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



FORM 10-K



(Mark One)ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended September 30, 2009ORo

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period
from                                  to


Commission file number: 000-30863

GRAPHIC

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

Delaware

04-3064173(State or other jurisdiction of incorporation)

(I.R.S. Employer Identification No.)25 Dan Road, Canton, MA

02021(Address of principal executive offices)

(Zip Code)


Registrant's
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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period
that the registrant was required to submit and post such
files). Yes o    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this
chapter) 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, a non-accelerated filer, or a smaller reporting
company. See definitions of "large accelerated filer", "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer o

Accelerated filer ý

Non-accelerated filer o (Do not check if a smaller reporting company)

Smaller reporting company 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, 2009 was approximately $18,676,000.

The
number of shares outstanding of the registrant's Common Stock as of December 10, 2009 was 41,994,009 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our proxy statement relating to the 2010 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, 2009        TABLE OF CONTENTS



PART IITEM 1.

BUSINESS


1ITEM 1A.

RISK FACTORS


10ITEM 1B.

UNRESOLVED STAFF COMMENTS


22ITEM 2.

PROPERTIES


22ITEM 3.

LEGAL PROCEEDINGS


22ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS


23PART IIITEM 5.

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


25ITEM 6.

SELECTED FINANCIAL DATA


28ITEM 7.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


29ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


46ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


47ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE


79ITEM 9A.

CONTROLS AND PROCEDURES


79ITEM 9B.

OTHER INFORMATION


80PART IIIITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE


80ITEM 11.

EXECUTIVE COMPENSATION


80ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS


80ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE


80ITEM 14.

PRINCIPAL ACCOUNTING FEES AND SERVICES


80PART IVITEM 15.

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES


81SIGNATURES


82


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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", "NEI", "the Company", "we", "us" or "our" are to Network Engines, Inc., a Delaware
corporation, and its subsidiaries.

PART I

ITEM 1.    BUSINESS

Overview

Headquartered in Canton, Massachusetts, NEI designs and manufactures server-based platforms and appliance solutions on which software
applications are applied for both enterprise and telephony information technology ("IT") networks. We also provide support services related to solution design, integration control, global logistics,
"Smart Services" and support and maintenance programs. To date, a large portion of our revenues has been derived from the sale of application platform solutions to customers serving data storage,
network security, carrier communications, and enterprise communications markets. Application platforms are pre-configured server-based network infrastructure devices, sometimes referred to
as appliances or application-ready platforms, engineered to deliver specific software application functionality, ease deployment challenges, improve integration and manageability, accelerate time to
market and increase the security of that software application in an end user's network. An application platform is also intended to reduce the total cost of ownership associated with the deployment
and ongoing maintenance of software applications when applied to a customer's IT infrastructure.

We
market our application platform solutions to original equipment manufacturers, or OEMs, and independent software vendors, or ISVs that then deliver their software applications in the
form of a network-ready device. We offer our customers an extensive suite of services associated with solution design, integration control, global logistics, Smart Services, and support and
maintenance. We produce and fulfill devices branded for our customers, and we derive our revenues primarily from the sale of value-added hardware platforms to these customers. Our customers
subsequently resell and support these platforms under their own brands to their customer bases. Our customers include, but are not limited to: ArcSight, Inc., AVST, Inc.,
Bomgar, Inc., Bradford Networks, EMC Corporation, Sepaton, Inc., Sophos, Plc.,Tekelec, and Tektronix, Inc.

By
virtue of our ability to offer a wide range of engineering, manufacturing, supply-chain, logistics, and support services, we believe we are well positioned to be the application
platform solution and service experts of choice among OEMs and ISVs looking to more efficiently deploy their applications and service offerings.

Industry Background

Traditionally, networking solutions were built utilizing custom-designed hardware and proprietary operating systems. Networking
solution vendors used custom components and systems in an effort to meet the high-performance demands of their customers, such as increasing networking speeds, packet

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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, development, and testing related to requisite customization. Networking solution vendors generally employed internal research, engineering, manufacturing and integration experts 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, the networking solutions market has evolved toward the manufacture and use of open systems, built using commercially available standard components and industry standard
operating systems. At the same time, the speed and processing power of standard microprocessors reached performance levels that adequately met the demands of many networking applications. Popular
operating system ("OS") platforms, such as Windows and Linux, also increased in sophistication and capability and were increasingly used as the 'embedded' operating system environment for networking
applications.

The
evolution of server-based appliances, built with commercially available standard components, has allowed OEMs and ISVs to focus their development efforts and resources more on
their application software and less on the system integration challenges of their business. Software application vendors now recognize that custom hardware, in many cases, is no longer critical in
meeting their customers' performance requirements. Such systems are being integrated into standardized hardware platforms and, therefore, hardware alone no longer differentiates a system in the
marketplace. Based on the fact that most application platforms can now be built using standard, commodity hardware and operating systems, 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 OEMs and ISVs will increasingly use application platforms and appliances and
outsource more elements of their solution design, integration control, evaluation, test, manufacturing and global logistics to partner vendors like NEI that specialize in these skills.

While
there are many markets in which an appliance platform may serve, adoption of our core integration and service capabilities is most prevalent in the data storage, network security,
enterprise communications and carrier telecommunications markets. The network security applications that we believe are most prone to benefit from deployment in the form of an application platform
solution include network security gateways, user identification and authentication, email security and archiving, web content filtering, network intrusion (detection and prevention) and event
monitoring, device relationship management, digital rights management, and web services security management. The data storage applications that we believe are most prone to benefit from deployment in
the form of an application platform solution include storage security, backup and recovery, virtual tape libraries, storage resource management and data migration, archival systems,
de-duplication and logging. The enterprise communications applications that we believe are most prone to benefit from deployment in the form of an application platform solution include
unified communications applications, such as voice over internet protocol ("VoIP"), Internet protocol private branch exchange ("IP-PBX"), audio and web conferencing, unified messaging, and
instant messaging. The carrier communications applications that we believe are most prone to benefit from deployment in the form of an application platform solution include provisioning the
mobile-to-IP network connectivity for the increasing number of Smartphones, as well as the mobile number portability.

Another
significant trend driving the growth of the data storage, network security and communications markets is the decentralization of storage management, network security and
communications applications. We believe that enterprises are increasingly deploying management 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, managing and upgrading have become
a critical aspect of managing the IT network of an enterprise.

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The
storage, security and communications needs of businesses continue to grow and, given the limited resources of many 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.

Finally,
consumer demand for seamless, converged communications is driving carriers to use more highly integrated solutions. These market pressures, combined with increased competition,
are accelerating the need for standards-based solutions purposely and affordably built for deploying next generation applications.

Business Strategy

Our objective is to become the industry's leading provider of application platform solutions and services. The key elements of our
strategy include:

Strengthen existing relationships and engage with new OEMs and ISVs to sell application platform solutions.We believe that
offering
customers a comprehensive platform solution supported by an extensive suite of services, including solution design, integration control, Smart Services, global logistics and post-sales
support and maintenance plans, enables them to accelerate their deployment and improve the integration of their software while achieving a low total cost of ownership over the long term. This allows
customers to focus on their core competencies: developing their technology. We believe that our lifecycle management expertise and value-added Smart Services provide us with a competitive advantage in
the marketplace that we intend to leverage to attract new OEMs and ISVs, as well as pursue additional opportunities within our existing customer base. During fiscal year 2009 we achieved 63 new
design wins, which included 33 new customers. A "design win" occurs when a customer or prospective customer notifies us that we have been selected to integrate the customer's application. Some of
these customers generated meaningful revenue for us during the year, while others are in various stages of product and market development. Over the next year we will be focused on cultivating new
customers and opportunities in order to generate additional revenues, winning competitive bids, and continuing to engage with new customers on a more complete solution-based level. We also have begun
to pursue (and in some cases we have won) larger opportunities which we expect to have a more significant impact on our net revenues. These opportunities may have gross margins which are lower than
current levels, but we believe that such opportunities can be leveraged over our existing infrastructure and production capabilities without requiring us to incur significant additional operating
costs, allowing us to improve our operating margins. We currently target OEMs and ISVs whose technology aligns with the benefits of deployment in the form of an application platform, and who
have adequate sales and marketing resources to bring such platforms to market. These customers are in the data storage, network security, carrier communications and enterprise communications markets,
where adoption of application platform solutions has been most prevalent.

Create and market value-added services that buyers of application platform solutions require in order to accelerate their time to market and reduce total cost of
ownership.We believe that our services are a key competitive differentiation point and an important element of the total solution we provide. These services are
offered to ease the integration of application platforms into an end-user's network, improve platform integrity and security, ensure longer appliance uptimes, automate the management of
deployed platforms, and potentially create new customer revenue streams. As a business strategy, these services are considered to help improve customer loyalty and the rate at which customers purchase
support and maintenance programs along with our application platform solutions.

Develop and integrate technologies that improve the functionality, security, manageability and deployment of application platforms.We
intend to
continue to enhance our proprietary technologies and, where appropriate, integrate other third-party technologies and standard components that deliver the promise of highly managed application
platform solutions. Our NEI Element Manager technology

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enables
the remote management of such platforms through a secure web-based management sub-system. We believe NEI Element Manager will enhance our ability to enable complete
appliance lifecycle management. Historically NEI Element Manager was only deployed on Windows-based platforms. However, in support of our lifecycle management offering, we have developed NEI Element
Manager for certain versions of Linux as well.

Products and Services

We design and manufacture turn-key application solutions on which software applications are applied to enterprise and
telephony IT networks. We offer an extensive suite of products and services, enabling our customers to accelerate their time to market, optimize their application deployment solutions and, in many
cases, to utilize our solution design, integration control, Smart Services, global logistics (i.e., infrastructure for fulfillment of those appliance solutions) and support and maintenance
programs.

Our
products and services are described in more detail below:



The core of our business is designing comprehensive application platform solutions and acting as partners (in conjunction with our OEM
and ISV customers) to bring successful products to market. We strive to engage with our customers at all levels of their organization, particularly with engineering and product management, to optimize
the solution by focusing on the convergence of the hardware, operating system, utilities and application software. We make use of standard third-party solutions as well as custom platform designs,
depending on the customer's configuration, application and volume requirements. Our application platform hardware engineering team is well versed in purpose-built design technologies, generally
utilizing standard off-the-shelf components and sub-systems. The development of application platform 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 skills in order
to deliver custom solutions to specific customers. We have developed a highly structured platform deployment and lifecycle process, which involves all major aspects of a proposed application design,
from performance requirements to branding, packaging and quality assurance. We define the customer engagement and ultimate delivery of the product in stages and identify the mutual development
responsibilities for both the customer and ourselves. This model is designed to ensure that the engagement with our customer is well managed and executed in order to anticipate and implement all
aspects and requirements of the solution development. The key phases of this process consist of the following:



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Our
OS Hardening and Packaging services remove unnecessary and/or obscure code and features in the underlying operating system to reduce the footprint, improve performance and reduce the
vulnerability exposure of our customer's platforms and appliances. As a result, we build a more robust operating system for our customers and better develop their application platform solutions using
efficiently minimized Windows or Linux environments. NEI is capable of providing package management with automated update services that update and maintain the operating system when and if patches and
updates become available. We undertake all Windows and Linux compatibility and performance testing to ensure seamless interoperability, reliability and consistency.

We
brand the application platform for our OEM and ISV customers. Branding is applied to the platform chassis or bezel 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
third-party production agencies that are highly experienced in equipment packaging and strategic branding techniques. We also employ 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' application platforms.

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



We have sophisticated manufacturing facilities at our locations in Canton, Massachusetts and Plano, Texas. These facilities allow us to
scale our production capabilities to meet various levels of production requirements. This allows us to provide our customers with the appropriate type of manufacturing resources and skill sets needed
to best meet the volume requirements of a particular product. For certain products, we supplement our production capacity and make provisions to maintain continuity of supply through a relationship
with a contract manufacturer. The Canton and Plano manufacturing facilities are ISO 9001:2000 and TL 9000 certified. In full compliance with ISO 9001:2000 and TL 9000, we provide
high-quality internal manufacturing and test services for our customers. The advanced integration control processes, comprehensive systems, and manufacturing test suites that we develop
with our customers are designed to ensure quality and traceability 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. Our hardware
engineering expertise also enables us to internally develop certain components or systems in the event that off-the-shelf technology does not meet our customers' needs. Our
customers' products undergo a complete system test and burn-in period prior to final inspection, racking, packaging, and shipping.



We believe our industry, in which hardware and operating systems and other physical or virtual apparatus are becoming commodity
components, requires specialty logistics services. We extend to our customers a variety of services associated with license management, regulatory approvals, global shipping, material handling,
returns, refurbishment, and full inventory control that customers themselves would otherwise be required to accommodate. These services are intended to help customers consolidate and streamline their
business logistics operations and reduce the associated expenses.

We
provide our customers with global logistics support and order fulfillment by delivering the final product to either our customer or, at their request, directly to their end user
customers all over the

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world.
Drop-shipping products to end users can result in lower freight fees, reduce the costs associated with receiving and turning over inventory, improve
just-in-time delivery and lower the risk of lost or damaged goods. For customers with a production schedule forecast, we offer management and distribution services that
eliminate the customer's need to stock and handle finished goods. We can maintain finished goods in Canton, Plano, and the Netherlands.

In
order to streamline the sharing of information related to these services, we provide customers with access to a secure, self-service web portal. This portal allows
customers to view product manufacturing, inventory and consignment status as well as other operational events. Customers can also request additional information and use a link to automatically receive
notification of shipments and inventory levels.



We believe our expertise in designing purpose-built hardware platforms using standards-based components is a significant competitive
advantage. However, today's customers also require technology-enabling deployment services. We couple our hardware expertise with what we call "Smart Services" to simplify platform management and
enable more remote and automatic lifecycle controls. Smart Services consist of NEI Element Manager, NEI Update Service, and NEI Smart Task Manager. Together, these services allow customers to better
monitor, measure, maintain, and manage appliance platforms and deploy secure, hardened solutions for application platforms. NEI's customers may use our NEI Element Manager to manage multiple platform
deployments, monitor system health, automate OS updates, deploy software patches, upgrade applications, schedule back-ups and restore field-deployed units. NEI Update Service may be used
to automate the process and management of delivering software upgrades and other OS, application and configuration updates. This application serves as a secure medium for delivering encrypted updates
to field-deployed appliances. NEI Smart Task Manager may be used by end users to predefine and schedule monitoring, cleanup and backup tasks. NEI Smart Services may be used collectively to solve the
security, reliability and management problems that ISVs otherwise experience when attempting to update, monitor, track and backup appliances in the field.



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 our application
platform solutions to meet emerging requirements and capabilities of new versions of our customers' software or changes in their service offerings. To better enable our customers to meet these
challenges, we offer customers a variety of standard maintenance, support and service programs to extend product lifespan and maximize uptime. These programs help ensure high availability, rapid
response, effective troubleshooting, fast parts replacement and 24-hour support. We offer a variety of warranty services that support the products we sell. The standard warranty generally
provides for us to repair or replace any defective product within predetermined timeframes and generally spans periods between 12 and 36 months after initial product shipment, depending on the
product and our contractual relationships with certain customers. We offer a range of additional post-sales support services, including advanced replacement of defective units, warranty
coverage for extended periods, and global on-site support and repair. Some of our customers use advanced server replacement services for fast substitution in the event of field unit damage
or malfunction. Other support and service programs, such as anytime on-site service, are offered to give customers even more comprehensive coverage and support when uptime and availability
are considered mission critical.

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Customers

Our primary customer focus has been targeted towards OEMs and ISVs that wish to sell application platform and appliance
solutions to their customers. During the most recent fiscal quarter, we sold products and/or services to over 150 customers, including: ArcSight, Inc., AVST, Inc., Bomgar, Inc.,
Bradford Networks, EMC Corporation, Sepaton, Inc., Sophos Plc., and Tektronix, Inc. EMC and Tektronix were our only customers that represented more than 10% of total net revenues
for the year ended September 30, 2009, during which our sales to those customers were $52 million and $19 million, respectively, representing 35% and 13%, respectively, of total
net revenues. EMC and Tektronix were our only customers that represented more than 10% of total net revenues for the year ended September 30, 2008, during which our sales to those customers
were $82 million and $25 million, respectively, representing 42% and 13%, respectively, of total net revenues.

Sales and Marketing



Our sales team is focused on forming relationships with OEMs and ISVs seeking to deploy their application as a purpose-built
platform. We have a business development team that is focused on identifying and qualifying prospective customers and new projects. When an account is won, our business development and account
management teams begin to work on appropriate design and deployment strategies. We then involve other employees from hardware and software engineering, quality and product management to analyze the
prospective customer's requirements and design a platform solution. Our account management team then takes over the account upon general availability and manages the customer relationship.



Our marketing organization is divided into two key functions: product management and product marketing. Our product management team is
responsible for managing the technical relationship with our hardware platform, operating systems and components suppliers. The technical product management team researches the market to anticipate
trends and understand and evaluate new technologies that we can leverage in the design and integration of application platform solutions. They work closely with our sales and engineering team and our
OEM and ISV customers to define product and next generation technology requirements.

Our
product marketing team is responsible for building market awareness, brand nurturing, communicating key market and product messages, producing web and print collateral, target market
and lead development, customer testimonials and loyalty, corporate events and the general acceptance of NEI and our products and services. These marketing programs are executed in close cooperation
with our field sales teams.

Manufacturing

We provide manufacturing, test and fulfillment services for application platforms at our manufacturing facility located at our
headquarters in Canton, Massachusetts, and at our manufacturing facility located in Plano, Texas. Both locations are ISO 9001:2000 and TL 9000 certified. We operate multiple manufacturing lines
to scale the production capabilities to provide our customers with the appropriate type of manufacturing resources, business continuities and skill sets to best meet the volume, cost and quality
requirements of a particular product. In addition, our customized lines allow us to provide customers with rapid manufacturing turn around time, which provides a significant time to market advantage
for new products.

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We
also supplement our manufacturing capacity for certain products by utilizing third-party contract manufacturers with international locations. We use these partners to handle portions
of our ongoing volume requirements to ensure that we are able to handle surge and/or excess volume requirements. Some of these partners also provide certain repair and logistics services for us.
Having these partners, as well as our own two primary manufacturing and shipping locations, gives our customers better
assurance of continuity in the event that either of our Canton or Plano facilities is unexpectedly incapacitated.

We
also provide rack-mount system design and integration, in which varying combinations of interdependent appliances, computer sub-systems, telephony cards and
storage servers are configured, tested and shipped in chassis and data center racks for large-scale deployments.

Engineering

We believe that much of our future success depends on our ability to use standard hardware and software technologies to design
application platform solutions utilizing commercially available components and sub-systems acquired from third-party suppliers. We offer several standard hardware and software platforms on
which customers can deploy or modify applications to meet exact requirements. Any customization work typically involves hardware and software modifications adapted to enhance and accelerate the
development and deployment of application platforms. We employ teams of experienced engineers, contractors and suppliers with significant industry experience in high-density packaging,
application platform design, system software, quality assurance, testing and technical documentation. We also employ a team of field application engineers who interact with customers to assess
specific hardware and software requirements, detect and diagnose problems, engineer break-fix solutions and increase our overall platform solution performance.

Employees

As of September 30, 2009, we had 231 employees, of whom 101 were engaged in manufacturing, 10 were engaged in customer support,
43 were engaged in sales and marketing, 37 were engaged in research and development and 40 were engaged in general and administrative functions. We also utilize contract labor, and as of
September 30, 2009, we had 17 contract employees, predominantly in our manufacturing operations.

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 of certain products to the customer are held at its locations until the customer requires the products for its 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. 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. We 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. Our competitors

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also
include general-purpose server manufacturers that provide solutions for network equipment providers, communications equipment manufacturers and ISVs and build servers for the OEM marketplace.
These competitors include Dell, Hewlett-Packard, IBM and Sun Microsystems. In addition, we compete with other companies that specialize in building server products and providing some level of
integration services, such as Patriot Technologies, MBX Systems, NCS Technologies, Inc, and Super Micro Computer, Inc. We also may compete with certain providers of electronics manufacturing
services in the event they expand their service offerings.

Intellectual Property

We claim trademark rights for the use of the Network Engines and NEI names and related logos. We believe these rights provide us with
limited control 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 six
pending applications for patents relating to our current business, in particular, our NEI Element Manager and NEI Update Service technologies.

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. 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 our own intellectual property, we
seek to establish and maintain an extensive knowledge of leading technologies and to incorporate these technologies into our application platform solutions by leveraging the technological knowledge
and creative skills of our personnel.

Financial Information About Geographic Areas

See Note 17 to our Consolidated Financial Statements, entitled "Geographic Data", for financial information about geographic
areas. The Notes to our 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.nei.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 SEC 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 customer.

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

For the years ended September 30, 2009, 2008, and 2007, sales directly to EMC, our largest customer, totaled $52 million,
$82 million, and $99 million, respectively, accounting for 35%, 42%, and 83% of our total net revenues, respectively. These sales are primarily attributable to a limited number of
products pursuant to non-exclusive contracts. Although this concentration has decreased in recent years, 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 application platform
solutions in its existing and future products. In the fourth quarter of fiscal year 2009, we won new business to provide additional products to this customer. As a result, we expect our revenues from
this customer to increase starting in fiscal year 2010. However, gross margins associated with this customer are expected to decrease starting in fiscal year 2010, due to the nature of the new
business that we will be providing to this customer.

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 lifecycles, consolidation and pricing and margin pressures. As we have experienced in recent periods, advances in hard drive storage capacity could also result in
lower sales volumes to this customer. 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 we may be unable to accurately predict
revenues, profitability and cash flows.

Under
the terms of our non-exclusive contracts, 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 agreements in the event that we attempt
to assign our rights under the agreements 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 we may be unable to accurately
predict revenues, profitability and cash flows.

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Risks related to business strategy.

Our future success is dependent upon our ability to generate significant revenues from application platform design relationships.

We believe we must diversify our revenues and a major component of our business strategy is to form application platform design
relationships with new OEMs and ISVs. Under this strategy, we work with our customers to design an application platform branded with their name. The customers then perform all of the selling
and marketing efforts related to sales of their branded appliance.

There
are multiple risks associated with this strategy including:



Additionally,
our future success will depend on our ability to establish relationships with new customers while expanding sales of application platform solutions within our existing
customer base. 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.

We
have begun to pursue (and in some cases we have won) larger opportunities which we expect to have a more significant impact on our net revenues. These opportunities may have gross
margins which are lower than current levels, but we believe that such opportunities can be leveraged over our existing infrastructure without requiring us to incur significant additional operating
costs. However, if we cannot meet customer demand utilizing our existing infrastructure, we may need to increase our infrastructure and associated operating costs, which would negatively impact our
operating results. Also, our revenue growth may be lower than expected if we are unsuccessful in winning large opportunities, which would lead us to pursue smaller opportunities in order to grow
revenues.

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

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 application platform 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 application platforms. 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 application platform solutions 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. We believe that our services are a key competitive differentiation point and an important element of the total solution we offer. If our current and prospective customers
do not find the services we offer to be of value to them or their end users, they may decide to perform these services in-house or we may lose their business to competitors. If this were
to occur, our revenues and operating results would be adversely impacted.

Our business could be harmed if we fail to adequately integrate new technologies into our application platform solutions 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 application platform 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.

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Risks related to the application platform markets.

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

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

Our
expectations for the growth of the application platform 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 application platforms, provide more capabilities and/or flexibility than application platforms or are offered
at a lower cost. This could force us to lower the prices of our application platform solutions or could result in fewer sales of these products, which would negatively impact our revenues and decrease
our gross profits.

To
an extent, the application platform market is trending towards virtual application platforms and services and cloud computing. A virtual application platform is a software solution,
comprised of one or more virtual machines that is packaged, maintained, updated, and managed as a unit. Cloud computing is a web-based concept, whereby vendors provide customers with a
virtual (i.e. web-based) network appliance infrastructure, reducing the customer's need to purchase appliance hardware. While we currently provide virtual application platforms, our
revenues and operating results may be negatively impacted if current and prospective customers move toward using virtual or cloud-based platforms provided by other vendors.

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 lifecycles, changes in customer demands and evolving industry standards. In the application platform 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 application platform solutions 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 hardware of our application platforms 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 design new products and services or achieve and maintain market
acceptance of them once they have come to market. Furthermore, when we do release 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 application platform 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.

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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.

In the past, we have incurred significant net losses and could incur net losses in the future. At September 30, 2009 and
September 30, 2008, our accumulated deficit was $141 million and $138 million, respectively. If we are successful in winning large opportunities in future periods but cannot meet
our customer requirements utilizing our existing infrastructure and production capabilities, we may need to increase our infrastructure. This would increase operating expenses and negatively impact
our operating results. Also, our revenue growth may be lower than expected if we are unsuccessful in winning large opportunities, which would lead us to pursue smaller opportunities in order to grow
revenues. 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 October 2007, we entered into an agreement with Silicon Valley Bank to provide for a line of credit. We view this line of credit 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 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 August 5, 2010. 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 an adverse change in our business. If we experience an increase in order
activity from our customers, our cash balance may decrease due to the need to purchase inventories to fulfill those orders. If this occurs, we may have to draw on this facility, or secure other
financing, in order to maintain our liquidity. As of December 14, 2009, we had 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:



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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 various reasons, which could cause our operating results to fall below expectations and thus impact the
market price of our common stock.

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:



If the products and services that we sell become more commoditized and competition in the data storage, network security, carrier communications and enterprise
communications 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 data storage, network security, carrier communications and enterprise communications 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 these 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

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gross
profits, we also must continue to reduce the manufacturing cost of our application platform solutions. Our efforts to produce higher margin application platform solutions, continue to improve
our application platform solutions and produce new application platform solutions 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 application platform solutions 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 and may lose new customer opportunities. If
we are unable to offset decreases in the prices we are able to charge our customers and/or our gross margin percentage with increased sales volumes, our business will suffer.

An intangible asset represents a significant portion of our assets, and any impairment of the intangible asset would adversely impact our operating results.

At September 30, 2009, the carrying value of our intangible asset, which consists of customer relationships associated with our
acquisition of Alliance Systems, Inc. ("Alliance Systems"), was approximately $8.1 million, net of accumulated amortization. We will continue to incur non-cash charges
relating to the amortization of our intangible asset over its remaining useful life. Future determinations of significant write-offs of the intangible asset resulting from an impairment
test or any accelerated amortization of the intangible asset could have a significant impact on our operating results and affect our ability to achieve or maintain profitability. Although we do not
believe that any impairment of the intangible asset exists at this time, in the event that any indicators of possible impairment exist, we may record charges which could have a material adverse effect
on our results of operations. Such indicators include, but are not limited to, a worsening in customer attrition rates compared to historical attrition rates, or lower than initially anticipated cash
flows associated with customer relationships.

Risks related to competition.

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

In the application platform 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 application platforms 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 application platform 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 support than our application platform 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 application platform solutions could become undesirable.

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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 a larger vendor rather than purchase products from us. 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 services and promote our brand in the marketplace. We believe that to compete successfully we will need OEMs and ISVs to recognize us as a top-tier provider of
application platform solutions and services. If we are unable to increase market awareness and promote ourselves as a leading provider of application platform 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 application platform 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, telephony 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 application platform solutions. Shortages in supply or quality issues related to these key components for an extended time would cause delays in the production of our application platform
solutions, 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

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able
to manufacture and deliver our application platform solutions 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 we are able to secure other sources of supply for such components, our costs to purchase such components could increase, which would negatively
impact our gross margins. A significant portion of our components are purchased from suppliers located in China. During the past year, several factories in China have closed without notice. If a
factory which supplies parts to us closes with little or no notice, we could experience shortages and difficulties in locating alternative sources of supply.

Tighter management of inventories across global supply chains may lead to longer lead times for our purchases of certain inventory components. If we are unable to manage our
supply chain and maintain sufficient inventories to meet customer demand, this could result in lost sales and customers.

Due largely to the recent economic downturn, we have experienced tighter management of inventories across our supply chain, resulting
in longer lead times to obtain inventory components from our vendors. To a significant degree, we plan our purchasing of inventory components based on forecasts of future demand from our customers. If
actual order volumes from our customers exceed those forecasts, we may experience supply depletions or shortages. In some cases, this may lead to delays in our deliveries of products to our customers
due to the long lead times required to obtain new supplies of certain inventory components. In other cases, this may cause our customers to cancel their orders with us. These factors could adversely
impact our relationships with our customers and could cause certain customers to seek other sources of product supply. Also, we may purchase larger quantities of certain inventory components in order
to mitigate the risks described
above. Such inventory may later become excess or obsolete, which would result in higher than expected costs to write down inventory to its net realizable value.

If our application platform solutions 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.

As application platform solutions are complex, they may contain errors that can be detected at any point in a product's lifecycle. If
flaws in design, production, assembly or testing of our products (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 application platform solutions and have experienced delays in the shipment of our products during the period required to correct
these errors or we have had to replace defective products that were already shipped. Errors in our application platform solutions may be found in the future and any of these errors could be
significant. Significant errors, including those discussed above, may result in:



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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 application platform solutions fail to conform to warranted specifications, customers could demand a refund for the purchase price
and assert claims for damages.

Moreover,
because our application platform 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.

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

We use rolling forecasts based on anticipated product orders to determine our application platform component requirements. Lead times
for materials and components that we order may change 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 application platform solutions to customers, resulting in a loss of sales or customers. Any of these occurrences would negatively impact our business and
operating results.

Other risks related to our business.

Our operating results would suffer if we or our customers 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 application platform
solutions 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 application platform solutions infringed their intellectual property rights. We do not believe that our application platform solutions employ
technology that infringes the proprietary rights of any third parties. We are also not aware of any claims made against any of our customers related to their infringement of the proprietary rights of
other parties in relation to products that include our application platform

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solutions.
Other parties may make claims against us or our customers that, with or without merit, could:



In
addition, other parties may make claims against our customers related to products that are incorporated into our application platform solutions. Our business could be adversely
affected if such claims resulted in the inability of our customers to continue producing the infringing product.

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, 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.

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

Our manufacturing facilities 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 the
year ended September 30, 2009, the closing price of our common stock ranged from a low of $0.29 to a high of $1.32, and in the year ended September 30, 2008, from a low of $0.55 to a
high of $2.12. The market for technology and micro-cap stocks has been extremely volatile and frequently reaches levels that bear no relationship to the past or present

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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.

If the market price of our common stock is not quoted on a national exchange, our ability to raise future capital may be hindered and the market price of our common stock
may be negatively impacted.

At certain times in the past, the market price of our common stock has been less than $1.00 per share. If we are unable to meet the
stock price listing requirements of NASDAQ, our common stock could be de-listed from the NASDAQ Global Market. If our common stock were de-listed from the NASDAQ Global Market,
among other things, this could result in a number of negative implications, including reduced liquidity in our common stock as a result of the loss of market efficiencies associated with NASDAQ and
the loss of federal preemption of state securities laws, as well as the potential loss of confidence by suppliers, customers and employees, the loss of institutional investor interest, fewer business
development opportunities and greater difficulty in obtaining financing. As of December 14, 2009, we were in compliance with all applicable requirements for continued listing on the NASDAQ
Global Market.

A continued or prolonged downturn in the economy could have a material adverse effect on our financial performance and other aspects of our business.

The current downturn in the economy, and any further slowdown in future periods, could adversely affect our business in ways that we
are unable to fully anticipate. Tightened credit markets may negatively impact operations by affecting solvency of customers, suppliers and other business partners, or the ability of our customers to
obtain credit to finance purchases of our products and services, which in turn could lead to increased difficulty in collecting accounts receivable. Tightened credit markets may also negatively impact
our ability to borrow funds, if needed, either under our line of credit with Silicon Valley Bank or from other sources. In addition, government responses to the disruptions in the financial markets
may not stabilize the markets or increase liquidity or the availability of credit for us or our customers. A widespread reduction of global business activity could cause customers to reduce capital
expenditures, put increased pricing pressure on our products and services, and subject us, our suppliers and our customers to interest rate risks and tax changes that could impact our financial
strength. These and other economic factors could have a material adverse effect on our financial condition, operating results and liquidity.

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.

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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.

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 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.

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, and in our Plano, Texas location where we lease approximately 83,000 square feet of manufacturing and office space. We believe that our Canton and
Plano facilities 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 several underwriters of our initial public
offering. The suit alleges,inter alia, 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 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
October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice. On December 5, 2006, the United States Court of Appeals for the Second
Circuit overturned the District Court's certification of a plaintiff class. On April 6, 2007, the Second Circuit

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denied
plaintiffs' petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On September 27, 2007, plaintiffs filed a motion for
class certification in certain designated "focus cases" in the District Court. That motion has since been withdrawn. On November 13, 2007, the issuer defendants in certain designated "focus
cases" filed a motion to dismiss the second consolidated amended class action complaints that were filed in those cases. On March 26, 2008, the District Court issued an Opinion and Order
denying, in large part, the motions to dismiss the amended complaints in the "focus cases." On April 2, 2009, the plaintiffs filed a motion for preliminary approval of a new proposed settlement
between plaintiffs, the underwriter defendants, the issuer defendants and the insurers for the issuer defendants. On June 10, 2009, the District Court issued an opinion preliminarily approving
the proposed settlement, and scheduling a settlement fairness hearing for September 10, 2009. On October 5, 2009, the District Court issued an opinion granting plaintiffs' motion for
final approval of the settlement, approval of the plan of distribution of the settlement fund, and certification of the settlement classes. Various notices of appeal of the District Court's
October 5, 2009 order have now been filed. We are unable to predict the outcome of this suit and as a result, no amounts have been accrued as of September 30, 2009.

Customer Claim

On January 20, 2009, a lawsuit was filed in the United States District Court for the Eastern District of Texas against us and
several other co-defendants. The suit, filed by Cordsen Engineering GmbH ("Cordsen"), a former customer of Alliance Systems, alleges breach of contract and other claims with regard
to certain products that Cordsen purchased from Alliance Systems (prior to our acquisition of Alliance Systems) and which Cordsen alleges did not meet its desired specifications. (See Note 3 in
the notes to the consolidated financial statements for details regarding the acquisition.) Cordsen alleges that by virtue of our acquisition of Alliance Systems in October 2007, we became the assignee
of Alliance Systems' agreement with Cordsen. The Alliance Systems selling stockholders have agreed with us to undertake the defense of the action insofar as it relates to activities that occurred
principally before we acquired Alliance Systems, and have agreed to bear any costs associated with this action. We believe this claim is without merit. We are unable to predict the ultimate outcome of
this claim and are unable to estimate the amount of any potential loss we might incur as a result of this claim, and therefore no amounts have been accrued relating to this claim as of
September 30, 2009. With regard to this claim, we intend to pursue reimbursement from the former shareholders of Alliance Systems for any losses incurred by us, pursuant to the terms of the
Alliance Systems merger agreement.

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, 2009.

EXECUTIVE OFFICERS OF THE COMPANY

Name

Age

PositionGregory A. Shortell


65

President, Chief Executive Officer and DirectorDouglas G. Bryant


52

Chief Financial Officer, Treasurer and SecretaryCharles N. Cone, III


53

Senior Vice President of Sales and MarketingRichard P. Graber


49

Senior Vice President of Engineering and Operations


Gregory
A. Shortell

Gregory
A. Shortell joined NEI in January 2006 as President and Chief Executive Officer. Mr. Shortell also joined as a Director in January 2006. Prior
to joining NEI, Mr. Shortell was, from February 1998 to January 2006, Senior Vice President Global Sales and Marketing for Nokia

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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 NEI, 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.

Charles
N. Cone, III

Charles
N. Cone, III joined Alliance Systems in January 1999 as President. He became our Senior Vice President of Operations in October 2007 upon our
acquisition of Alliance Systems. In August 2008, he became our Senior Vice President of Sales and Marketing. Previously, he served as Vice President of M&S Systems, a nationally recognized consumer
electronics manufacturer. In addition, he held management positions at Texas Instruments and Marlow Industries, a winner of the 1991 Malcolm Baldrige National Quality Award.

Richard
P. Graber

Richard
P. Graber joined NEI in October 2003 as Vice President of Engineering and Operations, and later became our Senior Vice President of Engineering and
Operations in August 2008. Prior to joining NEI, 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.

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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

NEI's 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 periods indicated:

2009

2008Fiscal Year Ended September 30:

High

Low

High

LowFirst Quarter

$
0.57

$
0.29

$
2.12

$
1.57Second Quarter


0.57


0.35


1.64


1.36Third Quarter


0.85


0.56


1.72


1.10Fourth Quarter


1.32


0.77


1.18


0.55


(b)   Holders of record

As of December 9, 2009, there were approximately 225 holders of record of our common stock. Because many of such shares are held by brokers and other
institutions on behalf of stockholders, we are 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 2010 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.

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(e)   Performance Graph

The following graph compares the cumulative total return to holders of our common stock for the period from September 30, 2004 through September 30,
2009 with the cumulative total return over such period of the NASDAQ Stock Market (U.S.) Index, NASDAQ Computer Index, and the RDG Technology Composite.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*Among Network Engines, Inc., The NASDAQ Composite Index
The RDG Technology Composite Index And The NASDAQ Computer Index

GRAPHIC



The
graph assumes the investment of $100 in our common stock and in each of such indices (and the reinvestment of all dividends). Measurement points are the last trading days of each of
the years ended September 30, 2004, 2005, 2006, 2007, 2008 and 2009. The performance shown is not necessarily indicative of future performance.

The
information included under the heading "Performance Graph" in Item 5 of this Annual Report on Form 10-K is "furnished" and not "filed" and shall not be
deemed to be "soliciting material" or subject to Regulation 14A, shall not be deemed "filed" for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise
subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Exchange Act.

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(f)    Stock Repurchase Program

The following is a summary of stock repurchases for each month during the fourth quarter of the year ended September 30, 2009:

Month

Number of Shares
Purchased as
Part of Publicly
Announced
Program(1)

Average Price
Paid Per Share

Maximum Dollar Value
that May Yet Be Used
for Purchases Under
the ProgramJuly 2009


235,042

$
0.87

$
3,061,000August 2009


62,500

$
1.02

$
2,997,000September 2009







$
2,997,000Total


297,542

$
0.90


(1)All
of the shares of common stock set forth in this column were purchased pursuant to the program publicly announced on June 12, 2008. On this date,
we announced that our Board of Directors had authorized the repurchase of up to $5 million of common stock through a share repurchase program. The program does not have an expiration date. All
repurchases described in the table above were effected pursuant to written Rule 10b5-1 trading plans. From the program's inception through September 30, 2009, we repurchased
2,423,346 shares at an average cost of $0.83 per share. Upon the expiration of the first 10b5-1 plan on November 7, 2008, we suspended repurchases of common stock. On
March 16, 2009, we announced that we would resume the repurchase of common stock under a new 10b5-1 plan as part of the share repurchase program previously authorized by our Board
of Directors.


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ITEM 6.    SELECTED FINANCIAL DATA

The following selected financial data are derived from the financial statements of Network Engines, Inc. The historical results
presented are not necessarily indicative of future results. The consolidated statements of operations data for the years ended September 30, 2009, 2008, and 2007 and the consolidated balance
sheet data as of September 30, 2009 and 2008 have been derived from our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K. The
selected consolidated statements of operations data for the years ended September 30, 2006 and 2005 and the selected consolidated balance sheet data as of September 30, 2007, 2006, and
2005 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 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. On October 11, 2007, we completed our acquisition of Alliance Systems.
The results for the year ended September 30, 2008 only include activity from this acquisition since October 12, 2007. As such, the presentation of historical financial information and
any discussion regarding the comparison of historical financial information to financial information for the year ended September 30, 2008, does not include any financial information for
Alliance Systems prior to October 12, 2007, unless otherwise indicated.

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

Year Ended September 30,2009

2008

2007

2006

2005Net revenues

$
148,722

$
197,495

$
119,627

$
118,696

$
98,071Gross profit


22,521


32,343


23,252


19,871


17,061Operating expenses(a)(b)


25,795


41,056


22,584


26,628


33,637(Loss) income from operations


(3,274
)

(8,713
)

668


(6,757
)

(16,576
)Net (loss) income


(3,198
)

(8,477
)

2,502


(5,447
)

(15,583
)Net (loss) income per common sharebasic and diluted

$
(0.07
)
$
(0.19
)
$
0.06

$
(0.14
)
$
(0.42
)Weighted average shares outstandingbasic


42,817


43,856


40,637


38,207


37,461Weighted average shares outstandingdiluted


42,817


43,856


41,256


38,207


37,461




September 30,Balance Sheet Data:

2009

2008

2007

2006

2005Cash, cash equivalents, short-term investments and restricted cash

$
21,039

$
10,050

$
44,650

$
32,865

$
37,409Working capital


44,163


40,960


55,384


47,891


48,484Total assets


76,670


78,065


74,822


61,061


59,804Long-term debt, less current portion











60


79Total stockholders' equity


51,570


54,352


55,508


48,403


49,861


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

Overview

We design and manufacture application platform solutions that enable original equipment manufacturers, or OEMs, and independent
software vendors, or ISVs that then deliver their software applications in the form of a network-ready device. Application platforms are pre-configured server-based network infrastructure
devices, engineered to deliver specific software application functionality, ease deployment challenges, improve integration and manageability, accelerate time-to-market and
increase the security of that software
application in an end user's network. We offer our customers an extensive suite of services including solution design, integration control, global logistics, Smart Services, and support and
maintenance. We produce and fulfill devices branded for our customers, and derive our revenues primarily from the sale of value-added hardware platforms to these customers. Our customers subsequently
resell and support these platforms under their own brands to their customer bases.

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 application platforms. 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 application platform 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, on-site support, and advanced replacement of application platforms. 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 costs of maintenance are expensed in the same period as incurred.

Contracts
and/or customer purchase orders generally serve as the evidence 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.

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For
revenue arrangements that contain multiple elements, such as the sale of both product and post-sales support and/or extended warranty and related services element, in
which software is not incidental to the product as a whole, 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 application platform. For revenue arrangements that contain multiple elements in which software is not
included or is incidental to the product as a whole, we allocate revenue to the extended warranty and related services element based on separately priced contractual rates for those elements.

We
recognize revenue when the revenue recognition criteria for each element of the sale are met. If we are 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. We include shipping
and handling costs reimbursed by our customers, if any, as net revenues and cost of revenues.

We
record provisions for estimated sales returns in the same period the related revenues are recorded, as a reduction of revenue. These provisions are based on historical return
experience.



We value inventory at the lower of cost or estimated market value, 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 standard warranty on 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 standard warranty obligation include shipping, internal and external labor, and travel. Significant judgment and estimates are involved in estimating our warranty
reserve. Although our application platform solutions primarily use standards-based technologies, certain of our application platform solutions 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 application platform solutions, 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.



We measure stock-based compensation cost at the grant date, based on the fair value of the award, and recognize that cost as an expense
over the employee's requisite service period (generally the vesting period of the equity award).

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We
determine the fair value of stock options on the grant date 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. For stock options granted on or after January 1, 2008, we determined the expected term based on analysis
of our historical exercise and post-vesting cancellation behavior. For stock options granted prior to January 1, 2008, we determined the expected term using the midpoint between the
vesting date and the end of the
contractual term of the options, also known as the "simplified method". We have determined the expected volatility based on a weighted average of the historical volatility of the market price of our
common stock. 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
periods. Historical forfeitures are used as a starting point for developing our estimate of future forfeitures.



We review long-lived assets, including definite-lived intangible assets, to determine if any adverse conditions exist that
would indicate impairment. Factors that could lead to an impairment of acquired customer relationships include a worsening in customer attrition rates compared to historical attrition rates, or lower
than initially anticipated cash flows associated with customer relationships. We assess the recoverability of long-lived assets based on the projected undiscounted future cash flows
estimated to be generated over the asset's remaining life. The amount of impairment, if any, is measured based on the excess of the carrying value over fair value. Fair value is generally 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.

Goodwill
represents the excess purchase price over the fair value of the net tangible and intangible assets acquired. During the year ended September 30, 2008, we performed our
annual impairment review, which required us to determine the fair value of the Company as a whole since it is considered the reporting unit to which all goodwill is allocated. We estimated the fair
value of the reporting unit utilizing industry accepted valuation techniques that included the present value of estimated future cash flows using a risk-adjusted discount rate, and a
market multiple approach, which considered our market capitalization adjusted for a control premium. Step one of this assessment resulted in the carrying value of the reporting unit exceeding the fair
value. In step two of the impairment analysis, we compared the implied fair value of goodwill to the carrying value. The implied fair value of goodwill was determined to be zero. Consequently, we
determined that goodwill was fully impaired; resulting in an impairment charge of $8.7 million for the year ended September 30, 2008.



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, 2009, we determined that it is more
likely than not that all of our deferred tax assets will not be realized, and, accordingly, we 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 resulting reduction of the valuation allowance will be recorded as a tax benefit. To the extent that net operating
losses, when realized, relate to stock option deductions of approximately $6.8 million, the resulting benefits will be credited to additional paid-in capital.

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Management judgment is required in assessing the collectibility of accounts receivable, for which we do not require collateral. We
maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. In determining the adequacy of the allowance for doubtful
accounts, management specifically analyzes individual accounts receivable, historical bad debt write-offs, customer concentrations, customer creditworthiness, current economic conditions,
accounts receivable aging trends and the payment terms we extend to our customers. If the financial condition of our customers were to deteriorate, we may have to record additional allowances. The
allowance for bad debts can vary depending on the level and timing of quarterly revenues as well as the timing of the resolution of specifically reserved doubtful accounts receivable, either through
collection or write-off.

Comparability of Financial Information

On October 11, 2007, we completed our acquisition of Alliance Systems, which is fully described in Note 3 to our
consolidated financial statements included herein, in Item 8. Our financial results only include the financial results of Alliance Systems for periods subsequent to October 11, 2007. As
such, the presentation of historical financial information and any discussion regarding the comparison of historical financial information does not include any financial information for Alliance
Systems prior to October 12, 2007, unless otherwise indicated.

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.

Year Ended September 30,2009

2008

2007Dollars

% of Net
Revenues

Dollars

% of Net
Revenues

Dollars

% of Net
RevenuesNet revenues

$
148,722


100.0
%
$
197,495


100.0
%
$
119,627


100.0
%Gross profit(a)


22,521


15.1
%

32,343


16.4
%

23,252


19.4
%Operating expenses(b)(c)


25,795


17.3
%

41,056


20.8
%

22,584


18.9
%(Loss) income from operations


(3,274
)

(2.2
)%

(8,713
)

(4.4
)%

668


0.5
%Net (loss) income


(3,198
)

(2.2
)%

(8,477
)

(4.3
)%

2,502


2.1
%


---

Discussion of Fiscal Years 2009 and 2008



Our revenues are derived primarily from sales of application platform solutions to our OEM and ISV customers.

Net
revenues decreased for the year ended September 30, 2009 as compared to the year ended September 30, 2008, primarily due to decreases in sales volumes to many of our
customers as a result of the global economic downturn. These decreases were partially offset by revenues generated from

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new
customer wins secured in recent periods. Sales volumes have also decreased in part due to the fact that some of our storage customers are using larger hard disk drives, enabling them to provide
their customers with the same storage capacity with fewer appliances. In addition, during fiscal year 2009, we began transitioning away from some of our non-strategic, transactional
revenues to projects that are more in line with our business model.



Gross profit represents net revenues recognized less the cost of revenues. Cost of revenues includes cost of materials, manufacturing
costs, warranty costs, inventory write-downs, shipping and handling costs and customer support costs. Manufacturing costs 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 decreased for the year ended September 30, 2009, as compared to the year ended September 30, 2008. The
decrease from the prior year was primarily due to manufacturing costs remaining fairly constant from the prior year relative to
the decrease in net revenues, changes in customer and product mix, and an increase in inventory write-downs.

Gross
profit is affected by customer and product mix, component material costs, pricing and the volume of orders as well as by the mix of product manufactured internally compared to
product manufactured by a contract manufacturer, which carries higher manufacturing costs. In addition, during fiscal year 2009, we won some new business which has gross margins that are lower than
current levels. We have pursued such opportunities in order to increase revenues and leverage those revenues over a fixed infrastructure to improve operating margins. We may seek opportunities to win
additional new revenues with gross margins which are lower than current levels.



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:

Year Ended September 30,2009

2008Increase (Decrease)% of Net
Revenues



% of Net
RevenuesDollars

Dollars

Dollars

PercentageOperating expenses:Research and development

$
6,345


4.2
%
$
8,643


4.4
%
$
(2,298
)

(26.6
)%Selling and marketing


8,213


5.5
%

11,099


5.6
%

(2,886
)

(26.0
)%General and administrative


9,088


6.1
%

10,310


5.2
%

(1,222
)

(11.9
)%Amortization of intangible asset


1,756


1.2
%

1,891


1.0
%

(135
)

(7.1
)%Settlement of acquisition dispute


393


0.3
%







393


Restructuring charge








444


0.2
%

(444
)

(100.0
)%Impairment of goodwill








8,669


4.4
%

(8,669
)

(100.0
)%Total operating expenses

$
25,795


17.3
%
$
41,056


20.8
%
$
(15,261
)

(37.2
)%




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, material costs for prototype and test units and other expenses related to the design, development, testing and enhancements of our application
platform solutions. We expense all of our research and

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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 expense, and provides the changes in thousands and percentages:

Year Ended September 30,2009

2008Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageResearch and development:Compensation and related expenses

$
4,040


63.6
%
$
5,521


63.9
%
$
(1,481
)

(26.8
)%Stock-based compensation


246


3.9
%

725


8.4
%

(479
)

(66.1
)%Prototype


977


15.4
%

813


9.4
%

164


20.2
%Consulting and professional services


569


9.0
%

779


9.0
%

(210
)

(27.0
)%Other


513


8.1
%

805


9.3
%

(292
)

(36.3
)%Total research and development

$
6,345


100
%
$
8,643


100
%
$
(2,298
)

(26.6
)%


Research
and development expenses decreased in the year ended September 30, 2009, as compared to the year ended September 30, 2008, primarily due to decreases in
compensation and related expenses, and stock-based compensation. Compensation and related expenses decreased primarily due to a decrease in headcount, and lower employee bonus expense. Average
headcount was 36 for fiscal year 2009, compared to 46 for fiscal year 2008. Lower average headcount was primarily attributable to the completed integration of Alliance Systems. Employee bonuses are
based on the achievement of certain targets for net revenues and results of operations. For the year ended September 30, 2008, targets were partially achieved for the first half of the year,
resulting in certain employee bonus payouts, which are included in compensation and related expenses. No employee bonus expense was recorded for the year ended September 30, 2009 because
targets for revenue and results of operations were not achieved. Stock-based compensation expense decreased primarily due to variations in the timing and fair values of stock options awarded in the
current year and prior years, and the periods over which the expenses related to those awards have been recognized. Our application platform development strategy
emphasizes the utilization of standard component technologies, which utilize off-the-shelf components. However, we expect that in some cases, significant development efforts
will be required to fulfill our current and potential customers' needs using customized platforms. Because prototype and consulting costs are largely project-driven, we expect that these costs will be
variable and could fluctuate depending on the timing and magnitude of our development projects.

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Selling and marketing expenses consist primarily of salaries and commissions for personnel engaged in sales and marketing, and 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 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:

Year Ended September 30,2009

2008Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageSelling and marketing:Compensation and related expenses

$
6,171


75.1
%
$
8,006


72.1
%
$
(1,835
)

(22.9
)%Stock-based compensation


291


3.5
%

323


2.9
%

(32
)

(9.9
)%Marketing programs


574


7.0
%

758


6.8
%

(184
)

(24.3
)%Travel


344


4.2
%

704


6.3
%

(360
)

(51.1
)%Other


833


10.2
%

1,308


11.9
%

(475
)

(36.3
)%Total selling and marketing

$
8,213


100
%
$
11,099


100
%
$
(2,886
)

(26.0
)%


Selling
and marketing expenses decreased in the year ended September 30, 2009, as compared to the year ended September 30, 2008, primarily due to decreases in compensation
and related expenses, travel, and other expenses. The decrease in compensation and related expenses was primarily attributable to the decrease in headcount and lower commissions and bonuses. Average
headcount was 44 for fiscal year 2009, compared to 57 for fiscal year 2008. Lower average headcount was primarily attributable to the completed integration of Alliance Systems. The decrease in
commissions was due to the decrease in net revenues. Employee bonuses are based on the achievement of certain targets for net revenues and results of operations. For the year ended
September 30, 2008, targets were partially achieved for the first half of the year, resulting in certain bonus payouts, which are included in compensation and related expenses. No employee
bonus expense was recorded for the year ended September 30, 2009 because targets for revenue and results of operations were not achieved. Travel expenses decreased primarily due to the decrease
in headcount and efforts undertaken during fiscal
year 2009 to reduce non-essential employee travel. The decrease in other costs was primarily driven by lower outside consulting expenses.



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 director and officer insurance. The following table summarizes the most
significant components of general and administrative expense for the periods

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indicated,
in thousands and as a percentage of total general and administrative expense, and provides the changes in thousands and percentages:

Year Ended September 30,2009

2008Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageGeneral and administrative:Compensation and related expenses

$
4,384


48.2
%
$
4,936


47.9
%
$
(552
)

(11.2
)%Stock-based compensation


630


6.9
%

715


6.9
%

(85
)

(11.9
)%Consulting and professional services


2,488


27.4
%

3,026


29.3
%

(538
)

(17.8
)%Director and officer insurance


208


2.3
%

256


2.5
%

(48
)

(18.8
)%Other


1,378


15.2
%

1,377


13.4
%

1


0.1
%Total general and administrative

$
9,088


100.0
%
$
10,310


100
%
$
(1,222
)

(11.9
)%


General
and administrative expenses decreased in the year ended September 30, 2009, as compared to the year ended September 30, 2008, primarily due to decreases in
compensation and related expenses and consulting and professional services expenses. The decrease in compensation and related expenses was primarily due to lower headcount and lower employee bonus
expense. Average headcount was 40 for fiscal year 2009, compared to 43 for fiscal year 2008. Lower average headcount was primarily attributable to the completed integration of Alliance Systems.
Employee bonuses are based on the achievement of certain targets for net revenues and results of operations. For the year ended September 30, 2008, targets were partially achieved for the first
half of the year, resulting in certain bonus payouts, which are included in compensation and related expenses. No employee bonus expense was recorded for the year ended September 30, 2009
because targets for revenue and results of operations were not achieved. Also, we incurred $175,000 in severance charges related to the termination of certain former Alliance Systems employees during
the year ended September 30, 2008. The decrease in consulting and professional services expenses was primarily due to costs incurred during the year ended September 30, 2008 related to
the acquisition and completed integration of
Alliance Systems. This decrease was partially offset by higher legal expenses due to the acquisition dispute and arbitration.



Amortization of the intangible asset decreased to $1.8 million for the year ended September 30, 2009, as compared to
$1.9 year ended September 30, 2008. Amortization expense for the intangible asset decreases annually over its life of 17 years, to reflect the fact that the economic benefit
expected to be received from the intangible asset declines over time.



The acquisition of Alliance Systems was structured to include an adjustment to decrease the purchase price based on the net working
capital of Alliance Systems as of October 11, 2007, as defined in the merger agreement, and therefore approximately $4.0 million of the cash paid was contingently returnable to us and
therefore previously recorded as contingently returnable acquisition consideration. The former Alliance Systems shareholders disputed the amounts claimed by us under this provision of the merger
agreement. In September 2009, we engaged in arbitration with the former Alliance Systems shareholders to resolve the disputed claims as provided for in the merger agreement. In October 2009, the
arbitrator's decision was rendered. As a result, approximately $3.6 million of the contingently returnable consideration was returned to us from escrow funds on November 3, 2009; as such
this amount has been recorded as refundable acquisition consideration in our consolidated balance sheet as

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of
September 30, 2009. The $393,000 not returned to us was recorded as settlement of acquisition dispute in the fiscal year 2009 statement of operations.



Interest and other income, net decreased to $0.1 million for the year ended September 30, 2009 as compared to
$0.4 million for the year ended September 30, 2008. This decrease was primarily attributable to net foreign currency exchange losses of $65,000 recorded for the
year ended September 30, 2009, compared to net foreign currency exchange gains of $142,000 recorded during the year ended September 30, 2008. These gains and losses relate primarily to
VAT refunds receivable. The refundable VAT amounts, which we pay on products and services purchased from our contract manufacturer located in Ireland, are denominated in Euros. Interest income
decreased by $46,000, which was attributable to lower interest rates on the cash balances held by us during the year ended September 30, 2009, as compared to the year ended September 30,
2008.



There was no provision for income taxes for the year ended September 30, 2009 because we generated a taxable loss for the year.
The provision for income taxes for the year ended September 30, 2008 was $0.2 million, due to the taxable income generated during the year.

Discussion of Fiscal Years 2008 and 2007



Net revenues increased for the year ended September 30, 2008 as compared to the year ended September 30, 2007, primarily
due to the acquisition of Alliance Systems on October 11, 2007. If the acquisition had occurred at the beginning of fiscal year 2007, net revenues would have decreased by approximately
$24.8 million, when comparing pro forma net revenues for the years ended September 30, 2008 and 2007. The pro forma decrease would have been attributable primarily to lower sales volumes
during the second half of fiscal year 2008. In the years ended September 30, 2008 and 2007, net revenues from sales to EMC totaled $81.9 million and $98.8 million, respectively,
representing 42% and 83% of total net revenues, respectively. In addition, net revenues from other customers totaled $115.6 million for the year ended September 30, 2008 as compared to
$20.8 million for the year ended September 30, 2007. This growth was primarily attributable to the acquisition of Alliance Systems.



Gross profit as a percentage of net revenues decreased for the year ended September 30, 2008 as compared to the year ended
September 30, 2007. The decrease from the prior year was primarily due to lower gross margins associated with the Alliance Systems business and changes in customer and product mix.

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

Year Ended September 30,2008

2007Increase (Decrease)% of Net
Revenues



% of Net
RevenuesDollars

Dollars

Dollars

PercentageOperating expenses:Research and development

$
8,643


4.4
%
$
8,723


7.3
%
$
(80
)

(0.9
)%Selling and marketing


11,099


5.6
%

6,265


5.2
%

4,834


77.2
%General and administrative


10,310


5.2
%

7,596


6.4
%

2,714


35.7
%Amortization of intangible asset


1,891


1.0
%







1,891


Restructuring Charge


444


0.2
%







444


Impairment of Goodwill


8,669


4.4
%







8,669


Total operating expenses

$
41,056


20.8
%
$
22,584


18.9
%
$
18,472


81.8
%




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:

Year Ended September 30,2008

2007Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageResearch and development:Compensation and related expenses

$
5,521


63.9
%
$
5,229


59.9
%
$
292


5.6
%Stock-based compensation


725


8.4
%

1,169


13.4
%

(444
)

(38.0
)%Prototype


813


9.4
%

664


7.6
%

149


22.4
%Consulting and outside services


779


9.0
%

870


10.0
%

(91
)

(10.5
)%Other


805


9.3
%

791


9.1
%

14


1.8
%Total research and development

$
8,643


100
%
$
8,723


100
%
$
(80
)

(0.9
%)


Research
and development expenses decreased for the year ended September 30, 2008 as compared to the year ended September 30, 2007, primarily due to a decrease in
stock-based compensation, partially offset by increases related to the acquisition of Alliance Systems. Because our research and development expenses are project driven, the timing of these
expenditures can vary. If the acquisition had occurred at the beginning of fiscal year 2007, research and development expenses would have decreased by approximately $1.8 million, when comparing
pro forma research and development expenses for the years ended September 30, 2008 and 2007. On a pro forma basis, there would have been decreases in compensation, primarily due to lower
headcount, stock-based compensation, consulting and other costs.

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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:

Year Ended September 30,2008

2007Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageSelling and marketing:Compensation and related expenses

$
8,006


72.1
%
$
4,291


68.5
%
$
3,715


86.6
%Stock-based compensation


323


2.9
%

304


4.9
%

19


6.3
%Marketing programs


758


6.8
%

640


10.2
%

118


18.4
%Travel


704


6.4
%

449


7.2
%

255


56.8
%Consulting


132


1.2
%

58


0.9
%

74


127.6
%Other


1,176


10.6
%

523


8.3
%

653


124.9
%Total selling and marketing

$
11,099


100
%
$
6,265


100
%
$
4,834


77.2
%


Selling
and marketing expenses increased for the year ended September 30, 2008 as compared to the year ended September 30, 2007, primarily due to the acquisition of
Alliance Systems. Selling and marketing headcount increased from 23 as of September 30, 2007, to 48 as of September 30, 2008. If the acquisition had occurred at the beginning of fiscal
year 2007, selling and marketing expenses would have decreased by approximately $2.4 million, when comparing pro forma selling and marketing expenses for the years ended September 30,
2008 and 2007. On a pro forma basis, there would have been lower compensation and related expenses, primarily due to lower average headcount during the year ended September 30, 2008 as compared
to the year ended September 30, 2007. There also would have been a decrease in consulting costs and an increase in marketing program costs, primarily due to attendance at more trade shows.



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:

Year Ended September 30,2008

2007Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageGeneral and administrative:Compensation and related expenses

$
4,936


47.9
%
$
3,343


44.0
%
$
1,593


47.7
%Stock-based compensation


715


6.9
%

801


10.5
%

(86
)

(10.7
)%Professional services


3,026


29.3
%

2,312


30.4
%

714


30.9
%Director and officer insurance


256


2.5
%

315


4.2
%

(59
)

18.7
%Other


1,377


13.4
%

825


10.9
%

552


66.9
%Total general and administrative

$
10,310


100
%
$
7,596


100
%
$
2,714


35.7
%


39

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Table of Contents

General and administrative expenses increased for the year ended September 30, 2008 as compared to the year ended September 30, 2007, primarily due
to the acquisition of Alliance Systems. General and administrative headcount increased from 26 as of September 30, 2007, to 40 as of September 30, 2008. Professional services increased
in part due to audit fees incurred in the year ended September 30, 2008 related to the acquisition of Alliance Systems. If the acquisition had occurred at the beginning of fiscal year 2007,
general and administrative expenses would have decreased by approximately $2.8 million, when comparing pro forma general and administrative expenses for the years ended September 30,
2008 and 2007. The pro forma decrease would have been attributable to decreases in compensation and stock-based compensation expenses and other expenses. The pro forma decrease in compensation and
related expenses would have been primarily due to lower headcount during fiscal year 2008 as compared to fiscal year 2007.



Amortization of the intangible asset increased by $1.9 million for the year ended September 30, 2008, as compared to the
year ended September 30, 2007. The increase was due to the amortization of the intangible asset related to the acquisition of Alliance Systems, which occurred on October 11, 2007.



We recorded a restructuring charge of $0.4 million during the fourth quarter of the year ended September 30, 2008,
consisting of one-time benefits associated with the termination of 14 employees. Of the total charge recorded, $0.1 million was included in accrued compensation as of
September 30, 2008 and was fully paid during the first quarter of fiscal year 2009.



We performed our annual impairment assessment of goodwill as of September 30, 2008. Our assessment for impairment required us to
determine the fair value of the Company as a whole since it is considered the reporting unit to which all goodwill is allocated. We estimated the fair value of the reporting unit utilizing industry
accepted valuation techniques that included the present value of estimated future cash flows using a risk-adjusted discount rate, and a market multiple approach, which considered our
market capitalization adjusted for a control premium. These valuation techniques require significant judgments by management, including estimates and assumptions about our projected future operating
results, discount rates, and long-term growth rates. Our forecasts of future revenue were based on expected future growth from new as well as existing customers, and historical trends. In
addition, we considered the expected gross margins attainable in the future and the required level of operating expenses needed to conduct our business.

Step
one of our impairment assessment resulted in the carrying value of the reporting unit exceeding the fair value. In step two of our impairment analysis, we compared the implied fair
value of goodwill to its carrying value. The implied fair value of goodwill was determined to be zero. Consequently, we determined that goodwill was fully impaired, resulting in an impairment charge
of $8.7 million for the year ended September 30, 2008.



Interest and other income, net decreased to $0.4 million for the year ended September 30, 2008 from $2.0 million
for the year ended September 30, 2007. This decrease was primarily due to lower interest income, attributable to lower cash and short-term investment balances held by us during
fiscal year 2008 as compared to fiscal year 2007.

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Provision for income taxes increased to $0.2 million for the year ended September 30, 2008 from $0.1 million for
the year ended September 30, 2007. This increase was primarily due to higher taxable income for state income tax purposes, which was primarily related to the acquisition of Alliance Systems in
October 2007.

Liquidity and Capital Resources

The following table summarizes cash flow activities for the periods indicated (in thousands):

Year Ended September 30,2009

2008

2007Net (loss) income

$
(3,198
)
$
(8,477
)
$
2,502Non-cash adjustments to net (loss) income


4,477


14,053


3,353Changes in working capital


11,611


(4,329
)

4,750Cash provided by operating activities


12,890


1,247


10,605Cash (used in) provided by investing activities


(938
)

(34,986
)

23,655Cash (used in) provided by financing activities


(916
)

(636
)

2,129Effect of exchange rate differences on cash





(25
)

Increase (decrease) in cash and cash equivalents


11,036


(34,400
)

36,389Cash and cash equivalents at beginning of year


10,003


44,403


8,014Cash and cash equivalents at end of year

$
21,039

$
10,003

$
44,403




Cash provided by operating activities of $12.9 million during the year ended September 30, 2009 was the result of net
cash provided by changes in working capital and the impact of non-cash adjustments to net loss, partially offset by the net loss for the period. Non-cash adjustments to net
loss consisted primarily of depreciation and amortization expense of $2.7 million and stock-based compensation of $1.3 million. Of the $11.6 million net changes in working
capital, $8.3 million resulted from a decrease in inventories. The change in inventories was related to the depletion of inventories on hand and lower purchases during the year ended
September 30, 2009, resulting from the downward trend in revenues, and efforts we undertook to minimize inventory quantities on hand. Changes in working capital during the year ended
September 30, 2009 also included the receipt of $2.5 million of income tax refunds related to taxes paid by Alliance Systems in prior years. Changes in working capital in all periods are
also impacted by variations in the timing of cash receipts, cash disbursements, inventory receipts and invoicing to customers.

Cash
provided by operating activities of $1.2 million during the year ended September 30, 2008 was the result of non-cash adjustments to net income, partially
offset by the net loss and changes in working capital. Non-cash adjustments to net loss consisted primarily of a goodwill impairment charge of $8.7 million, depreciation and
amortization expense of $3.3 million, and stock-based compensation of $1.9 million. Changes in working capital primarily related to the use of $10.5 million to settle accounts
payable and accrued expenses, partially offset by $4.3 million and $1.6 million in cash provided as the result of changes in accounts receivable and inventory, respectively.

Cash
provided by operating activities of $10.6 million during the year ended September 30, 2007 was attributable to net income of $2.5 million and changes in working
capital of $4.8 million as well as non-cash adjustments to net income of $3.4 million. Non-cash adjustments to net income consisted

41

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Table of Contents

primarily
of stock-based compensation of $2.5 million and depreciation expense of $846,000. Changes in working capital primarily related to $4.1 million generated due to changes in
accounts payable and accrued expenses, partially offset by $1.7 million used due to changes in inventory. Changes in working capital also included an increase in deferred revenue of
$2.5 million, which was primarily related to the transfer of certain support obligations from Microsoft.



Cash used in investing activities during the year ended September 30, 2009 consisted of the use of approximately
$0.9 million of cash for purchases of property and equipment. Cash used in investing activities during the year ended September 30, 2008 primarily related to the use of approximately
$34 million of cash for the acquisition of Alliance Systems. Cash provided by investing activities during the year ended September 30, 2007 resulted from net sales of
$24.8 million of short-term investments, partially offset by the use of $888,000 for purchases of property and equipment.



Cash used in financing activities during the year ended September 30, 2009 consisted primarily of $1.1 million used to
repurchase shares of our common stock, partially offset by the receipt of $0.2 million as the result of stock option exercises and purchases under the Employee Stock Purchase Plan. Cash used in
financing activities during the year ended September 30, 2008 consisted primarily of $0.9 million of cash used to repurchase shares of our common stock. This was
partially offset by employee stock option exercises and purchases under the Employee Stock Purchase Plan, which provided $0.3 million of cash. Cash provided by financing activities during the
year ended September 30, 2007 consisted of $2.1 million of cash received as a result of employee stock option exercises and purchases under the Employee Stock Purchase Plan. As of
September 30, 2009, offerings under the Employee Stock Purchase Plan had ceased due to a lack of sufficient shares remaining in the Plan. Although additional shares may be proposed for
shareholder authorization in the future, there are no current plans to propose any additional shares.

On
June 12, 2008, our Board of Directors authorized the repurchase of up to $5 million of our common stock through a share repurchase program. As authorized by the program,
shares may be purchased in the open market or through privately negotiated transactions, in a manner consistent with applicable securities laws and regulations. This stock repurchase program does not
obligate us to acquire any specific number of shares, does not have an expiration date, and may be terminated at any time by our Board of Directors. All repurchases are expected to be funded from our
current cash balances or from cash generated from operations. To facilitate repurchases of shares under this program, we have established Rule 10b5-1 plans intended to comply with
the requirements of Rule 10b5-1 and Rule 10b-18 under the Securities Exchange Act of 1934. A Rule 10b5-1 plan permits the repurchase of shares
by a company at times when it otherwise might be prevented from doing so under insider trading laws or because of company blackout periods, provided that the plan is adopted when the company is not
aware of material non-public information. Pursuant to the plan, a broker designated by us has the authority to repurchase shares, in accordance with the terms of the plan, without further
direction from us. The amount and timing of specific repurchases are subject to the terms of the plan and market conditions. Upon the expiration of the first 10b5-1 plan on
November 7, 2008, we suspended repurchases of our common stock. We resumed the stock repurchase program on March 16, 2009 under a new 10b5-1 plan, as authorized by the Board
of Directors. During the year ended September 30, 2009, we repurchased 1,516,545 shares of our common stock at an average cost of $0.71 per share. From the inception of the share repurchase
program through September 30, 2009, we had repurchased 2,423,346 shares of our common stock at an average cost of $0.83 per share. As of September 30, 2009, the maximum dollar value that
may yet be used for purchases under the program was $2,997,000.

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On October 11, 2007, we entered into a Loan and Security Agreement with Silicon Valley Bank (the "Bank"). On August 5,
2008, we entered into the First Loan Modification Agreement with the Bank (the "Modification Agreement"). The Modification Agreement amended the Loan Agreement to extend its term to August 5,
2010, and to change the amount of the revolving loan facility to $10 million. The Modification Agreement did not change the interest rate on the line, which
is equal to one quarter of a point (0.25%) below the current prime rate with interest payable monthly. As of December 14, 2009, we had not drawn on this line of credit.

Contractual Obligations and Commitments

The following table sets forth certain information concerning our obligations and commitments to make certain payments, as of
September 30, 2009 (in thousands):

Payments Due by PeriodLess than
1 Year

1-3 Years

4-5 Years

After
5 Years

TotalOperating leases

$
1,478

$
1,718

$


$


$
3,196Capital lease obligation


38


47








85Total

$
1,516

$
1,765

$


$


$
3,281


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



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

In
the event that our available cash resources and our Silicon Valley Bank line of credit are not sufficient, or if an event of default occurs, such as failure to achieve certain
financial covenants, that limits our ability to borrow under the line of credit, we may 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 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

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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, collectively, "HarbourVest"), one of our significant stockholders. HarbourVest is also a stockholder in Sepaton, Inc. ("Sepaton"). During the year ended
September 30, 2009, we recorded revenues of $2.0 million related to sales of application platform solutions and services to Sepaton. Sepaton became one of our customers during the year
ended September 30, 2009. We had $1.1 million in accounts receivable outstanding from Sepaton at September 30, 2009.

Mr. Wadsworth
also serves as a director of Innoveer Solutions, Inc. ("Innoveer"), formerly Akibia Consulting. We previously engaged Innoveer to perform certain professional
services related to our customer resource management ("CRM") software system. We did not incur any expenses related to these services during the years ended September 30, 2009 and 2008. During
the year ended September 30, 2007, we incurred approximately $40,200 of expenses related to these services. We had no amounts outstanding to Innoveer at September 30, 2009 or 2008.

John
A. Blaeser, our Lead Director, also serves as a director of Imprivata, Inc. ("Imprivata"). During the years ended September 30, 2009, 2008, and 2007, we recorded
revenues of $861,000, $135,000, and $0, respectively, related to sales of application platform solutions and services to Imprivata. We had $142,000 and $91,000 in accounts receivable outstanding from
Imprivata at September 30, 2009 and 2008, respectively.

Charles
A. Foley, one of our directors, also serves as the Chief Executive Officer of TimeSight Systems ("TimeSight", formerly known as Digital Ocular Networks). During the years ended
September 30, 2009, 2008, and 2007, we recorded revenues of $106,000, $38,000, and $6,000, respectively, related to sales of application platform solutions to TimeSight. We had $15,000 and
$11,000 in accounts receivable outstanding from TimeSight at September 30, 2009 and 2008, respectively.

Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board ("FASB") issued the FASB Accounting Standards Codification ("Codification"). The
Codification has become the single source of authoritative generally accepted accounting principles ("GAAP") recognized by the FASB to be applied by nongovernmental entities in the United States.
Rules and interpretive releases of the Securities and Exchange Commission ("SEC") under the authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants.
The Codification was effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification superseded all existing non-SEC
accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification is non-authoritative. The adoption of
the Codification in our annual reporting for the year ended September 30, 2009 did not have any impact on our financial position, results of operations, or cash flows.

In
September 2006, the FASB issued authoritative guidance which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting
principles, and expands disclosures about fair value measurements. This guidance was effective for fiscal years beginning after November 15, 2007; however, the FASB delayed the effective date
to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities, except those items recognized or disclosed at fair value on an annual or more frequent
basis. We adopted the

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guidance,
as it applies to our financial assets and liabilities which are recognized or disclosed at fair value on a recurring basis (at least annually), as of October 1, 2008, and this
adoption did not have any impact on our financial position, results of operations or cash flows. We do not expect the adoption of this guidance as it relates to nonfinancial assets and nonfinancial
liabilities to have a material impact on our financial position, results of operations, or cash flows.

In
December 2007, the FASB issued authoritative guidance related to business combinations. This guidance establishes principles and requirements for how the acquirer recognizes and
measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, recognizes and measures the goodwill acquired in the
business combination or a gain from a bargain purchase and determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the business combination. This guidance is effective for business combinations on a prospective basis for which the acquisition
date is on or after the beginning of our first annual reporting period beginning on or after December 15, 2008. We do not expect the adoption of this guidance to have a material impact on our
financial position, results of operations, or cash flows.

In
April 2008, the FASB issued authoritative guidance used to determine the useful life of intangible assets. This guidance amends the factors that should be considered in developing
renewal or extension assumptions used to determine the useful life of a recognized intangible asset. This change is intended to improve the consistency between the useful life of a recognized
intangible asset and the period of expected cash flows used to measure the fair value of the asset. The requirement for determining useful lives must be applied prospectively to intangible assets
acquired after the effective date and the disclosure requirements must be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. This guidance is
effective as of the beginning of our fiscal year that begins after December 15, 2008. We do not expect this guidance to have a material impact on our financial position, results of operations,
or cash flow.

In
April 2009, the FASB issued authoritative guidance for interim fair value disclosures of financial instruments and the recognition and presentation of other than temporary impairments
of financial instruments. This guidance impacts certain aspects of fair value measurement and related disclosures. The provisions of the guidance were effective for interim periods ending after
June 15, 2009. We adopted this guidance for the interim reporting period ended June 30, 2009. The adoption of this guidance did not have a material impact on our financial position,
results of operations, or cash flows.

In
May 2009, the FASB issued authoritative guidance that establishes accounting and reporting standards for events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. In particular, entities must disclose the date through which subsequent events have been evaluated and the basis for selecting that date; that is, whether
that date represents the date the financial statements were issued or were available to be issued. This guidance is effective for fiscal years and interim periods ending after June 15, 2009 and
will be applied prospectively. The adoption of this guidance did not have a material impact on our financial position, results of operations, or cash flows. In accordance with this guidance, we
evaluated subsequent events through December 14, 2009, the date of issuance of our consolidated financial statements. With the exception of the subsequent event related to the acquisition
dispute and arbitration, which is fully described in Note 3 to our consolidated financial statements included herein, in Item 8, no material recognizable subsequent events occurred
during this period.

In
October 2009, the FASB issued authoritative guidance for multiple-deliverable revenue arrangements, which amends previously issued guidance to require an entity to use an estimated
selling price when vendor specific objective evidence or acceptable third party evidence does not exist for any products or services included in a multiple element arrangement. The arrangement
consideration should be allocated among the products and services based upon their relative selling prices, thus

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eliminating
the use of the residual method of allocation. This standard also requires expanded qualitative and quantitative disclosures regarding significant judgments made and changes in applying
this guidance. This standard is effective on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption
and retrospective application are also permitted. We are in the process of evaluating when we will adopt this guidance and whether the adoption will have a material impact on our financial position,
results of operations, or cash flow.

In
October 2009, the FASB issued authoritative guidance for certain revenue arrangements that include software elements. Under this guidance, tangible products containing software
elements that function together to deliver the product's essential functionality are no longer within the scope of software revenue guidance. Entities that sell joint hardware and software products
that meet this scope exception will be required to follow the guidance for multiple-deliverable revenue arrangements. This standard is effective on a prospective basis for revenue arrangements entered
into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption and retrospective application are also permitted. We are in the process of evaluating when we
will adopt this guidance and whether the adoption will have a material impact on our financial position, results of operations, or cash flow.

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We engage in certain transactions which are denominated in currencies other than the U.S. dollar (primarily the Euro). These
transactions may subject us to exchange rate risk based on fluctuations in currency exchange rates, which occur between the time such a transaction is recognized in our financial statements and the
time that the transaction is settled. However, based on the historical magnitudes and timing of such transactions, we do not believe we are subject to material exchange rate risk. We do not engage in
any foreign currency hedging transactions. We are exposed to market risk related to changes in interest rates. In the past, we have invested excess cash balances in cash equivalents and
short-term investments, and if we were to do so in the future, 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 would not be material. In addition, we believe that a hypothetical 10% increase or decrease in interest rates would not have a material adverse effect on
our financial condition.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



PageREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

48CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2009 AND 2008

49CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 2009, 2008 AND 2007

50CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE (LOSS) INCOME FOR THE YEARS ENDED SEPTEMBER 30, 2009,
2008 AND 2007

51CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED SEPTEMBER 30, 2009, 2008 AND 2007

52NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

53


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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, 2009 and September 30, 2008, and the results of their operations and their cash flows for each of the three years in the period
ended September 30, 2009 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, 2009, based on criteria established inInternal 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 uncertain tax positions in fiscal 2008.

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.

/s/
PricewaterhouseCoopers LLP

Boston,
Massachusetts
December 14, 2009

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

September 30,2009

2008ASSETSCurrent assets:Cash and cash equivalents

$
21,039

$
10,003Restricted cash





47Accounts receivable, net of allowances of $117 and $122 at September 30, 2009 and 2008, respectively


27,479


26,403Refundable acquisition consideration


3,629


Income tax receivable


17


2,585Inventories


13,078


21,380Prepaid expenses and other current assets


1,504


2,009Total current assets


66,746


62,427Property and equipment, net


1,622


1,549Intangible asset, net


8,128


9,884Contingently returnable acquisition consideration





4,022Other assets


174


183Total assets

$
76,670

$
78,065LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilities:Accounts payable

$
14,200

$
11,745Accrued compensation and other related benefits


1,466


1,327Accrued warranty


641


931Other accrued expenses


2,043


2,291Deferred revenue


4,233


5,173Total current liabilities


22,583


21,467Deferred revenue, net of current portion


2,517


2,246Total liabilities


25,100


23,713Commitments and contingencies (Note 12)Stockholders' equity:Preferred stock, $.01 par value, 5,000,000 shares authorized, and no shares issued and outstanding





Common stock, $.01 par value, 100,000,000 shares authorized; 47,132,540 and 46,753,826 shares issued; 42,147,336 and 43,285,167 shares outstanding at
September 30, 2009 and 2008, respectively


471


468Additional paid-in capital


196,711


195,228Accumulated deficit


(140,770
)

(137,572
)Treasury stock, at cost, 4,985,204 and 3,468,659 shares at September 30, 2009 and 2008, respectively


(4,842
)

(3,772
)Total stockholders' equity


51,570


54,352Total liabilities and stockholders' equity

$
76,670

$
78,065


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

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

Year Ended September 30,2009

2008

2007Net revenues

$
148,722

$
197,495

$
119,627Cost of revenues


126,201


165,152


96,375Gross profit


22,521


32,343


23,252Operating expenses:Research and development


6,345


8,643


8,723Selling and marketing


8,213


11,099


6,265General and administrative


9,088


10,310


7,596Amortization of intangible asset


1,756


1,891


Settlement of acquisition dispute


393





Restructuring charge





444


Impairment of goodwill





8,669


Total operating expenses


25,795


41,056


22,584(Loss) income from operations


(3,274
)

(8,713
)

668Interest and other income, net


76


436


1,953(Loss) income before income taxes


(3,198
)

(8,277
)

2,621Provision for income taxes





200


119Net (loss) income

$
(3,198
)
$
(8,477
)
$
2,502Net (loss) income per sharebasic and diluted

$
(0.07
)
$
(0.19
)
$
0.06Shares used in computing basic net (loss) income per share


42,817


43,856


40,637Shares used in computing diluted net (loss) income per share


42,817


43,856


41,256


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

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NETWORK ENGINES, INC.        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE (LOSS) INCOME        (in thousands, except share data)

Shares of
Common StockCommon
Stock
Par value

Additional
Paid-in
Capital

Accumulated
Deficit

Treasury
Stock

Total
Stockholders'
Equity

Comprehensive
(Loss) IncomeIssued

In TreasuryBalance, September 30, 2006


41,751,304


(2,561,858
)
$
418

$
182,420

$
(131,597
)
$
(2,838
)
$
48,403Issuance of common stock upon stock option exercises


1,732,789





17


1,948








1,965Issuance of common stock under employee stock purchase plan


106,790





1


183








184Stock compensation related to grants of stock options to employees











2,454








2,454Net income














2,502





2,502

$
2,502$
2,502Balance, September 30, 2007


43,590,883


(2,561,858
)
$
436

$
187,005

$
(129,095
)
$
(2,838
)
$
55,508Issuance of common stock for acquisition of Alliance Systems


2,904,301





29


5,965








5,994Issuance of common stock upon stock option exercises


9,500








17








17Issuance of common stock under employee stock purchase plan


249,142





3


296








299Stock compensation related to grants of stock options to employees











1,945








1,945Purchase of treasury stock





(906,801
)










(934
)

(934
)Net loss














(8,477
)




(8,477
)
$
(8,477
)$
(8,477
)Balance, September 30, 2008


46,753,826


(3,468,659
)
$
468

$
195,228

$
(137,572
)
$
(3,772
)
$
54,352Issuance of common stock upon stock option exercises


14,642








11








11Issuance of common stock under employee stock purchase plan


364,072





3


164








167Stock compensation related to grants of stock options to employees











1,308








1,308Purchase of treasury stock





(1,516,545
)










(1,070
)

(1,070
)Net loss














(3,198
)




(3,198
)
$
(3,198
)$
(3,198
)Balance, September 30, 2009


47,132,540


(4,985,204
)
$
471

$
196,711

$
(140,770
)
$
(4,842
)
$
51,570


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

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

Year Ended September 30,2009

2008

2007Cash flows from operating activities:Net (loss) income

$
(3,198
)
$
(8,477
)
$
2,502Adjustments to reconcile net (loss) income to net cash provided by operating activities:Depreciation and amortization


2,667


3,311


846Stock-based compensation


1,312


1,946


2,446Provision for doubtful accounts


83


126


54Settlement of acquisition dispute


393





Impairment of goodwill





8,669


Loss on disposal of fixed assets


22


1


7Changes in operating assets and liabilities, net of impact of acquisition:Accounts receivable


(1,159
)

4,304


(387
)Income taxes receivable


2,568





Inventories


8,298


1,556


(1,722
)Prepaid expenses and other assets


559


76


183Accounts payable


2,455


(6,353
)

3,142Accrued warranty


(290
)

(185
)

487Accrued expenses


(151
)

(3,934
)

513Deferred revenue


(669
)

207


2,534Net cash provided by operating activities


12,890


1,247


10,605Cash flows from investing activities:Acquisition, net of cash assumed





(30,203
)

Contingently returnable acquisition payment





(4,022
)

Payment for disposition of subsidiary





(231
)

Purchases of property and equipment


(938
)

(530
)

(888
)Purchases of short-term investments








(17,500
)Sales of short-term investments








42,304Changes in other assets








(261
)Net cash (used in) provided by investing activities


(938
)

(34,986
)

23,655Cash flows from financing activities:Purchase of treasury stock


(1,070
)

(934
)

Proceeds from issuance of common stock


178


316


2,149Payments on capital lease obligations


(24
)

(18
)

(20
)Net cash (used in) provided by financing activities


(916
)

(636
)

2,129Effect of exchange rate differences on cash





(25
)

Net increase (decrease) in cash and cash equivalents


11,036


(34,400
)

36,389Cash and cash equivalents, beginning of year


10,003


44,403


8,014Cash and cash equivalents, end of year

$
21,039

$
10,003

$
44,403Supplemental cash flow information:Cash paid for income taxes

$
63

$
146

$
Supplemental disclosure of non-cash investing and financing activities:Assets acquired under capital lease

$
67

$


$
Common stock issued for acquisition

$


$
5,994

$



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

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NETWORK ENGINES, INC.        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Nature of Business

Network Engines, Inc. ("Network Engines", "NEI" or the "Company") designs and manufactures application platform solutions that enable original equipment manufacturers, or OEMs,
and independent software vendors, or ISVs, to deliver their software applications in the form of a network-ready device. Application platforms are pre-configured server-based network
infrastructure devices engineered to deliver specific software application functionality, ease deployment challenges, improve integration and manageability, accelerate
time-to-market and increase the security of that software application in an end user's network. The Company offers its customers an extensive suite of services including
solution design, integration control, global logistics, Smart Services, and support and maintenance. The Company produces and fulfills devices branded for its customers, and derives its revenues
primarily from the sale of value-added hardware platforms to these customers. These customers subsequently resell and support the platforms under their own brands to their customer bases.

The
Company operates as one segment, which reflects the way that management views the Company's operations.

2. Summary of Significant Accounting Policies



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



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.



The Company held $21.0 million in cash and cash equivalents as of September 30, 2009. Cash equivalents consisted of a
money market fund purchased with an original maturity of three months or less. Cash equivalents are measured at fair value, as described in more detail in Note 6. The Company did not hold any
cash equivalents or short-term investments as of September 30, 2008, and did not hold any short-term investments as of September 30, 2009. As of
September 30, 2009, the Company held no restricted cash. As of September 30, 2008, $47,000 in restricted cash was pledged as collateral for a letter of credit related to the lease of one
of the Company's office facilities. The restriction of this amount was released during the quarter ended June 30, 2009, as the letter of credit is now supported by the Company's bank line of
credit (see Note 15).



Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash
equivalents and accounts receivable. When the Company opts to invest excess

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies (Continued)

cash,
it invests primarily in municipal bonds, money market funds of major financial institutions, and 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, based on analysis of individual accounts receivable, historical bad debt write-offs, customer concentrations, customer creditworthiness,
current economic conditions, accounts receivable aging trends and the payment terms the Company extends to its customers. 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 30,2009

2008

2007EMC Corporation


35
%

42
%

83
%Tektronix, Inc.(1)


13
%

13
%






Accounts Receivable atSeptember 30,
2009

September 30,
2008EMC Corporation


30
%

30
%Tektronix, Inc.


17
%

17
%


---



Financial instruments, including cash equivalents, restricted cash, accounts receivable, and accounts payable, are carried in the
financial statements at amounts that approximate their fair value as of September 30, 2009 and 2008. For additional fair value disclosures, see Note 6.



Inventories are valued at the lower of cost or market value, 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 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

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies (Continued)

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.



The Company recognizes the fair value of stock-based awards as stock-based compensation expense, net of an estimated forfeiture rate,
over the employee's requisite service period (generally the vesting period of the equity award). The Company uses the Black-Scholes valuation model for estimating the fair value of the stock options
granted.



Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired. The
Company reviewed goodwill for impairment as of September 30, 2008, using a two-step process. In the first step, an entity's net assets are segregated into reporting units and
compared to their fair values. 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 reporting unit's goodwill exceeds the
implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The Company has one reporting unit and estimated the fair value of the reporting unit using
widely accepted valuation techniques, including the present value of estimated future cash flows using a risk-adjusted discount rate, and market multiple analyses. These types of analyses
require significant judgments by management. During the year ended September 30, 2008, the Company recorded a goodwill impairment charge of $8,669,000 (see Note 4).

Other
intangible and long-lived assets primarily consist of property and equipment and an intangible asset with a definite life. Guidance provided by the Financial Accounting
Standards Board ("FASB") requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the projected undiscounted cash
flows estimated to be generated by those assets are less than the assets' carrying value. The amount of impairment, if any, is measured based on the excess of the carrying value over fair value. Fair
value is generally 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.

Factors
that could lead to an impairment of the intangible asset (acquired customer relationships) include, but are not limited to, a worsening in customer attrition rates compared to
historical attrition rates, or lower than initially anticipated cash flows associated with customer relationships.



The functional currency for the Company's foreign subsidiary is the U.S. dollar. Net foreign currency transaction gains (losses) are
included in the determination of net income (loss). For the years ended September 30, 2009, 2008, and 2007, gains (losses) from transactions in foreign currencies were $(65,000), $142,000 and
$8,000, respectively.

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2. Summary of Significant Accounting Policies (Continued)



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 application platforms. 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 application platform 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, on-site support, and advanced replacement of application platforms. 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 costs of maintenance are expensed in the same period as incurred.

Contracts
and/or customer purchase orders generally serve as the evidence 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 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 and/or extended warranty and related services element, in
which software is not incidental to the product as a whole, 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 application platform. For revenue arrangements that contain multiple elements, in which software is not
included or is incidental to the product as a whole, the Company allocates revenue to the extended warranty and related services element based on separately priced contractual rates for those
elements.

The
Company recognizes revenue when the revenue recognition criteria for each element of the sale are 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 reimbursed by its customers, if any, as net revenues and cost of revenues.

The
Company records provisions for estimated sales returns in the same period the related revenues are recorded, as a reduction of revenue. These provisions are based on historical
return experience.



The Company offers a standard 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

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2. Summary of Significant Accounting Policies (Continued)

shipment.
Based upon historical experience and expectations 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. Warranty expense is recorded as a component of cost of revenues. The Company also offers extended warranties on certain of its products. Revenues from sales of
these extended warranties are recognized over the terms of the related warranty periods. Costs incurred to fulfill claims under extended warranties are expensed as incurred.



Advertising costs are expensed as incurred. Advertising expenses for the years ended September 30, 2009, 2008, and 2007 were
$76,000, $74,000, and $76,000, respectively.



Research and development costs, except for certain software development costs, are expensed as incurred. As they relate 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.



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 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.

The
Company adopted authoritative guidance regarding uncertainty in income taxes as of October 1, 2007. The guidance prescribes a recognition threshold that a tax position is
required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods,
disclosure and transition issues. Because the Company has recorded a full valuation allowance against its deferred tax assets, the adoption of the guidance had no impact on the Company's retained
earnings or reported liabilities.



Comprehensive (loss) income is comprised of two components: net (loss) income and other comprehensive (loss) income. During the years
ended September 30, 2009, 2008 and 2007, comprehensive (loss) income was equal to net (loss) income.



Basic net (loss) income per share is computed by dividing net (loss) income by the weighted average number of common shares outstanding
during the period. Diluted net (loss) income per share

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2. Summary of Significant Accounting Policies (Continued)

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. For
years in which the Company incurs a net loss, diluted net loss per share is the same as basic net loss per share because the inclusion of these common stock equivalents would be
anti-dilutive.

The
following table sets forth the computation of basic and diluted net (loss) income per share as well as the weighted average potential common stock excluded from the calculation of
net (loss) income per share because their inclusion would be anti-dilutive (in thousands, except per share data):

Year Ended September 30,2009

2008

2007Numerator:Net (loss) income

$
(3,198
)
$
(8,477
)
$
2,502Denominator:Shares used in computing basic net (loss) income per share


42,817


43,856


40,637Common stock equivalents from employee stock options








619Shares used in computing diluted net (loss) income per share


42,817


43,856


41,256Net (loss) income per share:Basic

$
(0.07
)
$
(0.19
)
$
0.06Diluted

$
(0.07
)
$
(0.19
)
$
0.06Anti-dilutive potential common stock equivalents excluded from the calculation of net (loss) income per share:Options to purchase common stock


6,971


7,469


3,884




In June 2009, the FASB issued the FASB Accounting Standards Codification ("Codification"). The Codification has become the single
source of authoritative generally accepted accounting principles ("GAAP") recognized by the FASB to be applied by nongovernmental entities in the United States. Rules and interpretive releases of the
Securities and Exchange Commission ("SEC") under the authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. The Codification was effective for
financial statements issued for interim and annual periods ending after September 15, 2009. The Codification superseded all existing non-SEC accounting and reporting standards. All
other non-grandfathered non-SEC accounting literature not included in the Codification is non-authoritative. The adoption of the Codification in the annual
reporting for the year ended September 30, 2009 did not have any impact on the Company's financial position, results of operations, or cash flows.

In
September 2006, the FASB issued authoritative guidance which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting
principles and expands disclosures about fair value measurements. This guidance was effective for fiscal years beginning after November 15, 2007; however, the FASB delayed the effective date to
fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities, except those items recognized or disclosed at fair value on an annual or more frequent
basis. The Company adopted this guidance, as it applies to its financial assets and liabilities which are recognized or disclosed at fair

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2. Summary of Significant Accounting Policies (Continued)

value
on a recurring basis (at least annually), as of October 1, 2008, and this adoption did not have any impact on its financial position, results of operations or cash flows. The Company does
not expect the adoption of this guidance as it relates to nonfinancial assets and nonfinancial liabilities to have a material impact on its financial position, results of operations, or cash flows.

In
December 2007, the FASB issued authoritative guidance related to business combinations. This guidance establishes principles and requirements for how the acquirer recognizes and
measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, recognizes and measures the goodwill acquired in the
business combination or a gain from a bargain purchase and determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the business combination. This guidance is effective for business combinations on a prospective basis for which the acquisition
date is on or after the beginning of the Company's first annual reporting period beginning on or after December 15, 2008. The Company does not expect the adoption of this guidance to have a
material impact on its financial position, results of operations, or cash flows.

In
April 2008, the FASB issued authoritative guidance used to determine the useful life of intangible assets. This guidance amends the factors that should be considered in developing
renewal or extension assumptions used to determine the useful life of a recognized intangible asset. This change is intended to improve the consistency between the useful life of a recognized
intangible asset and the period of expected cash flows used to measure the fair value of the asset. The requirement for determining useful lives must be applied prospectively to intangible assets
acquired after the effective date and the disclosure requirements must be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. This guidance is
effective as of the beginning of the Company's fiscal year that begins after December 15, 2008. The Company does not expect the adoption of this guidance to have a material impact on its
financial position, results of operations, or cash flow.

In
April 2009, the FASB issued authoritative guidance for interim fair value disclosures of financial instruments and the recognition and presentation of other than temporary impairments
of financial instruments. This guidance impacts certain aspects of fair value measurement and related disclosures. The provisions of the guidance were effective for interim periods ending after
June 15, 2009. The Company adopted this guidance for the interim reporting period ended June 30, 2009. The adoption of this guidance did not have a material impact on the Company's
financial position, results of operations, or cash flows.

In
May 2009, the FASB issued authoritative guidance that establishes accounting and reporting standards for events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. In particular, entities must disclose the date through which subsequent events have been evaluated and the basis for selecting that date; that is, whether
that date represents the date the financial statements were issued or were available to be issued. This guidance is effective for fiscal years and interim periods ending after June 15, 2009 and
will be applied prospectively. The adoption of this guidance did not have a material impact on the Company's financial position, results of operations, or cash flows. In accordance with this guidance,
the Company evaluated subsequent events through December 14, 2009, the date of issuance of its consolidated financial statements. With the exception of the subsequent event related to the
acquisition dispute and arbitration, which is fully described in Note 3, no material recognizable subsequent events occurred during this period.

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2. Summary of Significant Accounting Policies (Continued)

In October 2009, the FASB issued authoritative guidance for multiple-deliverable revenue arrangements, which amends previously issued guidance to require an entity to use an estimated
selling price when vendor specific objective evidence or acceptable third party evidence does not exist for any products or services included in a multiple element arrangement. The arrangement
consideration should be allocated among the products and services based upon their relative selling prices, thus eliminating the use of the residual method of allocation. This guidance also requires
expanded qualitative and quantitative disclosures regarding significant judgments made and changes in applying this guidance. This guidance is effective on a prospective basis for revenue arrangements
entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption and
retrospective application are also permitted. The Company is in the process of evaluating when it will adopt this guidance and whether the adoption will have a material impact on its financial
position, results of operations, or cash flow.

In
October 2009, the FASB issued authoritative guidance for certain revenue arrangements that include software elements. Under this guidance, tangible products containing software
elements that function together to deliver the product's essential functionality are no longer within the scope of software revenue guidance. Entities that sell joint hardware and software products
that meet this scope exception will be required to follow the guidance for multiple-deliverable revenue arrangements. This guidance is effective on a prospective basis for revenue arrangements entered
into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption and retrospective application are also permitted. The Company is in the process of evaluating
when it will adopt this guidance and whether the adoption will have a material impact on its financial position, results of operations, or cash flow.

3. Business Combination

On October 11, 2007, in order to increase the Company's presence in the application platform marketplace, the Company acquired all of the equity of Alliance Systems, Inc.
("Alliance Systems"), a privately held corporation located in Plano, Texas, which provided application platforms and related equipment supporting carrier communications and enterprise communications
solutions. The initial aggregate purchase price of approximately $40,947,000 was funded through a cash payment of $32,820,000 and the issuance of 2.9 million shares of the Company's common
stock valued at approximately $5,994,000, which was based on the average market price of the Company's common stock over the period of two days before and after the terms of the acquisition were
announced. The Company also incurred acquisition-related fees and expenses of approximately $1,139,000, and approximately $994,000 of costs related to certain exit activities of the acquired business.
The Company's cash payment included repayment of Alliance Systems' working capital line of credit of approximately $6,727,000, and $800,000 due under a note payable to Alliance Systems' majority
stockholder.

The
acquisition was structured to include an adjustment to decrease the purchase price based on the net working capital of Alliance Systems as of October 11, 2007, as defined in
the merger agreement, and therefore approximately $4.0 million of the cash paid was contingently returnable to the Company and therefore previously recorded as contingently returnable
acquisition consideration. The former Alliance Systems shareholders disputed the amounts claimed by the Company under this provision of the merger agreement. In September 2009, the Company engaged in
arbitration with the former Alliance Systems shareholders to resolve the disputed claims as provided for in the merger

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3. Business Combination (Continued)

agreement.
In October 2009, the arbitrator's decision was rendered. As a result, approximately $3.6 million of the contingently returnable consideration was returned to the Company from escrow
funds on November 3, 2009; as such this amount has been recorded as refundable acquisition consideration in the Company's consolidated balance sheet as of September 30, 2009. The
$393,000 not returned to the Company was recorded as settlement of acquisition dispute in the fiscal year 2009 statement of operations.

The
components of the purchase price allocation for Alliance Systems are as follows (in thousands):

Net assets acquiredCash

$
362Accounts receivable


13,641Income tax receivable


2,585Inventory


12,799Prepaid and other current assets


923Property and equipment


1,347Deferred tax asset


5,170Intangible asset


11,775Goodwill


8,669Other assets


127Accounts payable


(7,836
)Income tax payable


(127
)Deferred tax liability


(5,170
)Other accrued expenses


(4,160
)Deferred revenue


(3,180
)Total net assets acquired

$
36,925


The
acquired intangible asset was customer relationships, which is amortized over the period of economic benefit expected to be received, resulting in a weighted average amortization
period of 4.97 years. The transaction, which was nontaxable to the Company, resulted in the Company recording deferred tax liabilities of $5,170,000 related to the differences between the
financial statement and the tax bases of the acquired assets and liabilities. As a result of the recorded deferred tax liabilities, the Company determined it would more likely than not realize the tax
benefits from certain of its historical deferred tax assets, and therefore reduced its valuation allowance accordingly. The goodwill recorded was not deductible for tax purposes.

During
the year ended September 30, 2008, the Company executed certain restructuring activities with respect to portions of the acquired business. These activities primarily
consisted of $548,000 in severance costs for reductions in staffing levels and $446,000 in costs related to the disposition of Alliance Systems' German subsidiary. In connection with these exit
activities the Company recorded the estimated liabilities as part of the cost of the acquisition. The Company disposed of Alliance Systems' German subsidiary on February 12, 2008. There were no
amounts accrued at September 30, 2008 or 2009 related to these exit activities.

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3. Business Combination (Continued)

The
Company included, as a component of the net assets acquired, an estimated liability for approximately $123,000 for uncertain tax positions. These uncertain tax positions related to
state tax filing requirements. This liability, which included an estimate for interest and penalties, was based on the known facts at the time of the purchase price allocation.

The
Company's consolidated financial statements include Alliance Systems' operating results from the date of acquisition. The following unaudited pro forma information presents a summary
of consolidated results of operations of the Company and Alliance Systems as if the acquisition had occurred at the beginning of each period presented, with pro forma adjustments to give effect to
amortization of the
intangible asset, and certain other adjustments together with related tax effects (in thousands, except per share amounts):

Unaudited, pro formaYear Ended
September 30,2008

2007Net revenues

$
199,781

$
224,576(Loss) income from continuing operations(a)

$
(8,210
)
$
1,414Net (loss) income

$
(8,210
)
$
2,207Net (loss) income per shareBasic

$
(0.19
)
$
0.05Diluted

$
(0.19
)
$
0.05


(a)Includes
$1,939,000 of amortization of the intangible asset and $388,000 of additional costs related to the fair value adjustment of inventory in each of
the years ended September 30, 2008 and 2007.


4. Goodwill and Intangible Assets

The Company recorded goodwill and an intangible asset as the result of its acquisition of Alliance Systems. The acquired intangible asset is customer relationships, which is being
amortized over 17 years, which is the estimated period of economic benefit expected to be received, resulting in a weighted average amortization period of 4.97 years. The following table
presents the intangible asset balances as of September 30, 2009 and September 30, 2008 (in thousands):

September 30, 2009

September 30, 2008Gross
Carrying
Amount

Accumulated
Amortization

Net Book
Value

Gross
Carrying
Amount

Accumulated
Amortization

Net Book
ValueCustomer relationships

$
11,775

$
3,647

$
8,128

$
11,775

$
1,891

$
9,884


Amortization
expense was $1,756,000 for the year ended September 30, 2009. The estimated future amortization expense for the intangible asset as of September 30, 2009 by
fiscal year is $1,554,000 for 2010, $1,330,000 for 2011, $1,119,000 for 2012, $868,000 for 2013, $678,000 for 2014, and $2,579,000 thereafter. The Company reviews long-lived assets,
including definite-lived intangible assets, to determine if any adverse conditions exist that would indicate impairment. Factors that could lead to an impairment of acquired customer relationships
include a worsening in customer attrition rates

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4. Goodwill and Intangible Assets (Continued)

compared
to historical attrition rates, or lower than initially anticipated cash flows associated with customer relationships. If it is determined that an adverse condition exists, the Company
assesses the recoverability of long-lived assets based on the projected undiscounted future cash flows estimated to be generated over the asset's remaining life. The amount of impairment,
if any, is measured based on the excess of the carrying value over fair value. Fair value is generally 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.

Goodwill
represented the excess purchase price over the fair value of the net tangible and intangible assets acquired. As of September 30, 2008, the Company performed its annual
impairment review, which required the Company to determine the fair value of the Company as a whole since it is considered the reporting unit to which all goodwill is allocated. The Company estimated
the fair value of the reporting unit utilizing industry accepted valuation techniques that included the present value of estimated future cash flows using a risk-adjusted discount rate,
and a market multiple approach, which considered the Company's market capitalization adjusted for a control premium. Step one of this assessment resulted in the carrying value of the reporting unit
exceeding the fair value. In step two of the impairment analysis, the Company compared the implied fair value of goodwill to the carrying value. The implied fair value of goodwill was determined to be
zero. Consequently, the Company determined that goodwill was fully impaired, resulting in an impairment charge of $8,669,000 for the year ended September 30, 2008.

5. Cash and Cash Equivalents

Cash and cash equivalents consisted of the following (in thousands):

September 30,2009

2008Cash

$
4,009

$
10,003Money market fund


17,030


Total cash and cash equivalents

$
21,039

$
10,003


6. Fair Value Measurements

On October 1, 2008, the Company adopted authoritative guidance related to fair value measurements. The adoption did not have a material impact on the Company's financial
statements and did not result in any adjustments to the opening balance of accumulated deficit as of October 1, 2008.

This
guidance establishes a framework for measuring fair value and expands related disclosures. The framework requires fair value to be determined based on the exchange price that would
be received to sell an asset or paid to transfer a liability (an "exit price") in the principal or most advantageous market for the asset or liability in an orderly transaction between market
participants.

The
valuation techniques are based upon observable and unobservable inputs. Observable or market inputs reflect market data obtained from independent sources, while unobservable inputs
reflect the Company's assumptions about market participant assumptions based on best information available.

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6. Fair Value Measurements (Continued)

Observable
inputs are the preferred source of fair values. These two types of inputs create the following fair value hierarchy:



As
of September 30, 2009, the Company held certain assets that are required to be measured at fair value on a recurring basis, consisting of a money market fund, which is
classified as cash equivalents. The following table presents the fair value hierarchy for the Company's financial assets measured at fair value on a recurring basis as of September 30, 2009 (in
thousands):

Fair Value Measurements at
September 30, 2009 Using:Level 1
Inputs

Level 2
Inputs

Level 3
InputsAssets:Money market fund

$
17,030

$


$



Effective
October 1, 2008, the Company also adopted authoritative guidance regarding the fair value option, which allows an entity to choose to measure certain financial
instruments and liabilities at fair value on an investment-by-investment basis. Subsequent fair value measurement for the financial instruments and liabilities an entity
chooses to measure at fair value will be recognized in earnings. As of September 30, 2009, the Company had not elected this option for any eligible financial instrument.

The
net asset amount recorded in the balance sheet (carrying amount) and the estimated fair values of financial instruments at September 30, 2009 consisted of the following:

Carrying Amount

Fair ValueAssets:Money market fund

$
17,030

$
17,030


The
fair values of the money market fund were based on the quoted market prices on securities exchanges.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

7. Inventories

Inventories consisted of the following (in thousands):

September 30,2009

2008Raw materials

$
8,246

$
13,402Work in process


1,063


1,442Finished goods


3,769


6,536Total inventories

$
13,078

$
21,380


8. Property and Equipment

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

September 30,Useful Life

2009

2008Office furniture and equipment

5 years

$
1,035

$
1,024Engineering and production equipment

3 years


2,011


1,795Computer equipment and software

3 years


5,605


4,916Leasehold improvements

Shorter of lease term or
useful life of asset


2,643


2,59411,294


10,329Less: accumulated depreciation and amortization




(9,672
)

(8,780
)$
1,622

$
1,549


Depreciation
and amortization expense related to property and equipment was approximately $911,000, $1,420,000, and $846,000 for the years ended September 30, 2009, 2008, and
2007, respectively.

9. 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 Company's Board of Directors upon its issuance.

Common Stock Repurchase Program

On June 12, 2008, the Board of Directors of the Company authorized the repurchase of up to $5 million of its common stock
through a share repurchase program. As authorized by the program, shares may be purchased in the open market or through privately negotiated transactions, in a manner consistent with applicable
securities laws and regulations. This stock repurchase program does not obligate the Company to acquire any specific number of shares, does not have an expiration date, and may be terminated at any
time by the Company's Board of Directors. All repurchases are expected to

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9. Stockholders' Equity (Continued)

be
funded from the Company's current cash balances or from cash generated from operations. To facilitate repurchases of shares under this program, the Company has established
Rule 10b5-1 plans intended to comply with the requirements of Rule 10b5-1 and Rule 10b-18 under the Securities Exchange Act of 1934. A
Rule 10b5-1 plan permits the repurchase of shares by a company at times when it otherwise might be prevented from doing so under insider trading laws or because of company blackout
periods, provided that the plan is adopted when the company is not aware of material non-public information. Pursuant to the plan, a broker designated by the Company has the authority to
repurchase shares, in accordance with the terms of the plan, without further direction from the Company. The amount and timing of specific repurchases are subject to the terms of the plan and market
conditions. Upon the expiration of the first 10b5-1 plan on November 7, 2008, the Company suspended repurchases of its common stock. The Company resumed the stock repurchase program
on March 16, 2009 under a new 10b5-1 plan, as authorized by the Board of Directors. During the three months ended September 30, 2009, the Company repurchased 297,542 shares
of its common stock at an average cost of $0.90 per share. During the year ended September 30, 2009, the Company repurchased 1,516,545 shares of its common stock at an average cost of $0.71 per
share. From the inception of the share repurchase program through September 30, 2009, the Company had repurchased 2,423,346 shares of its common stock at an average cost of $0.83 per share. As
of September 30, 2009, the maximum dollar value that may yet be used for purchases under the program was $2,997,000.

10. 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, collectively,
"HarbourVest"), one of the Company's significant stockholders. HarbourVest is also a stockholder in Sepaton, Inc. ("Sepaton"). During the year ended September 30, 2009, the Company
recorded revenues of $2.0 million related to sales of application platform solutions and services to Sepaton. Sepaton became one of the Company's customers during the year ended
September 30, 2009. The Company had $1.1 million in accounts receivable outstanding from Sepaton at September 30, 2009.

Mr. Wadsworth
also serves as a director of Innoveer Solutions, Inc. ("Innoveer"), formerly Akibia Consulting. The Company previously engaged Innoveer to perform certain
professional services related to its customer resource management ("CRM") software system. The Company did not incur any expenses related to these services during the years ended September 30,
2009 and 2008. During the year ended September 30, 2007, the Company incurred approximately $40,200 of expenses related to these services. The Company had no amounts outstanding to Innoveer at
September 30, 2009 or 2008.

John
A. Blaeser, the Company's Lead Director, also serves as a director of Imprivata, Inc. ("Imprivata"). During the years ended September 30, 2009, 2008, and 2007 the
Company recorded revenues of $861,000, $135,000, and $0, respectively, related to sales of application platform solutions and services to Imprivata. The Company had $142,000 and $91,000 in accounts
receivable outstanding from Imprivata at September 30, 2009 and 2008, respectively.

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10. Related Party Transactions (Continued)

Charles
A. Foley, one of the Company's directors, also serves as the Chief Executive Officer of TimeSight Systems ("TimeSight", formerly known as Digital Ocular Networks). During the
years ended September 30, 2009, 2008, and 2007, the Company recorded revenues of $106,000, $38,000, and $6,000, respectively, related to sales of application platform solutions to TimeSight.
The Company had $15,000 and $11,000 in accounts receivable outstanding from TimeSight at September 30, 2009 and 2008, respectively.

11. 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 options 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 from the grant date. The option price per share is determined by the Board of Directors.

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 number of shares of common stock outstanding 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 1999 Plan. During the years ended September 30, 2009, 2008 and 2007,
the Company increased the number of shares available under the 1999 Plan by 0 shares, 2,051,450 shares, and 750,000 shares, respectively. As of September 30, 2009, the Company was authorized to
grant options, restricted stock or other awards of up to 16,608,723 shares of common stock under the 1999 Plan, and 3,073,640 shares were available for future grant. However, no future grants will be
awarded under the 1999 Plan, as it had a 10 year term and expired in October 2009. No awards were granted subsequent to September 30, 2009 under the 1999 Plan.

In
May 2000, the Company's shareholders approved the 2000 Director Stock 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. Each non-employee director receives an initial grant of 50,000 shares upon appointment to the Company's
board, which vests in equal annual installments over four years beginning on the first anniversary of the grant date. Subsequent annual grants of 15,000 shares to each non-employee
director vest 100% on 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 the Director Plan, resulting in a total of 825,000 shares authorized to be issued. Under the Director Plan, options to purchase 885,000 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, 2009. As of September 30, 2009, there were no shares available for future
grant.

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, March 2007, and March 2008, the

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. Stock Incentive Plans and Stock-Based Compensation (Continued)

Company's
shareholders approved increases of 500,000, 250,000, and 350,000 additional shares, respectively, of common stock authorized to be issued under the Purchase Plan, resulting in a total of
1,850,000 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 using funds withheld through payroll deductions 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 is equal to 85% of the closing price of the Company's common stock
at the end of the offering period. During the years ended September 30, 2009, 2008, and 2007, 364,072, 249,142, and 106,790 shares of common stock were issued under the Purchase Plan,
respectively. As of September 30, 2009, there were no shares available for issuance under the Company's Purchase Plan. Although additional shares may be proposed for shareholder authorization
in the future, there are no current plans to propose any additional shares.

In
March 2009, the Company's shareholders approved the 2009 Stock Incentive Plan (the "2009 Plan"). Under the 2009 Plan, stock options and restricted stock or other stock-based awards
for up to 750,000 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 from the grant date. The option price per share is determined by the Board of Directors, but is not less
than 100% of the fair market value of the stock on the day the option is granted. Each non-employee director receives an initial grant of 50,000 shares upon appointment to the Company's
board, which vests in equal annual installments over four years beginning on the first anniversary of the grant date. Subsequent annual grants of 15,000 shares to each non-employee
director vest 100% on the first anniversary of the grant date. The number of shares that may be allocated to be awarded to non-employee directors cannot exceed 20% of the maximum number of
shares
authorized under the 2009 Plan. As of September 30, 2009, the Company is authorized to grant options, restricted stock or other awards up to 750,000 shares of common stock under the 2009 Plan,
and 750,000 shares were available for future grant.

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

Year Ended September 30,2009

2008

2007Cost of revenues

$
147

$
183

$
171Research and development


245


725


1,169Selling and marketing


290


323


305General and administrative


630


715


801Total stock-based compensation expense

$
1,312

$
1,946

$
2,446


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 various
significant assumptions, including the expected term, the expected volatility of the price of the Company's common stock over the expected term, the risk-free interest rate over the
expected term, and the

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. Stock Incentive Plans and Stock-Based Compensation (Continued)

Company's
expected annual dividend yield. The Company believes that the valuation model and the approaches utilized to develop the underlying assumptions are appropriate in calculating the fair values
of the Company's stock options granted during the years ended September 30, 2009, 2008 and 2007. 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 awards based on the probability of employees completing the required
service periods. Historical forfeitures are used as a starting point for developing estimates of future forfeitures.

Assumptions
used to determine the fair values of options granted using the Black-Scholes valuation model were:

Year Ended September 30,2009

2008

2007Expected term(1)


3.50 to 6.00 years


5.50 to 6.25 years


5.50 to 6.25 yearsExpected volatility factor(2)


66.82% to 80.11%


54.89% to 59.05%


62.28% to 78.21%Risk-free interest rate(3)


1.28% to 2.21%


2.70% to 4.13%


4.15% to 4.70%Expected annual dividend yield


%


%


%


---

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.

The
Company issues common stock from previously authorized but unissued shares to satisfy option exercises and purchases under its Employee Stock Purchase Plan.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. Stock Incentive Plans and Stock-Based Compensation (Continued)

A summary of stock option activity under the 1999 Plan, 2009 Plan, and the Director Plan follows:

Number of
Shares

Weighted
Average
Exercise
Price

Weighted
Average
Remaining
Contractual
Term
(in years)Outstanding, September 30, 2008


7,483,042

$
2.35Granted


1,173,000

$
0.40Exercised


(14,642
)
$
0.75Forfeited


(241,796
)
$
1.89Expired


(440,196
)
$
2.30Outstanding, September 30, 2009


7,959,408

$
2.08


6.46Exercisable at September 30, 2009


5,527,983

$
2.44


5.64


All
options granted during the years ended September 30, 2009, 2008, and 2007 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 $0.23, $1.12, and $1.44 per share, respectively, determined using the Black-Scholes option pricing model. As of September 30, 2009, 3,823,640
shares were available for future grants under the 1999 Plan, 2009 Plan, and the Director Plan and the Company had reserved 7,959,408 shares of common stock for the exercise of outstanding stock
options.

At
September 30, 2009, the aggregate intrinsic value of options outstanding and options exercisable was $956,000 and $270,000, 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, 2009, 2008 and 2007 was $6,000, $2,000, and $1,908,000, respectively.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. Stock Incentive Plans and Stock-Based Compensation (Continued)

The
following table summarizes the stock options outstanding at September 30, 2009:

Options OutstandingOptions ExercisableWeighted Average
Remaining
Contractual
Term (in years)Exercise Price Range

Number

Weighted
Average
Exercise Price

Number

Weighted Average
Exercise Price$  0.24 - $  0.38


136,078

$
0.37


7.26


41,703

$
0.36$  0.39 - $  0.39


1,028,438

$
0.39


9.19


191,535

$
0.39$  0.50 - $  1.27


690,675

$
0.95


3.23


653,781

$
0.96$  1.36 - $  1.36


1,451,782

$
1.36


6.27


1,270,308

$
1.36$  1.38 - $  1.59


1,230,082

$
1.52


7.36


796,873

$
1.49$  1.60 - $  2.11


560,191

$
1.84


5.43


466,294

$
1.86$  2.12 - $  2.12


1,070,187

$
2.12


7.91


469,423

$
2.12$  2.19 - $  2.76


921,100

$
2.46


6.17


767,816

$
2.49$  3.03 - $  8.62


796,125

$
6.03


4.16


795,500

$
6.03$12.88 - $39.81


74,750

$
16.86


0.82


74,750

$
16.867,959,408

$
2.08


6.46


5,527,983

$
2.44


At
September 30, 2009, unrecognized compensation expense related to unvested stock options was $1,368,000, which is expected to be recognized over a weighted average period of
2.16 years.

During
each of the years ended September 30, 2009, 2008 and 2007, the Company granted 5,000 options to a non-employee. These options were accounted for at their fair
value resulting in immaterial amounts of compensation expense recorded during the years ended September 30, 2009, 2008 and 2007.

12. Commitments and Contingencies



The Company leases its office and manufacturing space under non-cancelable operating leases. During the year ended
September 30, 2006, the Company entered into an amendment of the lease of its headquarters building in Canton, Massachusetts. 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 included a provision for free rent for one month in fiscal year 2007 and has rent escalation clauses in 2008 and
2009. Additionally, the lease amendment provided the Company with the option to renew the lease for an additional two year period at the then-current market rate. During the year ended
September 30, 2008, the Company entered into another amendment of its headquarters office space lease, which extended the lease term through March 2012 with an option to further extend through
March 2014. This lease amendment included a provision for free rent for approximately two months in fiscal year 2009. Accordingly, rent expense was recognized on a straight-line basis and
any amounts paid which are greater than or less than the amount expensed were recorded as deferred rent liabilities.

The
Company also leases 83,000 square feet of office and manufacturing space in Plano, Texas. The lease term continues through July 2011, and the lease includes options to extend the
lease term for two additional five-year periods at then-current market rates. The lease includes annual rent escalation clauses, and accordingly, rent expense is recognized on
a straight-line basis, as described above.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. Commitments and Contingencies (Continued)

As
of September 30, 2009, the future minimum lease payments under the Company's non-cancelable operating leases were as follows (in thousands):

Year Ending September 30,2010


1,4782011


1,3612012


357Total

$
3,196


Rent
expense for the years ended September 30, 2009, 2008 and 2007 was $1,590,000, $1,415,000, and $713,000, respectively.



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. Although certain provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim related to
acquisitions other than Alliance
Systems is unlikely. As a result, the Company had not recorded any liabilities for such indemnification clauses as of September 30, 2009. As of September 30, 2009, the Company had
received two claims related to the Alliance Systems acquisition. For one of the claims, the Company paid a settlement of $88,000 during the fiscal year ended September 30, 2008. The second
claim was brought in January 2009 by Cordsen Engineering GmbH ("Cordsen"), a former customer of Alliance Systems, alleging that certain products that Cordsen purchased from Alliance Systems
(prior to the Company's acquisition of Alliance Systems) were defective and did not meet Cordsen's desired specifications. Cordsen alleges that by virtue of the Company's acquisition of Alliance
Systems in October 2007, the Company became the assignee of Alliance Systems' agreement with Cordsen. The Alliance Systems selling stockholders have agreed with the Company to undertake the defense of
the action insofar as it relates to activities that occurred principally before the Company acquired Alliance Systems, and have agreed to bear any costs associated with this action. The Company
believes this claim is without merit. The Company is unable to predict the ultimate outcome of this claim and is unable to estimate the amount of any potential loss it might incur as a result of this
claim, and therefore no amounts have been accrued relating to this claim as of September 30, 2009. With regard to any claims which the Company has received or may receive in the future related
to the Alliance Systems acquisition, the Company intends to pursue reimbursement from the former shareholders of Alliance Systems for any losses incurred by the Company as a result of such claims,
pursuant to the terms of the Alliance Systems merger agreement.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. Commitments and Contingencies (Continued)

believes
the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of September 30, 2009 and 2008.



The Company offers and fulfills warranty services on certain of its application platform solutions. 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 expectations of future conditions, the Company reserves for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue.

The
following table presents changes in the Company's product warranty liability (in thousands):

Year Ended
September 30,2009

2008Beginning balance

$
931

$
1,046Acquisitions





70Accruals for warranties issued


1,101


2,010Fulfillment of warranties during the period


(1,391
)

(2,195
)Ending balance

$
641

$
931




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 former Chairman and Chief Executive Officer), Douglas G. Bryant (the Company's Chief Financial Officer), and several
underwriters of the Company's initial public offering. The suit alleges,inter alia, 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 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
October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice. On December 5, 2006, the United States Court of Appeals for the Second
Circuit overturned the District Court's certification of the a plaintiff class. 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 September 27, 2007, plaintiffs filed a motion for class certification in certain designated "focus cases" in the District
Court. That motion has since been withdrawn. On November 13, 2007, the issuer defendants in certain designated "focus cases" filed a motion to dismiss the second consolidated amended class
action complaints that were filed in those cases. On March 26, 2008, the District Court issued an Opinion and Order denying, in large part, the motions to dismiss the amended complaints in the
"focus cases." On April 2, 2009, the plaintiffs filed a motion for preliminary approval of a new proposed settlement between plaintiffs, the underwriter

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. Commitments and Contingencies (Continued)

defendants,
the issuer defendants and the insurers for the issuer defendants. On June 10, 2009, the Court issued an opinion preliminarily approving the proposed settlement, and scheduling a
settlement fairness hearing for September 10, 2009. On October 5, 2009, the Court issued an opinion granting plaintiffs' motion for final approval of the settlement, approval of the plan
of distribution of the settlement fund, and certification of the settlement classes. Various notices of appeal of the District Court's October 5, 2009 order have been filed. The Company is
unable to predict the outcome of this suit and as a result, no amounts have been accrued as of September 30, 2009.

13. Income Taxes

Due to a taxable loss incurred during the year ended September 30, 2009, the Company did not record a provision for any federal, state, or foreign income taxes in the current
year. For the years ended September 30, 2008 and 2007, the Company recorded provisions of $57,000 and $98,000, respectively, in alternative minimum tax expense in connection with the federal
limitation on alternative minimum tax net operating loss carryforwards. In addition, for the year ended September 30, 2008, the Company also recorded a provision for state income taxes of
$138,000 related to certain tax jurisdictions where the Company previously did not generate net operating losses which could be used to offset current taxes. In particular, these jurisdictions were
attributable to states in which Alliance Systems historically had filed income tax returns. For the years ended September 30, 2008, and 2007, the Company recorded provisions of $5,000, and
$21,000, respectively, for foreign income taxes owed by its subsidiary in the United Kingdom.

The
following table presents 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 (in thousands):

Year Ended September 30,2009

2008

2007At U.S. federal statutory rate

$
(1,088
)
$
(2,814
)
$
855State taxes, net of federal effect


(113
)

256


231Foreign taxes





5


21Non-deductible expenses and other items


446


3,354


457AMT Tax





57


98Effect of change in valuation allowance


755


(658
)

(1,543
)Provision for income taxes

$


$
200

$
119


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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. Income Taxes (Continued)

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. Net deferred tax assets consisted of the following (in thousands):

September 30,2009

2008Deferred tax assets:Net operating losses

$
31,053

$
29,702Tax credit carryforwards


1,762


1,778Capitalized research and engineering


513


1,154Temporary differences


7,287


7,856Total deferred tax assets


40,615


40,490Valuation allowance for deferred tax assets


(37,364
)

(36,536
)Net deferred tax assets


3,251


3,954Deferred tax liabilities:Intangible asset


(3,251
)

(3,954
)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, 2009 and
2008, a valuation allowance was recorded for the full amount of the deferred tax asset due to the uncertainty of its 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, 2009, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $88,304,000 and $17,153,000, respectively.
For federal income tax purposes these net operating loss carryforwards will expire as follows: $44,281,000 in 2021, $22,686,000 in 2022, $3,458,000 in 2023, $1,172,000 in 2024, $9,187,000 in 2025 and
$3,982,000 thereafter. For state income tax purposes these net operating loss carryforwards will expire as follows: $9,182,000 in 2010, and $3,823,000 in 2011.

The
Company also has available research and development credits for federal and state income tax purposes as of September 30, 2009 of approximately $1,584,000 and $571,000,
respectively, which expire at various dates from 2010 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.

The
Company has an uncertain tax position of approximately $540,000 related to the validity of certain tax credit carryforwards. The Company has recorded an allowance in the amount of
$540,000 for this uncertainty to reduce the value of the deferred tax asset pertaining to the tax credit

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. Income Taxes (Continued)

carryforwards.
Because the Company has significant operating loss carryforwards to offset future taxable income, the Company does not expect to utilize any of these credits in the near term, and as a
result, the Company does not expect that the uncertain tax position will change significantly within the next twelve months.

The
Company adopted authoritative guidance related to accounting for uncertainty in income taxes on October 1, 2007. Because the Company has recorded a full valuation allowance
against its deferred tax assets, the adoption of this guidance had no impact on the Company's retained earnings or reported liabilities. Under this guidance, the Company classifies any penalties and
interest as a component of the income tax provision. As part of the accounting for the acquisition of Alliance Systems, the Company has included, as a component of the net assets acquired, an
estimated liability for approximately $123,000 for uncertain tax positions. These uncertain tax positions related to state tax filing requirements. This liability, which included an estimate of
$31,000 for interest and penalties, was based on the known facts at the time of the purchase price allocation. As of September 30, 2009, approximately $52,000 was accrued for interest and
penalties related to uncertain tax positions.

The
Company files its tax returns as prescribed by the tax laws of the jurisdictions in which it operates. The Company's tax filings for federal and state jurisdictions for the years
from 2002 to 2008 are still subject to examination.

A
reconciliation of the beginning and ending amount of gross uncertain tax positions (in thousands) is presented in the table below.

Year Ended September 30,2009

2008Beginning balance

$
710

$
540Reclassification of prior year liability


43


Increase for prior years





Increase for current year





47Acquired uncertain tax positions





123Reductions related to settlements with tax authorities





Reductions related to expiration of statute of limitations





Ending balance

$
753

$
710


14. 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, 2009, the Company had not made any contributions to this plan.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. Line of Credit

On October 11, 2007, the Company entered into a Loan and Security Agreement with Silicon Valley Bank (the "Bank"). On August 5, 2008, the Company and the Bank entered into
the First Loan
Modification Agreement (the "Modification Agreement"). The Modification Agreement amended the Loan Agreement to extend its term to August 5, 2010, and to change the amount of the revolving loan
facility to $10 million. The Modification Agreement did not change the interest rate on the line, which is equal to one quarter of a point (0.25%) below the current prime rate with interest
payable monthly. As of December 14, 2009, the Company had not drawn on this line of credit.

16. Restructuring Charge

The Company recorded a restructuring charge of $444,000 during the fourth quarter of the year ended September 30, 2008, consisting of one-time benefits associated with
the termination of 14 employees. Of the total charge recorded, $98,000 was included in accrued compensation as of September 30, 2008 and was fully paid during the first quarter of fiscal year
2009.

17. Geographic Data

All of the Company's long-lived assets were located in the United States as of
September 30, 2009 and 2008. The following table summarizes the Company's revenues by geographic region, in thousands:

Year Ended September 30,2009

2008

2007United States

$
111,997

$
149,311

$
84,209Foreign countries


36,725


48,184


35,418Total net revenues

$
148,722

$
197,495

$
119,627


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

Year Ended September 30,2009

2008

2007Ireland

$
19,146

$
27,472

$
30,849China


4,346


1,025


Canada


2,874


3,760


1,469United Kingdom


2,983


3,486


2,943Other


7,376


12,441


157Total

$
36,725

$
48,184

$
35,418


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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

18. 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 EndedDecember 31,
2008

March 31,
2009

June 30,
2009

September 30,
2009(in thousands, except per share data)Net revenues

$
37,235

$
37,461

$
33,329

$
40,697Gross profit


5,608


5,768


5,037


6,108Net loss


(466
)

(670
)

(1,243
)

(819
)Basic and diluted net loss per share

$
(0.01
)
$
(0.02
)
$
(0.03
)
$
(0.02
)Basic weighted average shares outstanding


43,137


43,177


42,764


42,198Diluted weighted average shares outstanding


43,137


43,177


42,764


42,198




Three Months EndedDecember 31,
2007

March 31,
2008

June 30,
2008

September 30,
2008(in thousands, except per share data)Net revenues

$
54,340

$
55,174

$
47,046

$
40,935Gross profit


9,740


8,899


7,650


6,054Net income (loss)


1,241


300


(283
)

(9,735
)Basic and diluted net income (loss) per share

$
0.03

$
0.01

$
(0.01
)
$
(0.22
)Basic weighted average shares outstanding


43,656


44,009


44,090


43,672Diluted weighted average shares outstanding


44,021


44,306


44,090


43,672


Net
loss for the three months ended September 30, 2009 includes a $393,000 charge related to the settlement of an acquisition dispute. Net loss for the three months ended
September 30, 2008 includes a goodwill impairment charge of $8,669,000 and a restructuring charge of $444,000.

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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, 2009. Based on this
evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2009, 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, 2009. 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, 2009, the Company's internal control over financial reporting was effective based on those criteria.

The
effectiveness of the Company's internal control over financial reporting as of September 30, 2009 has been audited by PricewaterhouseCoopers LLP, an independent
registered public accounting firm, as stated in their report which appears under Item 8.

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Changes in Internal Control Over Financial Reporting

During the quarter ended September 30, 2009, no change in the Company's internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred 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, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

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 2010 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, under the sections captioned "Election of Directors", "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 2010 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.

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 2010 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 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 2010 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 under the sections captioned
"Board and Committees" and "Certain Relationships and Related Party Transactions" and is incorporated herein by reference.

ITEM 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required by this item is included under the caption "Ratification of the Selection of Independent Registered Public
Accounting Firm" in our Proxy Statement related to the 2010 Annual

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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.

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":



PageReport of Independent Registered Public Accounting Firm

48Consolidated Balance Sheets as of September 30, 2009 and 2008

49Consolidated Statements of Operations for the years ended September 30, 2009, 2008 and 2007

50Consolidated Statements of Stockholders' Equity and Comprehensive (Loss) Income for the years ended September 30,
2009, 2008 and 2007

51Consolidated Statements of Cash Flows for the years ended September 30, 2009, 2008 and 2007

52Notes to Consolidated Financial Statements

53




Schedule IIValuation and Qualifying Accounts for each of the three fiscal years ended September 30, 2009.

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, 2009.

NETWORK ENGINES, INC.By:

/s/ GREGORY A. SHORTELL Gregory A. Shortell President and Chief Executive Officer


Pursuant
to the requirements of the Securities Exchange Act of 1934, the report has been signed as of December 14, 2009 below by the following persons on behalf of the registrant
and in the capacities indicated.

Name

Title/s/ GREGORY A. SHORTELL Gregory A. Shortell

President and Chief Executive Officer (Principal Executive Officer) and Director/s/ DOUGLAS G. BRYANT Douglas G. Bryant

Chief Financial Officer, Treasurer and Secretary (Principal Financial Officer and Principal Accounting Officer)/s/ JOHN A. BLAESER John A. Blaeser

Director/s/ CHARLES A. FOLEY Charles A. Foley

Director/s/ GARY E. HAROIAN Gary E. Haroian

Director/s/ DENNIS A. KIRSHY Dennis A. Kirshy

Director/s/ FONTAINE K. RICHARDSON Fontaine K. Richardson

Director/s/ ROBERT M. WADSWORTH Robert 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
Period2007

Allowance For Doubtful Accounts

$
29

$
3

$


$
322008

Allowance For Doubtful Accounts

$
32

$
126

$
36

$
1222009

Allowance For Doubtful Accounts

$
122

$
83

$
88

$
1172007

Allowance For Sales Returns

$


$
51

$
20

$
312008

Allowance For Sales Returns

$
31

$
1,527

$
1,364

$
1942009

Allowance For Sales Returns

$
194

$
629

$
733

$
902007

Deferred Tax Asset Valuation Allowance

$
42,300

$
(898
)
$
1,543

$
39,8592008

Deferred Tax Asset Valuation Allowance

$
39,859

$
(2,125
)
$
658

$
37,0762009

Deferred Tax Asset Valuation Allowance

$
36,536

$
755

$
(73
)
$
37,364


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EXHIBIT INDEX

Exhibit No.

Exhibit2.1

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).3.3

Third Amended and Restated By-laws of the Company (filed as Exhibit 3.01 to the Company's Current Report on Form 8-K dated February 8, 2008 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).


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Exhibit No.

Exhibit10.9*

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).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 Fourth 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 Company10.20

Summary of the Company's Non-Employee Director Compensation10.21

Fifth Amendment dated July 20, 2006 to Lease for 25 Dan Road, Canton, Massachusetts (Filed as Exhibit 10.21 to the Company's Annual Report on Form 10-K for fiscal year ended September 30, 2008 and
incorporated by reference herein)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).


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Exhibit No.

Exhibit10.24

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).10.25*

Executive Retention Agreement, dated January 11, 2008, between the Company and Gregory A. Shortell (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated January 17, 2008 and
incorporated by reference herein).10.26*

Executive Retention Agreement, dated January 11, 2008, between the Company and Douglas G. Bryant (filed as Exhibit 99.2 to the Company's Current Report on Form 8-K dated January 17, 2008 and
incorporated by reference herein).10.27*

Executive Retention Agreement, dated January 11, 2008, between the Company and Hugh W. Kelly (filed as Exhibit 99.3 to the Company's Current Report on Form 8-K dated January 17, 2008 and incorporated
by reference herein).10.28*

Executive Retention Agreement, dated January 11, 2008, between the Company and Kevin J. Murphy Jr. (filed as Exhibit 99.4 to the Company's Current Report on Form 8-K dated January 17, 2008 and
incorporated by reference herein).10.29*

Executive Retention Agreement, dated January 11, 2008, between the Company and Richard P. Graber (filed as Exhibit 99.5 to the Company's Current Report on Form 8-K dated January 17, 2008 and
incorporated by reference herein).10.30

First Loan Modification Agreement, dated as of August 5, 2008, by and among Network Engines, Inc., Alliance Systems, Inc. and Silicon Valley Bank (Filed as Exhibit 10.1 to the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 2008 and incorporated by reference herein).10.31

Sixth Amendment dated August 6, 2008 to Lease for 25 Dan Road, Canton, Massachusetts (Filed as Exhibit 10.31 to the Company's Annual Report on Form 10-K for fiscal year ended September 30, 2008 and
incorporated by reference herein)10.32*

Amended and Restated Executive Retention Agreement, dated September 17, 2008, between the Company and Richard P. Graber (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated
September 23, 2008 and incorporated by reference herein).10.33*

Executive Retention Agreement, dated October 12, 2008, between the Company and Charles N. Cone III (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated October 17, 2008 and
incorporated by reference herein).10.34*

The Company's 2009 Incentive Plan (filed as Exhibit 10.34 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2009 and incorporated by reference herein).10.35*

Form of Incentive Stock Option Agreement under the 2009 Incentive Plan (filed as Exhibit 10.35 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2009 and incorporated by
reference herein).10.36*

Form of Non-statutory Stock Option Agreement under the 2009 Incentive Plan (filed as Exhibit 10.36 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2009 and incorporated by
reference herein).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).


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Exhibit No.

Exhibit21.1

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.


*Indicates
management contract or compensatory plan or arrangement.


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