acquireshares of the Company’s common stock owned by Mr. Genovesi as of the dateof the agreement or subsequently acquired (collectively the “Pledged Securities”).

Additionally, Mr. Genovesi pledged to the Companyall additional securities or other consideration from time to time acquired byMr. Genovesi in substitution for, or in respect of the Pledged Securities.

If Mr. Genovesi had elected to sell anyadditional Pledged Securities during the term of the agreement, all proceeds ofsuch sale would have been applied to any amounts payable under theReimbursement Agreement. In addition to the Pledged Securities, the obligationsof Mr. Genovesi under the Reimbursement Agreement were collateralized by asecond mortgage on certain real property owned by Mr. Genovesi. OnJanuary 27, 2003, Mr. Genovesi satisfied his obligations in fullunder each of the Guarantee, the Reimbursement Agreement, the Recourse Note andthe pledge agreement.

In April 2001, the Company entered into fullrecourse loan agreements with certain employees and certain officers of theCompany, all of whom were employees or officers of the Company at that time(the “Loan Agreements”). The Loan Agreements were executed to avoid substantialsales of the Company’s common stock by these employees and officers as a resultof alternative minimum tax obligations incurred by these employees and officersin connection with their exercise of options to purchase shares of theCompany’s common stock. The amount loaned to the employees and officers underthe Loan Agreements was approximately $736,000, which was recorded net ofapproximately $228,000 of reserves for uncollectibility. Outstanding amountsunder the Loan Agreements accrued interest at a rate of 4.63% per annum andwere originally due and payable in full upon the earlier of one year from thedate of each individual agreement or thirty days after termination ofemployment with the Company, unless termination was involuntary and withoutcause. In conjunction with the Loan Agreements, each employee and officerpledged all shares of capital stock, and options to purchase capital stock, ofthe Company then owned, or acquired in the future (the “Pledged Stock”), andany distributions on the Pledged Stock or proceeds from their sale. Amounts dueunder these Loan Agreements were included in the balance sheet as notesreceivable from stockholders.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**10. RELATED PARTYTRANSACTIONS (Continued)**

In April 2002, one former officer’s loan withprincipal of $54,000 was repaid in full, including accrued interest ofapproximately $2,500, through a payment to the Company of $29,800 of cash and asale to the Company of 30,000 shares of the Company’s common stock. The priceper share of the Company’s common stock was based on the market price as of theclose of business on the date of the repurchase. Because the amountsoutstanding under certain of the Loan Agreements exceeded the value of theCompany’s common stock pledged as collateral, in January 2002, the Companyextended the repayment dates to September 2002 for loans with an aggregateprincipal amount of $226,996 due from one of its current officers and one ofits former officers and in March 2002, the Company extended the repaymentdates to July 2002 for the remaining loans with a net principal amount of$255,000. Subsequently, in early July 2002, the Company also extended therepayment dates for these remaining loans to September 2002. In September 2002,loans to one current officer and one former officer totaling approximately$240,000 were repaid in full, including accrued interest of approximately$13,000, through sales to the Company of 230,777 shares of the Company’s commonstock in exchange for the retirement of these loans. The remaining loans duefrom one former officer and one former employee totaling approximately $489,000as of December 31, 2002, were repaid in full, including accrued interestof approximately $33,000, in January 2003 through the repurchase by theCompany of 278,600 shares of the Company’s common stock. For all purchasesnoted above, the price per share of the Company’s common stock was based on themarket price as of the close of business on the dates of these repurchases.

As of December 31, 2002, the Company determinedthat there was no need for reserves for the uncollectibility of thesestockholder notes receivable and reversed reserves of $228,000 as a decrease togeneral and administrative expenses during the year ended September 30,2003.

All shares of the Company’s common stock repurchasedunder these related party agreements were recorded as treasury stock at thecost to repurchase.

In connection withthe Company’s acquisition of TidalWire, the Company paid $1,144,615 to AscentVenture Partners (together with its affiliated entities, “Ascent”) and$2,205,828 to HarbourVest Partners (together with its affiliated entities, “HarbourVest”),two substantial stockholders of the Company at that time. At the time of theacquisition, Ascent and HarbourVest owned approximately 18.1% and 16.3% of theoutstanding common stock of the Company, respectively. Ascent and HarbourVestalso owned 12.9% and 24.9% of the outstanding common stock of TidalWire,respectively. Pursuant to the terms of the merger agreement, the Company alsoissued 480,706 shares and 926,386 shares of its common stock previously held astreasury stock to Ascent and HarbourVest, respectively, and made theaforementioned cash payments to Ascent and HarbourVest in exchange for all ofthe TidalWire common stock held by Ascent and HarbourVest. The considerationpaid to Ascent and HarbourVest may be deemed to have been indirectly paid toFrank M. Polestra and Robert M. Wadsworth, two of the Company’s directors atthe time. As a managing member or general partner of each of the generalpartners that controlled Ascent, Mr. Polestra may be deemed to haveindirectly received the $1,144,615 of cash paid to Ascent as well as beneficialownership of 480,706 shares of the Company’s common stock issued to Ascent. Asa managing director of the limited liability corporation that controlsHarbourVest, Mr. Wadsworth may be deemed to have indirectly received the$2,205,828 of cash paid to HarbourVest as well as beneficial ownership of926,386 shares of the Company’s common stock issued to HarbourVest.

Mr. Wadsworth, is also a director of PSI Holding Group, Inc.(“PSI”), the parent company of Akibia, Inc. (“Akibia”). During the yearsended September 30, 2005 and 2004, HarbourVest owned greater 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**10. RELATEDPARTY TRANSACTIONS (Continued)**

than 5% of the outstandingstock of the Company and greater than 5% of the outstanding stock of PSI. Whilethe Company was selling third-party data storage networking products it engagedAkibia to provide certain customer support and warranty fulfillment servicesrelated to the Company’s sales of HBAs. The Company’s agreement with Akibiaexpired in March 2005 as scheduled. However, the terms of the agreementrequired Akibia fulfill the warranty services for the entire warranty period. Akibiacharged the Company a quarterly fixed fee of $83,000 and a variable fee basedupon the Company’s sales of HBAs, which ended in December 2004. For theyears ended September 30, 2005, 2004 and 2003, the Company recognized$201,000, $1,070,000 and $972,000, respectively, of expense as a result of thiswarranty fulfillment services agreement with Akibia. In connection with thiscustomer support and warranty fulfillment services agreement, the Company alsosold product to Akibia to allow Akibia to fulfill the Company’s warrantyobligations for these products. For the years ended September 30, 2005,2004 and 2003, the Company recorded revenues of approximately $40,000, $143,000and $93,000, respectively, from sales of HBAs to Akibia. The Company alsopurchased certain products sold through its Distribution segment from Akibia tofulfill customer orders. For the year ended September 30, 2004, theCompany purchased approximately $19,000 of inventory from Akibia for resale tothe Company’s Distribution segment customers. No such purchases were madeduring the year ended September 30, 2005.

In addition, duringthe year ended September 30, 2004, the Company sold approximately $60,000,respectively, of server appliance products to Akibia for resale. The Companyhad no sales of server appliance products to Akibia during the year ended September 30,2005. In addition, the Company engaged Akibia to provide certain customersupport and warranty fulfillment services to certain of its server appliancecustomers in both its OEM Appliance and Distribution segments. Under the termsof this agreement, the Company was obligated to pay Akibia certain fixed feesand certain activity-based fees based on actual warranty experience. TheCompany no longer engages Akibia for these support services. As a result, therewere no expenses recorded for the year ended September 30, 2005. For theyear ended September 30, 2004, the Company recorded expenses totalingapproximately $50,500, related to this agreement. At September 30, 2004,the Company had amounts payable to Akibia of approximately $143,000, andamounts receivable from Akibia of $51,000. There were no amounts receivablefrom or payable to Akibia at September 30, 2005. In November 2005, Mr. JohnA. Blaeser, one of the Company’s directors, also joined the board of directorsof Akibia.

Mr. Wadsworth also serves as a director of InnoveerSolutions, Inc. (“Innoveer”), formerly Akibia Consulting, a subsidiary ofAkibia. The Company previously engaged Innoveer to perform certain professionalservices related to an upgrade of its customer resource management (“CRM”)software system that was completed during fiscal year 2004. The Companyincurred approximately $243,000 related to this upgrade project in the yearended September 30, 2004. The Company also engages Innoveer to provideprofessional services related to modifications of its CRM software system. Duringthe year ended September 30, 2005, the Company incurred approximately$14,300 related to these services. The Company had no amounts outstanding toInnoveer at September 30, 2005 and 2004.

Several of the Company’s directors have relationshipsoutside of their positions on the Company’s board of directors. John A.Blaeser, one of the Company’s directors, was the president and CEO of thepublic company Concord Communications, Inc. prior to its acquisition byComputer Associates, Inc. on June 7, 2005, and served on its board ofdirectors. Robert M. Wadsworth, also one of the Company’s directors, is amanaging director of the limited liability corporation that controlsHarbourVest Partners 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**10. RELATEDPARTY TRANSACTIONS (Continued)**

(andits affiliates), one of the Company’s significant stockholders. Mr. Wadsworthwas also a director of Concord Communications, where he was the chairman of thecompensation committee of its board of directors, which determined the compensationand benefits of Concord Communications’ executive officers, including thecompensation of Mr. Blaeser. Further, Gary E. Haroian, one of the Company’sdirectors, was formerly Chief Financial Officer of Concord Communications whileMr. Blaeser was the Chief Executive Officer of that organization, and wasformerly the Controller of Stratus Computer while John H. Curtis, our Presidentand Chief Executive Officer, was Chief Financial Officer of that organization.

Mr. Polestra, a former director of the Company, was amanaging director of Ascent Venture Partners. Both Mr. Polestra and Mr. Blaeserare limited partners in one of Ascent Venture Partner’s funds, which ownsgreater than 5% of the outstanding capital stock of Network IntelligenceCorporation. Network Intelligence Corporation has a contract with the Companyto purchase certain of its products. For the years ended September 30,2005, 2004 and 2003, revenues from sales to Network Intelligence Corporationwere approximately $ 4,040,000, $3,200,000, and $2,670,000, respectively. At September 30, 2005 and 2004, theCompany had $871,000 and $474,000, respectively, of receivables from NetworkIntelligence Corporation.

During the year ended September 30,2005 the Company engaged the consulting services of Mapleworks Technologies (“Mapleworks”),a software development services provider. Both Mr. Blaeser and Mr. Wadsworthare investors in Mapleworks and are members of its board of advisors. For theyear ended September 30, 2005 the Company incurred $18,000 related tothese consulting services.

**11. STOCK INCENTIVE PLANS**

In October 1999, the Company’s shareholdersapproved the 1999 Stock Incentive Plan (the “1999 Plan”). Under the 1999Plan, stock option and restricted stock or other stock-based awards for up to4,747,902 shares of common stock may be issued to employees, officers,directors, consultants and advisors of the Company. Options are granted forterms of up to ten years and vest over varying periods. Option grants to newemployees generally vest 25% on the first anniversary of the grant date andthereafter in equal quarterly installments over the next three years.Subsequent grants to existing employees generally vest in equal quarterlyinstallments over four years. The option price per share is determined by theboard of directors on the grant date.

In May 2000, the Company’s shareholders approvedan increase of 3,300,000 in the number of shares authorized under the 1999 Planand an automatic annual increase in the number of shares authorized under the1999 Plan. The automatic annual increase is equal to the lesser of: 5% of theoutstanding shares on the first day of each fiscal year; 4,000,000 shares; oran amount determined by the board of directors, which is subject to a maximumof 20,047,902 authorized shares under the plan. During the year ended September 30,2003, the Company increased the number of shares available under the plan by1,539,037. The Company’s board of directors elected not to authorize anadditional increase in the shares available for issuance during the year ended September 30,2005 and 2004. As a result, as of September 30, 2005, the Company isauthorized to grant options, restricted stock or other awards of up to13,057,273 shares of common stock.

In May 2000, the Company’s shareholders approvedthe 2000 Director Option Plan. Under the 2000 Director Option Plan, the Companymay make formula grants of stock options to non-employee directors 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**11. STOCKINCENTIVE PLANS (Continued)**

of upto 500,000 shares of common stock. In March 2004, the Company’sshareholders approved an increase of an additional 325,000 shares of commonstock authorized to be issued under this plan, resulting in a total of 825,000options authorized to be issued. Under the 2000 Director Option Plan, optionsto purchase 520,000 shares have been granted, options to purchase 45,000 shareshave been exercised and options to purchase 30,000 shares have been cancelledthrough September 30, 2005.

A summary of stock optionactivity follows:

| ** **                                       | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|------------------------------------------------|------------|
| Outstanding,  September 30, 2002            |       | 4,046,422                  |       |                                           | $          | 1.79 |   |   |
| Granted                                          |       | 2,350,500                  |       |                                           | 1.20       |   |   |
| Options assumed in acquisition of TidalWire Inc. |       | 1,035,033                  |       |                                           | 0.36       |   |   |
| Exercised                                        |       | (1,345,756                 | )          |                                           | 0.57       |   |   |
| Cancelled                                        |       | (546,812                   | )          |                                           | 2.69       |   |   |
| Outstanding, September 30, 2003             |       | 5,539,387                  |       |                                           | 1.48       |   |   |
| Granted                                          |       | 1,589,250                  |       |                                           | 5.08       |   |   |
| Exercised                                        |       | (720,991                   | )          |                                           | 0.98       |   |   |
| Cancelled                                        |       | (279,582                   | )          |                                           | 2.73       |   |   |
| Outstanding, September 30, 2004             |       | 6,128,064                  |       |                                           | 2.42       |   |   |
| Granted                                          |       | 1,733,250                  |       |                                           | 2.28       |   |   |
| Exercised                                        |       | (404,145                   | )          |                                           | 0.86       |   |   |
| Cancelled                                        |       | (755,901                   | )          |                                           | 3.03       |   |   |
| Outstanding,  September 30, 2005            |       | 6,701,268                  |       |                                           | $          | 2.41 |   |   |

 

As of September 30, 2005, 2004 and 2003, optionsto purchase 3,979,993, 3,077,193, and 2,303,745 shares of common stock, respectively,were exercisable with a weighted-average exercise price per share of $2.16,$1.83, and $1.72, respectively.

Thefollowing table summarizes the stock options outstanding at September 30,2005:

| ** **                         | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Exercise Price Range** | ** ** | ** **                   | ** ** | **Number**                   | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average Remaining  Contractual  Life (in years)** | ** ** | **Number** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $0.07–$  0.92       |       | 1,496,729                    |       |                         | $          | 0.62 |   |   |   | 5.85 |   |   | 1,340,165 |   |   | $ | 0.59 |   |   |
| $0.95–$  1.06       |       | 991,034                      |       |                         | $          | 1.01 |   |   |   | 6.98 |   |   | 684,830 |   |   | $ | 1.02 |   |   |
| $1.07–$  1.61       |       | 967,118                      |       |                         | $          | 1.24 |   |   |   | 6.08 |   |   | 866,179 |   |   | $ | 1.21 |   |   |
| $1.62–$  2.50       |       | 1,117,998                    |       |                         | $          | 1.96 |   |   |   | 8.52 |   |   | 254,185 |   |   | $ | 2.01 |   |   |
| $2.58–$  3.88       |       | 979,812                      |       |                         | $          | 2.80 |   |   |   | 9.11 |   |   | 177,732 |   |   | $ | 2.86 |   |   |
| $3.90–$  8.50       |       | 992,577                      |       |                         | $          | 5.88 |   |   |   | 7.94 |   |   | 531,559 |   |   | $ | 5.79 |   |   |
| $8.62–$39.81                  |       | 156,000                      |       |                         | $          | 14.38 |   |   |   | 6.01 |   |   | 125,343 |   |   | $ | 15.72 |   |   |
|                               |       | 6,701,268                    |       |                         | $          | 2.41 |   |   |   | 7.29 |   |   | 3,979,993 |   |   | $ | 2.16 |   |   |
|                                    |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**11. STOCKINCENTIVE PLANS (Continued)**

In May 2000, the Company’s shareholders approvedthe 2000 Employee Stock Purchase Plan (the “Purchase Plan”). Under the PurchasePlan, the Company may issue up to an aggregate of 750,000 shares of commonstock to eligible employees. In March 2004, the Company’s shareholdersapproved an increase of an additional 500,000 shares of common stock authorizedto be issued under the Purchase Plan, resulting in a total of 1,250,000 sharesauthorized to be issued. Eligible employees must be employed by the Company formore than 20 hours per week and more than five months in a fiscal year. Underthe Purchase Plan, the Company makes two offerings each fiscal year, at the endof which employees may purchase shares of common stock through payrolldeductions made over the term of each offering. The per-share purchase pricefor offerings in fiscal years prior to September 30, 2005, was equal tothe lesser of 85% of the closing price of the common stock at the beginning orend of the offering period. During the year ended September 30, 2005, theboard of directors amended the Purchase Plan to limit the per-share purchaseprice for offerings to 85% of the closing price at the end of the offeringperiod, beginning with the offering period ended May 15, 2005,. Offeringperiods begin on the 15th day of November and May each year.During the years ended September 30, 2005, 2004 and 2003, 258,901,250,070, and 169,876 shares of common stock, respectively, were issued underthe Purchase Plan.

During each of the yearsended September 30, 2005 and 2004 the Company granted 5,000 options to anon-employee. These options were accounted for at their fair value resulting inan immaterial amount of compensation expense recorded during the years ended September 30,2005 and 2004.

**12. STOCK WARRANTS**

Priorto October 1, 2000, the Company issued warrants to purchase 2,350,424shares of the Company’s common stock. The fair value of these warrants was$1,198,000. These warrants were issued in connection with multiple private debtand equity financing activities prior to the Company’s initial public offeringwith exercise prices ranging from $0.07 per share to $0.53 per share. During the years ended September 30, 2004and 2003, pursuant to the original warrant agreements, warrants to purchase546,420 and 1,052,738 shares of the Company’s common stock, respectively, wereexercised through cashless exercises and resulted in the issuance of 524,625and 988,451 shares of the Company’s common stock, respectively. All ofthe warrants issued by the Company were exercisable on the date of the grant.There were no stock warrants outstanding at September 30, 2005 and 2004. Thefollowing table summarizes stock warrant activity during each of the two yearsended September 30, 2004:

| ** **                            | ** ** | **Shares** | ** ** | **Exercise Price** | ** ** | **Expiration Date** | ** ** |
|---------------------------------------|------------|------------|------------|-------------------------|------------|--------------------------|------------|
| Outstanding,  September 30, 2002 |       | 1,599,158  |       |                    | $          | 0.34                     |       |   | October 2007–January 2009 |   |
| Cashless exercise of warrants         |       | (1,052,738 | )          |                    | $          | 0.33                     |       |   |   |   |
| Outstanding, September 30, 2003  |       | 546,420    |       |                    | $          | 0.37                     |       |   | December 2008–January 2009 |   |
| Cashless exercise of warrants         |       | (546,420   | )          |                    | $          | 0.37                     |       |   |   |   |
| Outstanding,  September 30, 2004 |       | —     |       |                    |       |                     |       |   |   |

 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**13. COMMITMENTS AND CONTINGENCIES**

*Operating Leases*

TheCompany leases its office space under non-cancelable operating leases. Duringthe year ended September 30, 2004, the Company entered into an amendmentof its office space lease. The amendment of this lease extended the lease termthrough March 2007 for 52,000 square feet of office and manufacturingspace and eliminated approximately 24,000 square feet of office space that theCompany previously subleased to a third party. This lease amendment required atermination payment by the Company of $54,000. As of September 30, 2005,the future minimum lease payments under the Company’s non-cancelable operatingleases were as follows (in thousands):

| **Year Ending September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                         |       | $          | 610        |       |
| 2007                                         |       | 305        |       |
| Total                                        |       | $          | 915        |       |

 

Rent expense for the yearsended September 30, 2005 and 2004 excluding the termination penaltyincurred with its lease amendment in 2004 was $637,000, and $581,000,respectively. Rent expense for the year ended September 30, 2003, net ofsublease income of approximately $311,000 was approximately $437,000.

*PurchaseObligations*

During fiscal 2004, theCompany entered into an arrangement to purchase software licenses related toits security appliances in its Distribution segment. As of September 30,2005 future minimum payments under this arrangement payable in the year ending September 30,2006 was $200,000.

*Guarantees andIndemnifications*

Acquisition-related indemnifications—When, as part ofan acquisition, the Company acquires all the stock of a company, the Companyassumes liabilities for certain events or circumstances that took place priorto the date of acquisition. The maximum potential amount of future payments theCompany could be required to make for such obligations is undeterminable. Whilethe provisions of the agreements remain in effect indefinitely, the Companybelieves that the probability of receiving a claim is unlikely. As a result,the Company has not recorded a liability for these indemnification clauses asof September 30, 2005 and 2004.

The Company enters intostandard indemnification agreements in the ordinary course of its business.Pursuant to these agreements, the Company indemnifies, holds harmless, andagrees to reimburse the indemnified party for losses suffered or incurred bythe indemnified party, generally its business partners or customers, inconnection with any patent, copyright, trademark, trade secret or otherintellectual property infringement claim by any third party with respect to itsproducts. The term of these indemnification agreements is generally perpetual.The Company has never incurred costs to defend lawsuits or settle claimsrelated to these indemnification agreements. As a result, the Company believesthe estimated fair value of these agreements is minimal. Accordingly, theCompany has no liabilities recorded for these indemnifications as of September 30,2005 and 2004.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**13. COMMITMENTS AND CONTINGENCIES(Continued)**

*Product warranties*

TheCompany offers and fulfills warranty services on certain of its serverappliances. In addition, while the Company was selling third-party data storagenetworking products it contracted with a third party to provide warrantyservices for these products. The Company’s agreement with this third-partywarranty provider expired in March 2005 as scheduled. However, the termsof the agreement require the third-party warranty provider to service theseproducts for the entire warranty period. Warranty terms vary in durationdepending upon the product sold but generally provide for the repair orreplacement of any defective products for periods of up to 36 months aftershipment. Based upon historical experience and expectation of futureconditions, the Company reserves for the estimated costs to fulfill customerwarranty obligations upon the recognition of the related revenue. Forwarranties related to third-party data storage networking products, the Companyrecorded warranty expense based on its agreement with its third-party warrantyfulfillment provider, whose fees were determined based on fixed periodicamounts as well as activity-based charges. The following table presents changesin the Company’s product warranty liability for the years ended September 30(in thousands):

| ** **                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Beginning balance                            |       | $        | 433        |     | $          | 605 |   |
| Accruals for  warranties issued              |       | 1,170    |       | 1648     |       |
| Fulfillment of  warranties during the period |       | (1,148   | )          | (1,820   | )          |
| Ending balance                               |       | $        | 455        |     | $          | 433 |   |

 

*Contingencies*

*Announcement TimingLawsuit*

On March 17, 2004, the United States DistrictCourt for the District of Massachusetts (the “Court”) consolidated a number ofpurported class action lawsuits filed against Network Engines, Inc. andcertain individual Network Engines defendants (collectively the “Defendants”). Thesesuits generally concern the timing of the announcement of an amendment toNetwork Engines’ agreement with EMC Corporation regarding the resale ofEMC-approved Fibre Channel HBAs. The Plaintiffs filed an amended consolidatedcomplaint on June 4, 2004. The Defendants on August 13, 2004 filed amotion to dismiss the amended consolidated complaint. The Plaintiffs on October 12,2004 filed an opposition to the Defendants’ motion to dismiss and theDefendants filed a reply to the Plaintiff’s opposition on November 12,2004. The Court on November 22, 2004 denied the Defendant’s motion todismiss the amended consolidated complaint. On December 23, 2004, theDefendants filed an answer to the amended consolidated complaint.

Since that time theparties have engaged in some informal discovery and, more recently, haveexchanged formal discovery requests. Discovery is to conclude on or before March 31,2006. The parties are currently actively pursuing settlement. No amounts havebeen accrued for this matter, since the anticipated settlement will be coveredin its entirety by the Company’s insurance provider.

*TidalWireAcquisition Lawsuit*

A purported class actionand derivative lawsuit was filed on January 7, 2003 in the Court ofChancery in the State of Delaware against the Company, and certain members ofits Board of Directors relating to the acquisition of TidalWire Inc. Theplaintiffs in the complaint alleged that the Company and the named 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**13. COMMITMENTSAND CONTINGENCIES (Continued)**

directorsof its Board of Directors breached their fiduciary duties by, among otherthings, paying an excessive amount in the acquisition of TidalWire Inc. andpurportedly failing to disclose material facts in the Company’s Joint ProxyStatement/Information Statement distributed to stockholders for approval of theissuance of shares of the Company’s Common Stock in the merger. The plaintiffssought damages, rescission of the merger and other relief. On October 30,2003, the court approved a settlement of the action negotiated by the parties,and that settlement became final on December 1, 2003. Under thesettlement, all claims against the Company and its individual board memberswere dismissed with prejudice, and (a) the defendants in the lawsuit paid$600,000 to the Company, (b) plaintiff’s attorney fees of $185,000 werepaid out of that $600,000 amount and (c) in the disclosure for the Company’snext annual meeting, the Company was required to detail certain informationconcerning relationships among its board members, which the Company hascomplied with. Payments to the Company under this settlement, net of paymentsof plaintiff’s attorney fees, were recorded as an increase of $415,000 toadditional paid-in capital during the quarter ended December 31, 2003.

*Initial PublicOffering Lawsuit*

On or about December 3, 2001, a putative classaction lawsuit was filed in the United States District Court for the SouthernDistrict of New York against the Company, Lawrence A. Genovesi (the Company’sChairman and former Chief Executive Officer), Douglas G. Bryant (the Company’sChief Financial Officer and Vice President of Finance and Administration), andthe following underwriters of the Company’s initial public offering:FleetBoston Robertson Stephens, Inc., Credit Suisse First Boston Corp.,Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc.(collectively, the “Underwriter Defendants”). An amended class actioncomplaint, captioned In re Network Engines, Inc. Initial Public OfferingSecurities Litigation, 01 Civ. 10894 (SAS), was filed on April 20, 2002.

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosingto investors that the Underwriter Defendants had solicited and receivedexcessive and undisclosed commissions from certain investors. The suit alsoalleges that the Underwriter Defendants entered into agreements with certaincustomers whereby the Underwriter Defendants agreed to allocate to thosecustomers shares of the Company’s common stock in the offering, in exchange forwhich the customers agreed to purchase additional shares of the Company’scommon stock in the aftermarket at pre-determined prices. The suit alleges thatsuch tie-in arrangements were designed to and did maintain, distort and/orinflate the price of the Company’s common stock in the aftermarket. The suitfurther alleges that the Underwriter Defendants received undisclosed and excessivebrokerage commissions and that, as a consequence, the Underwriter Defendantssuccessfully increased investor interest in the manipulated IPO securities andincreased the Underwriter Defendants’ individual and collective underwritings,compensation and revenues. The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of the Company’scommon stock between July 13, 2000 and December 6, 2000.

In July 2002, the Company, Lawrence A. Genovesiand Douglas G. Bryant joined in an omnibus motion to dismiss the suitchallenging the legal sufficiency of plaintiffs’ claims. The motion was filedon behalf of hundreds of issuer and individual defendants named in similarlawsuits. Plaintiffs opposed the motion, and the Court heard oral argument onthe motion in November 2002. On February 19, 2003, the Court issuedan opinion and order denying the motion as to the Company. However, in October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**13. COMMITMENTSAND CONTINGENCIES (Continued)**

On July 9, 2003, aSpecial Committee of the Company’s Board of Directors authorized the Company tonegotiate a settlement of the pending claims substantially consistent with amemorandum of understanding negotiated among class plaintiffs, all issuerdefendants and their insurers. The parties have negotiated the settlement,which provides, among other things, for a release of the Company and theIndividual Defendants for the conduct alleged in the amended complaint to bewrongful. The Company would agree to undertake other responsibilities under thesettlement, including agreeing to assign, or not assert, certain potentialclaims that it may have against its underwriters. Any direct financial impactof the proposed settlement is expected to be borne by the Company’s insurers. Anysuch settlement would be subject to various contingencies, including approvalby the Court overseeing the litigation. On February 15, 2005, the Courtissued an Opinion and Order preliminarily approving the settlement, providedthat the defendants and plaintiffs agree to a modification narrowing the scopeof the bar order set forth in the original settlement agreement. The partiesagreed to a modification narrowing the scope of the bar order, and on August 31,2005, the Court issued an order preliminarily approving the settlement. Noamounts have been accrued for this matter, since the anticipated settlementwill be covered in its entirety by the Company’s insurance provider.

**14. INCOME TAXES**

Due to the losses incurred during fiscal years 2005and 2003, the Company did not record a provision for any federal or stateincome taxes in those years. For the year ended September 30, 2004, theCompany incurred $44,000 in alternative minimum tax expense in connection withthe federal limitation on alternative tax net operating loss carryforwards.

Thefollowing is a reconciliation between the amount of the Company’s income taxesutilizing the U.S. federal statutory rate and the Company’s actual provisionfor income taxes for the years ended September 30 (in thousands):

| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| At U.S. federal  statutory rate                  |       | $        | (5,298     | )        | $          | (536     | )          | $ | (471 | ) |
| State taxes, net  of federal effect              |       | (415     | )          | (67      | )          | (18      | )          |
| Research and  development credits                |       | (460     | )          | (219     | )          | (21      | )          |
| Non-deductible  stock option compensation charge |       | —   |       | 135      |       | 335      |       |
| Non-deductible  expenses and other items         |       | 2,664    |       | 23       |       | 33       |       |
| Effect of change  in valuation allowance         |       | 3,509    |       | 708      |       | 142      |       |
| Provision for  income taxes                      |       | $        | —     |     | $          | 44       |       | $ | — |   |

 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**14. INCOMETAXES (Continued)**

Deferred income taxes reflect the net tax effects oftemporary differences between the carrying amounts of assets and liabilitiesfor financial reporting purposes and income tax purposes using enacted taxrates in effect for the year in which the differences are expected to reverse.As of September 30, 2005 and 2004, net deferred tax assets consisted ofthe following (in thousands):

| ** **                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Net operating  losses                 |       | $        | 32,220     |     | $          | 27,930 |   |
| Tax credit  carryforwards             |       | 2,550    |       | 2,058    |       |
| Capitalized  research and engineering |       | 3,384    |       | 4,128    |       |
| Temporary  differences                |       | 2,761    |       | 2,418    |       |
| Total deferred tax asset              |       | 40,915   |       | 36,534   |       |
| Valuation  allowance                  |       | (40,915  | )          | (36,534  | )          |
| Net deferred tax  asset               |       | $        | —     |     | $          | — |   |

 

A valuation allowance is established if it is morelikely than not that all or a portion of the deferred tax asset will not berealized. Accordingly, as of September 30, 2005 and 2004, a valuationallowance was recorded for the full amount of the deferred tax asset due to theuncertainty of their realization. Approximately $6.2 million of the netoperating loss carryforwards relate to disqualifying dispositions of incentivestock options, the tax benefit from which, if realized, will be credited toadditional paid-in capital.

As of September 30, 2005, the Company had netoperating loss carryforwards for federal and state income tax purposes ofapproximately $80,549,000. For federal income tax purposes these net operatingloss carryforwards will expire as follows: $44,404,000 in 2021, $22,686,000 in2022, $3,458,000 in 2023, $1,172,000 in 2024 and $8,829,000 in 2025. For stateincome tax purposes these net operating loss carryforwards will expirebeginning in 2006.

The Company also hasavailable research and development credits for federal and state income taxpurposes of approximately $1,889,000 and $548,000, respectively, which expireat various dates from 2006 through 2023. An ownership change, as defined in theInternal Revenue Code, resulting from the issuance of additional stock maylimit the amount of net operating loss and tax credit carryforwards that can beutilized annually to offset future taxable income and tax liabilities. Theamount of the annual limitation is determined based upon the Company’s valueimmediately prior to the ownership change. Subsequent significant changes inownership could further affect the limitations in future years.

**15. EMPLOYEE SAVINGS PLAN**

The Company sponsors asavings plan for its employees, who meet certain eligibility requirements,which is designed to be a qualified plan under section 401(k) of theInternal Revenue Code. Eligible employees are permitted to contribute to the401(k) plan through payroll deductions within statutory and plan limits.The Company may make discretionary contributions upon the approval of the 401(k) plantrustees and the Company’s board of directors. Through September 30, 2005,the Company has not made any contributions to the plan.

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**16. RESTRUCTURING ANDOTHER CHARGES**

During the year ended September 30, 2003, theCompany recorded a charge to operations of $507,000. This charge was comprisedentirely of future lease and lease-related payments and resulted from the continuedvacancy of certain leased facilities and the expected future vacancy of certainleased facilities occupied by a sub-tenant. When the Company restructured itsoperations during fiscal 2001, a portion of the charges that were recorded werebased on the curtailment of a planned expansion into leased facilities ofapproximately 24,000 square feet as well as vacating approximately 17,000square feet of leased space. In December 2002, based on the real estatemarket in the area of these facilities, the lack of interest in the spaces thatthe Company had been actively marketing to sublease and the deterioratingfinancial condition of the sub-tenant, the Company revised its estimates as tothe duration of an expected sublease of these facilities and the estimatedsublease income.

These revised estimates assumed no sublease incomefrom the Company’s vacant 17,000 square foot space through the end of theCompany’s original lease term, March 2005, and approximately $126,000 ofsublease income during the final nine months through March 2005 of itslease on the 24,000 square foot space. As a result, the Company recorded acharge to operations of $914,000. In the second quarter of fiscal 2003, theCompany received $30,000 of sublease income not previously anticipated and, asa result, reversed $30,000 of its restructuring accrual. In October 2003,the Company further amended its lease, which extended the lease term on itsprimary office and manufacturing space and eliminated the remaining lease onthe 24,000 square foot space as of October 31, 2003. This lease amendmentrequired the Company to pay a termination charge of $54,000. In addition, theCompany revised its estimate as to the expected future vacancy of the 17,000square foot space and determined that approximately 8,500 square feet of thisspace would be occupied by the Company beginning in October of fiscal2004. As a result of the Company’s lease amendment and revised estimates, theCompany reversed approximately $377,000 of its restructuring accrual duringfiscal 2003. Beginning in April 2005, the Company expects to utilize allof its leased space through the end of its amended lease term, March 2007.

During the year ended September 30, 2004, theCompany was permitted by its landlord to expand the production area of itsleased facilities. As such previous estimates related to expected unoccupiedleased space were revised. As a result, the Company reversed the remainingrestructuring accrual balance of $107,000 during fiscal 2004.

During the year ended September 30, 2005, theCompany discontinued sales of third-party data storage networking productsbased on a review of that portion of the business and its prospects. An amendment to a key distributionagreement, the commoditization of Fibre Channel HBA technology andincreasing competition in the market resulted in the Company experiencingdeclining gross profits related to its distribution of HBAs. As a result, theCompany recorded a restructuring charge of $366,000 during the quarter ended December 31,2004. Approximately $283,000 of the charge related to one-time terminationbenefits associated with terminating eleven employees in this portion of thebusiness during the quarter. The Company also incurred $83,000 for a fixedpayment related to its warranty fulfillment contract with an external serviceprovider. The Company completed its sales of its remaining third-party datastorage networking products during the quarter ended December 31, 2004. TheCompany completed its payments under this restructuring obligation during thequarter ended March 31, 2005.

89

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**16. RESTRUCTURING ANDOTHER CHARGES (Continued)**

Thefollowing table sets forth restructuring accrual activity during the yearsended September 30, 2005, 2004 and 2003 (in thousands):

| ** **                                                                      | ** ** | **Employee  Related** | ** ** | **Facility  Related** | ** ** | **Other** | ** ** | **Total** | ** **   |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------|------------|-----------|--------------|
| **Restructuring  and other charges accrual balance at September 30, 2002** |       |                  | $          | 32               |       |      |       | $         | 281     |   |   | $ | 42  |   | $ | 355  |   |
| Restructuring and other charges                                                 |       |                  |       |                  |       |      | 914        |      |         |   |   | 914 |   |
| Sublease income received in excess of estimates                                 |       |                  |       |                  |       |      | (30        | )         |         |   |   | (30 | ) |
| Revision of estimated liabilities for leased space                              |       |                  |       |                  |       |      | (377       | )         |         |   |   | (377 | ) |
| Cash payments                                                                   |       |                  | (13        | )                     |       |      | (513       | )         |         | (59 | ) | (585 | ) |
| Non-cash utilization                                                            |       |                  | (19        | )                     |       |      | (13        | )         |         | 32 |   | — |   |
| Restructuring and other charges accrual balance at  September 30, 2003     |       |                  | —     |                  |       |      | 262        |      |         | 15 |   | 277 |   |
| Reversal of excess restructuring                                                |       |                  |       |                  |       |      | (107       | )         |         |   |   | (107 | ) |
| Cash payments                                                                   |       |                  |       |                  |       |      | (155       | )         |         | (15 | ) | (170 | ) |
| **Restructuring and other charges accrual balance  at September 30, 2004** |       |                  | —     |                  |       |      | —     |      |         | — |   | — |   |
| Restructuring charge                                                            |       |                  | 283        |                  |       |      | —     |      |         | 83 |   | 366 |   |
| Cash payments                                                                   |       |                  | (283       | )                     |       |      | —     |      |         | (83 | ) | (366 | ) |
| **Restructuring  charge accrual balance at September 30, 2005**            |       |                  | $          | —           |       |      |       | $         | —  |   |   | $ | —  |   | $ | —  |   |

 

**17. SEGMENT AND GEOGRAPHICDATA**

The Company is organized into two reportable segments:OEM Appliance and Distribution. The Company’s segments have been determinedbased upon the channels through which the segments sell products. Sales ofserver appliances to the Company’s network equipment and ISV partners areincluded in the Company’s OEM Appliance segment. Sales of server appliances anddata storage products to VARs and systems integrators are included in theCompany’s Distribution segment. The accounting policies of these segments arethe same as those described in Note 2:  “Summaryof Significant Accounting Policies.” The Company evaluates its segments’performance based on net revenues, gross profit and segment operating income(loss), and the Company’s management regularly evaluates the Company’s segmentsin deciding how to allocate resources and assess performance. There are nointer-segment sales or transfers. Management does not review assets as part ofthe assessment of segment performance.

90

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**17.SEGMENT AND GEOGRAPHIC DATA (Continued)**

The following is a summaryof the Company’s operations by reporting segment (in thousands):

| ** **                      | ** ** | **OEM** | ** **   | **Distribution** | ** ** | **Total** | ** **    |
|---------------------------------|------------|---------|--------------|------------------|------------|-----------|---------------|
| **September 30, 2005**     |       |    |         |             |       |      |          |   |   |
| Net revenues                    |       | $       | 92,877  |             |       | $         | 5,194    |   |   | $ | 98,071  |   |
| Segment operating income (loss) |       | $       | 10,279  |             |       | $         | (19,003  | )(a) |   | $ | (8,724  | ) |
| **September 30,  2004**    |       |    |         |             |       |      |          |   |   |
| Net revenues                    |       | $       | 80,321  |             |       | $         | 56,434   |   |   | $ | 136,755  |   |
| Segment operating income (loss) |       | $       | 8,583   |             |       | $         | (3,778   | )(b) |   | $ | 4,805  |   |
| **September 30,  2003**    |       |    |         |             |       |      |          |   |   |
| Net revenues                    |       | $       | 43,289  |             |       | $         | 37,954   |   |   | $ | 81,243  |   |
| Segment operating  income       |       | $       | 2,177   |             |       | $         | 3,165    | (c) |   | $ | 5,342  |   |

----

(a)           Includes$7,769 related to the impairment of goodwill, $298 related to the impairment oflong-lived assets, and $366 of restructuring charges

(b)          Includes$4,013 related to the impairment of intangible assets, and $297 related toamortization of intangible assets

(c)           Includes $762 relatedto the amortization of intangible assets

TheCompany does not allocate general and administrative expenses to its reportablesegments, because these activities are managed separately from the reportablesegments. The Company did not allocate the costs of stock compensation to itsreportable segments, because these expenses pertain to employees across each ofthe segments. The Company did not allocate its 2004 and 2003 restructuringcharges, because these charges were not specifically related to either segment.A reconciliation of the totals reported for the reportable segments to the lossfrom operations in the consolidated financial statements is as follows, inthousands:

| ** **                                 | ** ** | **2005** | ** **    | **2004** | ** ** | **2003**     | ** ** |
|--------------------------------------------|------------|----------|---------------|----------|------------|--------------|------------|
| Total segment  operating income (loss)     |       | $        | (8,724   | )        | $          | 4,805   |       | $ | 5,342  |   |
| General and administrative                 |       | 7,838    |          | 6,430    |       | 5,856        |       |
| Stock  compensation                        |       | 14       |          | 390      |       | 928          |       |
| Restructuring and  other charges (credits) |       | —   |          | (107     | )          | 507          |       |
| Loss from  operations                      |       | $        | (16,576  | )        | $          | (1,908  | )          | $ | (1,949  | ) |

 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**17.SEGMENT AND GEOGRAPHIC DATA (Continued)**

All of the Company’slong-lived assets were located in the United States as of September 30,2005 and 2004. The following summarizes the Company’s revenues by geographicregion, in thousands:

| ** **          | ** ** | **Years ended September 30,** | ** **   |
|---------------------|------------|----------------------------------------------|--------------|
| ** **          | ** ** | **2005**                                     | ** **   | **2004** | ** ** | **2003** | ** ** |
| United States       |       | $                                            | 73,082  |   | $ | 113,457  |   | $ | 77,203  |   |
| Foreign countries   |       | 24,989                                       |         | 23,298 |   | 4,040 |   |
| Total net  revenues |       | $                                            | 98,071  |   | $ | 136,755  |   | $ | 81,243  |   |

 

Revenuesare attributed to countries based on the location of customers. Significantcomponents of revenues in foreign countries consisted of the following for theyears ended September 30 (in thousands):

| ** ** | ** ** | **2005** | ** **   | **2004** | ** ** |
|------------|------------|----------|--------------|----------|------------|
| Ireland    |       | $        | 23,646  |     | $          | 17,625  |   |
| Canada     |       | 1,014    |         | 2,930    |       |
|            |            |          |              |          |            |  |  |

 

**18. QUARTERLY FINANCIALDATA (UNAUDITED)**

Thefollowing information has been derived from unaudited consolidated financialstatements that, in the opinion of management, include all recurringadjustments necessary for a fair statement of such information.

| ** **                                             | ** ** | **Three Months Ended**                                   | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **December 31,  2004**                                        | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** |
| ** **                                             | ** ** | **(in thousands, except per share data)** | ** ** |
| Net Revenues                                           |       |                                                               | $          | 26,959  |   |   |   | $ | 23,673  |   |   | $ | 24,305  |   |   | $ | 23,133  |   |   |
| Gross profit                                           |       |                                                               | 5,043      |   |   |   | 5,121 |   |   | 4,085 |   |   | 2,812 |   |   |
| Net loss                                               |       |                                                               | (1,549     | ) |   |   | (1,112 | ) |   | (1,801 | ) |   | (11,121 | ) |   |
| Basic and diluted net loss per share                   |       |                                                               | $          | (0.04  | ) |   |   | $ | (0.03  | ) |   | $ | (0.05  | ) |   | $ | (0.29  | ) |   |
| Basic and diluted  weighted average shares outstanding |       |                                                               | 37,187     |   |   |   | 37,306 |   |   | 37,582 |   |   | 37,769 |   |   |

 

| ** **                                   | ** ** | **Three Months Ended**                                   | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **December 31,  2003**                                        | ** ** | **March 31,  2004** | ** ** | **June 30,  2004** | ** ** | **September 30,  2004** | ** ** |
| ** **                                   | ** ** | **(in thousands, except per share data)** | ** ** |
| Net Revenues                                 |       |                                                               | $          | 35,851  |   |   |   | $ | 35,619  |   |   | $ | 34,381  |   |   | $ | 30,904  |   |   |
| Gross profit                                 |       |                                                               | 7,074      |   |   |   | 6,319 |   |   | 5,772 |   |   | 4,743 |   |   |
| Net income (loss)                            |       |                                                               | (2,072     | ) |   |   | 975 |   |   | 726 |   |   | (1,248 | ) |   |
| Basic net income (loss) per share            |       |                                                               | $          | (0.06  | ) |   |   | $ | 0.03  |   |   | $ | 0.02  |   |   | $ | (0.03  | ) |   |
| Diluted net income (loss) per share          |       |                                                               | $          | (0.06  | ) |   |   | $ | 0.02  |   |   | $ | 0.02  |   |   | $ | (0.03  | ) |   |
| Basic weighted average shares outstanding    |       |                                                               | 35,712     |   |   |   | 36,578 |   |   | 36,886 |   |   | 37,052 |   |   |
| Diluted weighted  average shares outstanding |       |                                                               | 35,712     |   |   |   | 40,537 |   |   | 40,042 |   |   | 37,052 |   |   |

 

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**NETWORK ENGINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**18.QUARTERLY FINANCIAL DATA (UNAUDITED) (Continued)**

During the fourth quarter of fiscal 2005, the Companyrecorded goodwill and long-lived asset impairment charges of $7,769,000 and$273,000, respectively. During the third quarter of fiscal 2004, the Companyrecorded a reversal of approximately $107,000 of restructuring charges relatedto revised estimates as to the vacancy of certain leased facilities. During thefirst and fourth quarters of fiscal 2004, the Company recorded impairmentcharges of $3,614,000 and $399,000, respectively, related to the impairment ofintangible assets.

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**ITEM 9. CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM9A. CONTROLS AND PROCEDURES**

**Disclosure Controlsand Procedures**

Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act) as of September 30, 2005. Based on this evaluation, ourchief executive officer and chief financial officer concluded that, as of September 30,2005, our disclosure controls and procedures were (1)  effectivelyaccumulated and communicated information to the Company’s management, asappropriate, to allow timely decisions regarding required disclosure  (2) effective, in that they providereasonable assurance that information required to be disclosed by the Companyin the reports that it files or submits under the Securities Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.

**Management’s AnnualReport on Internal Control Over Financial Reporting**

The management ofNetwork Engines, Inc. is responsible for establishing and maintainingadequate internal control over financial reporting. Internal control overfinancial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgatedunder the Securities Exchange Act of 1934 as a process designed by, or underthe supervision of, the company’s principal executive and principal financialofficers and effected by the company’s board of directors, management and otherpersonnel, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles andincludes those policies and procedures that:

·       Pertainto the maintenance of records that in reasonable detail accurately and fairlyreflect the transactions and dispositions of the assets of the company;

·       Providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and

·       Providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Network Engines’ management assessed the effectivenessof the Company’s internal control over financial reporting as of September 30,2005. In making this assessment, it used the criteria set forth in InternalControl-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Based on our assessment, weconcluded that, as of September 30, 2005, the Company’s internal controlover financial reporting is effective based on those criteria.

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PricewaterhouseCoopers,LLP, Network Engines’ Independent Registered Public Accounting Firm, auditedour assessment of the effectiveness of the Company’s internal control overfinancial reporting as of September 30, 2005, as stated in their reportappearing under Item 8.

**Changes in InternalControl Over Financial Reporting**

No change in the Company’sinternal control over financial reporting occurred during the fiscal year endedSeptember 30, 2005 that has materially affected, or is reasonably likelyto materially affect, the Company’s internal control over financial reporting.

**ITEM9B. OTHER INFORMATION**

None.

95

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**PART III**

**ITEM10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

The information requiredby this item relating to directors, code of ethics, audit committee, and auditcommittee financial expert of the Company and Section 16(a) beneficialownership reporting compliance is contained in our Proxy Statement related tothe 2006 Annual Meeting of Shareholders, under the sections captioned “Election of Directors”, “AdditionalInformation About Directors” and “Section 16(a) Beneficial OwnershipReporting Compliance”, and is incorporated herein by reference in response tothis item. The information regarding executive officers is included in Part Iof this Form 10-K under the section captioned “Executive Officers of theCompany”.

**ITEM11. EXECUTIVE COMPENSATION**

The information requiredby this item is included under the section captioned “Executive Compensation”in our Proxy Statement related to the 2006 Annual Meeting of Shareholders andis incorporated herein by reference.

**ITEM 12. SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

The information requiredby this item relating to security ownership of certain beneficial owners andmanagement, and securities authorized for issuance under equity compensationplans, is included in our Proxy Statement related to the 2006 Annual Meeting ofShareholders under the section captioned “Stock Ownership of Directors,Officers and Greater-Than-5%-Stockholders” and is incorporated herein byreference.

**ITEM13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

The information requiredby this item relating to certain relationships and related transactions isincluded in our Proxy Statement related to the 2006 Annual Meeting ofShareholders under the section captioned “Certain Relationships and RelatedTransactions” and is incorporated herein by reference.

**ITEM14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**

The information required by this item is includedunder the captions “Ratification of Independent Registered Public AccountingFirm—Principal Accountant Fees and Services” and “Policy on Audit CommitteePre-Approval of Audit and Permissible Non-Audit Services of IndependentRegistered Public Accounting Firm” in our Proxy Statement related to the 2006Annual Meeting of Shareholders and is incorporated herein by reference.

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**PART IV**

**ITEM15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

**(a) (1) Financial Statements**

Thefollowing consolidated financial statements are filed as part of this reportunder“Item 8—Financial Statements and Supplementary Data”:

|                                                                                                                                          | ** ** | **Page** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent  Registered Public Accounting Firm                                                                                 |       | 57       |
| Consolidated Balance Sheets as of  September 30, 2005 and 2004                                                                      |       | 59       |
| Consolidated Statements of  Operations for the years ended September 30, 2005, 2004 and 2003                                   |       | 60       |
| Consolidated Statements of  Stockholders’ Equity and Comprehensive Loss for the years ended  September 30, 2005, 2004 and 2003 |       | 61       |
| Consolidated Statements of  Cash Flows for the years ended September 30, 2005, 2004 and 2003                                   |       | 63       |
| Notes to  Consolidated Financial Statements                                                                                              |       | 64       |

 

**(a) (2) List of Schedules**

Schedule II—Valuation and Qualifying Accounts for eachof the three fiscal years ended September 30, 2005.

Allother schedules to the consolidated financial statements are omitted as therequired information is either inapplicable or presented in the consolidatedfinancial statements.

**(a) (3) List of Exhibits**

The exhibits which are filed with this report or whichare incorporated by reference are set forth in the Exhibit Index hereto.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this Report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on December 14,2005.

|        | **NETWORK ENGINES, INC** |
|--------|--------------------------|
|   | By:                      | /s/ JOHN H. CURTIS |
|   |                     | John H. Curtis |
|   |                     | President and Chief Executive Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Report has beensigned as of December 14, 2005 below by the following persons on behalf ofthe Registrant and in the capacities indicated.

|                             | **Name** | ** **                                                                                                  | ** ** | ** ** | **Title** | ** ** |
|-----------------------------|----------|-------------------------------------------------------------------------------------------------------------|------------|------------|-----------|------------|
| /s/ JOHN  H. CURTIS         |     | President and  Chief Executive Officer (Principal Executive                                                 |
| John  H. Curtis             |     | Officer)                                                                                                    |
| /s/ DOUGLAS  G. BRYANT      |     | Vice President of  Finance and Administration, Chief                                                        |
| Douglas  G. Bryant          |     | Financial Officer,  Treasurer and Secretary (Principal Financial Officer and Principal Accounting  Officer) |
| /s/ LAWRENCE  A. GENOVESI   |     | Director                                                                                                    |
| Lawrence  A. Genovesi       |     |                                                                                                        |
| /s/ JOHN  A. BLAESER        |     | Director                                                                                                    |
| John  A. Blaeser            |     |                                                                                                        |
| /s/ FONTAINE  K. RICHARDSON |     | Director                                                                                                    |
| Fontaine  K. Richardson     |     |                                                                                                        |
| /s/ DENNIS  A. KIRSHY       |     | Director                                                                                                    |
| Dennis  A. Kirshy           |     |                                                                                                        |
| /s/ ROBERT  M. WADSWORTH    |     | Director                                                                                                    |
| Robert  M. Wadsworth        |     |                                                                                                        |
| /s/ GARY  E. HAROIAN        |     | Director                                                                                                    |
| Gary E. Haroian             |     |                                                                                                        |

 

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**SCHEDULE II**

**NETWORKENGINES, INC.Valuation and Qualifying Accounts(in thousands)**

| ** **       | ** ** | ** **                              | ** ** | **Balance At** | ** ** | ** **                    | ** ** | ** **    | ** ** | **Balance**    | ** **   |
|------------------|------------|-----------------------------------------|------------|---------------------|------------|-------------------------------|------------|---------------|------------|----------------|--------------|
| **Fiscal  Year** | ** ** | ** **                              | ** ** | **Description**     | ** ** | **Beginning  of Period** | ** ** | **Additions** | ** ** | **Deductions** | ** **   | **At End  of Period** | ** ** |
| 2003             |       | Allowance For Doubtful Accounts         |       |                | $          | 240                      |       |          |       | $              | 166     |   |   |   | $ | 17  |   |   | $ | 389  |   |
| 2004             |       | Allowance  For Doubtful Accounts        |       |                | $          | 389                      |       |          |       | $              | 31      |   |   |   | $ | 230  |   |   | $ | 190  |   |
| 2005             |       | Allowance  For Doubtful Accounts        |       |                | $          | 190                      |       |          |       | $              | (4      | ) |   |   | $ | 111  |   |   | $ | 75  |   |
| 2003             |       | Allowance For Sales Returns             |       |                | $          | 109                      |       |          |       | $              | 247     |   |   |   | $ | 111  |   |   | $ | 245  |   |
| 2004             |       | Allowance  For Sales Returns            |       |                | $          | 245                      |       |          |       | $              | 228     |   |   |   | $ | 221  |   |   | $ | 252  |   |
| 2005             |       | Allowance  For Sales Returns            |       |                | $          | 252                      |       |          |       | $              | —  |   |   |   | $ | 252  |   |   | $ | —  |   |
| 2003             |       | Deferred Tax Asset Valuation Allowance  |       |                | $          | 37,889                   |       |          |       | $              | 142     |   |   |   | $ | 1,715  |   |   | $ | 36,316  |   |
| 2004             |       | Deferred  Tax Asset Valuation Allowance |       |                | $          | 36,316                   |       |          |       | $              | 708     |   |   |   | $ | 490  |   |   | $ | 36,534  |   |
| 2005             |       | Deferred Tax Asset  Valuation Allowance |       |                | $          | 36,534                   |       |          |       | $              | 3,509   |   |   |   | $ | (872  | ) |   | $ | 40,915  |   |
|                  |            |                                         |            |                     |            |                               |            |               |            |                |              |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**EXHIBIT INDEX**

| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                                                                                                                                                                                                 |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Agreement and Plan of  Merger dated November 11, 2002, among the Company, Ninja Acquisition Co.  and TidalWire Inc. (filed as Exhibit 2.1 to the Company’s Current Report  on Form 8-K dated November 15, 2002 and incorporated by reference  herein).                                             |
| 3.1                  |       | Second Amended and  Restated Certificate of Incorporation of the Company (filed as  Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the  fiscal year ended September 30, 2000 and incorporated by reference  herein).                                                                       |
| 3.2                  |       | Second Amended and  Restated By-laws of the Company (filed as Exhibit 3.2 to the Company’s  Annual Report on Form 10-K for the fiscal year ended September 30,  2000 and incorporated by reference herein).                                                                                             |
| 4.1                  |       | Specimen common stock  certificate (filed as Exhibit 4.1 to the Company’s registration  statement on Form S-1 (File No. 333-34286) and incorporated by  reference herein).                                                                                                                              |
| 10.1                 |       | Investor Rights  Agreement Investor Rights Agreement, dated December 20, 1999, among the  Company and certain of our investors (filed as Exhibit 10.6 to the  Company’s registration statement on Form S-1 (File No. 333-34286)  and incorporated by reference herein).                            |
| 10.2*                |       | The Company’s 1999 Stock  Incentive Plan (filed as Exhibit 10.2 to the Company’s registration  statement on Form S-1 (File No. 333-34286) and incorporated by  reference herein).                                                                                                                  |
| 10.3*                |       | Form of First  Amendment to the Company’s 1999 Stock Incentive Plan (filed as  Exhibit 10.16 to the Company’s registration statement on Form S-1  (File No. 333-34286) and incorporated by reference herein).                                                                                 |
| 10.4*                |       | Form of Incentive  Stock Option Agreement under the Company’s 1999 Stock Incentive Plan (filed  as Exhibit 10.3 to the Company’s registration statement on Form S-1  (File No. 333-34286) and incorporated by reference herein).                                                         |
| 10.5*                |       | The Company’s 2000  Employee Stock Purchase Plan, as amended (filed as Exhibit 10.4 to the  Company’s registration statement on Form S-1 (File No. 333-34286)  and incorporated by reference herein).                                                                                              |
| 10.6*                |       | The Company’s 2000  Director Stock Option Plan, as amended (filed as Exhibit 10.5 to the  Company’s registration statement on Form S-1 (File No. 333-34286)  and incorporated by reference herein).                                                                                                |
| 10.7*                |       | TidalWire Inc. 2001  Omnibus Stock Plan (filed as Exhibit 99.1 to the Company’s registration  statement on Form S-8 (File No. 333-49978) and incorporated by  reference herein).                                                                                                                        |
| 10.10*               |       | Form of option  granted to each of Frank M. Polestra and Robert M. Wadsworth on  March 16, 2000, under the Company’s 1999 Stock Incentive Plan (filed as  Exhibit 10.15 to the Company’s registration statement on Form S-1  (File No. 333-34286) and incorporated by reference herein). |
| 10.11*               |       | Incentive Stock Option  Agreement with John H. Curtis, dated March 21, 2001, under the Company’s  1999 Stock Incentive Plan (filed as Exhibit 10.23 to the Company’s  Quarterly Report on Form 10-Q for the fiscal quarter ended  March 31, 2001 and incorporated by reference herein).       |
| 10.12*               |       | Non-statutory Stock  Option Agreement with John H. Curtis, dated March 21, 2001 (filed as  Exhibit 10.24 to the Company’s Quarterly Report on Form 10-Q for  the fiscal quarter ended March 31, 2001 and incorporated by reference  herein).                                                       |

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| 10.13* |   | Employment Agreement, dated March 21, 2001,  between the Company and John H. Curtis (filed as Exhibit 10.22 to the  Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended  March 31, 2001 and incorporated by reference herein).                                                      |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14* |   | Executive Retention Agreement, dated April 12,  2002, between the Company and John H. Curtis (filed as Exhibit 10.37 to  the Company’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2002 and incorporated by reference herein).                                               |
| 10.18  |   | Lease dated  October 19, 1999 with New Boston Batterymarch, LP for 25 Dan Road,  Canton, Massachusetts (filed as exhibit 10.1 to the Company’s registration  statement of Form S-1 (File No. 333-34286) and incorporated by  reference herein).                                                      |
| 10.19  |   | First Amendment dated  February 1, 2000 and Second Amendment dated June 1, 2000 to Lease  for 25 Dan Road, Canton, Massachusetts (filed as Exhibit 10.18 to the  Company’s registration statement on Form S-1 (File No. 333-34286)  and incorporated by reference herein).                      |
| 10.20  |   | Third Amendment dated  September 14, 2000 and Forth Amendment dated October 14, 2003 to  Lease for 25 Dan Road, Canton, Massachusetts (filed as Exhibit 10.24 to  the Company’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2003 and incorporated by reference herein). |
| 10.21# |   | Purchase Agreement for  product between the Company and EMC Corporation, dated February 5, 2002  (filed as Exhibit 10.36 to the Company’s Quarterly Report on  Form 10-Q for the fiscal quarter ended March 31, 2002 and  incorporated by reference herein).                                         |
| 10.24  |   | Base Salaries of  Executive Officers of the Company                                                                                                                                                                                                                                                                           |
| 10.25  |   | Summary of the Company’s  Non-Employee Director Compensation                                                                                                                                                                                                                                                             |
| 14.1   |   | Code of Business Conduct  and Ethics of the Company (filed as Exhibit 14 to the Company’s Current  Report on form 8-K dated February 3, 2004 and incorporated by reference  herein).                                                                                                                           |
| 21.1   |   | Subsidiaries of the  Company.                                                                                                                                                                                                                                                                                                 |
| 23.1   |   | Consent of  PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                                                                       |
| 31.1   |   | Certification of John H.  Curtis, the Chief Executive Officer of the Company, pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                |
| 31.2   |   | Certification of Douglas  G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                             |
| 32.1   |   | Certification of John H.  Curtis, the Chief Executive Officer of the Company, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                |
| 32.2   |   | Certification of Douglas  G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                             |

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*                    Indicatesmanagement contract or compensatory plan or arrangement.

#                 Indicatesconfidential treatment requested as to certain portions, which portions wereomitted and filed separately with the Securities and Exchange Commissionpursuant to a Confidential Treatment Request.

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