Use these links to rapidly review the documentNETWORK ENGINES, INC. ANNUAL REPORT ON FORM 10-K For the Fiscal Year Ended September 30, 2007 TABLE OF CONTENTS ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K

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|(Mark One)                                                    |                                                                                         
|------------------------------------------------------------- | ----------------------------------------------------------------------------------------
|ý                                                             | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|For the fiscal year ended September 30, 2007                 
|OR                                                           
|o                                                             | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the transition period
from                             to

Commission file number: 000-30863

GRAPHIC

NETWORK ENGINES, INC.(Exact name of registrant as specified in its charter)

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

Registrant's
telephone number, including area code(781) 332-1000

Securities registered pursuant to Section 12 (b) of the Act:

Title of Each Class

Name of Exchange on which RegisteredCommon Stock, par value $0.01

NASDAQ Global Market


Securities
registered pursuant to Section 12 (g) of the Act:None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act.    Yes o No ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act.    Yes o No ý

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period than the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the
past 90 days.    Yes ý No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the registrant's knowledge, in definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K.    ý

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange
Act Rule 12b-2). Large accelerated filer o        accelerated
filer ý        non-accelerated filer o

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

The aggregate market value of the voting Common Stock held by nonaffiliates of the registrant on March 31, 2007 was approximately $69,643,000

The
number of shares outstanding of the registrant's Common Stock as of December 11, 2007: 44,008,612 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our proxy statement relating to the 2008 Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission no
later than 120 days after the end of our fiscal year, are incorporated by reference into Part III of this Form 10-K.



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NETWORK ENGINES, INC.  ANNUAL REPORT ON FORM 10-K  For the Fiscal Year Ended September 30, 2007        TABLE OF CONTENTS



|PART I    
|----------
|ITEM 1.   
|ITEM 1A.  
|ITEM 1B.  
|ITEM 2.   
|ITEM 3.   
|ITEM 4.   
|PART II   
|ITEM 5.   
|ITEM 6.   
|ITEM 7.   
|ITEM 7A.  
|ITEM 8.   
|ITEM 9.   
|ITEM 9A.  
|ITEM 9B.  
|PART III  
|ITEM 10.  
|ITEM 11.  
|ITEM 12.  
|ITEM 13.  
|ITEM 14.  
|PART IV   
|ITEM 15.  
|SIGNATURES

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This Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, that involve
risks and uncertainties. All statements other than statements of historical information provided herein are forward-looking statements and may contain projections relating to financial results,
economic conditions, trends and known uncertainties. Our actual results could differ materially from those discussed in the forward-looking statements as a result of a number of factors, including the
factors discussed in "Part I, Item 1A.Risk Factors" and elsewhere in this report and the risks discussed in our other filings with the Securities and Exchange Commission. Readers
are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis, judgment, belief or expectation only as of the date hereof. We undertake no
obligation to publicly reissue these forward-looking statements to reflect events or circumstances that arise after the date hereof.

References in this Annual Report on Form 10-K to "Network Engines", "the Company", "we", "us" or "our" are to Network Engines, Inc. a Delaware
corporation and its subsidiaries.

PART I

ITEM 1.    BUSINESS

Overview

Network Engines develops and manufactures server appliance solutions that deliver software applications on server appliances. To date, a large portion of our
revenues is derived from the sale of server appliances to customers in the data storage and network security markets. Server appliances are pre-configured network infrastructure devices
designed to optimally deliver specific software application functionality while facilitating ease of deployment, improved manageability and
increased security of that software application in a customer's network. A server appliance deployment is intended to reduce the total cost of ownership associated with the deployment and ongoing
maintenance of software applications within a customer's IT infrastructure.

We
develop and manufacture server appliance solutions that enable network equipment providers and independent software vendors, or ISVs, to deliver their software applications in the
form of a server appliance. We offer our customers a comprehensive suite of services, including development, manufacturing, fulfillment and post-sale support. We produce and fulfill
devices for our network equipment and ISV customers, and we derive our revenues primarily from the sale of value-added hardware platforms to these customers. These customers subsequently sell and
support the appliance under their own brands to their customer base. Our customers include, but are not limited to: Bomgar, Inc., Bradford Networks, Juniper Networks, Inc., EMC
Corporation, Nortel Networks Inc., Sophos, Plc. and Websense, Inc.

In
addition to our appliance and service offerings, we have also developed our proprietary appliance remote maintenance software called Network Engines Web Server, or NEWS,
to enhance our existing hardware, software and service capabilities for current and prospective customers. Our NEWS technology is a web-based appliance management
sub-system that enables deployment and maintenance tasks such as provisioning and remote system updates. By offering this technology across a wide range of server appliance solutions, we
believe this will enable our customers to remotely monitor and maintain server appliances in widely dispersed networks from a central site.

We
operate as one segment, and by virtue of our ability to offer a wide range of engineering, manufacturing, supply-chain and support services, we believe we are well positioned to be
the appliance company of choice for independent software providers, and network equipment providers looking to deploy their applications and service offerings in the form of an appliance.

On
October 11, 2007, we acquired privately-held Alliance Systems, Inc. ("Alliance Systems"), a leading provider of server appliances and computer infrastructure
supporting telecommunications and enterprise communications solutions. This acquisition, which was valued at approximately $40 million,

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was
funded through a combination of approximately $34 million in cash and the issuance of 2.9 million shares of our common stock.

Based
in Plano, Texas, Alliance Systems provides server appliances and enhanced support services for wireless, VoIP, contact center and enterprise communications solutions. The majority
of Alliance Systems' revenue comes from services to OEM customers. In its fiscal year ended December 31, 2006, Alliance Systems had more than 250 active customers, only two of which contributed
10% or more of
revenue, one at 15% and the other at 10%. Through the acquisition of Alliance Systems, we believe that we will be able to enter new vertical markets and expect to leverage a broader range of
capabilities to address market needs for converged solutions.

Headquartered
in Canton, Massachusetts, we were incorporated in 1989, and began developing custom server hardware platforms in 1997 for internet-based organizations, content
infrastructure providers and larger enterprises. In 1999, we achieved an important milestone by introducing a one-rack unit Intel-based server, representing a server only 1.75 inches in
height. At that time, we designed most of the hardware components that went into our servers and, as a result, we invested significant resources in the development of our products. In large part as a
result of the success of that product, we completed an initial public offering in July 2000. Subsequently, a significant number of companies entered the one-rack unit server
marketplace, much of the hardware components of server appliances became commoditized and, at the same time, the demand of internet-based organizations declined precipitously. As a result, we
restructured our operations in fiscal 2001, which among other things de-emphasized the use of proprietary components in server hardware platforms. In December 2002, we acquired
TidalWire, Inc., which was a specialty distributor of third-party data storage networking products. The acquisition enabled us to distribute third-party data storage networking connectivity
products for the leading Fibre Channel host bus adapter, or HBA, and storage switch manufacturers in the data storage industry to a customer base of value-added resellers, or VARs, and systems
integrators. During the first quarter of fiscal 2005, we decided to discontinue selling third-party data storage networking products after a review of that portion of the business and its future
prospects. The TidalWire acquisition also provided us with the ability to partner with ISVs to develop, manufacture, and distribute the ISVs' software applications in the form of server appliances.
Throughout fiscal 2003 and 2004, we established relationships with several ISV customers. During fiscal 2005 and 2006 we also developed, manufactured, sold, marketed and supported our NS Series
Security Appliances that were based on Microsoft's Internet Security and Acceleration ("ISA") Server software. Because sales of our NS Series appliances were less than expected in fiscal 2006 and
2005, we discontinued the sale and demand creation for these appliances. Today, we leverage our engineering and manufacturing expertise to deliver server appliance solutions to our ISV and network
equipment provider customers while seeking to establish new relationships with other ISVs, and network equipment provider customers.

Industry Background

Traditionally, networking solutions were built utilizing custom-designed hardware and proprietary operating systems. Vendors developed custom components and
systems in an effort to meet the high performance demands of their customers, such as increasing networking speeds, packet processing requirements and internal storage capabilities. While these highly
integrated systems were designed to address the performance demands of the customer, they were expensive due to the cost of research and development related to the requisite customization. Networking
solution vendors generally maintained internal research, development, manufacturing and integration expertise in both hardware and software, as both were critical aspects of a networking solution and
viewed as essential to maintaining a competitive advantage.

Over
time, much of the networking solutions market has evolved toward the development and manufacture of systems, built using commercially available standardized components and
standardized

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operating
system platforms. The speed and processing power of standard processors has reached a level where these processors can adequately meet the demands of many networking applications. Operating
system platforms, such as Windows and Linux, have also increased in capability and sophistication and can now be used as the embedded operating system environment for many of
today's networking applications.

This
evolution in the development and manufacturing of systems, or server appliances, built with commercially available standardized components has allowed networking equipment vendors
to refocus development efforts and resources on the application software and system integration aspects of their solutions. Vendors recognize that custom hardware development in many cases is no
longer critical in meeting their customers' performance requirements. Competing systems are being integrated and packaged on standardized hardware platforms and, therefore, hardware alone no longer
differentiates a system in the marketplace. Based on the fact that server appliance solutions can be built using standard commodity hardware and operating systems components, vendors recognize that
these aspects of their solution do not represent competitive differentiation points and are hence candidates for outsourcing. As a result, we believe that many network equipment providers 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 server appliance may ultimately be used, early adoption of the technology is most prevalent in the data storage and network security
markets. These markets are significant in size and have exhibited growth in recent years. The security applications that we believe are most likely to benefit from a server appliance solution include
firewalls, authentication, anti-virus, anti-spam, instant messaging or IM security, web content filtering, intrusion detection and prevention, device relationship management,
digital rights management and web services security management. The storage applications that we believe are most likely to benefit from deployment in the form of a server appliance include storage
security, backup and recovery, virtual tape libraries, storage resource management and data migration and archival systems.

Another
significant trend driving the growth of the data storage and network security markets is the decentralization of storage management applications and network security
applications. Enterprises are deploying applications both in data centers and at departmental and remote office locations. As a result, there is an increased need for applications that can be deployed
quickly and efficiently without the need for extensive internal IT resources. Furthermore, remote deployment, monitoring and upgrades have become a critical aspect of managing the IT network of an
enterprise.

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

Network Engines' Solution

We develop and manufacture server appliance solutions that enable our customers to deliver their software applications on server appliances. We achieve this by
delivering innovative platforms and services to our customers to enable secure, predictable and managed solutions. We focus on developing cost-effective server appliance solutions to meet
the performance requirements of our customers' software applications or service offering in order to address the deployment and cost of ownership needs of their customers. Key elements of our solution
include:

Appliance development expertise.The core of our business is developing and manufacturing high quality server appliance
solutions in conjunction with our network equipment and ISV customers. We have developed a structured appliance development process, which takes into account all major aspects of a product's design,
from performance requirements to branding, packaging and quality assurance. We strive to engage with our customers at multiple levels of their organization, including engineering

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and
product management, to optimize the product or suite of products by focusing on the integration of the hardware, operating system, utilities and application software. We make use of
in-house server platform designs and third-party server platforms, depending on the configuration, application and volume requirements. An element of our appliance development expertise
includes our Virtual Appliance Solution service that enables our ISV customers to meet the demand for virtual appliances from their enterprise customers. This service enables creation of virtual
appliance versions of our customer's application. The Virtual Appliance Solution service consists of the software image development and delivery, and the service component, which addresses the
management, maintenance and updating virtual appliances need to run properly from initial provisioning through end-of-life.

Flexible, high-quality manufacturing services.We have a sophisticated manufacturing facility at our headquarters
in Canton, Massachusetts, which is ISO 9001:2000 certified. Our advanced control processes and systems, and comprehensive manufacturing test suites that we develop with our customers, are designed to
ensure quality and trace ability at every key step of the manufacturing process. We believe our core strengths include our ability to react quickly to accommodate changes in customer demands,
including increasing order volumes, engineering changes to existing products and new product introductions. For certain high volume products, we supplement our production capacity and make provision
to maintain continuity of supply through a relationship with a contract manufacturer.

Custom design services.We believe our expertise in developing customized hardware platforms is a significant competitive
advantage with respect to customers with high volume requirements for whom commercially available platforms are not appropriate solutions. This capability is based on our heritage of designing and
optimizing custom server platforms, and is generally driven by our customers' specific requirements for features including density, low energy consumption, performance or cost optimization. Our
customization skills include hardware, firmware and software integration and packaging. Our team of skilled engineers, augmented by third-party contractors, has significant industry experience in
high-density packaging, server design, testing, quality assurance and technical documentation.

Appliance life cycle management.We operate in a technology environment in which platforms, operating systems, components and
software applications are constantly evolving. We proactively analyze these developments in order to maintain the operation of the software applications despite changes in the underlying technologies.
We also adapt the server appliance solutions to meet emerging requirements and capabilities of new versions of our customers' software or changes in their service offerings. To enable our customers to
meet these challenges we integrate our software technologies such as NEWS and Appliance Certified Edition ("ACE") Linux. Our NEWS appliance management system helps our customers manage, monitor and
maintain their appliances. ACE Linux provides a choice of operating system for our customers who develop their applications using Linux. ACE Linux enables us to provide our customers with an automated
update service that maintains the operating system when and if updates become available. We believe our expertise in life cycle management, and our ability to provide turnkey solutions for our
customers has become a critical factor in retaining existing and attracting new customers.

Business Strategy

Our objective is to become a leading global provider of server appliance solutions and services. The key elements of our strategy include:

Strengthen existing relationships and engage with new network equipment providers, independent software vendors (ISVs) and telecom service providers to sell
server appliance solutions.We believe that offering customers an appliance life cycle solution encompassing a comprehensive suite of services, including
development, manufacturing, fulfillment, and post-sales support, enables our customers to deploy their software applications in the form of a server appliance while achieving the lowest
total cost

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of
ownership over the long term. We believe that our appliance life cycle management offering and value-added software services provide us with a competitive advantage in the marketplace that we
intend to leverage to attract new ISVs, telecom service providers and network equipment providers, as well as develop additional opportunities within our existing customer base. During fiscal 2007 we
successfully engaged with 24 new ISV customers. Some of these customers generated meaningful revenue for us during the year, while others are in various stages of the product development life cycle.
Over the next year we will be focused on cultivating these new customers in order to generate revenues, and continuing to engage with new customers. We intend to identify new customers and
opportunities in order to diversify our revenue sources beyond our current customer base. We are targeting network equipment providers, ISVs and telecom service providers whose technology aligns with
the benefits of deployment in the form of a server appliance, and who have adequate sales and marketing resources to bring such appliances to market. To date, these customers have been in the data
storage and network security markets, where initial adoption of the server appliance solution has been most prevalent. However, with our acquisition of Alliance Systems we will expand the reach of our
products and services to the telecommunications and enterprise communications markets.

Develop and integrate technologies that improve the functionality, security, manageability and deployment of server
appliances.We intend to continue to enhance our proprietary technology, and integrate other third-party technologies that enable remote management and deployment
of server appliance solutions. Our NEWS technology enables the remote management of appliances through a secure web-based management system. We believe NEWS will
be the cornerstone of one of our key differentiatorsour ability to enable complete appliance lifecycle management. Historically NEWS was primarily deployed only on certain of
our appliances. However, in support of our appliance life cycle management offering we have developed NEWS for deployment across all our server appliance solutions, including those
appliances whose operating system is based on Linux. During fiscal 2007 we also announced our Virtual Appliance Services that allow our customers to deliver the same software on their server appliance
as a software only virtual appliance that can run on any commercial hypervisor. This allows our customers to respond to the changing needs of their customers and new technology developments.

Successfully integrate our acquisition of Alliance Systems to achieve significant cost savings and leverage synergies across a consolidated
company.We believe our acquisition of Alliance Systems, which formally closed in October 2007, will allow us to accelerate our strategic and financial
progress in several important ways. This acquisition brings us into important new vertical markets; specifically telecommunications and enterprise communications. We believe our combined product
offering represents a competitive advantage that could enhance our ability to win new business. There is also potential for cross-selling existing products and services as our combined company will
have a broader range of capabilities to address market needs for converged solutions. A successful integration of this
acquisition will enable us to realize cost savings, such as eliminating senior level management redundancies and realization of savings in the supply chain.

Products and Services

We develop and manufacture turn-key server appliance solutions that enable our network equipment, and ISV customers to deliver software applications
on a server appliance. We have developed a comprehensive suite of products and services, enabling our customers to accelerate the time to market for their products, to optimize their server appliance
solutions and in some cases enable them to utilize our infrastructure for fulfillment of those server appliance solutions.

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Our products and services are described in more detail below:



We have developed a structured approach to server appliance development. We define the customer engagement and ultimate delivery of the product in stages and
identify the responsibilities for both the customer and for ourselves. This program is designed to ensure that the engagement with our customer is well managed and executed and anticipates and
includes all aspects of the solution requirements. The key phases of the process consist of the following:



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



Our server appliance hardware design team is well versed in custom server design, generally utilizing standard off-the-shelf components
and sub-systems. The development of customized server appliance hardware requires significant design, packaging, regulatory and thermal profiling skills. Our embedded software design team
also performs low-level hardware driver development as well as BIOS modifications and tuning. We leverage these server development skills in order to deliver custom solutions to specific
customers.

Our
proprietary appliance management system; called NEWS, enhances our existing hardware, software and service capabilities for current and prospective customers. Our NEWS technology is
a web-based appliance management sub-system that enables deployment and maintenance tasks such as provisioning and remote system updates.

Our
offering of ACE Linux enables us to provide the operating system to our ISV customers that develop their applications on Linux. ACE Linux is capable of providing package management
with an automated update service that maintains the operating system when and if updates become available. We undertake all compatibility and performance testing to ensure the hardware works reliably
and consistently.

Our
Virtual Appliance Solution service enables our ISV customers to meet the demand for virtual appliances from their enterprise customers. This service enables creation of virtual
appliance versions of the ISV's application allowing enterprise customers more effective provisioning of software applications and better use of hardware assets. The Virtual Appliance Solution service
consists of the software image development and delivery, and the service component, which addresses the management,

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maintenance
and updating virtual appliances need to run properly from initial provisioning through end-of-life.



We provide internal manufacturing and test services for our customers. We operate separate manufacturing lines for high volume and low volume manufacturing. Our
high volume manufacturing process involves building the chassis, including the integration of the main logic board, memory, disk drive and PCI board into the chassis and testing of the final product.
Our low volume process involves branding of third-party supplied servers, as well as memory, disk drive and PCI board integration and testing. We maintain separate low and high volume lines in order
to provide our customers with the appropriate type of manufacturing resources and skill sets to best meet the volume requirements of a particular product. In addition, our low volume line allows us to
provide customers with rapid manufacturing turn around time, which provides a significant time to market advantage for new products. Our customers' products undergo system test and burn-in
prior to final inspection, packaging and shipment.



We brand the server appliance solution for our network equipment or ISV customer. Branding is applied to the server appliance itself as well as to all
accompanying documentation, including quick set-up guides, manuals, shipping cartons, shipping labels and paperwork. We provide in-house graphic arts services to facilitate
production of branding designs and we work with outside design and production agencies that are highly experienced in equipment packaging and branding approaches. We also have full-time
mechanical engineers who build customized bezels, LCD front panels, light-pipes, and other distinctive features to provide a custom look and feel for our customers' server appliances. We provide our
customers with logistics support and order fulfillment by delivering the final product to either our customer or, at their request, directly to the end user customers all over the world.

Customers

Our primary customer focus has been targeted towards network equipment vendors and ISVs that wish to sell server appliance solutions to their customers. During
the past fiscal quarter, we sold server appliances to 28 customers, including: Bomgar, Inc., Bradford Networks, Juniper Networks, Inc., EMC Corporation, Nortel Networks, Sophos,
Plc. and Websense, Inc. EMC was our only customer that represented more than 10% of our revenues for the years ended September 30, 2007, 2006, and 2005, during which our sales to EMC
were $99 million, or 83% of total net revenues, $97 million, or 81% of total net revenues, and $78 million, or 79% of total net revenues, respectively.

Sales and Marketing



Our sales team is focused on developing relationships with network equipment providers seeking to integrate a server appliance into their offerings and with ISVs
seeking to offer their application software as a server appliance solution. Once we have identified and qualified a prospective customer and a project is identified, a sales person meets with the
customer and begins to work on an appropriate strategy. We then involve other employees from sales, engineering, and product management to analyze the prospective customer's requirements and begin to
develop a solution.



Our marketing organization is aligned by two key functions: product management and marketing programs. Our product management team is responsible for managing the
technical relationship with

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our
hardware platform, operating systems and components suppliers. The product management team researches the market to anticipate trends and understand and evaluate new technologies that we can
leverage in the development and integration of server appliance solutions. They work closely with our engineering team and our network equipment provider and ISV customers to define product
requirements.

Our
marketing program team is responsible for building market awareness and acceptance of Network Engines and our products and services and generating qualified customer leads. These
programs were executed in cooperation with our field sales teams in North America and Europe.

Warranty and post sales support services

We offer a warranty on certain of the products we sell. The warranty generally provides for us to repair or replace a defective product within certain timeframes
and generally lasts for a period of up to 36 months after initial product shipment, depending on the product and our contractual relationships with certain customers. For most of our server
appliances we offer a range of post sales support services, including advanced replacement of defective units as well as repair and return service for appliance platforms covered by our contractual
warranty.

During
fiscal 2007 we assumed the support obligations and related deferred revenue from Microsoft pertaining to the existing installed base of its appliances running Microsoft's Internet
Server Acceleration software and Whale Communication's Intelligent Application Gateway ("IAG"). We also offer post sales support for on IAG appliances that we sell. For these IAG appliances, we offer
different post sales support service programs, including call center support, software subscription service, and 24-hour domestic advanced replacement of appliances. Our software
subscription service enables our Microsoft ISA Server and IAG based appliance customers to easily apply software updates for their appliances. Software updates may include patches, service packs and
feature enhancements, when and if available.

Manufacturing

We provide manufacturing, test and fulfillment services for server appliances through our 22,500 square foot manufacturing facility located at our headquarters in
Canton, Massachusetts. In October 2003, we received our initial ISO 9001:2000 certification and were recertified in November 2006. We operate separate server appliance manufacturing
lines for high volume and low volume manufacturing. We maintain two separate lines in order to provide our customers with the appropriate type of manufacturing resources and skill sets to best meet
the volume, cost and quality requirements of a particular product. In addition, our low volume line allows us to provide customers with rapid manufacturing turn around time, which provides a
significant time to market advantage for new products.

We
also supplement our manufacturing capacity for certain high volume products by utilizing a third-party contract manufacturer. We use this partner to handle a portion of our ongoing
volume requirements to ensure that they are prepared to handle surge and/or excess volume requirements and also as a disaster recovery site in the event that our Canton facility is shut down for any
reason.

Engineering

We believe that much of our future success depends on our ability to customize server appliances developed utilizing commercially available standard components
and platforms acquired from third-party suppliers. This customization includes both hardware and software modifications and enhancements to the standard platforms. We have assembled a team of highly
skilled engineers, contractors and suppliers with significant industry experience in high-density packaging, server appliance design, system software, quality assurance, testing and
technical documentation.

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Employees

As of September 30, 2007, we had 145 employees, of whom 43 were engaged in manufacturing, 11 were engaged in customer support, 23 were engaged in sales and
marketing, 42 were engaged in research and development and 26 were engaged in general and administrative. We also employ contract labor, predominately in our manufacturing operations. As of
September 30, 2007, we utilized 31 contract employees.

Backlog

Our backlog includes orders confirmed with a purchase order for products scheduled to be shipped within 180 days to customers with approved credit status.
Certain of our customers place large orders with us to be delivered over time. In addition, we have an inventory consignment agreement with our largest customer whereby shipments for certain products
to this customer are held at this customer's location until this customer requires the products for their production process. We do not recognize revenues from consignment shipments until the
consigned product is utilized. Also, certain of our customers, including our largest customer, have certain rights under our agreements with them to change the delivery timing of future shipments to
them. In addition, our agreement with our largest customer includes provisions that allow 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 do we believe that our backlog, as of any particular date, is necessarily indicative of actual net revenues for any future period.

Competition

Our markets are highly competitive, and we expect this competition to persist and intensify in the future. Our principal competitors are general-purpose server
manufacturers that provide solutions for network equipment providers and ISVs and build servers for the OEM marketplace. These competitors include Dell, Hewlett-Packard, IBM and Sun Microsystems. We
also compete with major distributor integrators, such as Arrow Electronics, Inc. and Avnet, Inc., that offer distribution as well as customized integration services to their customers.
In addition, we compete with smaller companies that specialize in building server products and providing some level of integration services, such Patriot Technologies, MBX Systems, NCS
Technologies, Inc., and SteelCloud, Inc. We also may compete with certain providers of electronics manufacturing services ("EMS") in the event they expand their service offerings.

Intellectual Property

We claim trademark rights for the use of the Network Engines name and the Network Engines logos. We believe these rights provide us with additional protection
over the use of these names and descriptions. We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to and distribution of our
software, documentation and other proprietary information. We also have nine patents that primarily pertain to our historical business and will remain in effect until 2020 or later. In addition, we
have one patent and one application for a patent.

We
have five patents applied for and in process for our NEWS based appliance framework technology, including our automated update management system, and we are continuing to
work on additional technology that we expect to be patented in the future.

Despite
our efforts to protect our proprietary rights, our competitors might independently develop similar technology and unauthorized parties may attempt to copy or otherwise obtain and
use our technology. Monitoring unauthorized use of our proprietary technology is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology,
particularly in

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foreign
countries where the laws may not protect our proprietary rights as fully as in the United States. Due to rapid technological changes in our market, we believe the various legal protections
available for our intellectual property are of limited value. In addition to such intellectual property, we seek to establish and maintain an extensive knowledge of leading technologies and to
incorporate these technologies into our appliance platforms by leveraging the technological knowledge and creative skills of our personnel.

Financial Information About Geographic Areas

See Note 16 to our Consolidated Financial Statements, entitled "Geographic Data", for financial information about geographic areas. The Notes to the
Company's Consolidated Financial Statements are contained herein in Item 8.

Access to Our Securities and Exchange Commission Reports and Other Information

We are subject to the information reporting requirements of the Securities Exchange Act of 1934 and are required to file annual, quarterly and current reports,
proxy statements and other information with the Securities and Exchange Commission (the "SEC"). These reports are publicly available on the SEC's website at www.sec.gov. Alternatively, the public may
read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE,
Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for more information on the operation of the Public Reference Room.

The
public may also access these materials through our website,www.networkengines.com, free of charge, as soon as reasonably practicable
after these reports are filed electronically with, or furnished to, the SEC. Additionally, we have posted a copy of our code of business conduct and ethics on our website, and we intend to disclose on
our website any amendments to, or waivers from, our code of
business conduct and ethics that are required to be publicly disclosed pursuant to the rules of the Securities and Exchange Commission or NASDAQ Global Market. We are not including the information
contained on our website as part of, or incorporating it by reference, in this Annual Report on Form 10-K.

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ITEM 1A.    RISK FACTORS

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

Risks of dependence on one strategic partner.

We derive a significant portion of our revenues from sales of server appliances directly to EMC and our revenues may decline significantly if this customer cancels or delays
purchases of our products, terminates its relationship with us or exercises certain of its contractual rights.

In
the years ended September 30, 2007, 2006, and 2005 sales directly to EMC, our largest customer, accounted for 83%, 81%, and 79% of our total net revenues, respectively. These
sales are primarily attributable to one product pursuant to a non-exclusive contract. Although this concentration will decrease as a result of our acquisition of Alliance Systems, we
anticipate that our future operating results will continue to depend heavily on sales to, and our relationship with, this customer. Accordingly, the success of our business will depend, in large part,
on this customer's willingness to continue to utilize our server appliance solutions in its existing and future products. Further, our financial success is dependent upon the future success of the
products we sell to this customer and the continued growth of this customer, whose industry has a history of rapid technological change, short product life cycles, consolidation and pricing and margin
pressures. A significant reduction in sales to this customer, or significant pricing and additional margin pressures exerted on us by this customer, would have a material adverse effect on our results
of operations. In addition, if this customer delays or cancels purchases of our products, our operating results would be harmed and our ability to accurately predict revenues, profitability and cash
flows would decrease.

Under
the terms of our non-exclusive contract, this customer has the right to enter into agreements with third parties for similar products, is not obligated to purchase any
minimum quantity of products from us and may choose to stop purchasing from us at any time, with or without cause. In addition, this customer may terminate the agreement in the event that we attempt
to assign our rights under the agreement to another party without this customer's prior approval. Furthermore, in the event that we default on certain portions of the agreement, this customer has the
right to manufacture certain products in exchange for a mutually agreeable royalty fee. If any of these events were to occur, or if this customer were to delay or discontinue purchases of our products
as a result of dissatisfaction or otherwise, our revenues and operating results would be materially adversely affected, our reputation in the industry might suffer, and our ability to accurately
predict revenues, profitability and cash flows would decrease.

Risks related to business strategy.

Our future success is dependent upon our ability to generate significant revenues from server appliance development relationships.

We believe we must diversify our revenues and a major component of our business strategy is to form server appliance development relationships with new network
equipment providers, ISVs and telecom service provider. Under this strategy, we work with our customers to develop a server appliance branded with their name. Our partner then performs all of the
selling and marketing efforts related to sales of their branded appliance.

There
are multiple risks associated with this strategy including:



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Additionally,
our future success will depend on our ability to establish relationships with new customers while expanding sales of server appliances to our existing customers. If these
customers are unsuccessful in their marketing and sales efforts, or if we are unable to expand our sales to existing customers and develop relationships with new customers, our revenues and operating
results could suffer.

The failure to successfully integrate our acquisition of Alliance Systems into our operations in the expected time frame, or at all, may adversely affect our future
results.

We
believe that the acquisition of Alliance Systems, completed in October 2007, will result in certain benefits, including expanded customer reach, increased product offerings,
and certain cost savings from economies of scale. However, to realize these anticipated benefits, Alliance Systems' business must be successfully integrated into our operations by focusing on,
manufacturing and supply chain, sales and marketing operations, and general and administrative. The success of the Alliance Systems acquisition will depend on our ability to realize these anticipated
benefits from integrating Alliance Systems' business into our operations. We may fail to realize the anticipated benefits of the acquisition on a timely basis, or at all, for a variety of reasons,
including the following:



If
we fail to successfully integrate Alliance Systems and realize the expected benefits of the acquisition it could have an adverse impact on our results of operations, and our ability
to generate cashflows from operations. As a result, we could have difficulty borrowing under our current credit facility or securing financing to fund operations in the future.

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We may not be able to effectively commercialize our appliances or may be at a competitive disadvantage if we cannot license or integrate third-party applications that are
essential for the functionality of certain appliances.

We
believe our success will depend on our ability to license or integrate certain applications from third-parties that would be incorporated in certain of our server appliance solutions.
Because we do not currently know with certainty which of these prospective technologies will be desired in the marketplace, we may incorrectly invest in development or prioritize our efforts to
integrate these technologies in our appliances. Additionally, even if we correctly focus our efforts, there can be no assurance that we will select the preferred provider of these technologies, the
third-party provider will be committed to the relationship and integration of their technology, or that they will license their technology to us without obtaining significant certification or
training, which could be costly and time consuming. If we are unable to successfully integrate the correct third-party technologies in a timely manner, our appliances may be inferior to other
competitive products in the marketplace, which may adversely affect the results of our operations and our ability to grow our business.

Our business could be harmed if we fail to adequately integrate new technologies into our server appliance products or if we invest in technologies that do not result in the
desired effects on our current and/or future product offerings.

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



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

Risks related to the server appliance markets.

If server appliances are not increasingly adopted as a solution to meet a significant portion of companies' application needs, the market for server appliances may not grow,
which could negatively impact our revenues.

We
expect that all of our future revenues will come from sales of server appliances and related maintenance. As a result, we are substantially dependent on the growing use of server
appliances to meet businesses' application needs. Our revenues may not grow and the market price of our common stock could decline if the server appliance market does not grow as rapidly as we expect.

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Our
expectations for the growth of the server appliance market may not be fulfilled if customers continue to use general-purpose servers or proprietary platforms. The role of our
products could, for example, be limited if general-purpose servers out-perform server appliances, provide more capabilities and/or flexibility than server appliances or are offered at a
lower cost. This could force us to lower the prices of our server appliance products or could result in fewer sales of these products, which would negatively impact our revenues and decrease our gross
profits.

The products that we sell are subject to rapid technological change and our sales will suffer if these products are rendered obsolete by new
technologies.

The
markets we serve are characterized by rapid technological change, frequent new product introductions and enhancements, potentially short product life cycles, changes in customer
demands and evolving industry standards. In the server appliance market, we attempt to mitigate these risks by utilizing standards-based hardware platforms and by maintaining an adequate knowledge
base of available technologies. However, the server appliance products that we sell could be rendered obsolete if products based on new technologies are introduced or new industry standards emerge and
we are not able to incorporate these technological changes into our products. In addition, we depend on third parties for the base platforms of our server appliances and we are at risk if these third
parties do not integrate new technologies. Releasing new products and services prematurely may result in quality problems, and delays may result in loss of customer confidence and market share. We may
be unable to develop new products and services or achieve and maintain market acceptance of them once they have come to market. Furthermore, when we do introduce new or enhanced products and services,
we may be unable to manage the transition from the older products and services to minimize disruption in customer ordering patterns, avoid excessive inventories of older products and deliver enough
new products and services to meet customer demand.

To
remain competitive in the server appliance market, we must successfully identify new product opportunities and partners and develop and bring new products to market in a timely and
cost-effective manner. Our failure to select the appropriate partners and keep pace with rapid industry, technology or market changes could have a material adverse effect on our business,
results of operations or financial condition.

Risks related to financial results.

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

Since
our inception, we have incurred significant net losses and could continue to incur net losses in the future. At September 30, 2007 and September 30, 2006 our
accumulated deficit was $129 million and $131 million, respectively. We believe that any future growth will require us to incur significant engineering, selling and marketing and
administrative expenses. As a result, we will need to generate significant revenues to achieve and sustain profitability. If we do not achieve and sustain profitability, the market price for our
common stock may decline. Even if we achieve sustained profitability there can be no guarantee that our stock price will increase.

We may not be able to borrow funds under our credit facility or secure future financing if there is a material adverse change in our business.

In
connection with our October 2007 acquisition of Alliance Systems, we entered into an agreement with Silicon Valley Bank to provide for a line of credit. We view this credit
facility as a source of available liquidity to fund fluctuations in our working capital requirements. This facility contains various conditions, covenants and representations with which we must be in
compliance in order to borrow funds. However, if we wish to borrow under this facility in the future, there can be no

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assurance
that we will be in compliance with these conditions, covenants and representations. In addition, this line of credit facility with Silicon Valley Bank expires on October 9, 2008.
After that, we may need to secure new financing to continue funding fluctuations in our working capital requirements. However, we may not be able to secure new financing, or financing on favorable
terms, if we experience a significant adverse change in our business. As of December 14, 2007, we have not drawn on this line of credit.

If our estimates or judgments relating to our critical accounting policies are based on assumptions that change or prove to be incorrect, our operating results could fall below
expectations of securities analysts and investors, resulting in a decline in our stock price.

Our
discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our consolidated
financial statements, including those related to:



We
base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of
financial condition and results of operations, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these and other estimates if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to
fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

Our quarterly revenues and operating results may also fluctuate for reasons other than seasonality, which could cause our operating results to fall below expectations and thus
impact the market price of our common stock.

In
addition to seasonality issues, our quarterly revenues and operating results are difficult to predict and may fluctuate significantly from quarter to quarter. None of our customers
are obligated to purchase any quantity of our products in the future nor are they obligated to meet forecasts of their product needs. Our operating expense levels are based in part on expectations of
future revenues and gross profits, which are partially dependent on our customers' ability to accurately forecast and communicate their future product needs. If revenues or gross profits in a
particular quarter do not meet expectations, operating results could suffer and the market price of our common stock could decline. Factors affecting quarterly operating results include:



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

Products
and services in the server appliance, data storage and network security markets may be subject to further commoditization as these industries continue to mature and other
businesses introduce additional competing products and services. Our gross profit as a percentage of revenues for our products may decrease in response to changes in our product mix, competitive
pricing pressures, or new product introductions into the server appliance, data storage and network security markets. If we are unable to offset decreases in our gross profits as a percentage of
revenues by increasing our sales volumes, or by decreasing our product costs, operating results will decline. Changes in the mix of sales of our products, including the mix of higher margin products
sold in smaller quantities and lower margin products sold in larger quantities, could adversely affect our operating results for future quarters. To maintain our gross profits, we also must continue
to reduce the manufacturing cost of our server appliance products. Our efforts to produce higher margin server appliance products, continue to improve our server appliance products and produce new
server appliance products may make it difficult
to reduce our manufacturing cost per product. Further, utilization of a contract manufacturer to produce a portion of our customer requirements for certain of our server appliance products may not
allow us to reduce our cost per product. If we fail to respond adequately to pricing pressures, to competitive products with improved performance or to developments with respect to the other factors
on which we compete, we could lose customers or orders. If we are unable to compete effectively, our business will suffer.

Risks related to competition.

Competition in the server appliance market is significant and if we fail to compete effectively, our financial results will suffer.

In
the server appliance market, we face significant competition from a number of different types of companies. Our competitors include companies who market general-purpose servers,
server virtualization software, specific-purpose servers and server appliances as well as companies that sell custom integration services utilizing hardware produced by other companies. Many of these
companies are larger than we are and have greater financial resources and name recognition than we do, as well as significant distribution capabilities and larger, more established service
organizations to support their products. Our larger competitors may be able to leverage their existing resources, including their extensive distribution capabilities and service organizations, to
provide a wider offering of products and services and higher levels of support on a more cost-effective basis than we can. We expect competition in the server appliance market to increase
significantly as more companies enter the market and as our existing competitors continue to improve the performance of their current products and to introduce new products and technologies. Such
increased competition could adversely affect sales of our current and future products. In addition, competing companies may be able to undertake more extensive promotional activities, adopt more
aggressive pricing policies and offer more attractive terms to their customers than we can. If our competitors provide lower cost products with greater functionality or

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support
than our server appliance solutions, or if some of their products are comparable to ours and are offered as part of a range of products that is broader than ours, our server appliance
solutions could become undesirable.

Even
if the functionality of competing products is equivalent to ours, we face a risk that a significant number of customers would elect to pay a premium for similar functionality from
an established vendor rather than purchase products from a less-established vendor. We attempt to differentiate ourselves from our competition by offering a wide variety of software
integration,
branding, supply-chain management, engineering, support, logistics and fulfillment services. If we are unable to effectively differentiate ourselves from our competition, we may be forced to offer
price reductions to maintain certain customers. As a result, our revenues may not increase and may decline, and our gross margins may decline. Furthermore, increased competition could lead to higher
selling expenses which would negatively affect our business and future operating results.

Risks related to marketing and sales efforts and customer service.

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

Although
we currently have a relatively small sales and marketing organization, we must continue to increase market awareness and sales of our products and promote our brand in the
marketplace. We believe that to compete successfully we will need network equipment providers, ISVs and systems integrators to recognize Network Engines as a top-tier provider of server
appliance platforms and custom integration services. If we are unable to increase market awareness and promote ourselves as a leading provider of server appliance solutions with our available
resources, we may be unable to develop new customer relationships or expand our product and service offerings at existing customers.

If we are unable to effectively manage our customer service and support activities, we may not be able to retain our existing customers or attract new
customers.

We
need to effectively manage our customer support operations to ensure that we maintain good relationships with our customers. We believe that providing a level of high quality customer
support will be a key differentiator for our product offerings and may require more technically qualified staff which could be more costly. If we are unable to provide this higher level of service we
may be unable to successfully attract and retain customers.

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

Risks related to product manufacturing.

Our dependence on sole source and limited source suppliers for key server appliance components makes us susceptible to supply shortages and potential quality issues that could
prevent us from shipping customer orders on time, or at all, and could result in lost sales and customers.

We
depend upon single source and limited source suppliers for our industry standard processors, main logic boards, certain disk drives, hardware platforms and power supplies as well as
certain of our chassis and sheet metal parts. Additionally, we depend on limited sources to supply certain other industry standard and customized components. We have in the past experienced, and may
in the future experience, shortages of or difficulties in acquiring components in the quantities and of the quality needed to produce our server appliance products. Shortages in supply or quality
issues related to these

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key
components for an extended time would cause delays in the production of our server appliance products, prevent us from satisfying our contractual obligations and meeting customer expectations, and
result in lost sales and customers. If we are unable to buy components in the quantities and of the quality that we need on a timely basis or at acceptable prices, we will not be able to manufacture
and deliver our server appliance products on a timely or cost effective basis to our customers, and our competitive position, reputation, business, financial condition and results of operations could
be seriously harmed.

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

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

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



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

Moreover,
because our server appliance solutions may be used in connection with critical computing systems services, including providing security to protect valuable information, we may
receive significant liability claims if they do not work properly. While our agreements with customers typically contain provisions intended to limit our exposure to liability claims, these
limitations do not preclude all potential claims. Liability claims could exceed our insurance coverage and require us to spend significant time and money in litigation or to pay significant damages.
Any claims for damages, even if unsuccessful, could seriously damage our reputation and business.

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If we do not accurately forecast our server appliance materials requirements, our business and operating results could be adversely affected.

We
use rolling forecasts based on anticipated product orders to determine our server appliance component requirements. Lead times for materials and components that we order vary
significantly depending on variables such as specific supplier requirements, contract terms and current market demand for those components. In addition, a variety of factors, including the timing of
product releases, potential delays or cancellations of orders, the timing of large orders and the unproven acceptance of new products in the market make it difficult to predict product orders. As a
result, our materials requirement forecasts may not be accurate. If we overestimate our materials requirements, we may have excess inventory, which would increase costs and negatively impact our cash
position. Our agreements with certain customers provide us with protections related to inventory purchased in accordance with the terms of these agreements; however, these protections may not be
sufficient to prevent certain losses as a result of excess or obsolete inventory. If we underestimate our materials requirements, we may have inadequate inventory, which could interrupt our
manufacturing and delay delivery of our server appliance products to customers, resulting in a loss of sales or customers. Any of these occurrences would negatively impact our business and operating
results.

Risks related to product dependence on intellectual property.

Our reliance upon contractual provisions, domestic patent, copyright and trade secret laws and patent applications to protect our proprietary rights may not be sufficient to
protect our intellectual property.

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

In
addition, the laws of the countries in which we may decide to market our services and solutions may offer little or no effective protection of our proprietary technology. Reverse
engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third parties to benefit from our technology without paying us for it, which could harm our
business. In addition, our U.S. patents have no effect in foreign jurisdictions and obtaining patent protection in foreign countries is expensive and time consuming.

Our operating results would suffer if we, our ISV or network equipment customers, or other third-party software providers from whom we license technology, were subject to an
infringement claim that resulted in protracted litigation, the award of significant damages against us or the payment of substantial ongoing royalties.

Substantial
litigation regarding intellectual property rights exists in the technology industry. We expect that server appliance products may be subject to third-party infringement
claims as the number of competitors in the industry segment grows and the functionality of products in different industry segments overlap. In the past we have received claims from third parties that
our server appliance products infringed their intellectual property rights. We do not believe that our server appliance products employ technology that infringes the proprietary rights of any third
parties. We are also not

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aware
of any claims made against any of our ISV or network equipment provider customers related to their infringement of the proprietary rights of other parties in relation to products that include
our server appliance products. Other parties may make claims against us that, with or without merit, could:



In
addition, other parties may make claims against our ISV or network equipment customers, or third-party software providers related to products that are incorporated into our server
appliance products. Our business could be adversely affected if such claims resulted in the inability of our customers to continue producing the infringing product, or if we are unable to cost
effectively continue licensing the third-party software.

Other risks related to our business.

If we fail to retain and attract appropriate levels of qualified employees and members of senior management, we may not be able to successfully execute our business
strategy.

Our
success depends in large part on our ability to retain and attract highly skilled engineering, sales, marketing, customer service and managerial personnel. If we are unable to
attract a sufficient number of qualified personnel, particularly personnel knowledgeable in software engineering and product management, we may not be able to meet key objectives such as developing,
upgrading, or enhancing our products in a timely manner, which could negatively impact our business and could hinder any future growth.

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

Section 404
of the Sarbanes-Oxley Act of 2002 requires our management to report on, and our independent registered public accounting firm to attest to, the effectiveness of our
internal control over financial reporting. We have an ongoing program to perform the system and process evaluation and testing necessary to comply with these requirements. As a result, we have
incurred increased expense and have devoted additional management resources to Section 404 compliance. Effective internal controls are necessary for us to provide reliable financial reports. If
we cannot provide reliable financial reports, our business and operating results could be harmed.

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

In
December 2001, a class action lawsuit relating to our initial public offering was filed against us, our chairman, one of our executive officers and the underwriters of our
initial public offering. For more information on lawsuits, see "Part I, Item 3Legal Proceedings." We are currently attempting to settle the lawsuit filed against us related to our
initial public offering. We are unable to predict the effects on our financial condition or business of the lawsuit related to our initial public offering or other lawsuits that may arise from time to
time. While we maintain certain insurance coverage, there can be no assurance that claims against us will not result in substantial monetary damages in excess of such insurance coverage. This class
action lawsuit, or any future lawsuits, could cause our director and officer insurance premiums to increase and could affect our ability to obtain director and officer

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insurance
coverage, which would negatively affect our business. In addition, we have expended, and may in the future expend, significant resources to defend such claims. This class action lawsuit, or
other similar lawsuits that may arise from time to time, could negatively impact both our financial condition and the market price of our common stock and could result in management devoting a
substantial portion of their time to these lawsuits, which could adversely affect the operation of our business.

If the site of our manufacturing operations were to experience a significant disruption in its operations, it would have a material adverse effect on our financial condition
and results of our operations.

Our
manufacturing facility and headquarters are concentrated in two locations. If the operations in either facility were disrupted as a result of a natural disaster, fire, power or other
utility outage, work stoppage or other similar event, our business could be seriously harmed for a period of at least one quarter as a result of interruptions or delays in our manufacturing,
engineering, or post sales support operations.

The market price for our common stock may be particularly volatile, and our stockholders may be unable to resell their shares at a profit.

The
market price of our common stock has been subject to significant fluctuations and may continue to fluctuate or decline. During fiscal 2006, the closing price of our common stock
ranged from a low of $1.12 to a high of $3.17, and in the year ended September 30, 2007, from a low of $1.73 to a high of $2.81. The market for technology stocks has been extremely volatile and
frequently reaches levels that bear no relationship to the past or present operating performance of those companies. General economic conditions, such as recession or interest rate or currency rate
fluctuations in the United States or abroad, could negatively affect the market price of our common stock. In addition, our operating results may be below the expectations of securities analysts and
investors. If this were to occur, the market price of our common stock may decrease significantly. In the past, following periods of volatility in the market price of a company's securities,
securities class action litigation has often been instituted against such companies. Such litigation could result in substantial cost and a diversion of management's attention and resources.

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

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We have anti-takeover defenses that could delay or prevent an acquisition and could adversely affect the market price of our common stock.

Our
Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock and, without any further vote or action on the part of the stockholders, to determine the
price, rights, preferences, privileges and restrictions of the preferred stock. This preferred stock, if issued, might have preference over the rights of the holders of common stock and could
adversely affect the market price of our common stock. The issuance of this preferred stock may make it more difficult for a third party to acquire us or to acquire a majority of our outstanding
voting stock. We currently have no plans to issue preferred stock.

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

ITEM 1B.    UNRESOLVED STAFF COMMENTS

None.

ITEM 2.    PROPERTIES

Our principal business operations are conducted in our corporate headquarters in Canton, Massachusetts where we lease approximately 52,000 square feet of
manufacturing and office space. We believe that our Canton facility will be adequate to meet our requirements for the foreseeable future.

ITEM 3.    LEGAL PROCEEDINGS

Initial Public Offering Lawsuit

On or about December 3, 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against
us, Lawrence A. Genovesi (our former Chairman and Chief Executive Officer), Douglas G. Bryant (our Chief Financial Officer and Vice President of Finance and Administration), and the following
underwriters of our 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 action complaint, captioned In re Network Engines, Inc. Initial Public Offering Securities Litigation, 01 Civ.
10894 (SAS), was filed on April 20, 2002.

The
suit alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to our initial public offering in July 2000 ("IPO") without
disclosing to investors that the Underwriter Defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit also alleges that the Underwriter Defendants
entered into agreements with certain customers whereby the Underwriter Defendants agreed to allocate to those customers shares of our common stock in the offering, in exchange for which the customers
agreed to purchase additional shares of our common stock in the aftermarket at pre-determined prices. The suit alleges that such tie-in arrangements were designed to and did
maintain, distort and/or inflate the price of our common stock in the aftermarket. The suit further alleges that the Underwriter Defendants received undisclosed and excessive brokerage commissions and
that, as a consequence, the Underwriter Defendants successfully increased investor interest in the manipulated IPO securities and increased the Underwriter Defendants' individual and collective
underwritings, compensation and revenues. The suit

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seeks
damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between July 13, 2000 and December 6, 2000.

In
July 2002, we, Lawrence A. Genovesi and Douglas G. Bryant joined in an omnibus motion to dismiss the suit challenging the legal sufficiency of plaintiffs' claims. The
motion was filed on behalf of hundreds of issuer and individual defendants named in similar lawsuits. Plaintiffs opposed the motion, and the Court heard oral argument on the motion in
November 2002. On February 19, 2003, the Court
issued an opinion and order denying the motion as to us. However, in October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.

On
July 9, 2003, a Special Committee of our Board of Directors authorized us to negotiate a settlement of the pending claims substantially consistent with a memorandum of
understanding negotiated among class plaintiffs, all issuer defendants and their insurers. The parties have negotiated the settlement, which provides, among other things, for a release of us and the
individual defendants for the conduct alleged in the amended complaint to be wrongful. We would agree to undertake other responsibilities under the settlement, including agreeing to assign, or not
assert, certain potential claims that we may have against the underwriters. Any direct financial impact of the proposed settlement is expected to be borne by our insurers. Any such settlement would be
subject to various contingencies, including approval by the Court overseeing the litigation. On February 15, 2005, the Court issued an Opinion and Order preliminarily approving the settlement,
provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to a modification narrowing
the scope of the bar order, and on August 31, 2005, the Court issued an order preliminarily approving the settlement and setting a public hearing on its fairness, which took place on
April 24, 2006. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court's certification of the class of plaintiffs who are pursuing
the claims that would be settled in the settlement against the underwriter defendants. Thereafter, the District Court ordered a stay of all proceedings in all of the lawsuits pending the outcome of
plaintiffs' petition to the Second Circuit for rehearing en banc and resolution of the class certification issue. On April 6, 2007, the Second Circuit denied plaintiffs' petition for rehearing,
but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On June 25, 2007, the District Court signed an order terminating the settlement.

We
are unable to predict the outcome of this suit and as a result, no amounts have been accrued as of September 30, 2007.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 2007.

EXECUTIVE OFFICERS OF THE COMPANY

Name

Age

PositionGregory A. Shortell

63

President, Chief Executive Officer and DirectorDouglas G. Bryant

50

Chief Financial Officer, Treasurer and SecretaryKevin J. Murphy Jr.

37

Chief Technology OfficerRichard P. Graber

47

Vice President of Engineering and OperationsHugh W. Kelly

48

Vice President of Worldwide MarketingPaul Butler

46

Vice President of Worldwide Sales


23

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Gregory
A. Shortell

Gregory A.
Shortell joined Network Engines in January 2006 as President and Chief Executive Officer. Mr. Shortell also joined as a Director in January 2006.
Prior to joining the Company, Mr. Shortell was, from February 1998 to January 2006, Senior Vice President Global Sales and Marketing, for Nokia Corporation, a multinational
technology corporation. Prior to Nokia, Mr. Shortell served, from June 1997 to February 1998, as Managing Director of International Operations for Ipsilon, a provider of network
communications equipment and, from March 1992 to June 1997 as Vice President, International at Xyplex Corporation, a provider of networking equipment.

Douglas
G. Bryant

Douglas G.
Bryant has served as Secretary since March 2000, Treasurer since January 1998 and Chief Financial Officer since September 1997. He was also Vice
President of Finance and Administration between March 2000 and December 2006. Prior to joining the Company, Mr. Bryant served as Chief Financial Officer of CrossComm Corporation,
a manufacturer of internetworking products, including routers and switches, from July 1996 to June 1997, and as Corporate Controller from September 1989 to June 1996.

Kevin
J. Murphy Jr.

Kevin
J. Murphy Jr. joined Network Engines in 2003 and became Network Engines' Chief Technology Officer on April 1, 2006. Prior to becoming the Chief Technology Officer,
Mr. Murphy served as Chief Architect and Director of Advanced Development for Network Engines since May 2003. Prior to joining Network Engines, Mr. Murphy founded Mantis
Solutions, Inc., a consulting company that helped companies optimize existing technologies, in December 2000.

Richard
P. Graber

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

Hugh
W. Kelly

Hugh W.
Kelly joined Network Engines in June 2006 as the Vice President of Worldwide Marketing. Prior to joining the Company, Mr. Kelly was the CEO and
co-founder of SQMworks, a telecommunications management software start-up, from January 2003 to May 2006. From January 2000 to December 2002,
Mr. Kelly served as Senior Vice President, Marketing and Business Development at Celox Networks, a developer of a highly scaleable edge router targeted at Tier 1
carriers. For the period of 1997 to 2000 Mr. Kelly was Vice President, Marketing for Visual Networks, a market leader in WAN service level management solutions.

Paul
Butler

Paul
Butler joined Network Engines in January 2007. Previously, from November 2005 to April 2006, Mr. Butler held the role of Vice President, Worldwide Sales
and Marketing for IneoQuest Technologies, a test and monitoring equipment firm for IPTV and VOIP networks. Prior to his work at IneoQuest Technologies, from January 1999 to October 2005,
Mr. Butler served as Vice President of Sales for Brooktrout Technology. Mr. Butler came to Brooktrout via their acquisition of Lucent Technologies' Computer Telephony Products division.
Mr. Butler worked at Lucent CTP from June 1997 to December 1998 and was the Managing Director and General Manager for EMEA where he managed sales in the OEM Telecom and CTI
markets. In November 2007, Mr. Butler departed Network Engines to pursue other opportunities.

24

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PART II

ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

(a) Market Information

Network Engines' 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 for our common stock. The following table sets forth the high and low closing sales prices per share for our common stock on the NASDAQ Global Market for the period indicated:

|               |  | Fiscal 2007 |      | Fiscal 2006
|-------------- |  | ----------- | ---- | -----------
|
|
|First Quarter  |  | $           | 2.81 |            
|Second Quarter |  |             | 2.62 |            
|Third Quarter  |  |             | 1.97 |            
|Fourth Quarter |  |             | 2.33 |            

(b) Holders of record

As of December 11, 2007, there were approximately 237 holders of record of our common stock. Because many of such shares are held by brokers and other
institutions on behalf of stockholders, the Company is unable to estimate the total number of stockholders represented by these record holders.

(c) Dividends

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

(d) Securities Authorized for Issuance under Equity Compensation Plans

The information required by this item is included under the caption "Equity Compensation Plan Information" in our Proxy Statement related to the 2008 Annual
Meeting of Shareholders to be filed
with the Securities and Exchange Commission no later than 120 days after the end of our fiscal year and is incorporated herein by reference.

(e) Performance Graph

The information required by this item is included under the caption "Comparative Stock Performance" in our Proxy Statement related to the 2008 Annual Meeting of
Shareholders to be filed with the Securities and Exchange Commission no later than 120 days after the end of our fiscal year and is incorporated herein by reference.

25

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ITEM 6.    SELECTED FINANCIAL DATA

The following selected financial data are derived from the financial statements of Network Engines. The historical results presented are not necessarily
indicative of future results. The consolidated statements of operations data for the years ended September 30, 2007, 2006 and 2005 and the consolidated balance sheet data as of
September 30, 2007 and 2006 have been derived from our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The consolidated statements of
operations data for the years ended September 30, 2004 and 2003 and the consolidated balance sheet data as of September 30, 2005, 2004, and 2003 are derived from our audited consolidated
financial statements not included in this Annual Report on Form 10-K. The selected consolidated financial data set forth below should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and "Financial Statements and Supplementary Data" and the related Notes included elsewhere in this Annual Report on
Form 10-K.

On
December 27, 2002, we completed our acquisition of TidalWire. The results for the year ended September 30, 2003 only include nine months of activity from our acquisition
of TidalWire. Further, the financial information for the year ended September 30, 2005 only includes three months of results related to the TidalWire business, since we exited that portion of
the business during the first fiscal quarter of 2005.

Selected Financial Data
(in thousands, except per share data)

|                                                     |  | Year ended September 30, |        
|---------------------------------------------------- |  | ------------------------ | -------
|
|Net revenues                                         |  | $                        | 119,627
|Gross profit                                         |  |                          | 23,252 
|Operating expenses(a)(b)                             |  |                          | 22,584 
|Income (loss) from operations                        |  |                          | 668    
|Net income (loss)                                    |  |                          | 2,502  
|Net income (loss) per common sharebasic and diluted |  | $                        | 0.06   
|Weighted average shares outstandingbasic            |  |                          | 40,637 
|Weighted average shares outstandingdiluted          |  |                          | 41,256 

|                                                                   |  | September 30,
|------------------------------------------------------------------ |  | -------------
|
|
|Cash, cash equivalents, short-term investments and restricted cash |  | $            
|Working capital                                                    |  | $            
|Total assets                                                       |  | $            
|Long-term debt, less current portion                               |  | $            
|Total stockholders' equity                                         |  | $            

---

26

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ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We develop and manufacture server appliance solutions that enable network equipment providers and independent software vendors, or ISVs, to deliver their software
applications in the form of a server appliance. Server appliances are pre-configured network infrastructure devices designed to optimally deliver specific software application
functionality and facilitate ease of deployment and support of a software application in a customer's network. We offer server appliance customers a comprehensive suite of services, including
development, manufacturing, fulfillment and post-sale support in addition to certain software products, such as our NEWS and ACE Linux products. We produce and fulfill devices branded for
our network equipment and ISV customers, and derive our revenues from the sale of value-added hardware platforms to these customers. These customers subsequently sell and support the device under
their own brands to their customer base.

During
the quarter ended December 31, 2006, we changed the manner in which we view information regarding our results of operations for purposes of making decisions affecting the
business. These changes included consolidation of financial and operational information reviewed to evaluate our operations, discontinuing market demand creation for our NS Series Security Appliances
and using certain of those products as reference platforms for developing and selling appliances to system integrators and ISVs, and the consolidation of our sales force. Therefore, we now have one
reportable segment, which represents how we evaluate our operations.

Critical Accounting Policies And Estimates

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of America. In preparing these financial statements, we have
made estimates and judgments in determining certain amounts included in the financial statements. We base our estimates and judgments on historical experience and other various assumptions that we
believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect
our more significant judgments and estimates used in the preparation of our financial statements.



Revenues from products are generally recognized upon delivery to customers if persuasive evidence of an arrangement exists, the fee is fixed or determinable,
collectibility is reasonably assured and title and risk of loss have passed to the customer. In the event we have unfulfilled future obligations, revenue and related costs are deferred until those
future obligations are met. We have an inventory consignment agreement with our largest customer related to certain server appliances. This customer notifies us when it utilizes inventory and we
recognize revenues from sales to this customer based upon these notifications.

Maintenance
revenues are derived from customer support agreements generally entered into in connection with the initial server appliance sales and subsequent renewals. Maintenance fees
are typically for one to three year renewable periods and include the right to unspecified software updates when and if available for certain agreements, hardware repairs, 24-hour customer
support, and advanced replacement of server appliances. Maintenance revenues are recognized ratably over the term of the maintenance period. Payments for maintenance fees are generally made in advance
and are included in deferred revenue. The associated maintenance expenses are expensed in the same period as incurred.

27

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Contracts
and/or customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and consignment usage notifications are used to verify
shipment or transfer of ownership, as applicable. We assess whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is
subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer's payment
history.

For
revenue arrangements that contain multiple elements, such as the sale of both product and post-sales support, in which software is not incidental to the product, we
determine fair value based upon vendor specific objective evidence, which is typically established through contractual post-sales support renewal rates whereby the residual fair value is
allocated to the server appliance. For revenue arrangements that contain multiple elements, in which software is not included
or is incidental to the product, we determine fair value based on objective and reliable evidence of fair value, which is typically determined through contractual refund rates for cancellations, and
stand-alone sales of post-sales support, whereby the residual fair value is allocated to the server appliance.

We
recognize revenue when the revenue recognition criteria for each element of the sale is met. If we are not able to derive the fair value of the undelivered element of the sale
(maintenance), all revenues from the arrangement are deferred and recognized ratably over the period of the support arrangement, which is typically one to three years. We include shipping and handling
costs, if any, reimbursed by our customers as net revenues and cost of revenues.



We value inventory at the lower of cost or estimated market, and determine cost on a first-in, first-out basis. We regularly review
inventory quantities on hand and record a write-down for excess or obsolete inventory based primarily on our estimated forecast of product demand and anticipated production requirements in
the near future. Any rapid technological changes and future product development could result in an increase in the amount of obsolete inventory quantities on hand. Agreements with certain of our
customers include inventory protection provisions, however, these provisions may not provide us with complete protection from loss due to excess or obsolete inventory.



We offer a warranty on certain of our products that generally provides for us to repair or replace any defective products for a period of up to 36 months
after shipment. We reserve for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue and record warranty expense as a component of cost of revenues.

Costs
included in our server appliance product warranty obligation include shipping, internal and external labor, and travel. Significant judgment and estimates are involved in
estimating our warranty reserve. Although our current server appliance products use more standards-based technologies than in the past, certain of our server appliance products incorporate proprietary
technologies, which may increase our risks related to product warranty obligations. In the past we have experienced unexpected component failures in certain of our server appliance products, which
have required us to increase our product warranty accruals. At the time any unexpected component failure arises, we assess the costs to repair any defects and record what we believe to be an
appropriate warranty obligation based on the information available. To the extent we may experience increased warranty claim activity, increased costs associated with servicing those claims, or use
estimates that prove to be materially different from actual claims, our product warranty obligations may need to be increased, resulting in decreased gross profits.

28

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We adopted the provisions of Statement of Financial Accounting Standards 123(R),"Share-Based Payment,"("SFAS 123(R)"), on October 1, 2005 which requires us to measure compensation cost at the grant date, based on the fair value of the award, and to recognize that cost as an expense over
the employee's requisite service period (generally the vesting period of the equity award). Prior to October 1, 2005, we accounted for stock-based compensation to employees in accordance with
Accounting Principles Board Opinion No. 25,"Accounting for Stock Issued to Employees,"("APB 25") and related interpretations. We also followed
the disclosure requirements of Statement of Financial Accounting Standards No. 123,"Accounting for Stock-Based Compensation"("SFAS 123"). We elected to adopt the modified prospective transition method as provided by SFAS 123(R) and, accordingly, financial statement amounts for the prior periods presented in
this Form 10-K have not been retroactively adjusted to reflect the fair value method of expensing stock-based compensation.

Under
SFAS 123(R), we determine the fair value of stock options awarded based on the grant date fair value of the award using an option pricing model. Such an option pricing model
requires us to make judgments for certain assumptions used, in particular, the expected term of the option and the expected volatility over that term. We have determined the expected term using the
midpoint between the vesting date and the end of the contractual term for our options, also known as the "simplified method" described under Staff Accounting Bulletin No. 107, ("SAB 107"). We
have determined our expected volatility based on a weighted average of historical volatility. In determining the amount of expense to be recorded, judgment is also required to estimate forfeitures of
the awards based on the probability of employees completing the required service period. Historical forfeitures are used as a starting point for developing our estimate of future forfeitures.



We record deferred tax assets and liabilities based on the net tax effects of tax credits, operating loss carryforwards and temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We then assess the likelihood that our deferred tax assets will be recovered
from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. The valuation allowance is based on our estimate of future taxable income and
the period over which our deferred tax assets will be recoverable. At September 30, 2007, we believe that it is more likely than not that all of our deferred tax assets will not be realized,
and, accordingly, we have recorded a valuation allowance against all of our deferred tax assets. If results of operations in the future indicate that some or all of the deferred tax assets will be
recovered, the reduction of the valuation allowance will be recorded as a tax benefit. To the extent that net operating losses, when realized, relate to stock options deductions of approximately
$2.4 million, the resulting benefits will be credited to additional paid-in capital.

29

---



Results of Operations

The following data summarizes the results of our operations for the past three fiscal years, in thousands and as a percentage of net revenues.

|                              |  | Fiscal year ended September 30, |        
|----------------------------- |  | ------------------------------- | -------
|
|
|Net revenues                  |  | $                               | 119,627
|Gross profit(a)               |  |                                 | 23,252 
|Operating expenses(b and c)   |  |                                 | 22,584 
|Income (loss) from operations |  |                                 | 668    
|Net income (loss)             |  |                                 | 2,502  

---

Discussion of Fiscal 2007 and 2006



Our revenues are derived from sales of server appliances primarily to our OEM network equipment and ISV customers.

Our
net revenues increased slightly for the year ended September 30, 2007 versus the same period in fiscal 2006. This was primarily due to higher sales volume partially offset by
lower average selling prices. Net revenues from sales to EMC represented 83% and 81% of net revenues in the year ended September 30, 2007 and 2006, respectively. In addition, net revenues from
other customers for the year ended September 30, 2007 was $20.8 million compared to $15.5 million for the year ended September 30, 2006, after excluding net revenues from
Network Intelligence Corporation due to its acquisition by EMC on September 18, 2006. This growth was attributable to the increase in revenue generated from new customers, an increase in
revenue from existing customers, and revenue for servicing IAG customers during fiscal 2007.



Gross profit represents net revenues recognized less the cost of revenues. Cost of revenues includes 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 and gross profit as a percentage of net revenues increased for the year ended September 30, 2007, compared to the year ended September 30, 2006. The increase
from the prior year was primarily due to increased service revenues which carry higher gross margins, the timing of cost reductions relative to price reductions to customers in relation to consistent
per unit gross margin
dollars. These increases were partially offset by higher warranty expenses and lower appliance average selling prices.

Our
gross profit is affected by product mix and product pricing as well as the timing, size and configuration of server appliance orders. Gross profit is also affected by the mix of
product

30

---



manufactured
internally compared to product manufactured by our contract manufacturer, which carries higher manufacturing costs. We expect gross profit to continue to be affected by these factors.



The most significant components of our operating expenses are research and development, selling and marketing, and general and administrative expenses. The
following table presents operating expenses during the periods indicated, in thousands and as a percentage of net revenues:

|                           |                          | For the year ended September 30, |      
|-------------------------- | ------------------------ | -------------------------------- | -----
|
|
|Operating expenses:        |                          |                                  |      
|Research and development   |                          | $                                | 8,723
|Selling and marketing      |                          |                                  | 6,265
|General and administrative |                          |                                  | 7,596
|                           |                          |                                  |      
|                           | Total operating expenses |                                  | $    
|                           |                          |                                  |      



Research and development expenses consist primarily of salaries and related expenses for personnel engaged in research and development, fees paid to consultants
and outside service providers, costs for prototype and test units and other expenses related to the design, development, testing and enhancements of our server appliance products. We expense all of
our research and development costs as they are incurred. The following table summarizes the most significant components of research and development expense for the periods indicated, in thousands and
as a percentage of total research and development expenses and provides the changes in thousands and percentages:

|                          |                                   | For the year ended September 30, |  
|------------------------- | --------------------------------- | -------------------------------- | -
|
|
|Research and development: |                                   |                                  |  
|                          | Compensation and related expenses |                                  | $
|                          | Stock-based compensation          |                                  |  
|                          | Prototype                         |                                  |  
|                          | Consulting and outside services   |                                  |  
|                          | Other                             |                                  |  
|                          |                                   |                                  |  
|                          |                                   | Total research and development   |  
|                          |                                   |                                  |  

Our
research and development expenses have increased slightly in the year ended September 30, 2007 as compared to the previous fiscal year's primarily due to increased
compensation and related expenses and consulting and outside services. The increase of compensation and related expenses is primarily related to salary cost of living adjustments occurring during the
year as well as the timing of new hires. The increase in consulting costs as well as the decrease in prototype costs relates to the timing of certain development projects.

31

---







Selling and marketing expenses consist primarily of salaries and commissions for personnel engaged in sales and marketing; costs associated with our marketing
programs, which include costs associated with our attendance at trade shows, public relations, product literature costs, web site enhancements and product evaluation costs; consulting and outside
services costs and travel. The following table summarizes the most significant components of selling and marketing expense for the periods indicated in thousands and as a percentage of total selling
and marketing expense and provides the changes in thousands and percentages:

|                       |                                   | For the year ended September 30, |  
|---------------------- | --------------------------------- | -------------------------------- | -
|
|
|Selling and marketing: |                                   |                                  |  
|                       | Compensation and related expenses |                                  | $
|                       | Stock-based compensation          |                                  |  
|                       | Marketing programs                |                                  |  
|                       | Travel                            |                                  |  
|                       | Consulting                        |                                  |  
|                       | Other                             |                                  |  
|                       |                                   |                                  |  
|                       |                                   | Total selling and marketing      |  
|                       |                                   |                                  |  

As
indicated in the table above, our selling and marketing expenses have significantly decreased. This decrease is the result of our strategic change to decrease demand creation sales
and marketing activities and more fully leverage our customers' sales and marketing resources. In particular resulting from this strategic change, we decreased headcount from 31 at
September 30, 2006 to 23 at September 30, 2007 thereby causing the compensation and related expenses to decrease as well as the stock-based compensation expense to decrease. In addition,
the reduction in marketing expenses and travel is a result of reduced spending on end user lead generation programs for our NS Series security appliances.



General and administrative expenses consist primarily of salaries and other related costs for executive, finance, information technology and human resources
personnel; professional services, which include legal, accounting, audit and tax fees, and costs of compliance with the Sarbanes-Oxley Act; and director and officer insurance. The following table
summarizes the most significant components of general and administrative expense for the periods indicated in thousands and as a percentage of total general and administrative expenses and provides
the changes in thousands and percentages:

|                            |                                   | For the year ended September 30, |  
|--------------------------- | --------------------------------- | -------------------------------- | -
|
|
|General and administrative: |                                   |                                  |  
|                            | Compensation and related expenses |                                  | $
|                            | Stock-based compensation          |                                  |  
|                            | Professional services             |                                  |  
|                            | Director and officer insurance    |                                  |  
|                            | Other                             |                                  |  
|                            |                                   |                                  |  
|                            |                                   | Total general and administrative |  
|                            |                                   |                                  |  

32

---



As
indicated in the table above, general and administrative expenses decreased slightly in the year ended September 30, 2007 as compared to the year ended September 30,
2006. Increases in compensation and related expenses, which were related to changes in our senior management and professional services, were offset by larger decreases in the cost of director and
officer insurance and other expenses. The increase in professional services is due primarily to costs associated with the investigation of embezzlement by a former non-management employee
which was detected during the fourth quarter of fiscal 2006 and was completed during the first quarter of fiscal 2007.



Interest and other income, net increased to $1,953,000 for the year ended September 30, 2007 from $1,358,000 for the year ended September 30, 2006.
This increase is primarily due to higher interest rates and higher balances of our cash, cash equivalents, and short-term investments.

Discussion of Fiscal 2006 and 2005



Net revenues from sales to EMC represented 81% and 79% of net revenues in the year ended September 30, 2006 and 2005, respectively Net revenues increased
from 2005 to 2006 primarily due to an increase in sales volumes to EMC partially offset by lower average selling prices as well as a decrease in our sales of third party data storage networking
products, which we no longer sold subsequent to December 31, 2004. Additionally, net revenues to customers, other than EMC, increased from $15.4 million in fiscal 2005 to
$20.8 million in fiscal 2006.



Gross profit increased for fiscal 2006 compared to fiscal 2005, primarily as a result of increased sales volumes partially offset by lower average selling prices.
Fiscal 2006 gross profit as a percentage of net revenues declined slightly due to lower average selling prices. In addition, we incurred additional costs related to marketing incentives and programs
that are required to be recorded as reductions of revenue, and the overhead of our customer support investments.



The following table presents operating expenses during the periods indicated, in thousands and as a percentage of net revenues:

|                                |                          | For the year ended September 30, |       
|------------------------------- | ------------------------ | -------------------------------- | ------
|
|
|Operating expenses:             |                          |                                  |       
|Research and development        |                          | $                                | 8,377 
|Selling and marketing           |                          |                                  | 10,522
|General and administrative      |                          |                                  | 7,729 
|Impairment of goodwill          |                          |                                  |      
|Restructuring and other charges |                          |                                  |      
|Impairment of long-lived assets |                          |                                  |      
|                                |                          |                                  |       
|                                | Total operating expenses |                                  | $     
|                                |                          |                                  |       

33

---





The following table summarizes the most significant components of research and development expense for the periods indicated, in thousands and as a percentage of
total research and development expense and provides the changes in thousands and percentages:

|                          |                                   | For the year ended September 30, |  
|------------------------- | --------------------------------- | -------------------------------- | -
|
|
|Research and development: |                                   |                                  |  
|                          | Compensation and related expenses |                                  | $
|                          | Stock-based compensation          |                                  |  
|                          | Prototype                         |                                  |  
|                          | Consulting and outside services   |                                  |  
|                          | Other                             |                                  |  
|                          |                                   |                                  |  
|                          |                                   | Total research and development   |  
|                          |                                   |                                  |  

Our
research and development expenses increased primarily as a result of recognizing stock-based compensation expense and increased compensation and related expenses partially offset by
a decrease in consulting and outside services. The increase in compensation and related expenses was primarily attributable to an increase in headcount from 40 employees at September 30, 2005
to 43 at September 30, 2006. The decrease in consulting and outside services is primarily due to the timing of certain engineering projects and the lower utilization of outside contractors for
software development in fiscal 2006.



The following table summarizes the most significant components of selling and marketing expense for the periods indicated in thousands and as a percentage of
total selling and marketing expense and provides the changes in thousands and percentages:

|                       |                                   | For the year ended September 30, |  
|---------------------- | --------------------------------- | -------------------------------- | -
|
|
|Selling and marketing: |                                   |                                  |  
|                       | Compensation and related expenses |                                  | $
|                       | Stock-based compensation          |                                  |  
|                       | Marketing programs                |                                  |  
|                       | Consulting and outside services   |                                  |  
|                       | Travel                            |                                  |  
|                       | Other                             |                                  |  
|                       |                                   |                                  |  
|                       |                                   | Total selling and marketing      |  
|                       |                                   |                                  |  

As
indicated in the table above, the primary components of the increase in selling and marketing expenses were stock-based compensation and compensation and related expenses. These were
partially offset by decreases in marketing programs and other expenses. The increase in compensation and related expenses was due to our expansion of our European sales force, which we began to form
in fiscal 2005. The reduction in our marketing programs was primarily related to reduced spending on end

34

---



user
lead generation programs for certain products in the second half of fiscal 2006. The decrease in other expenses primarily related to decreases in our recruiting expenses attributable to the
timing of newly hired employees and lower depreciation expense.



The following table summarizes the most significant components of general and administrative expense for the periods indicated in thousands and as a percentage of
total general and administrative expense and provides the changes in thousands and percentages:

|                            |                                   | For the year ended September 30, |  
|--------------------------- | --------------------------------- | -------------------------------- | -
|
|
|General and administrative: |                                   |                                  |  
|                            | Compensation and related expenses |                                  | $
|                            | Stock-based compensation          |                                  |  
|                            | Professional services             |                                  |  
|                            | Director and officer insurance    |                                  |  
|                            | Other                             |                                  |  
|                            |                                   |                                  |  
|                            |                                   | Total general and administrative |  
|                            |                                   |                                  |  

As
indicated in the table above, the primary component of the decrease in general and administrative expenses was decreased professional services. This decrease was partially offset by
the addition of stock-based compensation. The decrease in professional services was due primarily to a decrease in costs associated with the Sarbanes-Oxley compliance since fiscal 2006 was our second
year of implementation and a decrease in legal costs associated with the timing of certain litigation activities.



Based on the fact that we exited the portion of the TidalWire business during the first quarter of 2005, we determined that our goodwill was impaired resulting in
an impairment charge of $7,769,000 for the year ended September 30, 2005.



Interest and other income (expense), net increased from $993,000 in fiscal 2005 to $1,358,000 in fiscal 2006. This increase was primarily due to higher average
interest rates earned on our cash, cash equivalents, and short-term investments.

35

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Liquidity and Capital Resources

The following table summarizes cash flow activities for the fiscal years ended (in thousands):

September 30,2007

2006Net income (loss)

$
2,502

$
(5,447
)Non-cash adjustments to net income (loss)


3,353


3,783Changes in working capital


4,750


(3,741
)Cash provided by (used in) operating activities


10,605


(5,405
)Cash provided by investing activities


23,655


2,794Cash provided by financing activities


2,129


1,157Increase (decrease) in cash and cash equivalents


36,389


(1,454
)Cash and cash equivalents at beginning of year


8,014


9,468Cash and cash equivalents at end of year

$
44,403

$
8,014


The
following table presents our short-term investments as of the years ended (in thousands):

September 30,2007

2006Short-term investments

$


$
24,804




Cash flows provided by operating activities of $10.6 million for fiscal 2007 were attributable to a net income of $2.5 million and changes in
working capital of $4.8 million as well as an increase by non-cash adjustments to net income of $3.4 million. Non-cash adjustments to net income consisted
substantially of stock-based compensation of $2.5 million and depreciation expense of $846,000. Significant cash flow effects from changes in working capital for fiscal 2007 included a decrease
in cash flows from our $1.7 million increase in inventory offset by increased cash
flows from an increase in our accounts payable and accrued expenses of $4.1 million and a $2.5 million increase in our deferred revenue.

The
increases in our accounts payable and accrued expenses are primarily a result of increased sales volumes, in the quarter ended September 30, 2007, which also necessitated
increased purchasing volume. The increase in deferred revenue is primarily related to the transfer of the support obligations of the previously installed Whale appliances from Microsoft.



Cash flows provided by investing activities during fiscal 2007 resulted from net sales of $24.8 million of short-term available for sale
investments partially offset by $888,000 of investments made in property and equipment. Due to the acquisition of Alliance Systems on October 11, 2007, the company sold approximately
$25 million of short-term available for sale investments. This amount was partially offset by $398,000 of investments in property and equipment.



Cash flows provided by financing activities consisted of cash received as a result of employee stock option and stock purchase plan activity of
$2.1 million in fiscal 2007 compared to $1.2 million in fiscal

36

---



2006.
We expect employee stock option activity to continue in fiscal 2008; however, we cannot predict its level given the volatility of our stock price.

Contractual Obligations and Commitments

The following table sets forth certain information concerning our obligations and commitments to make certain payments (in thousands).

|                         |  | Payments Due by Period
|------------------------ |  | ----------------------
|
|Operating leases         |  | $                     
|Capital lease obligation |  |                       
|                         |  |                       
|Total                    |  | $                     
|                         |  |                       

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



We
believe that our available cash resources, including cash and cash equivalents, and cash that we expect to generate from sales of our products will be sufficient to meet our operating
and capital requirements through at least the next twelve months.

On
October 11, 2007, we completed our acquisition of Alliance Systems, Inc., a leading provider of server appliances and computer infrastructure supporting
telecommunications and enterprise communications. This acquisition, which was valued at approximately $40 million, was funded through a combination of approximately $34 million in cash
and the issuance of 2.9 million shares of our common stock. In connection with this acquisition, we entered into a Loan and Security Agreement (the "Loan Agreement") with Silicon Valley Bank.
The Loan Agreement provides us with a revolving line of credit in an amount up to the lesser of (a) $15,000,000 or (b) $5,000,000 plus 80% of our eligible accounts receivable, as defined
in the Loan Agreement. The line of credit matures and the principal balance outstanding is payable in full on October 9, 2008. As of December 14, 2007, we have not drawn on this line of
credit.

In
the event that our available cash resources and Silicon Valley Bank line of credit are not sufficient, after the line of credit matures on October 9, 2008, we would need to
raise additional funds. We may in the future seek to raise additional funds through borrowings, public or private equity financings or from other sources. There can be no assurance that additional
financing will be available at all or, if available, will be on terms acceptable to us. Additional equity financings could result in dilution to our shareholders. If additional financing is needed and
is not available on acceptable terms, we may need to reduce our operating expenses and scale back our operations.

Off-Balance Sheet Arrangements

We have not created, and are not party to, any special-purpose or off balance sheet entities for the purpose of raising capital, incurring debt or operating parts
of our business that are not consolidated

37

---



into
our financial statements. We have not entered into any transactions with unconsolidated entities whereby we have subordinated retained interests, derivative instruments or other contingent
arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity,
market risk or credit risk support to us.

Related Party Transactions

Robert M. Wadsworth, one of our directors, is a managing director of the limited liability corporation that controls HarbourVest 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, 2006 and 2005, HarbourVest owned greater than 5% of our outstanding stock and greater than 5% of the outstanding stock of PSI. While we were selling third-party data storage
networking products we engaged Akibia to provide certain customer support and warranty fulfillment services related our sales of host bus adapters (HBAs). Our agreement with Akibia expired in
March 2005 as scheduled. However, the terms of the agreement required Akibia to fulfill the warranty services for the entire warranty period. Akibia charged us a quarterly fixed fee of $83,000
and a variable fee based upon our sales of HBAs which ended December 2004. For the years ended September 30, 2007, 2006 and 2005 we recognized $0, $0, and $201,000, respectively, of
expense as a result of its HBA customer support and warranty fulfillment services agreements with Akibia. In connection with this customer support and warranty fulfillment services agreement, we also
sold HBAs to Akibia to allow Akibia to fulfill our warranty obligations for these products. For the years ended September 30, 2007, 2006 and 2005 we recorded revenues of $0, $0, and $40,000,
respectively, from sales of HBAs to Akibia. There were no amounts receivable from or payable to Akibia at September 30, 2007 or 2006. 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 of Innoveer Solutions, Inc. ("Innoveer"), formerly Akibia Consulting, a subsidiary of Akibia. We previously engaged Innoveer to
perform certain professional services related to its customer resource management ("CRM") software system. During the years ended September 30, 2007, 2006, and 2005, we incurred approximately
$40,200, $80,000, and $14,300, respectively, related to these services. We had $7,000 outstanding to Innoveer at September 30, 2006 and no amounts outstanding to Innoveer at
September 30, 2007.

Through
fiscal 2005, Mr. Frank Polestra, one of our former directors, was also a managing director of Ascent Venture Partners. Both Mr. Polestra and Mr. Blaeser were
limited partners in one of Ascent Venture Partner's funds, which owned greater than 5% of the outstanding capital stock of one of our customers, Network Intelligence Corporation, prior to its
acquisition by EMC Corporation on September 18, 2006. For the year ended September 30, 2005, revenues from sales to Network Intelligence Corporation were approximately $4,040,000.

In
September 2005, we engaged the consulting services of Mapleworks Technologies ("Mapleworks"), a software development services provider. Both Mr. Blaeser and
Mr. Wadsworth are investors in Mapleworks and are members of its board of advisors. In the years ended September 30, 2007, 2006, and 2005 we incurred $0, $82,000 and $18,000,
respectively, in fees for these consulting services. We had no amounts outstanding to Mapleworks at September 30, 2007 or 2006.

Charles
Foley, one of our directors, also serves as the CEO of Digital Ocular Networks ("Digital Ocular"). During the fiscal year ending September 30, 2007, we had revenues of
$6,000 related to sales of server appliances to Digital Ocular.

38

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Recent Accounting Pronouncements

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in the Current Year Financial Statements" ("SAB 108"). SAB 108 addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying
misstatements in current-year financial statements. SAB 108 requires us to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either
approach results in an error that is material in light of relevant quantitative and qualitative factors. The requirements of SAB 108 are effective for fiscal years ending after November 15,
2006. We adopted SAB 108 in the current fiscal year and the adoption of SAB 108 did not have an impact on our financial position, results of operations or cash flows.

In
September 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxesan
Interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in companies' financial statements in accordance with FASB
Statement No. 109, "Accounting for Income Taxes," and provides guidance on financial statement recognition and disclosure for tax positions taken or expected to be taken on a tax return. The
evaluation of a tax position in accordance with FIN 48 is a two-step process. The first step is recognition whereby companies must determine whether it is more likely than not that a tax
position will be sustained upon examination.
The second step is measurement whereby a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to
recognize in the financial statements. FIN 48 also provides guidance on derecognition of recognized tax benefits, classification, interest and penalties, accounting in interim periods, disclosure and
transition. The guidance of FIN 48 is applicable for fiscal years beginning after December 15, 2006. We are in the process of evaluating whether the adoption of FIN 48 will have a material
effect on our financial position, results of operations or cash flows.

In
September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, "Fair Value Measurements" ("FAS 157"). This statement address how companies
should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under accounting principles generally accepted in the United States. This Statement
is effective as of the beginning of the our fiscal year that begins after November 15, 2007. We are in the process of evaluating whether the adoption of this statement will have a material
impact on our financial position, results of operations and cash flows.

In
February 2007, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 159, "The Fair Value Option for Financial Assets and Financial
LiabilitiesIncluding an amendment of FASB Statement No. 115" ("FAS 159"). This Statement permits entities to choose to measure many financial instruments and certain other
items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. This Statement is
effective as of the beginning of our fiscal year that begins after November 15, 2007. We are in the process of evaluating whether the adoption of FAS 159 will have a material effect on
our financial position, results of operations and cash flows.

39

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ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We do not engage in any foreign currency hedging transactions and therefore, do not believe we are subject to material exchange rate 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 in interest rates on our financial position, results of operations and cash flows will not be material.

40

---





ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                                                     
|-------------------------------------------------------------------------------------------------------------------------------------
|REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM                                                                              
|CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2007 AND 2006                                                                        
|CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 2007, 2006 AND 2005                                          
|CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS) FOR THE YEARS ENDED SEPTEMBER 30, 2007, 2006 AND 2005
|CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED SEPTEMBER 30, 2007, 2006 AND 2005                                          
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                                                           

41

---





REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

In
our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Network
Engines, Inc. and its subsidiaries at September 30, 2007 and September 30, 2006, and the results of their operations and their cash flows for each of the three years in the period
ended September 30, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the
accompanying index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial
statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2007, based on criteria established in Internal
ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's
management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting, included in Management's Annual Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to
express opinions on these financial statements, on the financial statement schedule, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our
audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance
about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the
financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal
control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.
Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As
discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation in fiscal 2006.

A
company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures
that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

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

PricewaterhouseCoopers
LLP
Boston, Massachusetts
December 11, 2007

42

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NETWORK ENGINES, INC.        CONSOLIDATED BALANCE SHEETS        (in thousands, except share and per share data)

|                                              |                                                                                                                                                                                                 | September 30,              |                                           
|--------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------------------------
|
|ASSETS                                        |                                                                                                                                                                                                 |                            |                                           
|Current assets:                               |                                                                                                                                                                                                 |                            |                                           
|                                              | Cash and cash equivalents                                                                                                                                                                       |                            | $                                         
|                                              | Short-term investments                                                                                                                                                                          |                            |                                           
|                                              | Restricted cash                                                                                                                                                                                 |                            |                                           
|                                              | Accounts receivable, net of allowances of $32 and $29 at September 30, 2007 and 2006, respectively                                                                                              |                            |                                           
|                                              | Inventories                                                                                                                                                                                     |                            |                                           
|                                              | Prepaid expenses and other current assets                                                                                                                                                       |                            |                                           
|                                              |                                                                                                                                                                                                 |                            |                                           
|                                              |                                                                                                                                                                                                 | Total current assets       |                                           
|Property and equipment, net                   |                                                                                                                                                                                                 |                            | 1,128                                     
|Other assets                                  |                                                                                                                                                                                                 |                            | 281                                       
|                                              |                                                                                                                                                                                                 |                            |                                           
|                                              |                                                                                                                                                                                                 | Total assets               |                                           
|                                              |                                                                                                                                                                                                 |                            |                                           
|LIABILITIES AND STOCKHOLDERS' EQUITY          |                                                                                                                                                                                                 |                            |                                           
|Current liabilities:                          |                                                                                                                                                                                                 |                            |                                           
|                                              | Accounts payable                                                                                                                                                                                |                            | $                                         
|                                              | Accrued compensation and other related benefits                                                                                                                                                 |                            |                                           
|                                              | Accrued warranty                                                                                                                                                                                |                            |                                           
|                                              | Other accrued expenses                                                                                                                                                                          |                            |                                           
|                                              | Current portion of capital lease obligation                                                                                                                                                     |                            |                                           
|                                              | Deferred revenue                                                                                                                                                                                |                            |                                           
|                                              |                                                                                                                                                                                                 |                            |                                           
|                                              |                                                                                                                                                                                                 | Total current liabilities  |                                           
|Long-term portion of capital lease obligation |                                                                                                                                                                                                 |                            | 39                                        
|Deferred revenue, net of current portion      |                                                                                                                                                                                                 |                            | 1,285                                     
|                                              |                                                                                                                                                                                                 |                            |                                           
|                                              |                                                                                                                                                                                                 | Total liabilities          |                                           
|                                              |                                                                                                                                                                                                 |                            |                                           
|Commitments and contingencies (Note 11)       |                                                                                                                                                                                                 |                            |                                           
|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; 43,590,883 and 41,751,304 shares issued; 41,029,025 and 39,189,446 shares outstanding at September 30, 2007 and 2006, respectively |                            |                                           
|                                              | Additional paid-in capital                                                                                                                                                                      |                            |                                           
|                                              | Accumulated deficit                                                                                                                                                                             |                            |                                           
|                                              | Treasury stock, at cost, 2,561,858 shares at September 30, 2007 and 2006, respectively                                                                                                          |                            |                                           
|                                              |                                                                                                                                                                                                 |                            |                                           
|                                              |                                                                                                                                                                                                 | Total stockholders' equity |                                           
|                                              |                                                                                                                                                                                                 |                            |                                           
|                                              |                                                                                                                                                                                                 |                            | Total liabilities and stockholders' equity
|                                              |                                                                                                                                                                                                 |                            |                                           

The
accompanying notes are an integral part of the consolidated financial statements.

43

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NETWORK ENGINES, INC.        CONSOLIDATED STATEMENTS OF OPERATIONS        (in thousands, except per share data)

|                                                             |                                 | Year ended September 30, |        
|------------------------------------------------------------ | ------------------------------- | ------------------------ | -------
|
|Net revenues                                                 |                                 | $                        | 119,627
|Cost of revenues                                             |                                 |                          | 96,375 
|                                                             |                                 |                          |        
|Gross profit                                                 |                                 |                          | 23,252 
|Operating expenses:                                          |                                 |                          |        
|                                                             | Research and development        |                          |        
|                                                             | Selling and marketing           |                          |        
|                                                             | General and administrative      |                          |        
|                                                             | Restructuring and other charges |                          |        
|                                                             | Impairment of long-lived assets |                          |        
|                                                             | Impairment of goodwill          |                          |        
|                                                             |                                 |                          |        
|Total operating expenses                                     |                                 |                          | 22,584 
|                                                             |                                 |                          |        
|Income (loss) from operations                                |                                 |                          | 668    
|Interest and other income, net                               |                                 |                          | 1,953  
|                                                             |                                 |                          |        
|Income (loss) before income taxes                            |                                 |                          | 2,621  
|Provision for income taxes                                   |                                 |                          | 119    
|                                                             |                                 |                          |        
|Net income (loss)                                            |                                 | $                        | 2,502  
|                                                             |                                 |                          |        
|Net income (loss) per sharebasic and diluted                |                                 | $                        | 0.06   
|                                                             |                                 |                          |        
|Shares used in computing basic net income (loss) per share   |                                 |                          | 40,637 
|Shares used in computing diluted net income (loss) per share |                                 |                          | 41,256 

The
accompanying notes are an integral part of the consolidated financial statements.

44

---





NETWORK ENGINES, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)

(in thousands, except share data)

|                                                                                 |  | Shares of Common Stock |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|-------------------------------------------------------------------------------- |  | ---------------------- |  | ---------- | - | - | --- |  | - | ------- |  | - | -------- | - | - | -- | -
|
|Balance, September 30, 2004                                                      |  | 39,678,844             |  | (2,561,858 | ) |   | 397 |  |   | 177,688 |  |   | (110,567 | ) |   | (7 | )
|Issuance of common stock upon stock option exercises                             |  | 404,145                |  |            |   |   | 4   |  |   | 343     |  |   |          |   |   |    |  
|Issuance of common stock under employee stock purchase plan                      |  | 258,901                |  |            |   |   | 2   |  |   | 364     |  |   |          |   |   |    |  
|Amortization of deferred stock compensation to expense                           |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   | 7  |  
|Stock compensation related to grants of stock options to non-employee            |  |                        |  |            |   |   |     |  |   | 7       |  |   |          |   |   |    |  
|Tax benefit relating to incentive stock option and employee stock purchase plans |  |                        |  |            |   |   |     |  |   | 44      |  |   |          |   |   |    |  
|Net loss                                                                         |  |                        |  |            |   |   |     |  |   |         |  |   | (15,583  | ) |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|Balance, September 30, 2005                                                      |  | 40,341,890             |  | (2,561,858 | ) | $ | 403 |  | $ | 178,446 |  | $ | (126,150 | ) | $ |   |  
|Issuance of common stock upon stock option exercises                             |  | 1,152,424              |  |            |   |   | 12  |  |   | 870     |  |   |          |   |   |    |  
|Issuance of common stock under employee stock purchase plan                      |  | 256,990                |  |            |   |   | 3   |  |   | 290     |  |   |          |   |   |    |  
|Stock compensation related to grants of stock options to non-employee            |  |                        |  |            |   |   |     |  |   | 7       |  |   |          |   |   |    |  
|Stock compensation related to grants of stock options to employees               |  |                        |  |            |   |   |     |  |   | 2,807   |  |   |          |   |   |    |  
|Net loss                                                                         |  |                        |  |            |   |   |     |  |   |         |  |   | (5,447   | ) |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|Balance, September 30, 2006                                                      |  | 41,751,304             |  | (2,561,858 | ) | $ | 418 |  | $ | 182,420 |  | $ | (131,597 | ) | $ |   |  
|Issuance of common stock upon stock option exercises                             |  | 1,732,789              |  |            |   |   | 17  |  |   | 1,948   |  |   |          |   |   |    |  
|Issuance of common stock under employee stock purchase plan                      |  | 106,790                |  |            |   |   | 1   |  |   | 183     |  |   |          |   |   |    |  
|Stock compensation related to grants of stock options to employees               |  |                        |  |            |   |   |     |  |   | 2,454   |  |   |          |   |   |    |  
|Net income                                                                       |  |                        |  |            |   |   |     |  |   |         |  |   | 2,502    |   |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  
|Balance, September 30, 2007                                                      |  | 43,590,883             |  | (2,561,858 | ) | $ | 436 |  | $ | 187,005 |  | $ | (129,095 | ) | $ |   |  
|                                                                                 |  |                        |  |            |   |   |     |  |   |         |  |   |          |   |   |    |  

The accompanying notes are an integral part of the consolidated financial statements.

45

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NETWORK ENGINES, INC.        CONSOLIDATED STATEMENTS OF CASH FLOWS        (in thousands)

|                                                                       |                                                                                                    | Year Ended September 30,                       |       
|---------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------- | ---------------------------------------------- | ------
|
|Cash flows from operating activities:                                  |                                                                                                    |                                                |       
|                                                                       | Net income (loss)                                                                                  |                                                | $     
|                                                                       | Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |                                                |       
|                                                                       |                                                                                                    | Depreciation and amortization                  |       
|                                                                       |                                                                                                    | Stock compensation                             |       
|                                                                       |                                                                                                    | Provision for doubtful accounts                |       
|                                                                       |                                                                                                    | Loss on disposal of fixed assets               |       
|                                                                       |                                                                                                    | Impairment of intangible and long-lived assets |       
|                                                                       |                                                                                                    | Impairment of goodwill                         |       
|                                                                       | Changes in operating assets and liabilities:                                                       |                                                |       
|                                                                       |                                                                                                    | Accounts receivable                            |       
|                                                                       |                                                                                                    | Inventories                                    |       
|                                                                       |                                                                                                    | Prepaid expenses and other current assets      |       
|                                                                       |                                                                                                    | Accounts payable                               |       
|                                                                       |                                                                                                    | Accrued warranty                               |       
|                                                                       |                                                                                                    | Accrued expenses                               |       
|                                                                       |                                                                                                    | Deferred revenue                               |       
|                                                                       |                                                                                                    |                                                |       
|                                                                       | Net cash provided by (used in) operating activities                                                |                                                |       
|Cash flows from investing activities:                                  |                                                                                                    |                                                |       
|                                                                       |                                                                                                    | Purchases of property and equipment            |       
|                                                                       |                                                                                                    | Purchases of short-term investments            |       
|                                                                       |                                                                                                    | Sales of short-term investments                |       
|                                                                       |                                                                                                    | Changes in other assets                        |       
|                                                                       |                                                                                                    |                                                |       
|                                                                       | Net cash provided by (used in) investing activities                                                |                                                |       
|Cash flows from financing activities:                                  |                                                                                                    |                                                |       
|                                                                       |                                                                                                    | Proceeds from issuance of common stock         |       
|                                                                       |                                                                                                    | Payments on capital lease obligations          |       
|                                                                       |                                                                                                    |                                                |       
|                                                                       | Net cash provided by financing activities                                                          |                                                |       
|                                                                       |                                                                                                    |                                                |       
|Net increase (decrease) in cash and cash equivalents                   |                                                                                                    |                                                | 36,389
|Cash and cash equivalents, beginning of year                           |                                                                                                    |                                                | 8,014 
|                                                                       |                                                                                                    |                                                |       
|Cash and cash equivalents, end of year                                 |                                                                                                    |                                                | 44,403
|                                                                       |                                                                                                    |                                                |       
|Supplemental disclosure of non-cash investing or financing activities: |                                                                                                    |                                                |       
|Acquisition of equipment under capital lease obligation                |                                                                                                    | $                                              |      

The
accompanying notes are an integral part of the consolidated financial statements.

46

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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 enable network equipment providers and
independent software vendors, or ISVs, to deliver their software applications in the form of a server appliance. Server appliances are pre-configured network infrastructure devices
designed to optimally deliver specific software application functionality and facilitate ease of deployment and support of a software application in a customer's network. The Company offers its server
appliance customers a comprehensive suite of services, including development, manufacturing, fulfillment and post-sale support, in addition, to certain software products, such as the
Company's NEWS and ACE Linux products. The Company produces and fulfills devices branded for its network equipment and ISV customers, and derives its revenues from the sale of value-added hardware
platforms to these customers. These customers subsequently sell and support the device under their own brands to their customer base.

Prior
to October 1, 2006, the Company had two reportable segments, OEM Appliance and Distribution. In the OEM Appliance segment the Company developed and manufactured server
appliance solutions that enabled network enquipment providers and independent software vendors to deliver their software applications in the form of a server appliance. The Distribution segment
developed, manufactured, sold and marketed server appliances under the Company's own brand that were based on Microsoft's Internet Security and Acceleration (ISA) Server. The Company's Distribution
segment also previously distributed third-party data storage networking connectivity products for the leading Fibre Channel host bus adapter, or HBA, and storage switch manufacturers in the data
storage industry to a customer base of value-added resellers, and systems integrators. In early fiscal 2005, the Company decided to discontinue selling third-party data storage networking products
after a review of that portion of the business and its future prospects. Sales of these third-party data storage networking products ceased by December 31, 2004.

During
the quarter ended December 31, 2006, the Company changed the manner in which management viewed information regarding results of the Company's operations for purposes of
making decisions affecting the business. This resulted from changes in the operations of the Company, including consolidation of financial and operational information reviewed by management to
evaluate the Company's operations, discontinuing market demand creation for its NS Series Security Appliances, and the consolidation of the Company's sales force. Therefore, the Company has one
reportable segment, which represents how management evaluates the Company's operations.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and
balances have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the period. Actual results could differ from those estimates.

47

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Cash, Cash Equivalents, Short-term Investments and Restricted Cash

Cash equivalents consist principally of money market funds, commercial paper, and other marketable securities purchased with an original maturity of three months
or less. These investments are carried at cost, which approximates market value. For the year ended September 30, 2006, the Company also
invested excess cash in auction rate securities. These securities had long-term underlying maturities, however the market was highly liquid and the interest rates reset every 7, 28 or
35 days. The Company's intent was not to hold these securities to maturity, but rather to use the interest rate reset feature to sell securities to provide liquidity as needed. The Company's
short-term investments were classified as available for sale and carried at fair value, with unrealized gains and losses included in other comprehensive income or loss, which is a separate
component of stockholders' equity, until realized. At September 30, 2007 and 2006, there were no unrealized gains or losses. At September 30, 2007 and 2006, $247,000 and $47,000,
respectively, of cash was restricted and pledged as collateral for a letter of credit related to the lease of the Company's facilities and certain vendor purchases.

Concentrations of Risk



Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, short-term
investments and trade receivables. The Company invests primarily in municipal bonds, money market funds of major financial institutions as well as government agency securities. There are no
significant concentrations in any one issuer of securities. The Company provides credit to customers in the normal course of business and does not require collateral from its customers, but routinely
assesses their financial strength. The Company maintains reserves for potential credit losses and such losses have been within management's expectations.



The following 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, |  
|------------------ |  | --------------------------------------------- | - | ------------------------------------ | -
|
|EMC Corporation(1) |  | 83                                            | % | 81                                   | %

---

48

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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 financial statements at amounts that approximate their fair value as of September 30, 2007 and 2006.

Inventories

Inventories are valued at the lower of cost or market, with approximate cost determined using the first-in, first-out method. The Company
regularly reviews inventory quantities on hand and records a write-down for excess and obsolete inventory based primarily on its estimated forecast of product demand and anticipated
production requirements in the near future.

Property and Equipment

Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives. Leasehold improvements
are amortized over the shorter of the useful life of the improvement or the remaining term of the lease. Upon retirement or sale, the cost of the assets disposed of and the related accumulated
depreciation are removed from the accounts and any resulting gain or loss is included in the determination of net income or loss. Repairs and maintenance are charged to expense as incurred.

Stock Based Compensation

Effective October 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standards 123(R),"Share-Based
Payment,"("SFAS 123(R)"), which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS 123(R), stock-based
compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee's requisite service period (generally the vesting period of the
equity award). Prior to October 1, 2005, the Company accounted for share-based compensation to employees in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees,
"("APB 25") and related interpretations. The Company also followed the disclosure requirements of Statement
of Financial Accounting Standards No. 123,"Accounting for Stock-Based Compensation"("SFAS 123"). The Company elected to adopt the
modified prospective transition method as provided by SFAS 123(R) and, accordingly, financial statement amounts for the prior periods presented have not been retroactively adjusted to reflect
the fair value method of expensing stock-based compensation.

Goodwill

Goodwill is the amount by which the cost of acquired net assets exceeded the fair value of those net assets on the date of acquisition. In July 2001, the
FASB issued Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets" (SFAS 142). As a result, goodwill is no longer amortized but tested for impairment
under a two-step process. Under the first step, an entity's net assets are segregated into reporting units and compared to their fair value. If the carrying amount of a reporting unit
exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step compares the implied fair value of a reporting
unit's goodwill with the carrying amount of that goodwill. If the carrying amount of a

49

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reporting
unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Fair value is calculated as the present value of
estimated future cash flows using a risk-adjusted discount rate, which requires significant management judgment with respect to revenue and expense growth rates and the selection and use
of an appropriate discount rate. The Company performs an annual impairment analysis on any outstanding goodwill at the end of each fiscal year. During the year ended September 30, 2005, the
Company recorded an impairment charge of $7,769,000 related to goodwill (see Note 3).

Foreign Currencies

The functional currency for the Company's foreign subsidiary is the U.S. dollar. Net foreign currency losses included in the determination of net income (loss)
for the three years ended September 30, 2007, 2006 and 2005 were not significant.

Impairment of Long-lived Assets

Statement of Financial Accounting Standard No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS 144),
requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by
those assets are less than the assets' carrying amount. If such asset is considered to be impaired, the impairment to be recognized is the amount by which the carrying amount of the asset, if any,
exceeds its fair value determined using a discounted cash flow model.

Revenue Recognition

Revenues from products are generally recognized upon delivery to customers if persuasive evidence of an arrangement exists, the fee is fixed or determinable,
collectibility is reasonably assured and title and risk of loss have passed to the customer. In the event the Company has unfulfilled future obligations, revenue and related costs are deferred until
those future obligations are met. The Company has an inventory consignment agreement with its largest customer related to certain server appliances. This customer notifies the Company when it utilizes
inventory and the Company recognizes revenues from sales to this customer based upon these notifications.

Maintenance
revenues are derived from customer support agreements generally entered into in connection with the initial server appliance sales and subsequent renewals. Maintenance fees
are typically for one to three year renewable periods and include the right to unspecified software updates when and if available for certain agreements, hardware repairs, 24-hour customer
support, and advanced replacement of server appliances. Maintenance revenues are recognized ratably over the term of the maintenance period. Payments for maintenance fees are generally made in advance
and are included in deferred revenue. The associated maintenance expenses are expensed in the same period as incurred.

Contracts
and/or customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and consignment usage notifications are used to verify
shipment or transfer of ownership, as applicable. The Company assesses whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales
price is subject to refund or adjustment. The Company assesses collectibility based primarily on the

50

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creditworthiness
of the customer as determined by credit checks and analysis, as well as the customer's payment history.

For
revenue arrangements that contain multiple elements, such as the sale of both the product and post sales support, in which software is not incidental to the product, the Company
determines fair value based upon vendor specific objective evidence, which is typically established through contractual post-sales support renewal rates whereby the residual fair value is
allocated to the server appliance. For revenue arrangements that contain multiple elements, in which software is not included or is incidental to the product, the Company determines fair value based
on objective and reliable evidence of fair value, which is typically determined through contractual refund rates for cancellations or stand-alone sales of post sales support whereby the residual fair
value is allocated to the server appliance.

The
Company recognizes revenue when the revenue recognition criteria for each element of the sale is met. If the Company is not able to derive the fair value of the undelivered element
of the sale (i.e. maintenance), all revenues from the arrangement are deferred and recognized ratably over the period of the support arrangement, which is typically one to three years. The Company
includes shipping and handling costs, if any, reimbursed by its customers as net revenues and cost of revenues.

Product Warranties

The Company offers a warranty on products sold to its customers, which generally provides for repair or replacement of any defective products for a period of up
to 36 months after shipment. Based upon historical experience and expectation of future conditions, for the standard warranty, the Company accrues for the estimated costs to fulfill customer
warranty obligations upon the recognition of the related revenue. The Company also offers extended warranty on certain of its products. Revenues for sales of these extended warranties are recognized
over the term of the related warranty period.

Advertising Costs

Advertising costs are expensed as incurred. Advertising expenses for the years ended September 30, 2007, 2006, and 2005 were $358,000, $868,000 and
$965,000, respectively.

Research and Development

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

Income Taxes

Deferred tax assets and liabilities are determined based on the difference between the financial statement and the tax bases of assets and liabilities using
enacted tax rates in effect in the years in which the differences are expected to reverse. A valuation allowance against deferred tax assets is

51

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recorded
if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

Comprehensive Income (Loss)

Comprehensive income (loss) is comprised of two components, net income (loss) and other comprehensive income (loss). During the years ended September 30,
2007, 2006 and 2005, comprehensive income (loss) consisted of net income (loss).

Net Income (Loss) per Share

Basic net income (loss) per share has been computed by dividing net income (loss) by the weighted average number of common shares outstanding during the year.
Diluted net income (loss) per share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of
options to purchase common stock. During the years that the Company incurred a net loss, diluted net loss per share is the same as basic net loss per share since the inclusion of these common stock
equivalents would be anti-dilutive.

|                                                                                                               |                                                              | For the year ended September 30, |  
|-------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------ | -------------------------------- | -
|
|Numerator:                                                                                                     |                                                              |                                  |  
|                                                                                                               | Net income (loss)                                            |                                  | $
|Denominator:                                                                                                   |                                                              |                                  |  
|                                                                                                               | Shares used in computing basic net income (loss) per share   |                                  |  
|                                                                                                               | Common stock equivalents from employee stock options         |                                  |  
|                                                                                                               |                                                              |                                  |  
|                                                                                                               | Shares used in computing diluted net income (loss) per share |                                  |  
|Net income (loss) per share:                                                                                   |                                                              |                                  |  
|                                                                                                               | Basic                                                        |                                  | $
|                                                                                                               | Diluted                                                      |                                  | $
|Anti-dilutive potential common stock equivalents excluded from the calculation of net income (loss) per share: |                                                              |                                  |  
|                                                                                                               | Options to purchase common stock                             |                                  |  

Recent Accounting Pronouncements

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No.108, "Considering the Effects of Prior Year Misstatements
when Quantifying Misstatements in the Current Year Financial Statements" ("SAB 108"). SAB 108 addresses how the effects of prior-year uncorrected misstatements should be considered when
quantifying misstatements in current-year financial statements. SAB 108 requires an entity to quantify misstatements using a balance sheet and income statement approach and to evaluate
whether either approach results in an error that is material in light of relevant quantitative and qualitative factors. The requirements of SAB 108 are effective for fiscal years ending after
November 15, 2006. The
company adopted SAB 108 in the current fiscal year and the adoption of SAB 108 did not impact the Company's financial position, results of operations, or cash flows.

52

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In September 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income
Taxesan Interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in companies' financial statements in
accordance with FASB Statement No. 109, "Accounting for Income Taxes," and provides guidance on financial statement recognition and disclosure for tax positions taken or expected to be taken on
a tax return. The evaluation of a tax position in accordance with FIN 48 is a two step process. The first step is recognition whereby companies must determine whether it is more likely than not that a
tax position will be sustained upon examination. The second step is measurement whereby a tax position that meets the more-likely-than-not recognition threshold is
measured to determine the amount of benefit to recognize in the financial statements. FIN 48 also provides guidance on derecognition of recognized tax benefits, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. The guidance of FIN 48 is applicable for fiscal years beginning after December 15, 2006. The Company is in the process of evaluating
whether the adoption of FIN48 will have a material effect on the Company's financial position, results of operations, or cash flows.

In
September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, "Fair Value Measurements" ("FAS 157"). This statement address how companies
should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under accounting principles generally accepted in the United States. This Statement
is effective as of the beginning of the Company's fiscal year that begins after November 15, 2007. The Company is in the process of evaluating whether the adoption of this statement will have a
material impact on the Company's financial position, results of operations or cash flows.

In
February 2007, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 159, "The Fair Value Option for Financial Assets
and Financial LiabilitiesIncluding an amendment of FASB Statement No. 115" ("FAS 159"). This Statement permits entities to choose to measure many financial instruments and
certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. This
Statement is effective as of the beginning of the Company's fiscal year that begins after November 15, 2007. The Company is in the process of evaluating whether the adoption of FAS 159
will have a material effect on the Company's financial position, results of operations, or cash flows.

3. Goodwill and Intangible Assets

The Company performed its annual impairment assessment of goodwill as of September 30, 2005 using an appraisal based primarily on the estimated discounted
cash flows expected to be generated by each reporting unit. The discounted cash flows used in the appraisal were based on a number of estimates and assumptions made by the Company, including the
projected future operating results of each reporting unit, the discount rate, and the long-term growth rate. The Company based its revenue assumptions on estimates of relevant market
sizes, expected market growth rates, and actual fiscal 2005 results. In addition, to arrive at the implied fair value of the reporting unit's goodwill, the Company considered among other factors, the
expected required investments in technology development and sales and marketing efforts. This assessment resulted in an implied fair value of the reporting unit's goodwill that was significantly lower
than its carrying value. Consequently, the Company determined that its goodwill was fully impaired resulting in an impairment charge of $7,769,000 for the year ended September 30, 2005 (also
see Note 6).

53

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4. Cash, Cash Equivalents and Investments

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

|                                |                                   | September 30,
2007 |        | September 30,
2006
|------------------------------- | --------------------------------- | ------------------ | ------ | ------------------
|Cash and cash equivalents:      |                                   |                    |        |                   
|                                | Cash                              |                    |        | 3,836             
|                                | Money market funds                |                    |        | 37,941            
|                                | Commercial Paper                  |                    |        | 2,626             
|                                |                                   |                    |        |                   
|Total cash and cash equivalents |                                   | $                  | 44,403 |                   
|                                |                                   |                    |        |                   
|Short-term investments:         |                                   |                    |        |                   
|                                | Municipal auction rate securities |                    | $      |                  
|                                |                                   |                    |        |                   

5. Inventories

Inventories consisted of the following (in thousands):

|                |  | September 30,
|--------------- |  | -------------
|
|Raw materials   |  | $            
|Work in process |  |              
|Finished goods  |  |              
|                |  |              
|                |  | $            
|                |  |              

6. Property and Equipment

Property and equipment consisted of the following (in thousands):

|                                                |  |                                               |  | September 30,
|----------------------------------------------- |  | --------------------------------------------- |  | -------------
|
|Office furniture and equipment                  |  | 5 years                                       |  | $            
|Engineering and production equipment            |  | 3 years                                       |  |              
|Computer equipment and software                 |  | 3 years                                       |  |              
|Leasehold improvements                          |  | Shorter of lease term or
useful life of asset |  |              
|                                                |  |                                               |  |              
|                                                |  |                                               |  |              
|Less: accumulated depreciation and amortization |  |                                               |  |              
|                                                |  |                                               |  |              
|                                                |  |                                               |  | $            
|                                                |  |                                               |  |              

Depreciation
and amortization expense, related to property and equipment, was approximately $846,000, $1,004,000 and $1,163,000 for the years ended September 30, 2007, 2006, and
2005, respectively.

54

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In
the fourth quarter of fiscal 2005, the Company assessed the undiscounted cash flows expected to be generated by its Distribution segment, and determined that the carrying value of
certain equipment in its Distribution segment was not recoverable as determined in accordance with SFAS 144. As a result, the Company recognized an impairment charge of $313,000 for the year
ended September 30, 2005, of which approximately $15,000 was recorded in cost of revenues.

7. Capital Lease Agreement

During the year ended September 30, 2005, the Company entered into a lease agreement for certain office equipment that has been accounted for as a capital
lease. The Company has assets acquired under capital lease obligations amounting to $101,000 at September 30, 2007 and 2006. Accumulated amortization totals $47,000 and $27,000 at
September 30, 2007 and 2006, respectively. Amortization of such equipment is included in depreciation and amortization expense.

At
September 30, 2007, the minimal annual rental commitments under this capital lease agreement are as follows (in thousands):

2008


242009


242010


18Total minimum lease payments


66Less amount representing interest


7Present value of minimum lease payments


59Less current portion


20Capital lease obligation, net of current portion

$
39


8. Stockholders' Equity

Preferred Stock

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

9. Related Party Transactions

Robert M. Wadsworth, one of the Company's directors, is a managing director of the limited liability corporation that controls HarbourVest Partners (and its
affiliates), one of the Company's 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, 2006 and 2005, HarbourVest owned greater than 5% of the outstanding stock of the Company and greater than 5% of the outstanding stock of PSI. While the
Company was selling third-party data storage networking products it engaged Akibia to provide certain customer support and warranty fulfillment services related to the Company's sales of host bus
adapters (HBAs). The Company's agreement with Akibia

55

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expired
in March 2005 as scheduled. However, the terms of the agreement required Akibia to fulfill the warranty services for the entire warranty period. Akibia charged the Company a quarterly
fixed fee of $83,000 and a variable fee based upon the Company's sales of HBAs which ended December 2004. For the years ended September 30, 2007, 2006 and 2005 the Company recognized $0,
$0, and $201,000, respectively, of expense as a result of its HBA customer support and warranty fulfillment services agreements with Akibia. In connection with this customer support and warranty
fulfillment services agreement, the Company also sold HBAs to Akibia to allow Akibia to fulfill the Company's warranty obligations for these products. For the years ended September 30, 2007,
2006 and 2005 the Company recorded revenues of $0, $0, and $40,000, respectively, from sales of HBAs to Akibia. There were no amounts receivable from or payable to Akibia at September 30, 2007
or 2006. In November 2005, Mr. John A. Blaeser, one of the Company's directors, also joined the board of directors of Akibia.

Mr. Wadsworth
also serves as a director of Innoveer Solutions, Inc. ("Innoveer"), formerly Akibia Consulting, a subsidiary of Akibia. The Company previously engaged
Innoveer to perform certain professional services related to its customer resource management ("CRM") software system. During the years ended September 30, 2007, 2006, and 2005, the Company
incurred approximately $40,200, $80,000, and $14,300, respectively, related to these services. The Company had $7,000 outstanding to Innoveer at September 30, 2006 and no amounts outstanding to
Innoveer at September 30, 2007.

Through
fiscal 2005, Mr. Frank Polestra, a former director of the Company, was also a managing director of Ascent Venture Partners. Both Mr. Polestra and Mr. Blaeser
were limited partners in one of Ascent Venture Partner's funds, which owned greater than 5% of the outstanding capital stock of one of our customers, Network Intelligence Corporation, prior to its
acquisition by EMC Corporation on September 18, 2006. For the year ended September 30, 2005, revenues from sales to Network Intelligence Corporation were approximately $4,040,000.

In
September 2005, the Company engaged the consulting services of Mapleworks Technologies ("Mapleworks"), a software development services provider. Both Mr. Blaeser and
Mr. Wadsworth are investors in Mapleworks and are members of its board of advisors. In the years ended September 30,
2007, 2006, and 2005 the Company incurred $0, $82,000 and $18,000, respectively, in fees for these consulting services. The Company had no amounts outstanding to Mapleworks at September 30,
2007 or 2006.

Charles
Foley, one of the directors of the Company, also serves as the CEO of Digital Ocular Networks ("Digital Ocular"). During the fiscal year ending September 30, 2007, the
Company had revenues of $6,000 related to sales of server appliances to Digital Ocular.

10. Stock Incentive Plans and Stock-based Compensation

In October 1999, the Company's shareholders approved the 1999 Stock Incentive Plan (the "1999 Plan"). Under the 1999 Plan, stock option and restricted
stock or other stock-based awards for up to 4,747,902 shares of common stock may be issued to employees, officers, directors, consultants and advisors of the Company. Options are granted for terms of
up to ten years and vest over varying periods. Option grants to new employees generally vest 25% on the first anniversary of the employment date and thereafter in equal quarterly installments over the
next three years. Subsequent grants to existing employees generally vest in equal quarterly installments over four years. The option price per share is determined by the board of directors.

56

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In
May 2000, the Company's shareholders approved an increase of 3,300,000 in the number of shares authorized under the 1999 Plan and an automatic annual increase in the number of
shares authorized under the 1999 Plan. The automatic annual increase is equal to the lesser of: 5% of the outstanding shares on the first day of each fiscal year; 4,000,000 shares; or an amount
determined by the board of directors, which is subject to a maximum of 20,047,902 authorized shares under the plan. As of September 30, 2007, the Company is authorized to grant options,
restricted stock or other awards of up to 14,557,273 shares of common stock.

In
May 2000, the Company's shareholders approved the 2000 Director Option Plan (the "Director Plan"). Under the Director Plan, the Company may make formula grants of stock options
to non-employee directors of up to 500,000 shares of common stock. New directors to the Company's board are granted an initial grant of 50,000 shares, which vest in equal annual
installments over 4 years beginning on the first anniversary of the grant date. Subsequent annual grants of 15,000 shares to directors vest 100% upon the first anniversary of the grant date. In
March 2004, the Company's shareholders approved an increase of an additional 325,000 shares of common stock authorized to be issued under this plan, resulting in a total of 825,000 options
authorized to be issued. Under the Director Plan, options to purchase 720,000 shares have been granted, options to purchase 135,000 shares have been exercised and options to purchase 60,000 shares
have been cancelled through September 30, 2007.

In
May 2000, the Company's shareholders approved the 2000 Employee Stock Purchase Plan (the "Purchase Plan"). Under the Purchase Plan, the Company may issue up to an aggregate of
750,000 shares of common stock to eligible employees. In March 2004 and March 2007, the Company's shareholders approved an increase of an additional 500,000 and 250,000 shares,
respectively, of common stock authorized to be issued under the Purchase Plan, resulting in a total of 1,500,000 shares authorized to be issued. Eligible employees must be employed by the Company for
more than 20 hours per week and more than five months in a fiscal year. Under the Purchase Plan, the Company makes two offerings each fiscal year, at the end of which employees may purchase
shares of common stock through payroll deductions made over the term of each offering. Offering periods begin on the 15th day of November and May each year. The per share purchase price
for offerings prior to May 15, 2005, was equal to the lesser of 85% of the closing price of the common stock at the beginning or end of the offering period. During the year ended
September 30, 2005, the board of directors amended the Purchase Plan to limit the per share purchase price for offerings to 85% of the closing price at the end of the offering period, beginning
with the offering period ended May 15, 2005. During the year ended September 30, 2007, 2006, and 2005, 106,790, 257,000, and 259,000 shares of common stock were issued under the Purchase
Plan, respectively. The Company had 264,320 shares available for issuance under its Purchase Plan as of September 30, 2007.

57

---



The
following table presents stock-based employee compensation expenses included in the Company's consolidated statements of operations (in thousands):

|                           |                                        | Year Ended September 30,
|-------------------------- | -------------------------------------- | ------------------------
|
|Cost of revenues           |                                        | $                       
|Research and development   |                                        |                         
|Selling and marketing      |                                        |                         
|General and administrative |                                        |                         
|                           |                                        |                         
|                           | Total stock-based compensation expense |                         
|                           |                                        |                         

The
Company estimates the fair value of stock options using the Black-Scholes valuation model. This valuation model takes into account the exercise price of the award, as well as a
variety of significant assumptions. The assumptions used to estimate the fair value of stock options include the expected term, the expected volatility of the Company's stock over the expected term,
the risk-free interest rate over the expected term, and the Company's expected annual dividend yield. The Company believes that the valuation technique and the approach utilized to develop
the underlying assumptions are appropriate in calculating the fair values of the Company's stock options granted in the years ended September 30, 2007 and 2006. Estimates of fair value are not
intended to predict the value ultimately realized by persons who receive equity awards. In determining the amount of expense to be recorded, judgment is also required to estimate forfeitures of the
awards based on the probability of employees completing the required service period. Historical forfeitures are used as a starting point for developing our estimate of future forfeitures.

Assumptions
used to determine the fair value of options granted during the years ended September 30, 2007 and 2006, using the Black-Scholes valuation model were:

|                               |  | Year Ended September 30,
|------------------------------ |  | ------------------------
|
|Expected term(1)               |  | 5.5 to 6.25 years       
|Expected volatility factor(2)  |  | 62.28% to 78.21%        
|Risk-free interest rate(3)     |  | 4.15 to 4.70%           
|Expected annual dividend yield |  | %                      

---

58

---





Stock-based compensation expense related to the Company's Employee Stock Purchase Plan was determined based on the discount of 15% from the per share market price
on the close of the purchase period.

Prior
to October 1, 2005, the Company accounted for stock-based compensation to employees in accordance with APB 25. The Company also had previously adopted the provisions of
SFAS 123, which required disclosure only of stock-based compensation and its impact on net loss and net loss per share. The following table illustrates the effects on net loss and net loss per
share for the year ended September 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee awards.

|                                                            |                                                                     | 2005 |        
|----------------------------------------------------------- | ------------------------------------------------------------------- | ---- | -------
|Net lossas reported                                        |                                                                     | $    | (15,583
|                                                            | Add: Stock-based employee compensation expense included in net loss |      |        
|                                                            | Deduct: Total stock-based employee compensation expense             |      |        
|                                                            |                                                                     |      |        
|Net losspro forma                                          |                                                                     | $    | (18,652
|                                                            |                                                                     |      |        
|Net loss per share:                                         |                                                                     |      |        
|                                                            | Basic and dilutedas reported                                       |      | $      
|                                                            | Basic and dilutedpro forma                                         |      | $      
|Assumptions used in the determination of option fair value: |                                                                     |      |        
|Expected term:                                              |                                                                     |      |        
|                                                            | Stock options                                                       |      |        
|                                                            | Employee stock purchase plan                                        |      |        
|Risk free interest rate:                                    |                                                                     |      |        
|                                                            | Stock options                                                       |      |        
|                                                            | Employee stock purchase plan                                        |      |        
|Volatility                                                  |                                                                     |      | 120    
|Dividend rate                                               |                                                                     |      | 0      

In
prior years the Company recorded deferred stock compensation related to certain of its acquisitions and the issuance of stock options granted at prices deemed to be below fair market
value. The Company recognized stock compensation expense of approximately $14,000 for the year ended September 30, 2005. The Company had no deferred stock compensation remaining at
September 30, 2005.

The
Company issues common stock from previously authorized but unissued shares to satisfy option exercises and purchases under the Company's Purchase Plan.

59

---



A
summary of stock option activity under the Company's 1999 Plan and its Director Plan follows:

|                                  |           | Number of
Shares |            | Weighted
Average
Exercise
Price |      | Weighted
Average
Remaining
Contractual Term
(in years)
|--------------------------------- | --------- | ---------------- | ---------- | ------------------------------- | ---- | ------------------------------------------------------
|Outstanding, September 30, 2006   |           | 7,366,964        |            |                                 | 2.29 |                                                       
|                                  | Granted   |                  | 1,232,400  |                                 |      | 2.18                                                  
|                                  | Exercised |                  | (1,732,789 | )                               |      | 1.13                                                  
|                                  | Forfeited |                  | (511,358   | )                               |      | 2.13                                                  
|                                  | Expired   |                  | (263,862   | )                               |      | 4.58                                                  
|                                  |           |                  |            |                                 |      |                                                       
|Outstanding, September 30, 2007   |           | 6,091,355        |            | $                               | 2.51 |                                                       
|                                  |           |                  |            |                                 |      |                                                       
|Exercisable at September 30, 2007 |           | 3,378,127        |            | $                               | 2.99 |                                                       
|                                  |           |                  |            |                                 |      |                                                       

All
options granted during the years ended September 30, 2007, 2006, and 2005 were granted with exercise prices equal to the fair market value of the Company's common stock on the
grant date and had weighted average fair values of $1.44, $1.12, and $1.92 per share, respectively determined using the Black-Scholes option pricing model. As of September 30, 2007, 2,914,385
shares were available for future grants under the Plans and the Company had reserved 6,091,355 shares of common stock for the exercise of outstanding stock options.

At
September 30, 2007, the aggregate intrinsic value of options outstanding and options exercisable was $1,497,000 and $986,000, respectively. The intrinsic value of a stock
option is the amount by which the market value of the underlying stock exceeds the exercise price of the option.

The
aggregate intrinsic value of options exercised during the years ended September 30, 2007, 2006 and 2005 was $1,908,476, $1,294,000, and $425,000, respectively.

The
following table summarizes the stock options outstanding at September 30, 2007:

|             |  | Options Outstanding |  | Options Exercisable
|------------ |  | ------------------- |  | -------------------
|
|$0.07$1.05  |  | 656,703             |  | $                  
|$1.07$1.35  |  | 68,096              |  | $                  
|$1.36$1.36  |  | 1,461,782           |  | $                  
|$1.38$1.65  |  | 616,710             |  | $                  
|$1.66$2.04  |  | 696,698             |  | $                  
|$2.09$2.25  |  | 863,085             |  | $                  
|$2.36$2.76  |  | 668,000             |  | $                  
|$2.81$6.00  |  | 632,531             |  | $                  
|$8.00$8.62  |  | 341,625             |  | $                  
|$9.15$39.81 |  | 86,125              |  | $                  
|             |  |                     |  |                    
|             |  | 6,091,355           |  | $                  
|             |  |                     |  |                    

60

---



At
September 30, 2007, unrecognized compensation expense related to non-vested stock options was $2,598,000 which is expected to be recognized over a weighted average
period of 2.43 years.

During
each of the years ended September 30, 2007, 2006 and 2005 the Company granted 5,000 options to a non-employee. These options were accounted for at their fair
value resulting in an immaterial amount of compensation expense recorded during the years ended September 30, 2007, 2006 and 2005.

11. Commitments and Contingencies

Operating Leases

The Company leases its office space under non-cancelable operating leases. During the year ended September 30, 2006, the Company entered into
an amendment of its office space lease. The amendment of this lease extended the lease term through March 2009 for 52,000 square feet of office and manufacturing space. The lease amendment
includes a provision for free rent for one month in fiscal year 2007 and has rent escalation clauses in 2008 and 2009. Accordingly, rent expense is being recognized on a straight-line
basis and any amounts paid which are greater than or less than the amount expensed will be recorded on the balance sheet as deferred rent. Additionally, the lease amendment provides the Company with
the option to renew the lease for an additional two year period at the then current market rate. As of September 30, 2007, the future minimum lease payments under the Company's
non-cancelable operating leases were as follows (in thousands):

Year Ending September 30,2008


6882009


357Total

$
1,045


Rent
expense for the years ended September 30, 2007, 2006 and 2005 was $713,000, $654,000 and $637,000, respectively.

Guarantees and Indemnifications

Acquisition-related indemnificationsWhen, as part of an acquisition, the Company acquires all the stock of a company, the Company assumes liabilities
for certain events or circumstances that took place prior to the date of acquisition. The maximum potential amount of future payments the Company could be required to make for such obligations is
undeterminable. While the provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim is unlikely. As a result, the Company has not
recorded a liability for these indemnification clauses as of September 30, 2007 and 2006.

The
Company enters into standard indemnification agreements in the ordinary course of its business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to
reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its business partners or customers, in connection with any patent, copyright, trademark, trade
secret or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The Company has never
incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly,
the Company has no liabilities recorded for these indemnifications as of September 30, 2007 and 2006.

61

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Product warranties

The Company offers and fulfills warranty services on certain of its server appliances. In addition, while the Company was selling third-party data storage
networking products it contracted with a third party to provide warranty services for these products. The Company's agreement with this third-party warranty provider expired in March 2005 as
scheduled. However, the terms of the agreement require the third-party warranty provider to service these products for the entire warranty period. Warranty terms vary in duration depending upon the
product sold but generally provide for the repair or replacement of any defective products for periods of up to 36 months after shipment. Based upon historical experience and expectation of
future conditions, the Company reserves for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. For warranties related to third-party data storage
networking products, the Company recorded warranty expense based on its agreement with its third-party warranty fulfillment provider, whose fees were determined based on fixed periodic amounts as well
as activity-based charges.

The
following table presents changes in the Company's product warranty liability for the years ended September 30 (in thousands):

2007

2006Beginning balance

$
559

$
455Accruals for warranties issued


1,892


1,109Fulfillment of warranties during the period


(1,405
)

(1,005
)Ending balance

$
1,046

$
559


Contingencies



On or about December 3, 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against
the Company, Lawrence A. Genovesi (the Company's Chairman and former Chief Executive Officer), Douglas G. Bryant (the Company's Chief Financial Officer and Vice President of Finance and
Administration), and the 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 action complaint, captioned In re Network Engines, Inc. Initial
Public Offering Securities Litigation, 01 Civ. 10894 (SAS), was filed on April 20, 2002.

The
suit alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the Company's initial public offering in July 2000 ("IPO")
without disclosing to investors that the Underwriter Defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit also alleges that the Underwriter
Defendants entered into agreements with certain customers whereby the Underwriter Defendants agreed to allocate to those customers shares of the Company's common stock in the offering, in exchange for
which the customers agreed to purchase additional shares of the Company's common stock in the aftermarket at pre-determined prices. The suit alleges that such tie-in
arrangements were designed to and did maintain, distort and/or inflate the price of the Company's common stock in the aftermarket. The suit further alleges that the Underwriter Defendants received
undisclosed and excessive brokerage

62

---



commissions
and that, as a consequence, the Underwriter Defendants successfully increased investor interest in the manipulated IPO securities and increased the Underwriter Defendants' individual and
collective underwritings, compensation and revenues. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Company's common stock between
July 13, 2000 and December 6, 2000.

In
July 2002, the Company, Lawrence A. Genovesi and Douglas G. Bryant joined in an omnibus motion to dismiss the suit challenging the legal sufficiency of plaintiffs' claims. The
motion was filed on behalf of hundreds of issuer and individual defendants named in similar lawsuits. Plaintiffs opposed the motion, and the Court heard oral argument on the motion in
November 2002. On February 19, 2003, the Court issued an 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 case without prejudice.

On
July 9, 2003, a Special Committee of the Company's Board of Directors authorized the Company to negotiate a settlement of the pending claims substantially consistent with a
memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers. The parties have negotiated the settlement, which provides, among other things, for a release
of the Company and the individual defendants for the conduct alleged in the amended complaint to be wrongful. The Company would agree to undertake other responsibilities under the settlement,
including agreeing to assign, or not assert, certain potential claims that it may have against its underwriters. Any direct financial impact of the proposed settlement is expected to be borne by the
Company's insurers. Any such settlement would be subject to various contingencies, including approval by the Court overseeing the litigation. On February 15, 2005, the Court issued an Opinion
and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement
agreement. The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the Court issued an order preliminarily approving the settlement and setting a
public hearing on its fairness, which took place on April 24, 2006. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court's
certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Thereafter, the District Court ordered a stay of all
proceedings in all of the lawsuits pending the outcome of plaintiffs' petition to the Second Circuit for rehearing en banc and resolution of the class certification issue. On April 6, 2007, the
Second Circuit denied plaintiffs' petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On June 25, 2007, the District Court
signed an order
terminating the settlement. The Company is unable to predict the outcome of this suit and as a result, no amounts have been accrued as of September 30, 2007.

12. Income Taxes

Due to the losses incurred during fiscal years 2006 and 2005, the Company did not record a provision for any federal or state income taxes in those years. For the
year ended September 30, 2007, the Company incurred $98,000 in alternative minimum tax expense in connection with the federal limitation on alternative tax net operating loss carryforwards. For
the years ended September 30, 2007 and 2006, the Company recorded a provision of $21,000 and $48,000, respectively, for foreign income taxes owed by its subsidiary in the United Kingdom.

63

---



The
following is a reconciliation between the amount of the Company's income taxes utilizing the U.S. federal statutory rate and the Company's actual provision for income taxes for the
years ended September 30 (in thousands):

|                                        |  | 2007 |        | 2006 |   | 2005   |  
|--------------------------------------- |  | ---- | ------ | ---- | - | ------ | -
|At U.S. federal statutory rate          |  | $    | 855    |      | $ | (1,852 | )
|State taxes, net of federal effect      |  |      | 231    |      |   | (266   | )
|Foreign taxes                           |  |      | 21     |      |   | 48     |  
|Research and development credits        |  |      |        |      |   |       |  
|Non-deductible expenses and other items |  |      | 457    |      |   | 556    |  
|AMT Tax                                 |  |      | 98     |      |   |       |  
|Effect of change in valuation allowance |  |      | (1,543 | )    |   | 1,562  |  
|                                        |  |      |        |      |   |        |  
|Provision for income taxes              |  | $    | 119    |      | $ | 48     |  
|                                        |  |      |        |      |   |        |  

Deferred
income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and income tax purposes
using enacted tax rates in effect for the year in which the differences are expected to reverse. As of September 30, 2007 and 2006, net deferred tax assets consisted of the following (in
thousands):

2007

2006Net operating losses

$
30,408

$
33,488Tax credit carryforwards


2,486


1,968Capitalized research and engineering


1,897


2,641Temporary differences


5,068


4,203Total deferred tax asset


39,859


42,300Valuation allowance


(39,859
)

(42,300
)Net deferred tax asset

$


$



A
valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized. Accordingly, as of September 30, 2007 and
2006, a valuation allowance was recorded for the full amount of the deferred tax asset due to the uncertainty of their realization. Approximately $6.8 million of the net operating loss
carryforwards relate to disqualifying dispositions of incentive stock options, the tax benefit from which, if realized, will be credited to additional paid-in capital.

As
of September 30, 2007, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $86,333,000 and $17,593,000, respectively.
For federal income tax purposes these net operating loss carryforwards will expire as follows: $1,133,000 in 2019, $435,000 in 2020, $44,404,000 in 2021, $22,686,000 in 2022, $3,458,000 in 2023,
$1,172,000 in 2024, $9,187,000 in 2025 and $3,858,000 in 2026. For state income tax purposes these net operating loss carryforwards will expire beginning in 2007.

The
Company also has available research and development credits for federal and state income tax purposes of approximately $1,583,000 and $789,000, respectively, which expire at various
dates from

64

---



2007
through 2024. An ownership change, as defined in the Internal Revenue Code, resulting from the issuance of additional stock may limit the amount of net operating loss and tax credit carryforwards
that can be utilized annually to offset future taxable income and tax liabilities. The amount of the annual limitation is determined based upon the Company's value immediately prior to the ownership
change. Subsequent significant changes in ownership could further affect the limitations in future years.

13. Employee Savings Plan

The Company sponsors a savings plan for its employees, who meet certain eligibility requirements, which is designed to be a qualified plan under
section 401(k) of the Internal Revenue Code. Eligible employees are permitted to contribute to the 401(k) plan through payroll deductions within statutory and plan limits. The Company may make
discretionary contributions upon the approval of the 401(k)
plan trustees and the Company's board of directors. Through September 30, 2007, the Company has not made any contributions to the plan.

14. Restructuring and Other Charges

During the year ended September 30, 2005, the Company discontinued sales of third-party data storage networking products based on a review of that portion
of the business and its prospects. An amendment to a key distribution agreement, the commoditization of Fibre Channel HBA technology and increasing competition in the market resulted in the Company
experiencing declining gross profits related to its distribution of HBAs. As a result, the Company recorded a restructuring charge of $366,000 during the quarter ended December 31, 2004.
Approximately $283,000 of the charge related to one-time termination benefits associated with terminating eleven employees in this portion of the business during the quarter. The Company
also incurred $83,000 for a fixed payment related to its warranty fulfillment contract with an external service provider. The Company completed its sales of its remaining third-party data storage
networking products during the quarter ended December 31, 2004. The Company completed its payments under this restructuring obligation during the quarter ended March 31, 2005.

15. Subsequent EventAcquisition of Alliance Systems, Inc.

On October 9, 2007, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with Nautilus Acquisition Corp., a Texas corporation
and a wholly-owned subsidiary of the Company (the "Merger Sub"), Alliance Systems, Inc., a Texas corporation ("Alliance"), and Jonathan Shapiro, as Shareholder Representative. Pursuant to the
Merger Agreement, the Merger Sub was merged with and into Alliance (the "Merger") on October 11, 2007 (the "Effective Date"), with Alliance continuing after the Merger as the surviving
corporation and a wholly-owned subsidiary of the Company. The transaction was valued at approximately $40 million. Based on the value of Alliance's debt obligation at the time of the closing,
the transaction was funded through a combination of approximately $34 million in cash, which includes the payment of these debt obligations, and the issuance of approximately 2.9 million
shares of the Company's common stock.

On
October 11, 2007 the Company entered into a Loan and Security Agreement ("Loan Agreement") with Silicon Valley Bank (the "Bank"). The term of this agreement is for one year,
ending on October 9, 2008. The Loan Agreement provides the Company with a $15 million revolving loan facility. The interest rate on this line is equal to one quarter of a point (.25%)
below the current

65

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prime
rate with interest payable monthly. As of December 14, 2007, the Company has not drawn on this line of credit.

16. Geographic Data

All of the Company's long-lived assets were located in the United States as of September 30, 2007 and 2006. The following summarizes the
Company's revenues by geographic region, in thousands:

Years ended September 30,2007

2006

2005United States

$
84,209

$
86,564

$
73,082Foreign countries

$
35,418


32,132


24,989Total net revenues

$
119,627

$
118,696

$
98,071


Revenues
are attributed to countries based on the location of customers. Significant components of revenues in foreign countries consisted of the following for the years ended
September 30 (in thousands):

2007

2006

2005Ireland

$
30,849

$
29,125

$
23,646Canada


1,469


1,499


1,014United Kingdom


2,943


1,456


71


17. Quarterly Financial Data (Unaudited)

The following information has been derived from unaudited consolidated financial statements that, in the opinion of management, include all recurring adjustments
necessary for a fair statement of such information.

|                                              |  | Three Months Ended
|--------------------------------------------- |  | ------------------
|
|
|Net Revenues                                  |  | $                 
|Gross profit                                  |  |                   
|Net (loss)income                              |  |                   
|Basic and diluted net income (loss) per share |  | $                 
|Basic weighted average shares outstanding     |  |                   
|Diluted weighted average shares outstanding   |  |                   

|                                                      |  | Three Months Ended |       
|----------------------------------------------------- |  | ------------------ | ------
|
|
|Net Revenues                                          |  | $                  | 27,269
|Gross profit                                          |  |                    | 4,661 
|Net loss                                              |  |                    | (1,624
|Basic and diluted net loss per share                  |  | $                  | (0.04 
|Basic and diluted weighted average shares outstanding |  |                    | 37,867

66

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

None.

ITEM 9A.    CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of September 30, 2007. Based on this evaluation, our chief executive
officer and chief financial officer concluded that, as of September 30, 2007, our disclosure controls and procedures were (1) effective in accumulating and communicating information to
the Company's management, as appropriate, to allow timely decisions regarding required disclosure, and (2) effective, in that they provide reasonable assurance that information required to be
disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules
and forms.

Management's Annual Report on Internal Control Over Financial Reporting

The management of Network Engines, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. Internal
control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange
Act of 1934 as a process designed by, or under the supervision of, the company's principal executive and principal financial officers and effected by the company's board of directors, management and
other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles and includes those policies and procedures that:



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

Network
Engines' management assessed the effectiveness of the Company's internal control over financial reporting as of September 30, 2007. In making this assessment, it used the
criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment, we concluded that, as of
September 30, 2007, the Company's internal control over financial reporting is effective based on those criteria.

The
effectiveness of the Company's internal control over financial reporting as of September 30, 2007 has been audited by PricewaterhouseCoopers LLP, an independent registered
public accounting firm, as stated in their report which appears under Item 8.

67

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No change in the Company's internal control over financial reporting occurred during the fiscal year ended September 30, 2007 that has materially affected,
or is reasonably likely to materially affect, the Company's internal control over financial reporting.

ITEM 9B.    OTHER INFORMATION

None.

PART III

ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item relating to directors, code of ethics, audit committee, and audit committee financial expert of the Company and
Section 16(a) beneficial ownership reporting compliance is contained in our Proxy Statement related to the 2008 Annual Meeting of Shareholders to be filed with the SEC no later than
120 days after the end of our fiscal year, under the sections captioned "Election of Directors", "Additional Information About Directors" and "Section 16(a) Beneficial Ownership
Reporting Compliance", and is incorporated herein by reference in response to this item. The information regarding executive officers is included in Part I of this Form 10-K
under the section captioned "Executive Officers of the Company".

ITEM 11.    EXECUTIVE COMPENSATION

The information required by this item is included under the section captioned "Executive Compensation" in our Proxy Statement related to the 2008 Annual Meeting
of Shareholders to be filed with the SEC no later than 120 days after the end of our fiscal year and is incorporated herein by reference.

ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item relating to security ownership of certain beneficial owners and management, and securities authorized for issuance under
equity compensation plans, is included in our Proxy Statement related to the 2008 Annual Meeting of Shareholders to be filed with the SEC no later than 120 days after the end of our fiscal year
under the section captioned "Stock Ownership of Directors, Officers and Greater-Than-5%-Stockholders" and is incorporated herein by reference.

ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this item relating to certain relationships and related transactions is included in our Proxy Statement related to the 2008 Annual
Meeting of Shareholders to be filed with the SEC no later than 120 days after the end of our fiscal year under the section captioned "Certain Relationships and Related Transactions and Director
Indepdence" and is incorporated herein by reference.

ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item is included under the captions "Ratification of Independent Registered Public Accounting FirmPrincipal
Accountant Fees and Services" and "Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Registered Public Accounting Firm" in our
Proxy Statement related to the 2008 Annual Meeting of Shareholders

68

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to
be filed with the SEC no later than 120 days after the end of our fiscal year and is incorporated herein by reference.

PART IV

ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



The following consolidated financial statements are filed as part of this report under "Item 8Financial Statements and Supplementary Data":

|                                                                                                                                      |  | Page
|------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|Report of Independent Registered Public Accounting Firm                                                                               |  | 42  
|Consolidated Balance Sheets as of September 30, 2007 and 2006                                                                         |  | 43  
|Consolidated Statements of Operations for the years ended September 30, 2007, 2006 and 2005                                           |  | 44  
|Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss) for the years ended September 30, 2007, 2006 and 2005 |  | 45  
|Consolidated Statements of Cash Flows for the years ended September 30, 2007, 2006 and 2005                                           |  | 46  
|Notes to Consolidated Financial Statements                                                                                            |  | 47  



Schedule IIValuation and Qualifying Accounts for each of the three fiscal years ended September 30, 2007.

All
other schedules to the consolidated financial statements are omitted as the required information is either inapplicable or presented in the consolidated financial statements.



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

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized, on December 14, 2007.

| |  | NETWORK ENGINES, INC
| |  | --------------------
| |  | By:                 

Pursuant
to the requirements of the Securities Exchange Act Act of 1934, the report has been signed as of December 14, 2007 below by the following persons on behalf of the
registrant and in the capacities indicated.

|Name                                            |  | Title                                                                                                          
|----------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------
|                                                |  |                                                                                                                
|/s/GREGORY A. SHORTELLGregory A. Shortell       |  | President and Chief Executive Officer
(Principal Executive Officer) and Director                               
|/s/DOUGLAS G. BRYANTDouglas G. Bryant           |  | Chief Financial Officer, Treasurer and Secretary
(Principal Financial Officer and Principal Accounting Officer)
|/s/JOHN A. BLAESERJohn A. Blaeser               |  | Director                                                                                                       
|/s/CHARLES A. FOLEYCharles A. Foley             |  | Director                                                                                                       
|/s/GARY E. HAROIANGary E. Haroian               |  | Director                                                                                                       
|/s/DENNIS A. KIRSHYDennis A. Kirshy             |  | Director                                                                                                       
|/s/FONTAINE K. RICHARDSONFontaine K. Richardson |  | Director                                                                                                       
|/s/ROBERT M. WADSWORTHRobert M. Wadsworth       |  | Director                                                                                                       

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SCHEDULE II        NETWORK ENGINES, INC.  Valuation and Qualifying Accounts  (in thousands)

|Fiscal
Year |  | Description                            |  | Balance At
Beginning of
Period |        | Additions |   | Deductions |   | Balance At
End of
Period
|----------- |  | -------------------------------------- |  | ------------------------------ | ------ | --------- | - | ---------- | - | ------------------------
|2005        |  | Allowance For Doubtful Accounts        |  | $                              | 190    |           | $ | (4         | ) | $                       
|2006        |  | Allowance For Doubtful Accounts        |  | $                              | 75     |           | $ | 28         |   | $                       
|2007        |  | Allowance for Doubtful Accounts        |  | $                              | 29     |           | $ | 3          |   | $                       
|2005        |  | Allowance For Sales Returns            |  | $                              | 252    |           | $ |           |   | $                       
|2006        |  | Allowance For Sales Returns            |  | $                              |       |           | $ |           |   | $                       
|2007        |  | Allowance For Sales Returns            |  | $                              |       |           | $ | 51         |   | $                       
|2005        |  | Deferred Tax Asset Valuation Allowance |  | $                              | 36,534 |           | $ | 3,509      |   | $                       
|2006        |  | Deferred Tax Asset Valuation Allowance |  | $                              | 40,915 |           | $ | 1,562,     |   | $                       
|2007        |  | Deferred Tax Asset Valuation Allowance |  | $                              | 42,300 |           | $ | (898       | ) | $                       

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EXHIBIT INDEX

|Exhibit No. |  | Exhibit                                                                                                                                                                                                                                                                                                                                                                                                                    
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1         |  | Agreement and Plan of Merger, dated October 9, 2007, by and among Network Engines, Inc., Nautilus Acquisition Corp., a Texas corporation and a wholly-owned subsidiary of Network Engines, Alliance Systems, Inc., a Texas
corporation, and Jonathan Shapiro, as Shareholder Representative (Filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated October 15, 2007 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, 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*       |  | 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).                                                                                                                                       
|10.8*       |  | 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).                                                                                                                                       
|10.9*       |  | 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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|10.10* |  | 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).                                               
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.11* |  | 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).                                        
|10.12  |  | 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).                                                
|10.13  |  | 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).                     
|10.14  |  | 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).
|10.15  |  | 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).                                   
|10.16  |  | Severance Terms Agreement, dated January 9, 2006, between the Company and Gregory A. Shortell (Filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2005 and incorporated by
reference herein).                                         
|10.17  |  | Letter Agreement, dated January 6, 2006, between the Company and Gregory A. Shortell (Filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2005 and incorporated by reference
herein).                                                  
|10.18  |  | Offer Letter dated March 7, 2006 between Network Engines, Inc. and Kevin Murphy (Filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated April 6, 2006 and incorporated by reference herein).                                                                              
|10.19  |  | Base Salaries of Executive Officers of the Company                                                                                                                                                                                                                                         
|10.20  |  | Summary of the Company's Non-Employee Director Compensation                                                                                                                                                                                                                                
|10.21  |  | Fifth Amendment dated July 20, 2006 to Lease for 25 Dan Road, Canton, Massachusetts                                                                                                                                                                                                        
|10.22  |  | Offer Letter dated February 16, 2007 between Network Engines, Inc. and Paul Butler (Filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated March 1, 2007 and incorporated by reference herein).                                                                           
|10.23  |  | Severance Terms Agreement, dated February 26, 2007, between the Company and Paul Butler (Filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated March 1, 2007 and incorporated by reference herein).                                                                      
|10.24  |  | Loan and Security Agreement, dated as of October 11, 2007, by and among Network Engines, Inc., Alliance Systems, Inc. and Silicon Valley Bank (Filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated October 15,
2007 and incorporated by reference herein).             
|       |  |                                                                                                                                                                                                                                                                                            

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|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 Gregory A. Shortell, 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 Gregory A. Shortell, 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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