**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

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**(MarkOne)**

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

**For the fiscal year ended September 30,2006**

**OR**

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

**For the transition period from             to             **

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**Commissionfile number: 0-30863**

**NETWORK ENGINES, INC.**

(Exact name of registrantas specified in its charter)

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

 

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

Securities registeredpursuant to Section 12 (b) of the Act:  **Common Stock, $0.01 parvalue**

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

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

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

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

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

Indicate by checkmarkwhether the registrant is a large accelerated filer, and accelerated filer or anon-accelerated filer (as defined in Exchange Act Rule 12b-2).Large accelerated filer o accelerated filer x non-accelerated filer o

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

The aggregate market valueof the voting Common Stock held by non-affiliates of the registrant on March 31,2006 was approximately $97,596,000.

The number of shares outstanding of the registrant’sCommon Stock as of December 11, 2006: 40,503,441 shares.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portions of our proxystatement relating to the 2007 Annual Meeting of Shareholders, to be filed withthe Securities and Exchange Commission no later than 120 days after the end ofour fiscal year, are incorporated by reference into Part III of this Form 10-K.

 

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**NETWORKENGINES, INC.**ANNUAL REPORT ON FORM 10-KFor the Fiscal Year EndedSeptember 30, 2006

**TABLEOF CONTENTS**

| **PART I**   |   |                                                                                         |   |
|-------------------|--------|----------------------------------------------------------------------------------------------|--------|
| ITEM 1.           |   | BUSINESS                                                                                     |   | 1 |   |
| ITEM  1A.         |   | RISK  FACTORS                                                                                |   | 11 |   |
| ITEM 1B.          |   | UNRESOLVED STAFF COMMENTS                                                                    |   | 24 |   |
| ITEM 2.           |   | PROPERTIES                                                                                   |   | 24 |   |
| ITEM  3.          |   | LEGAL  PROCEEDINGS                                                                           |   | 24 |   |
| ITEM 4.           |   | SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS                                        |   | 25 |   |
| **PART II**  |   |                                                                                         |   |
| ITEM 5.           |   | MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED  STOCKHOLDER MATTERS                  |   | 27 |   |
| ITEM 6.           |   | SELECTED FINANCIAL DATA                                                                      |   | 28 |   |
| ITEM 7.           |   | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL   CONDITION AND RESULTS OF OPERATIONS |   | 29 |   |
| ITEM 7A.          |   | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT   MARKET RISK                                 |   | 45 |   |
| ITEM 8.           |   | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                  |   | 46 |   |
| ITEM 9.           |   | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURE        |   | 79 |   |
| ITEM 9A.          |   | CONTROLS AND PROCEDURES                                                                      |   | 79 |   |
| ITEM 9B.          |   | OTHER INFORMATION                                                                            |   | 80 |   |
| **PART III** |   |                                                                                         |   |
| ITEM 10.          |   | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                           |   | 81 |   |
| ITEM 11.          |   | EXECUTIVE COMPENSATION                                                                       |   | 81 |   |
| ITEM 12.          |   | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND  MANAGEMENT                              |   | 81 |   |
| ITEM 13.          |   | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                               |   | 81 |   |
| ITEM 14.          |   | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                       |   | 81 |   |
| **PART IV**  |   |                                                                                         |   |
| ITEM 15.          |   | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                   |   | 82 |   |
| **SIGNATURES**    |   | 83                                                                                           |   |

 

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*This Form 10-Kcontains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, that involve risks anduncertainties. All statements other than statements of historical informationprovided herein are forward-looking statements and may contain projectionsrelating to financial results, economic conditions, trends and knownuncertainties. Our actual results could differ materially from those discussedin the forward-looking statements as a result of a number of factors, includingthe factors discussed in Item 1A. Risk Factors and elsewhere in this report andthe risks discussed in our other filings with the Securities and ExchangeCommission. Readers are cautioned not to place undue reliance on these forward-lookingstatements, which reflect management’s analysis, judgment, belief orexpectation only as of the date hereof. We undertake no obligation to publiclyreissue these forward-looking statements to reflect events or circumstancesthat arise after the date hereof.*

**PART I**

**ITEM 1. BUSINESS**

**Overview**

Network Engines develops and manufactures serverappliance solutions that deliver software applications on server appliances. Todate, a large portion of our revenues is derived from the sale of server appliancesto customers in the data storage and network security markets. Serverappliances are pre-configured network infrastructure devices designed tooptimally deliver specific software application functionality whilefacilitating ease of deployment, improved manageability and increased securityof that software application in a customer’s network. A server appliancedeployment is intended to reduce the total cost of ownership associated withthe deployment and ongoing maintenance of software applications within acustomer’s information technology (“IT”) infrastructure. Through fiscal 2006 weoperated our business in two segments, our OEM Appliance segment and ourDistribution segment.

In our OEM Appliance segment, we develop andmanufacture server appliance solutions that enable network equipment providersand independent software vendors, or ISVs, to deliver their softwareapplications in the form of a server appliance. We offer our customers acomprehensive suite of services, including development, manufacturing,fulfillment and post-sale support. We produce and fulfill devices for ournetwork equipment and ISV customers, and we derive our revenues primarily fromthe sale of value-added hardware platforms to these customers. These customerssubsequently sell and support the appliance under their own brands to theircustomer base. Our OEM Appliance customers include, but are not limited to:Borderware, Inc., Juniper Networks, Inc., EMC Corporation, NortelNetworks Inc., and SurfControl, Plc.

During fiscal 2006 our Distribution segment developed,manufactured, sold, marketed and supported our NS Series SecurityAppliances that were based on Microsoft’s Internet Security and Acceleration (“ISA”)Server software. Previously, we entered into a relationship with MicrosoftCorporation (“Microsoft”) to license their ISA Server software. Microsoft’s ISAServer is an application firewall software product that also offers advancedvirtual private network (“VPN”) and web caching functionality. Microsoft’s ISAServer provides critical application inspection and firewalling along with webaccess control functionality required to secure business applications,specifically Microsoft applications such as Exchange Server, IIS Web Server and Sharepoint PortalServer. We integrated this software with server appliance platforms andour proprietary software to sell our NS Series Security Appliances,primarily to Microsoft-certified or network security experienced value addedresellers and systems integrators. To date, sales of our NS Series SecurityAppliances have not been significant.

During the second half of fiscal 2006, we begantransitioning our NS Series security appliance strategy from one in whichwe were trying to create end-user demand to one in which we began focusing moreon working with customers, including systems integrators (“SIs”) and ISVs, whoalready have strong brand, sales, and marketing presence. We believe this willallow us to focus our sales and marketing effort on the 

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server appliance as thepreferred delivery platform of business applications, whether in a standaloneor a software-as-a-service utility environment.

As an example of this revised strategy, during thesecond half of fiscal 2006 we were able to leverage our relationship withMicrosoft to establish a new relationship with a global systems integrator (“GSI”),to develop a managed branch solution for its current existing installedcustomer base. This managed branch solution utilizes a Microsoft ISA Serverbased appliance to provide a managed branch solution delivering integratedinformation technology (“IT”) services needed in a branch as a utility.

To this end, as part of our product developmentefforts, we are working on leveraging and extending our investment in ourproprietary appliance remote maintenance software called Network Engines WebServer, or NEWSTM, to enhance our existing hardware, software and servicecapabilities for current and prospective customers. Previously, our NEWSTMtechnology was only available on our NS Series Security Appliances as aweb-based appliance management sub-system that enabled deployment andmaintenance tasks such as provisioning and remote system updates. By offeringthis technology across a wider range of server appliance solutions, we believethis will enable our customers to remotely monitor and maintain serverappliances in widely dispersed networks from a central site.

Although we havehistorically operated as two distinct segments, we made substantial progressduring the year by leveraging the synergies across our business, includingoperations, product and our go-to-market strategy, to become a unifiedorganization. Specifically we have completed or have substantially completedthe following achievements:

·       Wehave combined our sales teams with each salesperson becoming more capable ofselling all of our product offerings.

·       Ourproduct development teams are concentrated on creating advances that can beutilized across the full spectrum of our products.

·       Weare utilizing common platforms for our appliance products.

·       OurNS Series products are now being used as ISA Server based platforms forsystems integrators and ISVs that will allow them to get to market quickly.

As a result of these changes, and by virtue of our ability to offer a wide range of engineering, manufacturing,supply-chain and support services, we believe we are well positioned tobe *THE* Appliance Company of choice forsystems integrators, independent software providers, and network equipmentproviders looking to deploy their applications and service offerings in theform of an appliance.

Headquartered in Canton,Massachusetts, we were incorporated in 1989, and began developing custom serverhardware platforms in 1997 for internet-based organizations, contentinfrastructure providers and larger enterprises. In 1999, we achieved animportant milestone by introducing a one-rack unit Intel-based server,representing a server only 1.75 inches in height. At that time, we designedmost of the hardware components that went into our servers and, as a result, weinvested significant resources in the development of our products. In largepart as a result of the success of that product, we completed an initial publicoffering in July 2000. Subsequently, a significant number of companiesentered the one rack unit server marketplace, much of the hardware componentsof server appliances became commoditized and, at the same time, the demand ofinternet-based organizations declined precipitously. As a result, werestructured our operations in fiscal 2001, which among other thingsde-emphasized the use of proprietary components in server hardware platforms. InDecember 2002, we acquired TidalWire, Inc., which was a specialtydistributor of third-party data storage networking products. The acquisitionenabled us to distribute third-party data storagenetworking connectivity products for the leading Fibre Channel host busadapter, or HBA, and storage switch manufacturers in the data storage industryto a customer base of value-added resellers, or VARs, and systems integrators. Duringthe first quarter of fiscal 2005, we decided 

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todiscontinue selling third-party data storage networking products after a reviewof that portion of the business and its future prospects. The TidalWireacquisition also provided us with the ability to partner with ISVs to develop,manufacture, and distribute the ISV’s software applications in the form ofserver appliances. Throughout fiscal years 2003 and 2004, we establishedrelationships with several ISV customers, including Microsoft. Today, we areleveraging our engineering and manufacturing infrastructure to deliver serverappliance solutions to our OEM customers and continuing to leverage ourrelationship with Microsoft to offer our ISA Server based server appliancesolutions, and establish new relationships with other ISVs, network equipmentproviders and systems integrators.

**Industry Background**

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

Over time, much of the networking solutions market hasevolved toward the development and manufacture of systems, built usingcommercially available standardized components and standardized operatingsystem platforms. The speed and processing power of standard processors hasreached a level where these processors can adequately meet the demands of many networkingapplications. Operating system platforms, such as Windows and Linux, have alsoincreased in capability and sophistication and can now be used as the ‘embedded’operating system environment for many of today’s networking applications.

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

While there are many applications for which a serverappliance may ultimately be used, early adoption of the technology is mostprevalent in the data storage and network security markets. These markets aresignificant in size and have exhibited robust growth in recent years. Thesecurity applications that we believe are most likely to benefit from a serverappliance solution include firewalls, authentication, anti-virus,anti-spam, instant messaging or IM security, web content filtering, intrusiondetection and prevention, device relationship management, digital rightsmanagement and web services security management. The storage applications thatwe believe are most likely to benefit from deployment in the form of a serverappliance include storage security, backup and recovery, virtual tapelibraries, storage resource management and data migration and archival systems.

Another significant trend driving the growth of thedata storage and network security markets is the decentralization of storagemanagement applications and network security applications. Enterprises are 

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deploying applicationsboth in data centers and at departmental and remote office locations. As aresult, there is an increased need for applications that can be deployedquickly and efficiently without the need for extensive internal IT resources. Furthermore,remote deployment, monitoring and upgrades have become a critical aspect ofmanaging the IT network of an enterprise.

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

**Network Engines’Solution**

*OEM Appliance Segment*

We develop and manufacture server appliance solutionsthat enable our customers to deliver their software applications on serverappliances. We achieve this by delivering innovative platforms and services toour customers to enable secure, predictable, and managed solutions. We focus ondeveloping cost-effective server appliance solutions to meet the performancerequirements of our customers’ software applications or service offering inorder to address the deployment and cost of ownership needs of their customers.Key elements of our solution include:

*Appliancedevelopment expertise.*   The core of our businessis developing and manufacturing high quality server appliance solutions inconjunction with our network equipment and ISV customers. We have developed astructured appliance development process, which takes into account all majoraspects of a product’s design, from performance requirements to branding,packaging and quality assurance. We strive to engage with our customers atmultiple levels of their organization, including engineering and productmanagement, to optimize the product or suite of products by focusing on theintegration of the hardware, operating system, utilities and applicationsoftware. We make use of in-house server platform designs and third-partyserver platforms, depending on the configuration, application and volumerequirements.

*Flexible,high-quality manufacturing services.*   We have asophisticated manufacturing facility at our headquarters in Canton,Massachusetts, which is ISO 9001:2000 certified. Our advanced control processesand systems, and comprehensive manufacturing test suites that we develop withour customers, are designed to ensure quality and trace-ability at every keystep of the manufacturing process. We believe our core strengths include ourability to react quickly to accommodate changes in customer demands, includingincreasing order volumes, engineering changes to existing products and newproduct introductions. For certain high-volume products, we supplement ourproduction capacity and make provision to maintain continuity of supply througha relationship with a contract manufacturer.

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

*Appliance life cyclemanagement.*   We operate in a technologyenvironment in which platforms, operating systems, components and softwareapplications are constantly evolving. We pro-actively analyze thesedevelopments in order to maintain the operation of the software applicationsdespite changes in the underlying technologies. We also adapt the serverappliance solutions to meet emerging requirements and capabilities of newversions of our customers’ software or changes in their service offerings. Webelieve our 

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expertise in lifecycle management, and our ability to provide turnkey solutions for ourcustomers has become a critical factor in retaining existing and attracting newcustomers.

*Distribution Segment*

During fiscal 2006, wedeveloped, manufactured, sold, marketed and supported our NS Series SecurityAppliances that were based on Microsoft’s ISA Server software. We integratedthis software with server appliance platforms and our proprietary software tosell our NS Series Security Appliances, primarily to Microsoft-certifiedor network security value added resellers and systems integrators. Revenuesgenerated during fiscal 2006, from sales of our NS Series appliances wasapproximately $1.4 million, which was significantly less than expected. Becausesales of our NS Series appliances were less than expected in fiscal 2006and 2005, in the future we do not anticipate significant sales from theseappliances, and do not intend to invest meaningful resources to create marketdemand for these appliances. We will, however, continue to offer Microsoft ISAServer-based server appliance solutions based on our NS Series appliancesto existing and prospective network equipment, ISV and systems integratorcustomers.

**Business Strategy**

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

*Strengthenexisting relationships and engage with new network equipment providers,independent software vendors (ISVs) and systems integrators to sell serverappliance solutions.*   We believe that offering customers an appliance life cycle solution encompassing acomprehensive suite of services, including development, manufacturing,fulfillment, and post-sales support, enables our customers to deploy theirsoftware applications in the form of a server appliance while achieving thelowest total cost of ownership over the long term. We believe that ourappliance life cycle management offering provides us with a competitiveadvantage in the marketplace that we intend to leverage to attract new ISVs,systems integrators and network equipment providers, as well as developadditional opportunities within our existing customer base. We intend toidentify new customers and opportunities in order to diversify our revenuesources beyond our current customer base. We are targetingnetwork equipment providers, ISVs and systems integrators whose technologyaligns with the benefits of deployment in the form of a server appliance, andwho have adequate sales and marketing resources to bring such appliances tomarket. To date these customers have been in the data storage and networksecurity markets, where initial adoption of the server appliance solution hasbeen most prevalent.

*Furtherdevelop and identify opportunities to supply server appliance solutionsleveraging Microsoft technologies.*   Historically,our efforts were focused on engaging and training Microsoft certified ornetwork security resellers and systems integrators to sell our branded NS Series SecurityAppliances, which included demand creation in the marketplace. Going forward,our focus will be on developing our existing and new relationships with globalsystems integrators and ISVs that wish to deploy appliance solutions using aMicrosoft ISA Server based platform, including managed-branch solutions. Indoing so, we believe we will be able to leverage the sales and marketingresources of these companies to deliver ISA Server based server appliances to abroader market that will include large enterprise level opportunities. Inaddition, we believe we must continue to leverage our relationship withMicrosoft, to identify opportunities with other systems integrators andindependent software providers.

*Developand integrate technologies that improve the functionality, security,manageability and deployment of server appliances.*   Weintend to continue to enhance our proprietary technology, and integrate otherthird-party technologies that enable remote management and deployment of serverappliance solutions. Our NEWSTM technology enables the remote management ofappliances through a secure web-based management system. We believe NEWSTM willbe the cornerstone of one of our key differentiators—our 

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ability to enable completeappliance lifecycle management. Going forward, we intend to expand ourappliance life cycle management offering, to include such technologies asdistributed management and monitoring. Historically NEWSTM was primarilydeployed only with our NS Series Security Appliances. However, in supportof our appliance life cycle management offering we are developing NEWSTM with thepotential of deployment across all our server appliance solutions. We havefiled multiple patents for our server appliance framework technology, uniquesecurity features including our automated update management system, and we arecontinuing to source additional technologies complimentary to existingmanagement technologies that we expect to integrate.

*Establish brand identityof Network Engines server appliances.*   NetworkEngines plans to employ a branding strategy that establishes Network Engines asthe server appliance development and manufacturing partner of choice. Thisstrategy is designed to establish company name recognition, product brandequity and identification in a broad range of markets.

**Products andServices**

We develop and manufacture turn-key server appliancesolutions that enable our network equipment, ISV and system intergatorcustomers to deliver software applications on a server appliance. We havedeveloped a comprehensive suite of products and services, enabling ourcustomers to accelerate the time to market for their products, to optimizetheir server appliance solutions and in some cases enable them to utilize ourinfrastructure for fulfillment of those server appliance solutions.

Our products and servicesare described in more detail below:

***Server appliancedevelopment***

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

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

·       Development:Engineering teams from Network Engines and application customer work togetherto define a prototype.

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

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

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

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

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

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***Custom serverdesign and integration***

Our server appliancehardware design team is well versed in custom server design, generallyutilizing standard off-the-shelf components and sub-systems. The development ofcustomized server appliance hardware requires significant design, packaging,regulatory and thermal profiling skills. Our embedded software design team alsoperforms low-level hardware driver development as well as BIOS modificationsand tuning. We also provide additional software services such as operatingsystem integration and hardening, and application development and integration.We leverage these competencies in order to deliver custom solutions to certainof our customers.

***Manufacturing andtest services***

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

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

We brand the serverappliance solution for our network equipment or ISV customer. Branding isapplied to the server appliance itself as well as to all accompanyingdocumentation, including quick set-up guides, manuals, shipping cartons,shipping labels and paperwork. We retain a full time graphic artist who isresponsible for production of branding designs and we work with outside designand production agencies that are highly experienced in equipment packaging andbranding approaches. We also have full-time mechanical engineers who buildcustomized bezels, LCD front panels, light-pipes, and other distinctivefeatures to provide a custom look and feel for our customers’ serverappliances. We deliver the final product to either our customer or, at their request,directly to the end user customers.

***NS Series Security Appliances***

Our NS Series SecurityAppliances combine the power of Microsoft’s ISA Server software applicationwith our server appliance integration expertise and our internally developedNetwork Engines Web Server (NEWSTM). Each NS Series Security Applianceis a third-generation application layer firewall, VPN and Web-cache solutionthat provides advanced protection against a wide range of new and emergingnetwork security threats, fast and secure Web access and is easy to use. Also,each network security appliance is sold with an annual support and maintenanceprogram, which includes hardware product warranties and a software updateservice. In addition, we have begun utilizing certain of our NS Series SecurityAppliances as the basis of our Microsoft ISA Server based platform offering.

***Network Engines Web Server (NEWS***TM)

Our proprietary appliance remote maintenance softwarecalled Network Engines Web Server, or NEWSTM, enhances our existing hardware,software and service capabilities for current and prospective customers. Previously,our NEWSTM technology was only available on our NS Series SecurityAppliances as a web-based appliance management sub-system that enableddeployment and maintenance tasks such as provisioning and remote system updates.By offering this technology across a wider range of server 

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appliance solutions in thefuture, we believe our customers will be able to remotely monitor and maintainserver appliances in widely dispersed networks from a central site.

NEWSTM makes use of a variety ofinstallation wizards and interfaces to manage server appliances forconfiguration and software updates. In particular, software update managementis a key consideration in security appliance management, especially in aMicrosoft environment. As part of a customer’s maintenance coverage, when andif available, software updates are provided to end users through a processavailable through NEWS TM. Thesesoftware updates are carefully reviewed and tested by our engineers beforebeing released to users through the NEWSTM management system.NEWSTM then manages the flow and installation ofthese software updates, allowing users to control their administration andautomatically schedule their implementation in a cost and time effective way.

**Customers**

Our primary customer focushas been targeted towards network equipment vendors and ISVs that wish to sellserver appliance solutions to their customers. During the past fiscal quarter,our OEM Appliance segment sold server appliances to 22 customers, including: Borderware, Inc., Juniper Networks, Inc., EMC Corporation,Nortel Networks, and SurfControl Plc. EMC was our only customer thatrepresented more than 10% of our revenues for the years ended September 30,2006 and 2005, during which our sales to EMC were $96.5 million, or 81% oftotal net revenues and $77.5 million, or 79% of total net revenues,respectively. Network Intelligence, Inc.historically has also been one of our customers, however, during September 2006,EMC Corporation acquired Network Intelligence, Inc.

**Sales and Marketing**

***Sales***

Our sales team is focused on developing relationshipswith network equipment providers seeking to integrate a server appliance intotheir offerings and with ISVs seeking to offer their application software as aserver appliance solution. Once we have identified and qualified a prospectivecustomer and a project is identified, a regional sales manager meets with thecustomer and begins to work on an appropriate strategy. We then involve otheremployees from sales, engineering, and product management to analyze theprospective customer’s requirements and begin to develop a solution.

In fiscal 2006, ourDistribution sales team was focused on engaging with resellers and distributorswho specialized in Microsoft infrastructure or network security products andservices to sell our branded NS Series Security Appliances. A significantnumber of these new relationships with Microsoft certified resellers and distributorswere cultivated through initial contacts derived from working closely withMicrosoft sales and marketing personnel.

***Marketing***

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

Our marketing program teamis responsible for building market awareness and acceptance of Network Enginesand our products and services and generating qualified customer leads. Duringthe fiscal year, this team was also responsible for defining channel marketingprograms for our NS Series product 

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line inorder to attract new channel customers as well as stimulate increased activityfrom our existing reseller base. These programs were executed in cooperationwith our field sales teams in North America and Europe.

**Warranty and postsales support services**

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

For our ISA Server basedappliances, we offer different post sales support service programs, includingcall center support, software subscription service, and twenty-four hourdomestic advanced replacement of appliances. Our software subscription serviceenables our ISA Server based appliance customers to easily apply softwareupdates for the ISA Server based appliances. Software updates may includepatches, service packs and feature enhancements, when and if available.

**Manufacturing**

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

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

**Engineering**

We believe that much ofour future success depends on our ability to customize server appliancesdeveloped utilizing commercially available standard components and platformsacquired from third-party suppliers. This customization includes both hardwareand software modifications and enhancements to the standard platforms. We haveassembled a team of highly skilled engineers, contractors and suppliers withsignificant industry experience in high-density packaging, server appliancedesign, system software, quality assurance, testing and technicaldocumentation. We have also made a considerable investment in our proprietarysoftware, NEWSÔ, which has beenused in our NS Series Security Appliances.

**Employees**

As of September 30,2006, we had 145 employees, of whom 37 were engaged in manufacturing, 9 wereengaged in customer support, 31 were engaged in sales and marketing, 43 wereengaged in research and development and 25 were engaged in general andadministrative. We also employ contract labor, predominately in ourmanufacturing operations. As of September 30, 2006, we utilized 29contract employees.

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**Backlog**

Our backlog includesorders confirmed with a purchase order for products scheduled to be shippedwithin 180 days to customers with approved credit status. Certain of ourcustomers place large orders with us to be delivered over time. In addition, wehave an inventory consignment agreement with our largest customer wherebyshipments for certain products to this customer are held at this customer’slocation until this customer requires the products for their production process.We do not recognize revenues from consignment shipments until the consignedproduct is utilized. Also, certain of our customers, including our largestcustomer, have certain rights under our agreements with them to change thedelivery timing of future shipments to them. In addition, our agreement withour largest customer includes provisions that allow this customer to cancelorders 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 forany future period.

**Competition**

Our markets are highly competitive, and we expect thiscompetition to persist and intensify in the future. The principal competitorsof our business are general-purpose server manufacturers that provide solutionsfor network equipment providers and ISVs and build servers for the OEMmarketplace. These competitors include Dell, Hewlett-Packard, IBM and SunMicrosystems. We also compete with major distributor integrators, such as ArrowElectronics, Inc. and Avnet, Inc., that offer distribution as well ascustomized integration services to their customers. In addition, we competewith smaller companies that specialize in building server products andproviding some level of integration services, such Patriot Technologies, MBXSystems, NCS Technologies, Inc., and SteelCloud, Inc. We also maycompete with certain providers of electronics manufacturing services (“EMS”) inthe event they expand their service offerings.

In fiscal year 2006, our NS Series Security Appliancescompeted with other technology companies that licensed Microsoft ISA Serversoftware, and developed their own security appliances, such as Hewlett-PackardCompany, Celestix Networks, Inc., and Pyramid Computer GmbH. In addition, we competed withtechnology companies in the firewall security industry that soldappliances using technology other than Microsoft ISA Server, including CiscoSystems, Inc., Nokia Corporation, Juniper Networks, Inc, WatchguardTechnologies, Inc. and SonicWALL, Inc.

**IntellectualProperty**

We claim trademark rights for the use of the NetworkEngines name and the Network Engines logos. We believe these rights provide uswith additional protection over the use of these names and descriptions. Weenter into confidentiality or license agreements with our employees,consultants and corporate partners, and control access to and distribution ofour software, documentation and other proprietary information. We also havenine patents that primarily pertain to our historical business and will remainin effect until 2020 or later. In addition, we have one patent and oneapplication for a patent that relate primarily to our OEM Appliance segment.

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

Despite our efforts toprotect our proprietary rights, our competitors might independently developsimilar technology and unauthorized parties may attempt to copy or otherwiseobtain and use our technology. Monitoring unauthorized use of our proprietarytechnology is difficult, and we cannot be certain that the steps we have takenwill prevent misappropriation of our technology, particularly in foreigncountries where the laws may not protect our proprietary rights as fully as inthe United States. Due to 

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rapidtechnological changes in our market, we believe the various legal protectionsavailable for our intellectual property are of limited value. In addition tosuch intellectual property, we seek to establish and maintain an extensiveknowledge of leading technologies and to incorporate these technologies intoour appliance platforms by leveraging the technological knowledge and creativeskills of our personnel.

**FinancialInformation About Geographic Areas**

See Note 15 to ourConsolidated Financial Statements, entitled “Segment and Geographic Data”, forfinancial information about geographic areas. The Notes to the Company’sConsolidated Financial Statements are contained herein in Item 8.

**Website Access toSecurities and Exchange Commission Reports**

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

**ITEM 1A.**        RISKFACTORS

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

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

**We derive a significant portion of our revenuesfrom sales of server appliances directly to EMC and our revenuesmay decline significantly if this customer cancels or delays purchases ofour products, terminates its relationship with us, or exercises certain of itscontractual rights.**

In the years ended September 30, 2006 and 2005,sales directly to EMC, our largest customer, accounted for 81% and 79% of ourtotal net revenues. Primarily all of these sales are attributable to one productpursuant to a non-exclusive contract. In addition, during September 2006EMC acquired Network Intelligence, Inc., one of our other sizeablecustomers, and as a result, the concentration of our sales with EMC willincrease in the near term . Our concentration of revenues with EMC would alsoincrease in the future in the event of further acquisitions of existingcustomers by EMC. We anticipate that our future operating results will continueto depend heavily on sales to, and our relationship with, this customer.Accordingly, the success of our business will depend, in large part, on thiscustomer’s willingness to continue to utilize our server appliance solutions inits existing and future products. Further, our financial success is dependentupon the future success of the products we sell to this customer and thecontinued growth, viability and financial stability of this customer, whoseindustry has experienced rapid technological change, short product life cycles,consolidation and pricing and margin pressures. A significant reduction insales to this customer, or significant pricing and additional margin pressuresexerted on us by this customer, would have a material adverse effect on ourresults of operations. In addition, if this customer delays or cancelspurchases of our products, our operating results would be harmed and ourability to accurately predict revenues, profitability and cash flows woulddecrease.

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Under the terms of ournon-exclusive contract, this customer has the right to enter into agreementswith third parties for similar products, is not obligated to purchase anyminimum quantity of products from us and may choose to stop purchasingfrom us at any time, with or without cause. In addition, this customermay terminate the agreement in the event that we attempt to assign ourrights under the agreement to another party without this customer’s priorapproval. Furthermore, in the event that we default on certain portions of theagreement, this customer has the right to manufacture certain products inexchange for a mutually agreeable royalty fee. If any of these events were tooccur, or if this customer were to delay or discontinue purchases of ourproducts as a result of dissatisfaction or otherwise, our revenues andoperating results would be materially adversely affected and our reputation inthe industry might suffer and our ability to accurately predict revenues,profitability and cash flows would decrease.

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

**Our future success is dependent upon our abilityto generate significant revenues from server appliance developmentrelationships.**

We believe we must diversify our revenues and a majorcomponent of our business strategy is to form server appliance developmentrelationships with new network equipment providers, ISVs, and systemsintegrators. Under this strategy, we work with our customers to develop aserver appliance, branded with their name. Our partner then performs all of theselling and marketing efforts related to sales of their branded appliance.

There are multiplerisks associated with this strategy including:

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

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

·       ourcustomers will most likely continue selling their software products as separateproducts in addition to selling it in the form of a server appliance,which will require us to effectively communicate the benefits of deliveringtheir software in the form of a server appliance;

·       ourreliance on our customers to perform all of the selling and marketingefforts associated with further sales of the server appliance product wedevelop with them;

·       continuedconsolidation within the network equipment and software industries that resultsin existing customers being acquired by other companies, and

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

Additionally, our future success will depend on ourability to establish relationships with new customers, as well as expandingsales of server appliances to our existing customers. If these customers areunsuccessful in their marketing and sales efforts, or if we are unable toexpand our sales to existing customers and develop relationships with new customers,our revenues and operating results could suffer.

**Market acceptance and demand of Microsoft’s ISAServer software will depend on Microsoft’s decision to prioritize andconcentrate its marketing efforts for this software, and on the success ofMicrosoft’s ISA Server software.**

Because certain of our server appliance solutionsutilize Microsoft’s ISA Server, our success with these solutions will depend onthe extent the marketplace perceives this software as superior to other formsof VPN, firewalling, caching, and security protection. We believe thisperception will be determined substantially as a result of marketing effortsundertaken by Microsoft directly. In order to achieve broad 

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recognition that ISAServer provides these features better than other competing products, we willrely to a significant extent on Microsoft’s financial and technical resourcesto educate the marketplace. If Microsoft does not prioritize these marketingand promotional campaigns, or delays the timing of such programs, then wemay not achieve significant sales of our Microsoft ISA Server based serverappliance solutions, including our managed branch appliances, whichmay adversely affect our business.

Even if Microsoft’s ISA Server software is widelyaccepted, customers may choose to purchase ISA Server in the form ofsoftware instead of a server appliance. Although many network securityapplications are sold in the form of an appliance to allow for betterdeployment, management and security, Microsoft could continue to sell and/orcustomers may elect to purchase ISA Server in the form of softwareonly or may choose to purchase appliances from other vendors. In thisevent, sales of our Microsoft ISA Server based server appliance solutions willbe adversely affected.

**If we are unable to effectively leverage ourrelationship with Microsoft to establish new relationships with independentsoftware vendors and other systems integrators our revenues and operatingresults may be adversely affected.**

In order for our offering of Microsoft ISA basedserver appliance solutions to be successful we believe we must establishrelationships with independent software vendors whose applications would alsobenefit from the advantages of ISA Server in the form of an appliance, andsystems integrators that currently have significant sales and marketingresources. To date, we have engaged with a limited number of ISVs and systemsintegrators, and Microsoft has been instrumental in our entering theserelationships. As such, we believe that building other relationships with ISVsand systems integrators will continue to depend, in part, on our relationshipwith Microsoft, and our ability to leverage that relationship to gain access toquality systems integrators, as well as other independent software vendors inorder sell ISA Server based appliances including our managed branch applianceto them. Therefore, we will need to further establish and strengthen ourrelationship with Microsoft in order to be considered a preferred provider ofISA Server in the form of an appliance. If we fail to strengthen ourrelationship with Microsoft and to enter into partnerships with key systemsintegrators and independent software vendors, our revenues and operatingresults may be adversely affected.

**We may not be able to effectivelycommercialize our appliances if we cannot continue to license or integratethird-party applications that are essential for the functionality of theseappliances.**

We believe our success will significantly depend onour ability to license or integrate certain applications from additionalthird-parties that would be incorporated in our server appliance solutions.Because we do not currently know with certainty which of these prospectivetechnologies will be desired in the marketplace, we may incorrectly investin development or prioritize our efforts to integrate these technologies in ourappliances. Additionally, even if we correctly focus our efforts, there can beno assurance that we will select the preferred provider of these technologies,or that the third-party provider will be committed to the relationship andintegration of their technology or that we will be able to integrate thesetechnologies in a timely manner. If we are unable to successfully integratethese third-party technologies in a timely manner, our appliances may beinferior with other competitive products in the marketplace, whichmay adversely affect the results of our operations and our ability to growour business.

We also believe our success will depend on our continuedability to license or integrate technology from Microsoft that is essential forthe functionality of certain of our appliances. A material adverse change inour relationship with Microsoft or the functionality of its software would havea significant adverse result on our operations. We depend on Microsoft todeliver reliable, high-quality software, develop new software on a timely andcost-effective basis and respond to evolving technology and changes in industrystandards. Further, if Microsoft does not continue to make ISA Server availableto OEM customers on a favorable basis, our ability to sell our appliancesmay be substantially reduced.

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**If we are unable to grow our internationalrevenues and successfully overcome the risks inherent in international businessactivities, the growth of our business may be limited.**

Our ability to growwill depend in part on the growth of our international revenues. If ourserver appliance solutions are not accepted across this region, our ability toincrease our revenues in this region would be limited. In addition, ourinternational sales are subject to the risks inherent in international businessactivities, including:

·       costof customizing products for foreign countries;

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

·       difficultiesin providing customer support;

·       reducedprotection of intellectual property rights and increased liability exposure;

·       regionaleconomic and political conditions; and

·       uniqueproduct requirements of certain foreign countries which may limit salesand/or require significant additional research and development investments.

The majority of our international sales currently areU.S. dollar-denominated. As a result, any increase in the value of the U.S.dollar relative to foreign currencies makes our products less competitive ininternational markets. Because of this our revenues may be adverselyaffected, or we may be required to denominate more of our sales in foreigncurrencies at some point in the future to remain competitive. In addition,because certain of our operating expenses related to our international salesare denominated in foreign currency, we may have difficulty controllingexpenses in the event of significant currency fluctuations.

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

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

·       wemay experience difficulties integrating new technologies into our currentor future products;

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

·       wemay incorporate technologies that do not result in the desiredimprovements to our current and/or future server appliance products;

·       wemay incorporate new technologies that either may not be desired byour customers or may not be compatible with our customer’s existingtechnology;

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

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

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

***Risks related to the server appliance, data storageand network security markets.***

**If server appliances are not increasingly adoptedas a solution to meet a significant portion of companies’ network security anddata storage application needs, the market for server appliances may notgrow, which could negatively impact our revenues.**

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

Our expectations for the growth of the serverappliance market may not be fulfilled if customers continue to usegeneral-purpose servers. The role of our products could, for example, belimited if general-purpose servers out-perform server appliances, providemore capabilities and/or flexibility than server appliances or are offered at alower cost. This could force us to lower the prices of our server applianceproducts or could result in fewer sales of these products, which wouldnegatively impact our revenues and decrease our gross profits.

**Theproducts that we sell are subject to rapid technological change and our saleswill suffer if these products are rendered obsolete by new technologies.**

The markets we serve are characterized by rapidtechnological change, frequent new product introductions and enhancements,potentially short product life cycles, changes in customer demands and evolvingindustry standards. In the server appliance market, we attempt to mitigatethese risks by utilizing standards-based hardware platforms and by maintainingan adequate knowledge base of available technologies. However, the serverappliance products that we sell could be rendered obsolete if products based onnew technologies are introduced or new industry standards emerge and we are notable to incorporate these technological changes into our products. In addition,we depend on third parties for the base platforms of our server appliances andwe are at risk if these third parties do not integrate new technologies.Releasing new products and services prematurely may result in qualityproblems, and delays may result in loss of customer confidence and marketshare. We may be unable to develop new products and services or achieveand maintain market acceptance of them once they have come to market.Furthermore, when we do introduce new or enhanced products and services, wemay be unable to manage the transition from the older products andservices to minimize disruption in customer ordering patterns, avoid excessiveinventories of older products and deliver enough new products and services tomeet customer demand.

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

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

**We have a history of losses and may continueto experience losses in the future, which could cause the market price of ourcommon stock to decline.**

Since our inception, we have incurred significant netlosses and could continue to incur net losses in the future. AtSeptember 30, 2006 and 2005 our accumulated deficit was $132 million and$126 million, respectively. We believe that any future growth will require usto incur significant engineering, selling and marketing and administrativeexpenses. As a result, we will need to generate significant revenues to achieveand sustain profitability. If we do not achieve and sustain profitability, themarket price for our common stock may decline.

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

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

·       revenuerecognition,

·       inventorywrite-downs;

·       stock-basedcompensation; and

·       warrantyreserves.

We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, as provided in our discussion and analysis of financialcondition and results of operations, the results of which form the basisfor making judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. Actual results may differfrom these and other estimates if our assumptions change or if actualcircumstances differ from those in our assumptions, which could cause our operatingresults to fall below the expectations of securities analysts and investors,resulting in a decline in our stock price.

**Our quarterly revenues and operating resultsmay fluctuate seasonally, which could result in decreased revenue from quarter toquarter, which in turn could cause the market price of our common stock todecline.**

Seasonal fluctuations in revenues and operatingresults in the data storage industry are common. In particular, this industrytypically experiences increased orders and resulting revenues in the quarterended December 31, and a subsequent decline in orders and resultingrevenues during the quarter ended March 31. With a substantial amount ofour revenues currently derived from data storage products, wemay experience significant quarter-to-quarter fluctuations in revenues andoperating results due to customers timing their orders based on their ownquarterly financial and/or operational considerations, which we have noinfluence over. In addition, to the extent that revenues from internationalsales become significant, we may experience seasonal fluctuations duringthe quarter ended September 30, as a result of European holiday patterns.

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

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

In addition toseasonality issues, our quarterly revenues and operating results are difficultto predict and may fluctuate significantly from quarter to quarter. Noneof our customers are obligated to purchase any quantity of our products in thefuture nor are they obligated to meet forecasts of their product needs. Ouroperating expense levels are based in part on expectations of futurerevenues and gross profits, which are partially dependent on our customers’ability to accurately forecast and communicate their future product needs. Ifrevenues or gross profits in a particular quarter do not meet expectations,operating results could suffer and the market price of our common stock coulddecline. Factors affecting quarterly operating results include:

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

·       theproduct mix of our sales;

·       thetiming of new product introductions by our OEM customers;

·       theavailability and/or price of products from suppliers;

·       theloss of key suppliers or customers;

·       pricecompetition;

·       costsassociated with our introduction of new server appliances and the marketacceptance of those products;

·       the mix of productmanufactured internally and by our contract manufacturer;

**If the products and services that we sell become morecommoditized and competition in the server appliance, data storageand network security markets continues to increase, then our gross profit as apercentage of net revenues may decrease and our operating resultsmay suffer.**

Products and services inthe server appliance, data storage and network security markets may besubject to further commoditization as these industries continue to mature andother businesses introduce additional competing products and services. Thegross profit as a percentage of revenues of our products may decrease, inresponse to changes in our product mix, competitive pricing pressures, or newproduct introductions into the server appliance, data storage and networksecurity markets. If we are unable to offset decreases in our gross profits asa percentage of revenues by increasing our sales volumes, or by decreasing ourproduct costs, operating results will decline. Changes in the mix of sales ofour products, including the mix of higher margin sales of products sold insmaller quantities and lower margin sales of products sold in largerquantities, could adversely affect our operating results for future quarters.To maintain our gross profits, we also must continue to reduce themanufacturing cost of our server appliance products. Our efforts to producehigher margin server appliance products, continue to improve our serverappliance products and produce new server appliance products may make itdifficult to reduce our manufacturing cost per product. Further, utilization ofa contract manufacturer to produce a portion of our customer requirements forcertain of our server appliance products may not allow us to reduce ourcost per product. If we fail to respond adequately to pricing pressures, tocompetitive products with improved performance or to developments with respectto the other factors on which we compete, we could lose customers or orders. Ifwe are unable to compete effectively, our business will suffer.

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***Risks related to competition.***

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

In the server appliance market, we face significantcompetition from a number of different types of companies. Our competitorsinclude companies who market general-purpose servers, server virtualizationsoftware, specific-purpose servers and server appliances as well as companiesthat sell custom integration services utilizing hardware produced by othercompanies. Many of these companies are larger than we are and have greaterfinancial resources and name recognition than we do, as well as significantdistribution capabilities and larger, more established service organizations tosupport their products. Our larger competitors may be able to leveragetheir existing resources, including their extensive distribution capabilitiesand service organizations, to provide a wider offering of products and servicesand higher levels of support on a more cost-effective basis than we can. Weexpect competition in the server appliance market to increase significantly asmore companies enter the market and as our existing competitors continue toimprove the performance of their current products and to introduce new productsand technologies. Such increased competition could adversely affect sales ofour current and future products. In addition, competing companies may beable to undertake more extensive promotional activities, adopt more aggressivepricing policies and offer more attractive terms to their customers than wecan. If our competitors provide lower cost products with greater functionalityor support than our server appliance solutions, or if some of their productsare comparable to ours and are offered as part of a range of products thatis broader than ours, our server appliance solutions could become undesirable.

Even if the functionalityof competing products is equivalent to ours, we face a risk that a significantnumber of customers would elect to pay a premium for similar functionality froman established vendor rather than purchase products from a less-establishedvendor. We attempt to differentiate ourselves from our competition by offeringa wide variety of software integration, branding, supply-chain management,engineering, support, logistics and fulfillment services. If we are unable toeffectively differentiate ourselves from our competition, we may be forcedto offer price reductions to maintain certain customers. As a result, ourrevenues may not increase and may decline, and our gross marginsmay decline. Furthermore, increased competition could lead to higherselling expenses which would negatively affect our business and futureoperating results.

***Risks related to marketing and sales efforts andcustomer service.***

**We need to effectivelymanage our sales and marketing operations to increase market awareness andsales of our products and to promote our brand recognition. If we fail to doso, our growth will be limited.**

Although we currently havea relatively small sales and marketing organization, we must continue toincrease market awareness and sales of our products and promote our brand in themarketplace. We believe that to compete successfully we will need networkequipment providers, ISVs and systems integrators to recognize Network Enginesas a top-tier provider of server appliance platforms and custom integrationservices. If we are unable to increase market awareness and promote ourselvesas a leading provider of server appliance solutions with our availableresources, we may be unable to develop new customer relationships or expand ourproduct and service offerings at existing customers.

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

We need to effectively manage our customer supportoperations to ensure that we maintain good relationships with our customers.Because our Microsoft ISA Server based appliances provide critical services forcertain applications, managing software updates to the appliance, when and ifthey are available, will be essential to the performance of the appliance. Inaddition, as we integrate more third 

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party softwareapplications our appliances will become increasingly complex to maintain andsupport. As a result, managing any updates released by Microsoft, or the thirdparty software vendor will require careful consideration to determine thesensitivity and impact on the function of our appliance. Additionally, anyupdates designated as vital to the function of our appliance will require rapiddeployment to ensure the customers’ applications are properly maintained. Weexpect that providing this increased customer service for our appliances willrequire more technically qualified staff either within the Company or fromthird parties, which could be more costly and if we are unable to provide thishigher level of service we may be unable to successfully sell ourappliances.

Our customers in some cases will provide support forthe end-user customers. We may be unable to provide these customers withthe necessary training and back-up support. Therefore they may be unableto provide end-user customers with the necessary level of support, whichmay be detrimental to our reputation and ability to sell our products.

If our customer supportorganization is unsuccessful in maintaining good customer relationships, wemay lose customers to our competitors and our reputation in the marketcould be damaged. As a result, we may lose revenues and our business couldsuffer. Furthermore, the costs of 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 sourcesuppliers for key server appliance components makes us susceptible to supplyshortages and potential quality issues that could prevent us from shippingcustomer orders on time, if at all, and could result in lost sales andcustomers.**

We depend upon singlesource and limited source suppliers for our industry-standard processors, mainlogic boards, certain disk drives, hardware platforms and power supplies aswell as certain of our cooling systems, chassis and sheet metal parts.Additionally, we depend on limited sources to supply certain otherindustry-standard and customized components. We have in the past experienced,and may in the future experience, shortages of or difficulties inacquiring components in the quantities and of the quality needed to produce ourserver appliance products. Shortages in supply or quality issues related tothese key components for an extended time would cause delays in the productionof our server appliance products, prevent us from satisfying our contractualobligations and meeting customer expectations, and result in lost sales andcustomers. If we are unable to buy components in the quantities and of thequality that we need on a timely basis or at acceptable prices, we will not beable to manufacture and deliver our server appliance products on a timely orcost-effective basis to our customers, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed.

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

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

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replacement costs orpotential damage to our reputation, any of which could have a material adverseeffect on our business, results of operations or financial condition.

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

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

·       diversionof engineering resources;

·       increasedmanufacturing costs;

·       theloss of new or existing server appliance customers;

·       injuryto our reputation and other customer relations problems; and

·       increasedmaintenance and warranty costs.

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

Moreover, because ourserver appliance solutions may be used in connection with criticalcomputing systems services, including providing security to protect valuableinformation, we may receive significant liability claims if they do notwork properly. While our agreements with customers typically contain provisionsintended to limit our exposure to liability claims, these limitations do notpreclude all potential claims. Liability claims could exceed our insurancecoverage and require us to spend significant time and money in litigation or topay significant damages. Any claims for damages, even if unsuccessful, couldseriously damage our reputation and business.

**Our future serverappliance revenue growth may be limited by our ability to expandproduction capacity.**

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

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

In the past, we expandedour internal production capacity through expansion and reorganization of ourcurrent production facilities. Although we believe that our current facility,along with our use of a contract manufacturer to supplement production, issufficient to support our business for the foreseeable 

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future,we may need additional production capacity. We believe that we couldexpand production levels in our existing facility by increasing the number ofmanufacturing shifts, but we are currently utilizing all availablemanufacturing space in our existing facility and have limited opportunity toexpand further. We would have difficulties expanding this facility beyond thislimited ability, and therefore, significant further expansion of the productioncapacity would require additional facilities. Expansion of our existingfacilities or additional facilities could require substantial investments,which could detract from our ability to invest in other areas of our businessand may not result in the desired return on investment, which couldnegatively affect our operating results.

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

We use rolling forecastsbased on anticipated product orders to determine our server appliance componentrequirements. Lead times for materials and components that we order varysignificantly, depending among other things, on specific supplier requirements,contract terms and current market demand for those components. In addition, avariety of factors, including the timing of product releases, potential delaysor cancellations of orders, the timing of large orders, and the unprovenacceptance of new products in the market make it difficult to predict productorders. As a result, our materials requirement forecasts may not beaccurate. If we overestimate our materials requirements, we may haveexcess inventory, which would increase costs and negatively impact our cashposition. Our agreements with certain customers provide us with protectionsrelated to inventory purchased in accordance with the terms of theseagreements; however, these protections may not be sufficient to preventcertain losses as a result of excess or obsolete inventory. If we underestimateour materials requirements, we may have inadequate inventory, which couldinterrupt our manufacturing and delay delivery of our server appliance productsto customers resulting in a loss of sales or customers. Any of theseoccurrences would negatively impact our business and operating results.

***Risks related to product dependence on intellectualproperty.***

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

Certain of our server appliance solutions aredifferentiated from the products of our competitors by our internally developedsoftware and hardware and the manner in which they are integrated into ourserver appliance solutions. If we fail to protect our intellectual property,other vendors could sell products with features similar to ours, which couldreduce demand for our solutions. We have taken what we believe to be thenecessary and appropriate steps to safeguard our intellectual property.However, these steps may afford us only limited protection. Othersmay develop technologies that are similar or superior to our technology ordesign around the patents we own. Despite the precautions we have taken, lawsand contractual restrictions may not be sufficient to preventmisappropriation of our technology or deter others from developing similartechnologies. In addition, there can be no guarantee that any of our patentapplications will result in patents, or that any such patents would provideeffective protection of our technology.

In addition, the laws ofthe countries in which we may decide to market our services and solutionsmay offer little or no effective protection of our proprietary technology.Reverse engineering, unauthorized copying or other misappropriation of ourproprietary technology could enable third parties to benefit from our technologywithout paying us for it, which could harm our business. In addition, our U.S.patents have no effect in foreign jurisdictions and obtaining patent protectionin foreign countries is expensive and time consuming.

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**Our operating results would suffer if we, our ISV ornetwork equipment customers, or other third-party software providers fromwhom we license technology, were subject to an infringement claim that resultedin protracted litigation, the award of significant damages against us or thepayment of substantial ongoing royalties.**

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

·       betime-consuming for us to address;

·       requireus to enter into royalty or licensing agreements;

·       resultin costly litigation, including potential liability for damages;

·       divertour management’s attention and resources; and

·       causeproduct shipment delays.

In addition, other partiesmay make claims against our ISV or network equipment customers, orthird-party software providers related to products that are incorporated intoour server appliance products. Our business could be adversely affected if suchclaims resulted in the inability of our customers to continue producing the infringingproduct, or if we are unable to cost effectively continue licensing thethird-party software.

***Other risks related to our business.***

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

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

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

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

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

In December 2001, aclass action lawsuit relating to our initial public offering was filedagainst us, our chairman, one of our executive officers and the underwriters ofour initial public offering. For more information on lawsuits, see “Part II,Item 1—Legal Proceedings.” We are currently attempting to settle the lawsuitfiled against us related to our initial public offering. We are unable topredict the effects on our financial condition or business of the lawsuitrelated to our initial public offering or other lawsuits that may arisefrom time to time. While we maintain certain insurance coverage, there can beno assurance that claims against us will not result in substantial monetarydamages in excess of such insurance coverage. This class action lawsuit,or any future lawsuits, could cause our director and officer insurance premiumsto increase and could affect our ability to obtain director and officerinsurance coverage, which would negatively affect our business. In addition, wehave expended, and may in the future expend, significant resources todefend such claims. This class action lawsuit, or other similar lawsuitsthat may arise from time to time, could negatively impact both ourfinancial condition and the market price of our common stock and could resultin management devoting a substantial portion of their time to these lawsuits,which could adversely affect the operation of our business.

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

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

**The market price for our common stock may beparticularly volatile, and our stockholders may be unable to resell their shares ata profit.**

The market price of our common stock has been subjectto significant fluctuations and may continue to fluctuate or decline.During fiscal 2005, the closing price of our common stock ranged from a low of$1.37 to a high of $3.16 and in the year ended September 30, 2006, from alow of $1.12 to a high of $3.17. The market for technology stocks has beenextremely volatile and frequently reaches levels that bear no relationship tothe past or present operating performance of those companies. General economicconditions, such as recession or interest rate or currency rate fluctuations inthe United States or abroad, could negatively affect the market price of ourcommon stock. In addition, our operating results may be below the expectationsof securities analysts and investors. If this were to occur, the market priceof our common stock may decrease significantly. In the past, followingperiods of volatility in the market price of a company’s securities, securitiesclass action litigation has often been instituted against such companies.Such litigation could result in substantial cost and a diversion of management’sattention and resources.

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

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

Our Board of Directors has the authority to issue upto 5,000,000 shares of preferred stock and, without any further vote or actionon the part of the stockholders, will have the authority to determine theprice, rights, preferences, privileges and restrictions of the preferred stock.This preferred stock, if issued, might have preference over the rights of theholders of common stock and could adversely affect the market price of ourcommon stock. The issuance of this preferred stock may make it moredifficult for a 

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third party to acquire usor to acquire a majority of our outstanding voting stock. We currently have noplans to issue preferred stock.

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

**ITEM 1B. UNRESOLVEDSTAFF COMMENTS**

None.

**ITEM 2. PROPERTIES**

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

**ITEM 3. LEGALPROCEEDINGS**

*Announcement TimingLawsuit*

On March 17, 2004, the United States DistrictCourt for the District of Massachusetts (the “Court”) consolidated a number ofpurported class action lawsuits filed against us and certain individualdefendants (collectively “us,” “we,” or “our”). These suits generally concernthe timing of the announcement of an amendment to our agreement with EMCCorporation regarding the resale of EMC-approved Fibre Channel HBAs. ThePlaintiffs filed an amended consolidated complaint on June 4, 2004. On August 13,2004, we filed a motion to dismiss the amended consolidated complaint. ThePlaintiffs on October 12, 2004 filed an opposition to our motion todismiss and we filed a reply to the Plaintiff’s opposition on November 12,2004. The Court on November 22, 2004 denied our motion to dismiss theamended consolidated complaint. On December 9, 2004, we filed an answer tothe amended consolidated complaint.

Since that time theparties engaged in some informal discovery, exchanged formal discoveryrequests, and then pursued active settlement discussions. On March 31,2006, the parties filed a motion for preliminary approval of a class actionsettlement. On April 4, 2006, the Court entered an Order preliminarilyapproving the settlement and scheduled deadlines for the settlement approvalprocess. The settlement was subject to a notice and comment period, duringwhich class members could object, opt out of the settlement, or file claimsunder the settlement. No class members objected to the settlement or opted outof the class. On July 25, 2006, the Court approved the settlement. TheCourt entered an Order and Final Judgment approving the terms of the settlementin its entirety. The terms of the settlement required our insurance provider topay $2,875,000 in full settlement of the claims asserted by the class.

*Initial PublicOffering Lawsuit*

On or about December 3, 2001, a putative class actionlawsuit was filed in the United States District Court for the Southern Districtof New York against the Company, Lawrence A. Genovesi (the Company’s Chairmanand former Chief Executive Officer), Douglas G. Bryant (the Company’s ChiefFinancial Officer and Vice President of Finance and Administration), and thefollowing underwriters of our initial public offering: FleetBoston RobertsonStephens, Inc., Credit Suisse First Boston Corp., Goldman Sachs &Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. collectively, theunderwriter 

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defendants. An amendedclass action complaint, captioned In re Network Engines, Inc. InitialPublic Offering Securities Litigation, 01 Civ. 10894 (SAS), was filed on April 20,2002.

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

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

On July 9, 2003, a Special Committee of our Boardof Directors authorized Network Engines to negotiate a settlement of thepending claims substantially consistent with a memorandum of understandingnegotiated among class plaintiffs, all issuer defendants and their insurers. Wehave negotiated the settlement, which provides, among other things, for arelease of Network Engines and the individual defendants for the conductalleged in the amended complaint to be wrongful. We would agree to undertakeother responsibilities under the settlement, including agreeing to assign, ornot assert, certain potential claims that we may have against the underwriters.Any direct financial impact of the proposed settlement is expected to be borneby our insurers. The settlement is subject to various contingencies, includingapproval by the Court overseeing the litigation. On February 15, 2005, theCourt issued an Opinion and Order preliminarily approving the settlement,provided that the defendants and plaintiffs agree to a modification narrowingthe scope of the bar order set forth in the original settlement agreement. Theparties agreed to a modification narrowing the scope of the bar order, and on August 31,2005, the Court issued an order preliminarily approving the settlement andsetting a public hearing on its fairness, which took place on April 24,2006. The Court’s final approval of the settlement remains pending.

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

**ITEM 4. SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

No matters were submittedto a vote of security holders during the fourth quarter of the fiscal yearended September 30, 2006.

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**EXECUTIVE OFFICERS OF THE COMPANY**

| **Name**             | ** ** | ** ** | ** ** | **Age** | ** ** | **Position**                                                                                     | ** ** |
|----------------------|------------|------------|------------|---------|------------|--------------------------------------------------------------------------------------------------|------------|
| Gregory A.  Shortell |       |       | 62         |    |       | President,  Chief Executive Officer and Director                                                 |       |
| Douglas G. Bryant    |       |       | 49         |    |       | Vice President of Finance and Administration, Chief  Financial  Officer, Treasurer and Secretary |       |
| Kevin J. Murphy Jr.  |       |       | 36         |    |       | Chief Technology Officer                                                                         |       |
| Richard P. Graber    |       |       | 46         |    |       | Vice President of Engineering and Operations                                                     |       |
| Hugh W. Kelly        |       |       | 47         |    |       | Vice President of  Worldwide Marketing                                                           |       |

 

GregoryA. Shortell

Gregory A. Shortell joinedNetwork Engines in January 2006 as President and Chief Executive Officer. Mr. Shortellalso joined as a Director in January 2006. Prior to joining the Company, Mr. Shortellwas, from February 1998 to January 2006, Senior Vice President GlobalSales and Marketing, for Nokia Corporation, a multinational technologycorporation. Prior to Nokia, Mr. Shortell served, from June 1997 to February 1998,as Managing Director of International Operations for Ipsilon, a provider ofnetwork communications equipment, and, from March 1992 to June 1997as Vice President, International at Xyplex Corporation, a provider ofnetworking equipment.

**DouglasG. Bryant**

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

**KevinJ. Murphy Jr.**

Kevin J. Murphy Jr. joinedNetwork Engines in 2003 and became the Network Engines’ Chief TechnologyOfficer on April 1, 2006. Prior to becoming the Chief Technology Officer, Mr. Murphyserved as Chief Architect and Director of Advanced Development for NetworkEngines since May, 2003. Prior to joining Network Engines, Mr. Murphyfounded Mantis Solutions, Inc., a consulting company that helped companiesoptimize existing technologies, in December 2000.

**RichardP. Graber**

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

**Hugh W.Kelly**

Hugh W. Kelly joinedNetwork Engines in June 2006 as the Vice President of Worldwide Marketing.Prior to joining the Company, Mr. Kelly wasthe CEO and co-founder of SQMworks, a telecommunications management softwarestart-up from January 2003 to May 2006. From January 2000 to December 2002,Mr. Kelly served as Senior Vice President, Marketing and BusinessDevelopment at Celox Networks, a developer of a highly scaleable edge routertargeted at Tier 1 carriers. For the period of 1997 to 2000 Mr. Kelly wasVice President, Marketing for Visual Networks, a market leader in WAN servicelevel management solutions.

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**PART II**

**ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY ANDRELATED STOCKHOLDERMATTERS**

*(a) MarketInformation*

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

| ** **                                              | ** ** | **Fiscal 2006** | ** ** | **Fiscal 2005** | ** ** |
|---------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| **Fiscal Year Ended September 30:** | ** ** | ** **           | ** ** | **High**             | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter                                           |       | $                    | 1.52       |                 | $          | 1.12 |   | $ | 2.80 |   | $ | 1.63 |   |
| Second Quarter                                          |       | 3.17                 |       | 1.27                 |       | 3.16 |   | 1.66 |   |
| Third Quarter                                           |       | 3.11                 |       | 1.63                 |       | 2.14 |   | 1.61 |   |
| Fourth Quarter                                          |       | 2.20                 |       | 1.56                 |       | 1.94 |   | 1.37 |   |
|                                                         |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

*(b) Holders ofrecord*

**As of December 11,2006, there were approximately 222 holders of record of our common stock.Because many of such shares are held by brokers and other institutions onbehalf of stockholders, the Company is unable to estimate the total number ofstockholders represented by these record holders.**

*(c) Dividends*

**We have never paid or declared anycash dividends on our common stock. We currently intend to retain any earningsfor future growth and, therefore, do not expect to pay cash dividends in theforeseeable future.**

*(d) RecentSales of Unregistered Securities*

During the fourth quarterof fiscal 2006, we did not issue any unregistered shares of our common stock.

*(e) Use ofProceeds*

On July 18, 2000, theCompany sold 7,475,000 shares of common stock in an initial public offering ata price of $17.00 per share pursuant to a Registration Statement on Form S-1(Registration No. 333-34286), which was declared effective by theSecurities and Exchange Commission on July 12, 2000. The aggregateproceeds to us from the offering were approximately $116.9 million reflectinggross proceeds of $127.0 million net of underwriting fees of approximately $8.9million and other offering costs of approximately $1.3 million. During theperiod from the offering through September 30, 2006, we used the proceedsfrom our initial public offering as follows: approximately $64.8 million tofund our operations, approximately $9.0 million for the purchase of propertyand equipment, approximately $4.6 million to repurchase our common stock undera stock repurchase plan and approximately $13.2 million for our acquisition ofTidalWire Inc.

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**ITEM6.**                SELECTED FINANCIALDATA

The following selectedfinancial data are derived from the financial statements of Network Engines.The historical results presented are not necessarily indicative of futureresults. The consolidated statement of operations data for the years ended September 30,2006, 2005 and 2004 and the consolidated balance sheet data as of September 30,2006 and 2005 have been derived from our consolidated financial statementsincluded elsewhere in this Annual Report on Form 10-K. Theconsolidated statement of operations data for the years ended September 30,2003 and 2002 and the consolidated balance sheet data as of September 30,2004, 2003, and 2002 are derived from our audited consolidated financialstatements not included in this Annual Report on Form 10-K. Theselected consolidated financial data set forth below should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and  “FinancialStatements and Supplementary Data” and the related Notes included elsewhere inthis Annual Report on Form 10-K.

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

**Selected FinancialData(in thousands, except per share data)**

| ** **                                                  | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net revenues                                                |       | $                                           | 118,696    |   | $ | 98,071 |   | $ | 136,755 |   | $ | 81,243 |   | $ | 14,534 |   |
| Gross profit                                                |       | 19,871                                      |       | 17,061 |   | 23,908 |   | 16,737 |   | 2,058 |   |
| Operating  expenses(a)(b)                                   |       | 26,628                                      |       | 33,637 |   | 25,816 |   | 18,686 |   | 17,775 |   |
| Loss from  operations                                       |       | (6,757                                      | )          | (16,576 | ) | (1,908 | ) | (1,949 | ) | (15,717 | ) |
| Net loss                                                    |       | (5,447                                      | )          | (15,583 | ) | (1,619 | ) | (1,385 | ) | (14,125 | ) |
| Net loss per common share—basic and diluted            |       | $                                           | (0.14      | ) | $ | (0.42 | ) | $ | (0.04 | ) | $ | (0.04 | ) | $ | (0.44 | ) |
| Weighted average  shares outstanding—basic and diluted |       | 38,207                                      |       | 37,461 |   | 36,594 |   | 33,142 |   | 32,270 |   |

 

| ** **                                                               | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|-------------------|------------|
| **Balance Sheet  Data:**                                                 | ** ** | ** **        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash, cash  equivalents, short-term investments and restricted cash |       | $                 | 32,865     |   | $ | 37,409 |   | $ | 39,635 |   | $ | 36,835 |   | $ | 56,196 |   |
| Working capital                                                          |       | $                 | 47,891     |   | $ | 48,484 |   | $ | 55,108 |   | $ | 50,218 |   | $ | 58,612 |   |
| Total assets                                                             |       | $                 | 61,061     |   | $ | 59,804 |   | $ | 78,021 |   | $ | 81,732 |   | $ | 64,210 |   |
| Long-term debt,  less current portion                                    |       | $                 | 60         |   | $ | 79 |   | $ | — |   | $ | — |   | $ | — |   |
| Total stockholders’  equity                                         |       | $                 | 48,403     |   | $ | 49,861 |   | $ | 64,673 |   | $ | 64,224 |   | $ | 60,876 |   |
|                                                                          |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

(b)          Includes $2.8 million,$14,000, $390,000, $928,000 and $4.3 million related to stock compensationcharges, in fiscal year 2006, 2005, 2004, 2003 and 2002, respectively.

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

**Overview**

We develop and manufactureserver appliance solutions that deliver primarily data storage and networksecurity applications on server appliances. Server appliances arepre-configured network infrastructure devices designed to optimally deliverspecific software application functionality and facilitate ease of deploymentand support of a software application in a customer’s network. Through fiscalyear 2006, we were organized into two reportable segments: OEM Appliance andDistribution. 

**OEM Appliancesegment**

In our OEM Appliance segment, we develop andmanufacture server appliance solutions that enable network equipment providersand independent software vendors, or ISVs, to deliver their data storage andnetwork security applications in the form of a server appliance. We offer ourserver appliance customers a comprehensive suite of services, includingdevelopment, manufacturing, fulfillment and post-sale support. We produce andfulfill devices branded for our network equipment and ISV customers, and deriveour revenues from the sale of value-added hardware platforms to these customers.These customers subsequently sell and support the device under their own brandsto their customer base. During the years ended September 30, 2006 and 2005,sales to EMC represented 82% and 83%, respectively, of our OEM Appliancesegment revenues.

For the years endedSeptember 30, 2006 and 2005 our OEM Appliance segment had segment operatingincome of $15.4 million and $10.3 million, respectively. Refer to footnote 15of our Consolidated Financial Statements contained in Item 8 of this report forpurposes of determining segment operating income.

**Distributionsegment**

In our Distribution segment, we developed, manufactured,sold, marketed and supported our NS Series Security Appliances that were basedon Microsoft’s Internet Security and Acceleration (ISA) Server. We licensedand integrated this software with server appliance platforms and ourproprietary software to sell our own branded server appliances primarily toMicrosoft-certified or network security value added resellers and systemsintegrators. Sales of these servers commenced in the first quarter of fiscalyear 2005. Sales of these appliances did not meet our expectations duringfiscal 2006 and 2005. Primarily as a result of these less than expected sales,in fiscal 2005 we recorded a goodwill impairment charge in our Distributionsegment of approximately $7.8 million. In the future, we do not expectsignificant sales of our NS Series appliances, and do not intend to investmeaningful resources to create market demand for these appliances. We will,however, continue to offer Microsoft ISA Server-based server appliance solutionsbased on our NS Series appliances to existing and prospective networkequipment, ISV and systems integrator customers.

Previously in our Distribution segment we alsodistributed third-party data storage networking connectivity products for theleading Fibre Channel host bus adapter, or HBA, and storage switchmanufacturers in the data storage industry to a customer base of value-addedresellers and systems integrators. An amendment to a key distribution agreement,the commoditization of Fibre Channel HBA technology, and the increasingcompetition in this market resulted in declining gross profits related to ourdistribution of HBAs. During the quarter ended December 31, 2004, wediscontinued sales of these third-party data storage networking products as aresult of those factors and the future prospects of this portion of oursegment. During the years ended September 30, 2005 and 2004, sales of thesethird-party data storage networking products represented 90% and 99%,respectively, of our Distribution segment revenues. 

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For the years endedSeptember 30, 2006 and 2005, our Distribution segment had segment operatinglosses of $12.4 million and $19.0 million, respectively. Refer to footnote 15of our Consolidated Financial Statements contained in Item 8 of this report forpurposes of determining segment operating loss.

**Critical AccountingPolicies And Estimates**

Our discussion andanalysis of financial condition and results of operations are based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Inpreparing these financial statements, we have made estimates and judgments indetermining certain amounts included in the financial statements. We base ourestimates and judgments on historical experience and other various assumptionsthat we believe to be reasonable under the circumstances. Actual results maydiffer from these estimates under different assumptions or conditions. Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our financial statements. 

***Revenue recognition***

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

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

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

For revenue arrangements that contain multiple elements,such as the sale of both product and post-sales support, in which software isnot incidental to the product, such as our sales of server appliances throughour Distribution segment, we determine fair value based upon vendor specificobjective evidence, which is typically established through contractualpost-sales support renewal rates whereby the residual fair value is allocatedto the server appliance. For revenue arrangements that contain multipleelements, in which software is not included or is incidental to the product,such as our sales of server appliances through our OEM Appliance segment, wedetermine fair value based on objective and reliable evidence of fair value,which is typically determined through contractual refund rates for cancellations,and stand-alone sales of post sales support, whereby the residual fair value isallocated to the server appliance. 

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

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***Inventories***

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

***Product Warranty Obligations***

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

*OEMServer appliance products*—Costs included in our serverappliance product warranty obligation include shipping, internal and externallabor, and travel. Significant judgment and estimates are involved inestimating our warranty reserve on our OEM server appliance products. Althoughour current OEM server appliance products use more standards-basedtechnologies than in the past, certain of our server appliance productsincorporate proprietary technologies, which may increase our risks related toproduct warranty obligations. In the past we have experienced unexpectedcomponent failures in certain of our server appliance products, which haverequired us to increase our product warranty accruals. At the time anyunexpected component failure arises, we assess the costs to repair any defectsand record what we believe to be an appropriate warranty obligation based onthe information available. To the extent we may experience increased warrantyclaim activity, increased costs associated with servicing those claims, or useestimates that prove to be materially different from actual claims, our productwarranty obligations may need to be increased, resulting in decreased grossprofits.

*NS Series SecurityAppliance products**—*Our NS SeriesSecurity Appliances typically do not include a general warranty. Instead,customers typically are required to purchase an annual maintenance program atthe time of the appliance purchase. 

***Stock-based compensation***

We adopted the provisions of Statement of FinancialAccounting Standards 123(R),*“Share-Based Payment,”* (“SFAS 123(R)”), on October 1, 2005which requires us to measure compensation cost at the grant date, based on thefair value of the award, and to recognize that cost as an expense over theemployee’s requisite service period (generally the vesting period of the equityaward). Prior to October 1, 2005, we accounted for stock-basedcompensation to employees in accordance with Accounting Principles BoardOpinion No. 25,*“Accounting for StockIssued to Employees,”* (“APB 25”) and related interpretations.We also followed the disclosure requirements of Statement of FinancialAccounting Standards No. 123,*“Accounting for Stock-Based Compensation”* (“SFAS 123”). Weelected to adopt the modified prospective transition method as provided bySFAS 123(R) and, accordingly, financial statement amounts for the priorperiods presented in this Form 10-K have not been retroactively adjustedto reflect the fair value method of expensing stock-based compensation.

Under SFAS 123(R), wedetermine the fair value of stock options awarded based on the grant-date fairvalue of the award using an option pricing model. Such an option pricing modelrequires us to make judgments for certain assumptions used, in particular, theexpected term of the option and the expected volatility over that term. We havedetermined the expected term using the midpoint between the vesting date andthe end of the contractual term for our options, also known as the “simplifiedmethod” described 

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underStaff Accounting Bulletin No. 107, (“SAB 107”). We have determined ourexpected volatility based on a weighted average of historicalvolatility. In determining the amount of expense to be recorded, judgmentis also required to estimate forfeitures of the awards based on the probabilityof employees completing the required service period. Historical forfeitures areused as a starting point for developing our estimate of future forfeitures.

***Income tax asset valuation***

We record deferred taxassets and liabilities based on the net tax effects of tax credits, operatingloss carryforwards and temporary differences between the carrying amounts ofassets and liabilities for financial reporting purposes and the amounts usedfor income tax purposes. We then assess the likelihood that our deferred taxassets will be recovered from future taxable income and, to the extent webelieve that recovery is not likely, we establish a valuation allowance. Thevaluation allowance is based on our estimate of future taxable income and theperiod over which our deferred tax assets will be recoverable. At September 30,2006, we believe that it is more likely than not that all of our deferred taxassets will not be realized, and, accordingly, we have recorded a valuationallowance against all of our deferred tax assets. If results of operations inthe future indicate that some or all of the deferred tax assets will berecovered, the reduction of the valuation allowance will be recorded as a taxbenefit. To the extent that net operating losses, when realized, relate tostock options deductions of approximately $2.7 million, the resulting benefitswill be credited to additional paid-in capital.

**Results ofOperations**

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

| ** **                        | ** ** | **Fiscal year ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **Dollars**                                             | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** |
| Net revenues                      |       | $                                                       | 118,696    |   |   | 100% |   |   | $ | 98,071 |   |   | 100% |   |   | $ | 136,755 |   |   | 100% |   |   |
| Gross profit(a)                   |       | 19,871                                                  |       |   | 17% |   |   | 17,061 |   |   | 17% |   |   | 23,908 |   |   | 18% |   |   |
| Operating  expenses(b and c) |       | 26,628                                                  |       |   | 22% |   |   | 33,637 |   |   | 34% | ** ** |   | 25,816 |   |   | 19% |   |   |
| Loss from  operations             |       | (6,757                                                  | )          |   | (6% | ) |   | (16,576 | ) |   | (17% | ) |   | (1,908 | ) |   | (1% | ) |   |
| Net loss                          |       | $                                                       | (5,447     | ) |   | (5% | ) |   | $ | (15,583 | ) |   | (16% | ) |   | $ | (1,619 | ) |   | (1% | ) |   |

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(a)           Includes approximately$181,000 related to stock based compensation in 2006.

(b)          Includes approximately$2.6 million, $14,000 and $390,000 related to stock-based compensation in 2006,2005 and 2004, respectively.

(c)           Includesapproximately $7.8 million related to an impairment charge for goodwill in2005, and $4.0 million related to an impairment charge for intangibleassets in 2004.

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**Discussion ofFiscal 2006 and 2005**

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

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

| ** **              | ** ** | **For the year ended September 30,** | ** **  |
|-------------------------|------------|---------------------------------------------------------------|-------------|
| ** **              | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **              | ** ** | **Dollars**                                                   | ** **  | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**      |       |                                                          |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | $                                                             | 117,302     |   |   | 100.0% |   |   | $ | 92,877 |   |   | 100.0% |   |   | $ | 24,425 |   |   | 26% |   |   |
| Gross profit            |       | 21,153                                                        |        |   | 18.0% |   |   | 17,133 |   |   | 18.4% |   |   | 4,020 |   |   | 23% |   |   |
| **Distribution:**       | ** ** | ** **                                                    | ** **  |   |   |   | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |
| Net revenues            |       | 1,394                                                         |        |   | 100.0% |   |   | 5,194 |   |   | 100.0% |   |   | (3,800 | ) |   | (73% | ) |   |
| Gross profit (loss)     |       | (1,282                                                        | )           |   | (92.0% | ) |   | (72 | ) |   | (1.4% | ) |   | (1,210 | ) |   | (1681% | ) |   |
| **Total net revenues**  |       | **$**                                                         | **118,696** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **98,071** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **20,625** | ** ** | ** ** | **21%** |   |   |
| **Total  gross profit** |       | **$**                                                         | **19,871**  | ** ** | ** ** | **16.7%** | ** ** | ** ** | **$** | **17,061** | ** ** | ** ** | **17.4%** | ** ** | ** ** | **$** | **2,810** | ** ** | ** ** | **16%** |   |   |

 

***Net revenues***

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

Our OEM Appliance segment net revenues increased infiscal year 2006 from fiscal year 2005 primarily due to an increase in salesvolumes to EMC, partially offset by lower average selling prices. Net revenuesfrom sales to EMC represented 82% of OEM Appliance net revenues for the yearended September 30, 2006 versus 83% for the year ended September 30, 2005. Netrevenues to other OEM Appliance customers for the year ended September 30, 2006increased to $20.8 million from $15.4 million for the year ended September 30,2005. Approximately $4.7 million of this increase is the result of net revenuegrowth among pre-existing OEM Appliance customers and approximately $0.7million of this increase is attributable to revenues from new OEM Appliancecustomers added in the past year.

Our Distribution segmentnet revenues during fiscal 2006 decreased significantly compared to netrevenues in fiscal 2005. Net revenues for fiscal 2005 were primarilyattributable to our final sales of third-party data storage networkingproducts, which we no longer sold subsequent to December 31, 2004. Duringthe year ended September 30, 2005 sales of these third-party data storagenetworking products represented 90% of our Distribution segment revenues. Netrevenues during fiscal 2006 consisted of sales of our NS Series SecurityAppliances that we sold through our channel of distributors and resellers.Sales of our NS Series products were less than expected during the year.In the future we do not anticipate significant sales from our NS SeriesAppliances, and do not intend to invest meaningful resources to create marketdemand for these appliances.

***Gross profit (loss)***

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

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Gross profit in our OEM Appliance segment increasedfor fiscal 2006 compared to fiscal 2005, primarily as a result of increasedsales volumes partially offset by lower average selling prices. Fiscal 2006gross profit as a percentage of net revenues in our OEM Appliance segmentdeclined due to lower average selling prices partially offset by higher salesvolumes. Gross loss in our Distribution segment was affected by certainmarketing incentives and programs we incurred to generate demand, that arerequired to be recorded as reductions of revenue, and the overhead of ourcustomer support investments. The decrease in gross profits and gross profitsas a percentage of net revenues in our Distribution segment was attributable toour exit from distributing third-party data storage networking products afterthe first quarter of fiscal 2005 combined with lower than expected sales of ourNS Series Security Appliances during fiscal 2006. 

Our gross profit isaffected by product mix and product pricing as well as the timing, size andconfiguration of server appliance orders. Gross profit is also affected by themix of product manufactured internally compared to product manufactured by ourcontract manufacturer, which carries higher manufacturing costs. We expectgross profit to continue to be affected by these factors.

***Operating Expenses***

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

| ** **                                      | ** ** | **For the year ended September 30,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                      | ** ** | **Dollars**                                                   | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and  development                       |       | $                                                             | 8,377      |   |   | 7% |   |   | $ | 7,504 |   |   | 8% |   |   | $ | 873 |   |   | 12% |   |   |
| Selling and  marketing                          |       | 10,522                                                        |       |   | 9% |   |   | 9,855 |   |   | 10% |   |   | 667 |   |   | 7% |   |   |
| General and  administrative                     |       | 7,729                                                         |       |   | 7% |   |   | 7,845 |   |   | 8% |   |   | (116 | ) |   | (1% | ) |   |
| Impairment of  goodwill                         |       | —                                                        |       |   | — |   |   | 7,769 |   |   | 8% |   |   | (7,769 | ) |   | (100% | ) |   |
| Restructuring and  other charges (credits)      |       | —                                                        |       |   | — |   |   | 366 |   |   | —% |   |   | (366 | ) |   | (100% | ) |   |
| Impairment of  intangible and long-lived assets |       | —                                                        |       |   | — |   |   | 298 |   |   | —% |   |   | (298 | ) |   | (100% | ) |   |
| Total operating expenses                        |       | $                                                             | 26,628     |   |   | 22% |   |   | $ | 33,637 |   |   | 34% |   |   | $ | (7,009 | ) |   | (21% | ) |   |

 

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*Research anddevelopment.*

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

| ** **                        | ** ** | **For the year ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                                   | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        | ** ** | ** **                                                    | ** ** |   | ** ** | ** ** |   | ** ** |   |   |   | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                             | 4,990      |   |   | 60% | ** ** |   | $ | 4,643 |   |   | 62% | ** ** |   | $ | 347 |   |   | 7% |   |   |
| Stock-based compensation          |       | 1,112                                                         |       |   | 13% | ** ** |   | — |   |   | —% | ** ** |   | 1,112 |   |   | —% |   |   |
| Prototype                         |       | 783                                                           |       |   | 9% | ** ** |   | 855 |   |   | 11% | ** ** |   | (72 | ) |   | (8% | ) |   |
| Consulting and outside services   |       | 607                                                           |       |   | 7% | ** ** |   | 1,136 |   |   | 15% | ** ** |   | (529 | ) |   | (47% | ) |   |
| Other                             |       | 885                                                           |       |   | 11% | ** ** |   | 870 |   |   | 12% | ** ** |   | 15 |   |   | 2% |   |   |
| Total research  and development   |       | $                                                             | 8,377      |   |   | 100% | ** ** |   | $ | 7,504 |   |   | 100% | ** ** |   | $ | 873 |   |   | 12% |   |   |

 

Our research and development expenses have increasedprimarily as a result of recognizing stock-based compensation expense andincreased compensation and related expenses partially offset by a decrease inconsulting and outside services. The increase in compensation and relatedexpenses is primarily attributable to an increase in headcount from 40employees at September 30, 2005 to 43 at September 30, 2006. Thedecrease in consulting and outside services relates primarily to the timing ofcertain engineering projects in our OEM appliance segment and the lowerutilization of outside contractors for software development in 2006.

Our server appliancedevelopment strategy emphasizes the utilization of standard, off-the-shelfcomponents in our server appliance platforms. However, we expect that in somecases significant development efforts will be required to fulfill our currentand potential ISV and network equipment customers’ needs. We expect thatresearch and development costs will continue to increase in fiscal 2007primarily due to certain development projects such as enhancements to ourappliance life cycle management, NEWS, and our managed-branch solution.

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*Selling and marketing.*

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

| ** **                        | ** ** | **For the year ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                                   | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                             | 6,439      |   |   | 61% |   |   | $ | 5,803 |   |   | 59% |   |   |   | $ | 636 |   |   |   | 11% |   |   |
| Stock-based compensation          |       | 770                                                           |       |   | 7% |   |   | 7 |   |   | —% |   |   |   | 763 |   |   |   | 10900% |   |   |
| Marketing programs                |       | 1,465                                                         |       |   | 14% |   |   | 1,994 |   |   | 20% |   |   |   | (529 | ) |   |   | (27% | ) |   |
| Consulting and outside services   |       | 435                                                           |       |   | 4% |   |   | 384 |   |   | 4% |   |   |   | 51 |   |   |   | 13% |   |   |
| Travel                            |       | 929                                                           |       |   | 9% |   |   | 828 |   |   | 8% |   |   |   | 101 |   |   |   | 12% |   |   |
| Other                             |       | 484                                                           |       |   | 5% |   |   | 839 |   |   | 9% |   |   |   | (355 | ) |   |   | (42% | ) |   |
| Total selling and  marketing      |       | $                                                             | 10,522     |   |   | 100% |   |   | $ | 9,855 |   |   | 100% |   |   |   | $ | 667 |   |   |   | 7% |   |   |

 

Our Distribution segment by its nature has incurredmore of the marketing and sales burden of the products that it sold and engagedin a higher level of marketing program activities than our OEM Appliancesegment. Sales in our OEM Appliance segment are to our ISV and networkequipment customers who market and sell their products, which incorporate ourserver appliances. As a result, our OEM Appliance segment engages in a limitedlevel of marketing programs.

As indicated in the table above, the primarycomponents of the increase in selling and marketing expenses are stock-basedcompensation and compensation and related expenses. These were partially offsetby decreases in marketing programs and other expenses. The increase in compensationand related expenses is due to our expansion of our European sales force, whichwe began to form in fiscal 2005. The reduction in our marketing programs isprimarily related to reduced spending on end user lead generation programs forour Distribution segment products in the second half of the year. The decreasein other expenses primarily relates to decreases in our recruiting expensesattributable to the timing of newly hired employees and lower depreciationexpense.

We believe that we must targetour selling and marketing efforts on network equipment providers and ISV’s inorder to enhance our position as a leading provider of server appliancesolutions. However, we expect selling and marketing expenses to decreaseslightly in fiscal 2007 as a result of reduced spending on end-user demandcreation.

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*General andadministrative.*

Generaland administrative expenses consist primarily of salaries and other relatedcosts for executive, finance, information technology and human resourcespersonnel; professional services, which include legal, accounting, audit andtax fees, and costs of compliance with the Sarbanes-Oxley Act; and director andofficer insurance. The following table summarizes the most significantcomponents of general and administrative expense for the periods indicated inthousands and as a percentage of total general and administrative expense andprovides the changes in thousands and percentages:

| ** **                        | ** ** | **For the year ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                                   | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:      |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                             | 3,075      |   |   | 40% |   |   | $ | 2,819 |   |   | 36% |   |   |   | $ | 256 |   |   |   | 9% |   |   |
| Stock-based compensation          |       | 744                                                           |       |   | 10% |   |   | 7 |   |   | —% |   |   |   | 737 |   |   |   | 10529% |   |   |
| Professional services             |       | 2,216                                                         |       |   | 29% |   |   | 3,185 |   |   | 41% |   |   |   | (969 | ) |   |   | (30% | ) |   |
| Director and officer insurance    |       | 806                                                           |       |   | 10% |   |   | 952 |   |   | 12% |   |   |   | (146 | ) |   |   | (15% | ) |   |
| Other                             |       | 888                                                           |       |   | 11% |   |   | 882 |   |   | 11% |   |   |   | 6 |   |   |   | 1% |   |   |
| Total general and  administrative |       | $                                                             | 7,729      |   |   | 100% |   |   | $ | 7,845 |   |   | 100% |   |   |   | $ | (116 | ) |   |   | (1% | ) |   |

 

As indicated in the table above, the primary componentof the decrease in general and administrative expenses are decreasedprofessional services. This decrease was partially offset by the addition ofstock-based compensation. The decrease in professional services is dueprimarily to a decrease in costs associated with the Sarbanes-Oxley compliancenow that we are in our second year of implementation and a decrease in legalcosts associated with the timing of certain litigation activities.

We expect modest increasesin our general and administrative expenses to in fiscal 2007; however this willbe dependent on costs associated with the timing of certain informationtechnology related projects and the relative costs to operate as a publiccompany.

*Impairment ofgoodwill*

In fiscal 2005 wedetermined that our goodwill was impaired resulting in an impairment charge of$7,769,000 for the year ended September 30, 2005. As a result, there wasno remaining goodwill on our balance sheet.

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

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

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**Discussion ofFiscal 2005 and 2004**

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

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

| ** **              | ** ** | **For the year ended September 30,** | ** ** |
|-------------------------|------------|---------------------------------------------------------------|------------|
| ** **              | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **              | ** ** | **Dollars**                                                   | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**      |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | $                                                             | 92,877     |   |   | 100.0% |   |   | $ | 80,321 |   |   | 100.0% |   |   | $ | 12,556 |   |   | 16% |   |   |
| Gross profit            |       | 17,133                                                        |       |   | 18.4% |   |   | 16,283 |   |   | 20.3% |   |   | 850 |   |   | 5% |   |   |
| **Distribution:**       | ** ** | ** **                                                    | ** ** |   |   |   | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |
| Net revenues            |       | 5,194                                                         |       |   | 100.0% |   |   | 56,434 |   |   | 100.0% |   |   | (51,240 | ) |   | (91% | ) |   |
| Gross profit (loss)     |       | (72                                                           | )          |   | (1.4% | ) |   | 7,625 |   |   | 13.5% |   |   | (7,697 | ) |   | (101% | ) |   |
| **Total net revenues**  | ** ** | **$**                                                         | **98,071** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **136,755** | ** ** | ** ** | **100.0%** | ** ** | ** ** | **$** | **(38,684** | **)** | ** ** | **(28%** | **)** | ** ** |
| **Total  gross profit** | ** ** | **$**                                                         | **17,061** | ** ** | ** ** | **17.4%** | ** ** | ** ** | **$** | **23,908** | ** ** | ** ** | **17.5%** | ** ** | ** ** | **$** | **(6,847** | **)** | ** ** | **(29%** | **)** | ** ** |

 

***Net revenues***

Our revenues were derived from sales of serverappliances primarily to our OEM network equipment and ISV customers. We alsoderived revenues from the distribution of third-party data storage networkingproducts, until we completed our exit from that portion of our Distributionbusiness during the quarter ended December 31, 2004.

Our OEM Appliance segment net revenues increased infiscal year 2005 from fiscal year 2004 primarily due to an increase in salesvolumes to EMC, which represented 83% of OEM Appliance net revenues for theyear ended September 30, 2005 versus 84% for the year ended September 30,2004. Net revenues to other OEM Appliance customers for the year ended September 30,2005 increased to $15.4 million from $12.9 million for the year ended September 30,2004. Approximately $2.1 million of this increase was the result of net revenuegrowth among pre-existing OEM Appliance customers and approximately $0.4million of this increase was attributable to revenues from new OEM Appliancecustomers added in during fiscal year 2005.

Our Distribution segmentnet revenues during fiscal 2005 decreased significantly compared to netrevenues in fiscal 2004. Net revenues for fiscal 2004 were attributable tosales of third-party data storage networking products, which we no longer soldsubsequent to December 31, 2004. During the years ended September 30,2005 and 2004, sales of these third-party data storage networking productsrepresented 90% and 99%, respectively, of our Distribution segment revenues.During fiscal 2005 we also had sales of our own branded NS Series SecurityAppliances, however sales from these server appliances were not significantduring fiscal 2005.

***Gross profit (loss)***

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

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***Operating Expenses***

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

| ** **                                           | ** ** | **For the year ended September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                           | ** ** | **Dollars**                                                   | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  Expenses:                                 |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and  development                            |       | $                                                             | 7,504      |   |   | 8% |   |   | $ | 6,174 |   |   | 5% |   |   | $ | 1,330 |   |   | 22% |   |   |
| Selling and  marketing                               |       | 9,855                                                         |       |   | 10% |   |   | 8,702 |   |   | 6% |   |   | 1,153 |   |   | 13% |   |   |
| General and  administrative                          |       | 7,845                                                         |       |   | 8% |   |   | 6,737 |   |   | 5% |   |   | 1,108 |   |   | 16% |   |   |
| Impairment of  goodwill                              |       | 7,769                                                         |       |   | 8% |   |   | — |   |   | —% |   |   | 7,769 |   |   | 100% |   |   |
| Restructuring and  other charges (credits)           |       | 366                                                           |       |   | —% |   |   | (107 | ) |   | —% |   |   | 473 |   |   | 442% |   |   |
| Impairment of  intangible and long-lived assets |       | 298                                                           |       |   | —% |   |   | 4,013 |   |   | 3% |   |   | (3,715 | ) |   | (93% | ) |   |
| Amortization of  intangible assets                   |       | —                                                        |       |   | —% |   |   | 297 |   |   | —% |   |   | (297 | ) |   | (100% | ) |   |
| Total operating  expenses                            |       | $                                                             | 33,637     |   |   | 34% |   |   | $ | 25,816 |   |   | 19% |   |   | $ | 7,821 |   |   | 30% |   |   |

 

*Research anddevelopment.*

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

| ** **                        | ** ** | **For the year ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                                   | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                             | 4,643      |   |   | 62% |   |   | $ | 3,267 |   |   | 53% |   |   | $ | 1,376 |   |   | 42% |   |   |
| Stock-based compensation          |       | —                                                        |       |   | —% |   |   | 18 |   |   | —% |   |   | (18 | ) |   | —% |   |   |
| Prototype                         |       | 855                                                           |       |   | 11% |   |   | 1,071 |   |   | 17% |   |   | (216 | ) |   | (20% | ) |   |
| Consulting and outside services   |       | 1,136                                                         |       |   | 15% |   |   | 987 |   |   | 16% |   |   | 149 |   |   | 15% |   |   |
| Other                             |       | 870                                                           |       |   | 12% |   |   | 831 |   |   | 13% |   |   | 39 |   |   | 5% |   |   |
| Total research  and development   |       | $                                                             | 7,504      |   |   | 100% |   |   | $ | 6,174 |   |   | 100% |   |   | $ | 1,330 |   |   | 22% |   |   |

 

Overall, our server appliance development expensesincreased as a result of an increase in software development activities relatedto our NS Series Security Appliances and the development and sustainedengineering efforts related to existing, new and prospective ISV and networkequipment customers. To support these development activities, we increased ourresearch and development personnel from 32 at September 30, 2004 to 40 at September 30,2005, which resulted in increased compensation costs. We also increased thenumber of consultants used to supplement our research and development personnellevels, primarily in the area of software development, which resulted inincreased consulting and outside service costs. Conversely, our prototypeexpenses for fiscal 2005 decreased from fiscal 2004 as a result of the timingof certain engineering projects in our OEM Appliance segment.

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*Selling andmarketing.*

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

| ** **                        | ** ** | **For the year ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                                   | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            | ** ** | ** **                                                    | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                             | 5,803      |   |   | 59% |   |   | $ | 6,192 |   |   | 71% |   |   | $ | (389 | ) |   | (6% | ) |   |
| Stock-based compensation          |       | 7                                                             |       |   | —% |   |   | 65 |   |   | —% |   |   | (58 | ) |   | (89% | ) |   |
| Marketing programs                |       | 1,994                                                         |       |   | 20% |   |   | 940 |   |   | 11% |   |   | 1,054 |   |   | 112% | ** ** |   |
| Consulting and outside services   |       | 384                                                           |       |   | 4% |   |   | 176 |   |   | 2% |   |   | 208 |   |   | 118% | ** ** |   |
| Travel                            |       | 828                                                           |       |   | 8% |   |   | 568 |   |   | 7% |   |   | 260 |   |   | 46% | ** ** |   |
| Other                             |       | 839                                                           |       |   | 9% |   |   | 761 |   |   | 9% |   |   | 78 |   |   | 10% | ** ** |   |
| Total selling and  marketing      |       | $                                                             | 9,855      |   |   | 100% |   |   | $ | 8,702 |   |   | 100% |   |   | $ | 1,153 |   |   | 13% | ** ** |   |

 

As indicated in the tableabove, the primary components of the increase in selling and marketing expenseswere marketing program costs offset in part by a decrease in compensationcosts. We increased the level of marketing programs during fiscal 2005 as aresult of the release of our NS Series Security Appliances. Our sellingand marketing personnel decreased slightly, in the aggregate, from 43 at September 30,2004 to 42 at September 30, 2005. This net decrease represented decreasesfrom terminations and attrition related to our exit from the distribution ofthird-party data storage networking products, partially offset by increasedhiring throughout the year related to our NS Series Security Appliances.As a result, compensation and related expenses decreased in the aggregateduring fiscal 2005 as compared to fiscal 2004. In addition, our consulting andoutside services and travel expenses increased from fiscal 2004 as a result ofour effort to build a channel of resellers and distributors for our NS Series SecurityAppliances. In particular we commenced our European sales operations during thequarter ended June 30, 2005.

*General andadministrative.*

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

| ** **                        | ** ** | **For the year ended September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                                   | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:      | ** ** | ** **                                                    | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Compensation and related expenses |       | $                                                             | 2,819      |   |   | 36% |   |   | $ | 2,616 |   |   | 39% |   |   | $ | 203 |   |   | 8% | ** ** |   |
| Stock-based compensation          |       | 7                                                             |       |   | —% |   |   | 307 |   |   | 5% |   |   | (300 | ) |   | (98% | ) |   |
| Professional services             |       | 3,185                                                         |       |   | 41% |   |   | 1,950 |   |   | 29% |   |   | 1,235 |   |   | 63% | ** ** |   |
| Director and officer insurance    |       | 952                                                           |       |   | 12% |   |   | 932 |   |   | 14% |   |   | 20 |   |   | 2% | ** ** |   |
| Other                             |       | 882                                                           |       |   | 11% |   |   | 932 |   |   | 14% |   |   | (50 | ) |   | (5% | ) |   |
| Total general and  administrative |       | $                                                             | 7,845      |   |   | 100% |   |   | $ | 6,737 |   |   | 100% |   |   | $ | 1,108 |   |   | 16% | ** ** |   |

 

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As indicated in the tableabove, the primary component of the increase in general and administrativeexpenses was increased consulting and professional services partially offset bya decrease in stock-based compensation. Stock compensation in fiscal 2004related to amortization of compensation expense attributable to options issuedin prior years with exercise prices below their deemed fair values. Thedecrease in stock compensation in fiscal 2005 compared to fiscal 2004 was dueto the completion of this amortization as scheduled. The increase inprofessional services was due primarily to increased costs related to our firstyear compliance with the Sarbanes-Oxley Act of 2002.

*Impairment ofgoodwill*

We performed our annualimpairment assessment of goodwill during the fourth quarter of fiscal 2005. Thisassessment was performed using an appraisal based primarily on the estimateddiscounted cash flows expected to be generated by our Distribution segment,which consisted only of our NS Series Security Appliances. The discountedcash flows used in the appraisal were based on a number of estimates and assumptionsmade by us, including the projected future operating results of ourDistribution segment, the discount rate, and the long-term growth rate. Webased our revenue assumptions on estimates of relevant market sizes, expectedmarket growth rates, and actual fiscal 2005 results. Sales of our NS Series SecurityAppliances did not meet our expectations during fiscal 2005 and we believedthat it would take several more quarters before revenues from sales of theseserver appliances became significant. These factors were significantcontributors in determining key assumptions used in our appraisal. In additionto these factors, we considered the continued expected investments intechnology development and sales and marketing efforts. Our assessment resultedin an implied fair value of the Distribution reporting unit’s goodwill that wassignificantly lower than its carrying value of that goodwill. Consequently, wedetermined that our goodwill was fully impaired resulting in an impairmentcharge of $7,769,000 for the year ended September 30, 2005.

*Restructuring andother charges.*

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

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

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

In connection with our acquisition of TidalWire in December 2002,we recorded a definite-lived intangible asset attributable to TidalWire’sexisting customer relationships. This asset was being amortized on astraight-line basis over its estimated useful life. In December 2003, weamended our agreement with EMC regarding distribution of EMC-approved HBAs. Thisamendment required us to pay a royalty to EMC for each EMC-approved HBA we sold.As a result of the negative effect of this amendment on our gross profits, weconsidered this amendment to be a triggering event requiring assessment forimpairment. As a result, during the quarter ended December 31, 2003 weconducted a detailed impairment analysis of our intangible assets. Thisanalysis resulted in the determination that the fair value of our intangibleassets was less than its carrying amount, which resulted in a charge tooperations of approximately $3,614,000 in the quarter ended December 31,2003. We also performed an impairment evaluation of the remaining carryingvalue of these intangible assets at September 30, 2004. This analysisresulted in an additional impairment charge of $399,000. The effect of thetotal fiscal 2004 impairment charge of $4,013,000 

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reduced the remainingcarrying value of these intangible assets to zero. As a result of thiselimination of the carrying value of the assets during fiscal 2004, there wasno amortization expense for fiscal 2005.

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

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

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

**Liquidity andCapital Resources**

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

| ** **                                       | ** ** | **September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Net loss                                         |       | $                      | (5,447     | ) | $ | (15,583 | ) |
| Non-cash  adjustments to net loss                |       | 3,783                  |       | 9,255 |   |
| Changes in  working capital                      |       | (3,741                 | )          | 4,793 |   |
| Cash (used in) operating activities              |       | (5,405                 | )          | (1,535 | ) |
| Cash provided by  (used in) investing activities |       | 2,794                  |       | (2,680 | ) |
| Cash provided by  financing activities           |       | 1,157                  |       | 709 |   |
| Decrease in cash and cash equivalents            |       | (1,454                 | )          | (3,506 | ) |
| Cash and cash  equivalents at beginning of year  |       | 9,468                  |       | 12,974 |   |
| Cash and cash  equivalents at end of year        |       | $                      | 8,014      |   | $ | 9,468 |   |

 

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

| ** **              | ** ** | **September 30,** | ** ** |
|-------------------------|------------|------------------------|------------|
| ** **              | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Short-term  investments |       | $                      | 24,804     |   | $ | 27,894 |   |
|                         |            |                        |            |  |  |  |  |

 

***Operating Activities***

Cash flows used in operating activities of $5.5million for fiscal 2006 were attributable to a net loss of $5.4 million andchanges in working capital of $3.7 million offset by non-cash adjustments tonet loss of $3.8 million. Non-cash adjustments to net loss consistedsubstantially of stock-based compensation of $2.8 million and depreciationexpense of $1.0 million. Significant cash flow effects from changes in workingcapital for fiscal 2006 included a decrease in cash flows of $6.7 million fromour increased accounts receivable balance partially offset by increased cashflows from an increase in our accounts payable of $1.4 million, $997,000from an increase in our accrued expenses and $789,000 from a reduction of ourinventory.

The increases in ouraccounts receivable, accounts payable, and accrued expenses are primarily aresult of increased sales volume to our largest OEM appliance customer whichalso has necessitated increased purchasing volume. Our days sales outstandingwas 53 days in fiscal 2006 compared to 39 days in 

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2005. Theincrease in our days sales outstanding is primarily due to fluctuations in thetiming of shipments to our large OEM customer.

***Investing Activities***

Cash flows provided byinvesting activities during fiscal 2006 resulted from net sales of $3.1 millionof short-term available for sale investments partially offset by $398,000 ofinvestments made in property and equipment. Cash flows used in investingactivities during fiscal 2005 were attributable to net purchases of $1.2million of short-term available for sale investments combined with $1.5 millionof investments in property and equipment.

***Financing Activities***

Cash flows provided byfinancing activities consisted of cash received as a result of employee stockoption and stock purchase plan activity of $1.2 million in fiscal 2006 comparedto $713,000 in fiscal 2005. We expect employee stock option activity tocontinue in fiscal 2007, however we cannot predict its level given thevolatility of our stock price.

***Contractual Obligations and Commitments***

The following table sets forth certain informationconcerning our obligations and commitments to make certain payments (inthousands).

| ** **                | ** ** | **Payments Due by Period** | ** ** |
|---------------------------|------------|-------------------------------------------|------------|
| ****                      | ** ** | **Less than  1 Year**           | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After  5 Years** | ** ** | **Total** | ** ** |
| Operating leases          |       |                                      | $          | 592 |   |   |   | $ | 1,045 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 1,637 |   |
| Capital lease  obligation |       |                                      | 24         |   |   |   | 48 |   |   |   | 18 |   |   |   | — |   |   | 90 |   |
| Total                     |       |                                      | $          | 616 |   |   |   | $ | 1,093 |   |   |   | $ | 18 |   |   |   | — |   |   | $ | 1,727 |   |

 

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

·       thetiming and size of orders from our largest customer;

·       ourability to enter into partnerships with network equipment providers, systemsintegrators and  independent softwarevendors;

·       thelevel of success of our customers in selling server appliance solutions thatinclude our server appliance hardware platforms;

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

·       marketdevelopments.

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

**Off-Balance SheetArrangements**

We have not created, andare not party to, any special-purpose or off balance sheet entities for thepurpose of raising capital, incurring debt or operating parts of our businessthat are not consolidated into 

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

**Related PartyTransactions**

Robert M. Wadsworth, one of our directors, is also adirector of PSI Holding Group, Inc. (“PSI”), the parent company of Akibia, Inc.(“Akibia”). During the years ended September 30, 2006 and 2005,HarbourVest owned greater than 5% of our outstanding stock and greater than 5%of the outstanding stock of PSI. While we were selling third-party data storagenetworking products we engaged Akibia to provide certain customer support andwarranty fulfillment services related to our sales of HBAs. Our agreement withAkibia expired in March 2005 as scheduled. However, the terms of theagreement required Akibia to fulfill the warranty services for the entirewarranty period. Akibia charged us a quarterly fixed fee of $83,000 and avariable fee based upon our sales of HBAs, which ended in December 2004.For the years ended September 30, 2006, 2005 and 2004, we recognized $0,$201,000 and $1,070,000, respectively, of expense as a result of this warrantyfulfillment services agreement with Akibia.  In connection with this customer support andwarranty fulfillment services agreement, we also sold product to Akibia toallow Akibia to fulfill our warranty obligations for these products. For theyears ended September 30, 2006, 2005 and 2004, we recorded revenues ofapproximately $0, $40,000 and $143,000, respectively, from sales of HBAs toAkibia. We also purchased certain products sold through our Distributionsegment from Akibia to fulfill customer orders. For the year ended September 30,2004, we purchased approximately $19,000 of inventory from Akibia for resale toour Distribution segment customers. No such purchases were made during theyears ended September 30, 2006 and 2005.

In addition, during the year ended September 30,2004, we sold approximately $60,000, respectively, of server appliance productsto Akibia for resale. We had no sales of server appliance products to Akibiaduring the years ended September 30, 2006 and 2005. In addition, weengaged Akibia to provide certain customer support and warranty fulfillmentservices to certain of our server appliance customers in both our OEM Applianceand Distribution segments. Under the terms of this agreement, we were obligatedto pay Akibia certain fixed fees and certain activity-based fees based onactual warranty experience. We no longer engage Akibia for these supportservices. As a result, there were no expenses recorded for the years ended September 30,2006 and 2005. For the year ended September 30, 2004, we recorded expensestotaling approximately $50,500, related to this agreement. There were noamounts receivable from or payable to Akibia at September 30, 2006 or 2005.In November 2005, Mr. John A. Blaeser, one of our directors, also joinedthe board of directors of Akibia.

Mr. Wadsworth also serves as a director ofInnoveer Solutions, Inc. (“Innoveer”), formerly Akibia Consulting, asubsidiary of Akibia. We previously engaged Innoveer to perform certainprofessional services related to an upgrade of our customer resource management(“CRM”) software system that was completed during fiscal year 2004. We incurredapproximately $243,000 related to this upgrade project in the year ended September 30,2004. We also engaged Innoveer to provide professional services related tomodifications of our CRM software system. During the years ended September 30,2006 and 2005, we incurred approximately $80,000 and $14,300, respectively,related to these services. We had $7,000 in fees owed to Innoveer at September 30,2006 and no amounts owed to Innoveer at September 30, 2005.

Through fiscal 2005, Mr. Polestra, one of ourformer directors, was a managing director of Ascent Venture Partners. Both Mr. Polestraand Mr. Blaeser are limited partners in one of Ascent Venture Partner’sfunds, which owned greater than 5% of the outstanding capital stock of NetworkIntelligence Corporation. Network Intelligence Corporation had a contract withus to purchase certain of its products. 

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For the years ended September 30,2005 and 2004, revenues from sales to Network Intelligence Corporation wereapproximately, $4,040,000, and $3,200,000, respectively.

Additionally, in September 2005,we engaged the consulting services of Mapleworks Technologies (“Mapleworks”), asoftware development services provider. Both Mr. Blaeser and Mr. Wadsworthare investors in Mapleworks and are members of its board of advisors. In theyears ended September 30, 2006 and 2005 we incurred $82,000 and $18,000,respectively, in fees for these consulting services. We had no amountsoutstanding to Mapleworks at September 30, 2006 or 2005.

**Recent AccountingPronouncements**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004), *“Share-Based Payment”* (“SFAS123(R)”). SFAS 123(R) is a revision of FASB Statement No. 123, *“Accounting for Stock-Based Compensation”*, supersedesAccounting Principles Board Opinion No. 25, *“Accountingfor Stock Issued to Employees”*, and amends FASB Statement No. 95,*“Statement of Cash Flows”*. SFAS 123(R) requiresall share-based payments to employees, including grants of employee stockoptions and stock purchases under employee stock purchase plans, to berecognized in the financial statements based on their fair values. We adoptedSFAS 123(R) using the modified prospective method during the quarter endedDecember 31, 2005. As noted in footnote 12, the adoption of SFAS 123(R) hada material impact on our consolidated statements of operations and net loss pershare.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin No.108,“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in the Current Year Financial Statements” (“SAB 108”). SAB 108addresses how the effects of prior-year uncorrected misstatements should beconsidered when quantifying misstatements in current-year financial statements.SAB 108 requires an entity to quantify misstatements using a balance sheet andincome statement approach and to evaluate whether either approach results in anerror that is material in light of relevant quantitative and qualitativefactors. The requirements of SAB 108 are effective for fiscal years endingafter November 15, 2006. The adoption of SAB 108 will not have an impacton our financial position, results of operations, or cash flows.

**ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

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

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**ITEM8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                                                                                                         | ** ** | ** ** | **Page** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING  FIRM                                                                                |       | 47         |
| CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2006  AND 2005                                                                          |       | 49         |
| CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS  ENDED SEPTEMBER 30, 2006, 2005 AND 2004                                            |       | 50         |
| CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND  COMPREHENSIVE LOSS FOR THE YEARS ENDED SEPTEMBER 30, 2006, 2005 AND 2004 |       | 51         |
| CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS  ENDED SEPTEMBER 30, 2006, 2005 AND 2004                                            |       | 53         |
| NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                                                              |       | 54         |

 

46

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

We have completedintegrated audits of Network Engines, Inc.’s 2006 and 2005 consolidatedfinancial statements and of its internal control over financial reporting as ofSeptember 30, 2006, and an audit of its 2004 consolidated financialstatements in accordance with the standards of the Public Company AccountingOversight Board (United States). Ouropinions, based on our audits, are presented below.

*Consolidated financial statements and financial statementschedule*

In our opinion, theconsolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in allmaterial respects, the financial position of Network Engines, Inc. and itssubsidiaries at September 30, 2006 and September 30, 2005, and theresults of their operations and their cash flows for each of the three years inthe period ended September 30, 2006 in conformity with accountingprinciples generally accepted in the United States of America. In addition, in our opinion, the financialstatement schedule listed in the index appearing under Item 15(a)(2) presentsfairly, in all material respects, the information set forth therein when readin conjunction with the related consolidated financial statements. Thesefinancial statements and financial statement schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements and financial statement schedule based on our audits. Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An audit offinancial statements includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

As discussed in Note 10 tothe consolidated financial statements, the Company changed the manner in whichit accounts for share-based compensation in fiscal 2006.

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Annual Report on Internal Control Over FinancialReporting appearing under Item 9A, that the Company maintained effectiveinternal control over financial reporting as of September 30, 2006 basedon criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of September 30,2006 based on criteria established in *Internal Control—IntegratedFramework* issued by the COSO. The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express opinions on management’s assessmentand on the effectiveness of the Company’s internal control over financialreporting based on our audit. We conducted our audit of internal control overfinancial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. An audit of internal control over financial reporting includesobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and 

47

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performing such otherprocedures as we consider necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinions.

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

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.
| PricewaterhouseCoopers LLP |
|----------------------------|
| Boston, Massachusetts      |
| December 11,  2006    |

 

48

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

| ** **                                                                                                                                                                                                   | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2006**               | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Current assets:**                                                                                                                                                                                          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Cash and cash equivalents                                                                                                                                                                                    |       | $                      | 8,014      |   | $ | 9,468 |   |
| Short-term investments                                                                                                                                                                                       |       | 24,804                 |       | 27,894 |   |
| Restricted cash                                                                                                                                                                                              |       | 47                     |       | 47 |   |
| Accounts receivable, net of allowances of $29 and  $76 at September 30, 2006 and 2005, respectively                                                                                                |       | 17,178                 |       | 10,442 |   |
| Inventories                                                                                                                                                                                                  |       | 8,445                  |       | 9,227 |   |
| Prepaid expenses and other current assets                                                                                                                                                                    |       | 1,460                  |       | 905 |   |
| Total current assets                                                                                                                                                                                         |       | 59,948                 |       | 57,983 |   |
| Property and equipment, net                                                                                                                                                                                  |       | 1,093                  |       | 1,699 |   |
| Other assets                                                                                                                                                                                                 |       | 20                     |       | 122 |   |
| Total assets                                                                                                                                                                                                 |       | $                      | 61,061     |   | $ | 59,804 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Current liabilities:**                                                                                                                                                                                     | ** ** | ** **             | ** ** | ** ** | ** ** |
| Accounts payable                                                                                                                                                                                             |       | $                      | 7,047      |   | $ | 5,645 |   |
| Accrued compensation and other related benefits                                                                                                                                                              |       | 1,762                  |       | 1,276 |   |
| Other accrued expenses                                                                                                                                                                                       |       | 2,180                  |       | 1,669 |   |
| Current portion of capital lease obligation                                                                                                                                                                  |       | 19                     |       | 18 |   |
| Deferred revenue                                                                                                                                                                                             |       | 1,049                  |       | 891 |   |
| Total current liabilities                                                                                                                                                                                    |       | 12,057                 |       | 9,499 |   |
| Long-term portion of capital lease obligation                                                                                                                                                                |       | 60                     |       | 79 |   |
| Deferred revenue                                                                                                                                                                                             |       | 541                    |       | 365 |   |
| Total liabilities                                                                                                                                                                                            |       | 12,658                 |       | 9,943 |   |
| Commitments and contingencies (Note 11)                                                                                                                                                                      |       |                   |       |   |   |
| **Stockholders’ equity:**                                                                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** |
| Preferred stock, $.01 par value, 5,000,000  authorized, and no shares issued and outstanding                                                                                                                 | ** ** | **—**             | ** ** | **—** | ** ** |
| Common stock, $.01 par value, 100,000,000 shares  authorized; 41,751,304 and 40,341,890 shares issued; 39,189,446 and  37,780,032 shares outstanding at September 30, 2006 and 2005,  respectively |       | 418                    |       | 403 |   |
| Additional paid-in capital                                                                                                                                                                                   |       | 182,420                |       | 178,446 |   |
| Accumulated deficit                                                                                                                                                                                          |       | (131,597               | )          | (126,150 | ) |
| Treasury stock, at cost, 2,561,858 shares at  September 30, 2006 and 2005, respectively                                                                                                                 |       | (2,838                 | )          | (2,838 | ) |
| Total stockholders’ equity                                                                                                                                                                              |       | 48,403                 |       | 49,861 |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                             |       | $                      | 61,061     |   | $ | 59,804 |   |

 

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,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net revenues                                                   |       | $                                           | 118,696    |   | $ | 98,071 |   | $ | 136,755 |   |
| Cost of revenues                                               |       | 98,825                                      |       | 81,010 |   | 112,847 |   |
| Gross profit                                                   |       | 19,871                                      |       | 17,061 |   | 23,908 |   |
| Operating expenses:                                            |       |                                        |       |   |   |   |   |
| Research and development                                       |       | 8,377                                       |       | 7,504 |   | 6,174 |   |
| Selling and marketing                                          |       | 10,522                                      |       | 9,855 |   | 8,702 |   |
| General and administrative                                     |       | 7,729                                       |       | 7,845 |   | 6,737 |   |
| Restructuring and other charges (credits)                      |       | —                                      |       | 366 |   | (107 | ) |
| Impairment of intangible and long-lived assets                 |       | —                                      |       | 298 |   | 4,013 |   |
| Impairment of goodwill                                         |       | —                                      |       | 7,769 |   | — |   |
| Amortization of intangible assets                              |       | —                                      |       | — |   | 297 |   |
| Total operating  expenses                                      |       | 26,628                                      |       | 33,637 |   | 25,816 |   |
| Loss from  operations                                          |       | (6,757                                      | )          | (16,576 | ) | (1,908 | ) |
| Interest income                                                |       | 1,358                                       |       | 993 |   | 333 |   |
| Loss before income taxes                                       |       | (5,399                                      | )          | (15,583 | ) | (1,575 | ) |
| Provision for income taxes                                     |       | 48                                          |       | — |   | 44 |   |
| Net loss                                                       |       | $                                           | (5,447     | ) | $ | (15,583 | ) | $ | (1,619 | ) |
| Net loss per  share—basic  and diluted                    |       | $                                           | (0.14      | ) | $ | (0.42 | ) | $ | (0.04 | ) |
| Shares used in computing  basic and diluted net loss per share |       | 38,207                                      |       | 37,461 |   | 36,594 |   |

 

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

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

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

 

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

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

| ** **                                                                       | ** ** | **Shares of Common** | ** ** | **Common**           | ** ** | **Additional**     | ** ** | ** **            | ** ** | ** **              | ** ** | ** **       | ** ** | **Total**                    | ** ** | ** **        | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------|------------|----------------------|------------|--------------------|------------|-----------------------|------------|-------------------------|------------|------------------|------------|------------------------------|------------|-------------------|------------|
| ** **                                                                       | ** ** | **Stock**                      | ** ** | **Stock**            | ** ** | **Paid-in**        | ** ** | **Accumulated ** | ** ** | **Deferred Stock** | ** ** | ** **       | ** ** | **Stockholders’ ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                       | ** ** | **Issued**                     | ** ** | **In Treasury** | ** ** | **Par value** | ** ** | **Capital**           | ** ** | **Deficit**             | ** ** | **Compensation** | ** ** | **Treasury Stock**      | ** ** | **Equity**        | ** ** | **Loss** | ** ** |
| Balance, September 30, 2005                                                 |       | 40,341,890                     |       |                 | (2,561,858 | )                  |       |                  | $          | 403                     |       |             |       | $                            | 178,446    |              |       |   | $ | (126,150 | ) |   |   | $ | — |   |   |   | $ | (2,838 | ) |   |   | $ | 49,861 |   |   |   |   |   |   |
| Issuance of common stock upon stock option  exercises                            |       | 1,152,424                      |       |                 |       |               |       |                  | 12         |                    |       |             | 870        |                         |       |              |       |   |   |   |   |   |   |   |   |   |   |   | 882 |   |   |   |   |   |   |
| Issuance of common stock under employee stock  purchase plan                     |       | 256,990                        |       |                 |       |               |       |                  | 3          |                    |       |             | 290        |                         |       |              |       |   |   |   |   |   |   |   |   |   |   |   | 293 |   |   |   |   |   |   |
| Stock compensation related to grants of stock  options to non-employee |       |                           |       |                 |       |               |       |                  |       |                    |       |             | 7          |                         |       |              |       |   |   |   |   |   |   |   |   |   |   |   | 7 |   |   |   |   |   |   |
| Stock compensation related to grants of stock  options to employees    |       |                           |       |                 |       |               |       |                  |       |                    |       |             | 2,807      |                         |       |              |       |   |   |   |   |   |   |   |   |   |   |   | 2,807 |   |   |   |   |   |   |
| Net loss                                                                         |       |                           |       |                 |       |               |       |                  |       |                    |       |             |       |                         |       |              | (5,447     | ) |   |   |   |   |   |   |   |   |   |   | (5,447 | ) |   |   | $ | (5,447 | ) |   |
|                                                                             |       |                           |       |                 |       |               |       |                  |       |                    |       |             |       |                         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | $ | (5,447 | ) |   |
| Balance,  September 30, 2006                                                |       | 41,751,304                     |       |                 | (2,561,858 | )                  |       |                  | $          | 418                     |       |             |       | $                            | 182,420    |              |       |   | $ | (131,597 | ) |   |   | $ | — |   |   |   | $ | (2,838 | ) |   |   | $ | 48,403 |   |   |   |   |   |   |

 

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

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

| ** **                                                                                 | ** ** | **Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from  operating activities:                                                     |       |                                        |       |   |   |   |   |
| Net loss                                                                                   |       | $                                           | (5,447     | ) | $ | (15,583 | ) | $ | (1,619 | ) |
| Adjustments to reconcile net loss to net cash (used  in) provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and amortization                                                              |       | 1,004                                       |       | 1,163 |   | 1,548 |   |
| Stock compensation                                                                         |       | 2,807                                       |       | 14 |   | 431 |   |
| Provision for doubtful accounts                                                            |       | (28                                         | )          | (4 | ) | 31 |   |
| Impairment of intangible and long-lived assets                                             |       | —                                      |       | 313 |   | 4,013 |   |
| Impairment of goodwill                                                                     |       | —                                      |       | 7,769 |   | — |   |
| Accrued income on short-term investments                                                   |       | —                                      |       | — |   | (13 | ) |
| Non-cash portion of restructuring and other charges  (credits)                             |       | —                                      |       | — |   | (107 | ) |
| Changes in operating assets and liabilities:                                               |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                        |       | (6,708                                      | )          | 2,784 |   | 695 |   |
| Inventories                                                                                |       | 789                                         |       | 5,115 |   | 595 |   |
| Prepaid expenses and other current assets                                                  |       | (555                                        | )          | 352 |   | 689 |   |
| Accounts payable                                                                           |       | 1,402                                       |       | (3,667 | ) | (4,552 | ) |
| Accrued expenses                                                                           |       | 997                                         |       | (554 | ) | 626 |   |
| Deferred revenue                                                                           |       | 334                                         |       | 763 |   | (110 | ) |
| Net cash (used in) provided by operating activities                                        |       | (5,405                                      | )          | (1,535 | ) | 2,227 |   |
| Cash flows from  investing activities:                                                     |       |                                        |       |   |   |   |   |
| Purchases of property and equipment                                                        |       | (398                                        | )          | (1,451 | ) | (1,025 | ) |
| Purchases of short-term investments                                                        |       | (44,210                                     | )          | (48,581 | ) | (28,290 | ) |
| Sales of short-term investments                                                            |       | 47,300                                      |       | 47,301 |   | 29,250 |   |
| Changes in other assets                                                                    |       | 102                                         |       | 51 |   | (52 | ) |
| Net cash provided by (used in) investing activities                                        |       | 2,794                                       |       | (2,680 | ) | (117 | ) |
| Cash flows from  financing activities:                                                     |       |                                        |       |   |   |   |   |
| Proceeds from issuance of common stock                                                     |       | 1,175                                       |       | 713 |   | 1,222 |   |
| Payments on capital lease obligations                                                      |       | (18                                         | )          | (4 | ) | — |   |
| Proceeds from settlement of litigation                                                     |       | —                                      |       | — |   | 415 |   |
| Net cash provided by financing activities                                                  |       | 1,157                                       |       | 709 |   | 1,637 |   |
| Net (decrease)  increase in cash and cash equivalents                                      |       | (1,454                                      | )          | (3,506 | ) | 3,747 |   |
| Cash and cash  equivalents, beginning of year                                              |       | 9,468                                       |       | 12,974 |   | 9,227 |   |
| Cash and cash  equivalents, end of year                                                    |       | $                                           | 8,014      |   | $ | 9,468 |   | $ | 12,974 |   |
| Supplemental  disclosure of non-cash investing or financing activities:                    |       |                                        |       |   |   |   |   |
| Acquisition of  equipment under capital lease obligation                                   |       | $                                           | —     |   | $ | 101 |   | $ | — |   |
| Issuance of common stock  upon cashless stock warrant exercises                            |       | $                                           | —     |   | $ | — |   | $ | 202 |   |

 

The accompanying notes are an integral part of theconsolidated financial statements.

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

**1. Nature of Business**

Network Engines, Inc. (“Network Engines” or the “Company”)develops and manufactures server appliance solutions that deliver primarilydata storage and network security software applications on server appliances. Serverappliances are pre-configured network infrastructure devices designed tooptimally deliver specific software application functionality and facilitateease of deployment and support of a software application in a customer’snetwork. The Company was organized into two reportable segments: OEM Applianceand Distribution.

In its OEM Appliance segment, the Company develops andmanufactures server appliance solutions that enable network equipment providersand independent software vendors, or ISVs, to deliver their software applicationsin the form of a server appliance. The Company offers its server appliancecustomers a comprehensive suite of services, including development,manufacturing, fulfillment and post-sale support. The Company produces andfulfills devices branded for its network equipment and ISV customers, andderives its revenues from the sale of value-added hardware platforms to thesecustomers. These customers subsequently sell and support the device under theirown brands to their customer base.

During fiscal 2006 and 2005, the Company’sDistribution segment developed, manufactured, sold and marketed serverappliances under its own brand that were based on Microsoft’s Internet Securityand Acceleration (ISA) Server. The Company licensed and integrated this softwarewith server appliance platforms and its proprietary software to sell its ownbranded server appliances primarily to Microsoft-certified value addedresellers and systems integrators.

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

**2. Summary of Significant Accounting Policies**

*Basis of Presentation*

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All intercompany transactions and balances have beeneliminated.

*Use of Estimates*

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

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

**2. Summary of Significant Accounting Policies(Continued)**

*Reclassifications*

Certain previouslyreported amounts have been reclassified to conform to the current periodpresentation.

*Cash, Cash Equivalents, Short-term Investments andRestricted Cash*

Cash equivalents consistsprincipally of money market funds, commercial paper, and other marketablesecurities purchased with an original maturity of three months or less. Theseinvestments are carried at cost, which approximates market value. The Companyalso invests excess cash in auction rate securities. These securities havelong-term underlying maturities, however the market is highly liquid and theinterest rates reset every 7, 28 or 35 days. The Company’s intent is not tohold these securities to maturity, but rather to use the interest rate resetfeature to sell securities to provide liquidity as needed. The Company’sshort-term investments are classified as available for sale and are carried atfair value, with unrealized gains and losses included in other comprehensiveincome or loss, which is a separate component of stockholders’ equity, untilrealized. At September 30, 2006, and 2005 there were no unrealized gainsor losses. At September 30, 2006 and 2005, $47,000 of cash was restrictedand pledged as collateral for a letter of credit related to the lease of theCompany’s facilities.

*Concentrations of Risk*

*Credit.*

Financial instruments thatpotentially subject the Company to concentrations of credit risk consistprincipally of cash, cash equivalents, short-term investments and tradereceivables. The Company invests primarily in municipal bonds, money marketfunds of major financial institutions as well as government agency securities.There are no significant concentrations in any one issuer of securities. TheCompany provides credit to customers in the normal course of business and doesnot require collateral from its customers, but routinely assesses theirfinancial strength. The Company maintains reserves for potential credit lossesand such losses have been within management’s expectations.

*Customers.*

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

| ** **          | ** ** | **Net Revenues for the year ended  September 30,** | ** ** | **Accounts Receivable at  September 30,** | ** ** |
|---------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **          | ** ** | **   2006   **                                     | ** ** | **   2005   **             | ** ** | **   2004   ** | ** ** | **    2006    ** | ** ** | **     2005     ** | ** ** |
| EMC  Corporation(1) |       |                                                                             | 81         | %                                                        |       |   | 79 | % |   |   | 49 | % |   |   | 85 | % |   |   | 67 | % |   |
|                     |            |                                                                                  |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          OnSeptember 18, 2006, EMC Corporation acquired Network Intelligence Inc.,which was also previously one of the Company’s customers. As a result, theCompany has included revenues from sales to Network Intelligence after September 18,2006 in determining net revenue from EMC Corporation. The Company has alsoincluded accounts receivable from Network Intelligence as of September 30,2006 in determining EMC Corporation’s receivable balance as of September 30,2006.

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

**2. Summary of Significant Accounting Policies (Continued)**

*Fair Value of Financial Instruments*

Financial instruments,including cash, cash equivalents, restricted cash, short-term investments,accounts receivable, and accounts payable, are carried in the financialstatements at amounts that approximate their fair value as of September 30,2006 and 2005.

*Inventories*

Inventories are valued atthe lower of cost or market, with approximate cost determined using thefirst-in, first-out method. The Company regularly reviews inventory quantitieson hand and records a write-down for excess and obsolete inventory basedprimarily on its estimated forecast of product demand and anticipatedproduction requirements in the near future.

*Property and Equipment*

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

*Intangible Assets and Goodwill*

Intangible assets that resulted from the Company’s December 2002acquisition of TidalWire Inc. consisted of customer relationships. During theyear ended September 30, 2004, these assets were amortized on astraight-line basis over their estimated useful lives of five years.

Goodwill is the amount bywhich the cost of acquired net assets exceeded the fair value of those netassets on the date of acquisition. In July 2001, the FASB issued Statementof Financial Accounting Standard No. 142, “Goodwill and Other IntangibleAssets” (SFAS 142). As a result, goodwill is no longer amortized but tested forimpairment under a two-step process. Under the first step, an entity’s netassets are segregated into reporting units and compared to their fair value. Ifthe carrying amount of a reporting unit exceeds its fair value, the second stepof the goodwill impairment test is performed to measure the amount ofimpairment loss, if any. The second step compares the implied fair value of areporting unit’s goodwill with the carrying amount of that goodwill. If thecarrying amount of a reporting unit’s goodwill exceeds the implied fair valueof that goodwill, an impairment loss is recognized in an amount equal to thatexcess. Fair value is calculated as the present value of estimated future cashflows using a risk-adjusted discount rate, which requires significantmanagement judgment with respect to revenue and expense growth rates and theselection and use of an appropriate discount rate. During the year ended September 30,2005, the Company recorded an impairment charge of $7,769,000 related togoodwill (see Note 3).

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

**2. Summary of Significant Accounting Policies(Continued)**

*Foreign Currencies*

The functional currencyfor the Company’s foreign subsidiary is the U.S. dollar. Net foreign currencylosses included in the determination of net loss for the two years ended September 30,2006, and 2005 were not significant.

*Impairment of Long-lived Assets*

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

*Revenue Recognition*

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

Maintenance revenues are derived from customer supportagreements generally entered into in connection with the initial serverappliance sales and subsequent renewals. Maintenance fees are typically for oneto three year renewable periods and can include the right to unspecifiedsoftware updates when-and-if-available, hardware repairs, 24-hourcustomer support, and advanced replacement of server appliances. Maintenancerevenues are recognized ratably over the term of the maintenance period.Payments for maintenance fees are generally made in advance and are included indeferred revenue.

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

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

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

**2. Summary of Significant Accounting Policies(Continued)**

contractual refund ratesfor cancellations or stand-alone sales of maintenance whereby the residual fairvalue is allocated to the server appliance.

The Company recognizesrevenue when the revenue recognition criteria for each element of the sale aremet. If the fair value of the element of the sale (i.e. maintenance) is unableto be derived, all revenues from the arrangement are deferred and recognizedratably over the period of the support arrangement, which is typically one tothree years. The Company includes shipping and handling costs, if any,reimbursed by its customers as net revenues and cost of revenues.

*Product Warranties*

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

*Advertising Costs*

Advertising costs areexpensed as incurred. Advertising expenses for the year ended September 30,2006 and 2005 were $868,000 and $965,000, respectively, and were not materialfor the year ended September 30, 2004.

*Research and Development*

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

*Income Taxes*

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

*Comprehensive Income (Loss)*

Comprehensive income(loss) is comprised of two components, net income (loss) and othercomprehensive income (loss). During the years ended September 30, 2006,2005 and 2004, comprehensive loss consisted of net loss.

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

**2. Summary of Significant Accounting Policies (Continued)**

*Net Loss per Share*

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

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

| ** **                        | ** ** | **As of September 30,** | ** ** |
|-----------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Options to  purchase common stock |       | 3,722                                  |       | 4,444 |   | 4,412 |   |

 

*Recent Accounting Pronouncements*

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004), *“Share-Based Payment”* (“SFAS123(R)”). SFAS 123(R) is a revision of FASB Statement No. 123, *“Accounting for Stock-Based Compensation”*, supersedes AccountingPrinciples Board Opinion No. 25, *“Accounting for StockIssued to Employees”*, and amends FASB Statement No. 95, *“Statement of Cash Flows”*. SFAS 123(R) requires allshare-based payments to employees, including grants of employee stock optionsand stock purchases under employee stock purchase plans, to be recognized inthe financial statements based on their fair values. The Company adopted SFAS123(R) using the modified prospective method during the quarter ended December 31,2005. As noted in footnote 12 below, the adoption of SFAS 123(R) had amaterial impact on the Company’s consolidated statements of operations and netloss per share.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin No.108,“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in the Current Year Financial Statements” (“SAB 108”). SAB 108addresses how the effects of prior-year uncorrected misstatements should beconsidered when quantifying misstatements in current-year financial statements.SAB 108 requires an entity to quantify misstatements using a balance sheet andincome statement approach and to evaluate whether either approach results in anerror that is material in light of relevant quantitative and qualitativefactors. The requirements of SAB 108 are effective for fiscal years endingafter November 15, 2006. The adoption of SAB 108 will not have an impacton the Company’s financial position, results of operations, or cash flows.

**3. Goodwill and Intangible Assets**

The Company performed its annual impairment assessmentof goodwill as of September 30, 2005 using an appraisal based primarily onthe estimated discounted cash flows expected to be generated by itsDistribution segment. The discounted cash flows used in the appraisal werebased on a number of estimates and assumptions made by the Company, includingthe projected future operating results of the Company’s Distribution segment,the discount rate, and the long-term growth rate. The Company based its revenueassumptions on estimates of relevant market sizes, expected market growthrates, and actual fiscal 

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

**3. Goodwill and Intangible Assets (Continued)**

2005 results. In addition,to arrive at the implied fair value of the reporting unit’s goodwill, theCompany considered among other factors, the expected required investments intechnology development and sales and marketing efforts. This assessmentresulted in an implied fair value of the reporting unit’s goodwill that wassignificantly lower than its carrying value. Consequently, the Companydetermined that its goodwill was fully impaired resulting in an impairmentcharge of $7,769,000 for the year ended September 30, 2005 (also see Note6).

On December 10, 2003, the Company amended itsagreement with EMC regarding the distribution of EMC-approved Fibre ChannelHBAs, effective January 1, 2004. As a result of this unfavorableamendment, the Company conducted a detailed analysis of its goodwill andintangible assets as of December 10, 2003. To assess the fair value of theCompany’s definite-lived intangible assets under SFAS 144, the Companyestimated the undiscounted future cash flows from these assets, based on aninternal analysis. The estimated undiscounted future cash flows from theseassets were less than the assets’ carrying value. As a result, the Companydetermined the fair value of these assets using a discounted cash flow analysisand an appraisal. This analysis and appraisal were based on a number of estimatesand assumptions, including the projected results of the Company’s sales ofEMC-approved Fibre Channel HBAs and the related gross profit. The estimatedfair value of these assets was less than the carrying amount, which resulted inan impairment charge during the quarter ended December 31, 2003 of$3,614,000.

In October 2004 theCompany decided to cease selling third-party data storage networking products. Thisdecision was based on a review of this portion of the business and itsprospects. As a result of the commoditization of the Fibre Channel HBAtechnology and increasing competition in the market, the Company experienceddeclining gross profits from sales of these products. In addition, future netrevenues and gross profits in this portion of the business were expected todeteriorate. As a result, the Company’s annual impairment assessment performedin the quarter ended September 30, 2004 based on the expected operatingresults of this portion of the business, resulted in an impairment charge of$399,000. The total impairment charged to operations during the year ended September 30,2004 was approximately $4,013,000, which resulted in the carrying value ofthese intangible assets being reduced to zero at September 30, 2004. Duringthe year ended September 30, 2004, the Company recorded amortizationexpense related to these intangible assets of $297,000.

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

**4. Cash, Cash Equivalents and Investments**

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

| ** **                          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2006**               | ** ** | **2005**               | ** ** |
| **Cash and cash equivalents:**      | ** ** |                   | ** ** | ** **             |       |   | ** ** | ** ** |   |
| Cash                                |       |                   | $          | 718                    | ** ** |   |   | $ | 2,722 | ** ** |   |
| Money market funds                  |       |                   | 5,105      | ** **             |       |   | 5,018 | ** ** |   |
| Commercial Paper                    |       |                   | 2,191      | ** **             |       |   | — | ** ** |   |
| Municipal bonds                     |       |                   | —     | ** **             |       |   | 1,728 | ** ** |   |
| **Total cash and cash equivalents** |       |                   | $          | 8,014                  | ** ** |   |   | $ | 9,468 | ** ** |   |
| **Short-term  investments:**        | ** ** |                   | ** ** | ** **             |       |   | ** ** | ** ** |   |
| Municipal auction  rate securities  |       |                   | $          | 24,804                 | ** ** |   |   | $ | 27,894 | ** ** |   |

 

**5. Inventories**

Inventoriesconsisted of the following (in thousands):

| ** **      | ** ** | **September 30,** | ** ** |
|-----------------|------------|------------------------|------------|
| ** **      | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Raw materials   |       | $                      | 4,628      |   | $ | 3,972 |   |
| Work in process |       | 432                    |       | 302 |   |
| Finished goods  |       | 3,385                  |       | 4,953 |   |
|            |       | $                      | 8,445      |   | $ | 9,227 |   |

 

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

**6. PROPERTYAND EQUIPMENT**

Propertyand equipment consisted of the following (in thousands):

| ** **                                       | ** ** | ** **                                      | ** ** | **September 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **Useful Life**                            | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Office furniture  and equipment                  |       | 5  years                                        |       | $                      | 836        |   | $ | 836 |   |
| Engineering and  production equipment            |       | 3  years                                        |       | 1,571                  |       | 1,589 |   |
| Computer  equipment and software                 |       | 3  years                                        |       | 3,390                  |       | 3,068 |   |
| Leasehold  improvements                          |       | Shorter  of lease term or  useful life of asset |       | 1,861                  |       | 1,821 |   |
|                                             |       |                                            |       | 7,658                  |       | 7,314 |   |
| Less: accumulated  depreciation and amortization |       |                                            |       | 6,565                  |       | 5,615 |   |
|                                             |       |                                            |       | $                      | 1,093      |   | $ | 1,699 |   |

 

Depreciation and amortization expense, related toproperty and equipment, was approximately $1,004,000, $1,163,000, and$1,251,000 for the years ended September 30, 2006, 2005, and 2004,respectively.

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

**7. CAPITAL LEASE AGREEMENT**

During the year ended September 30, 2005, theCompany entered into a lease agreement for certain office equipment that hasbeen accounted for as a capital lease. The Company has assets acquired undercapital lease obligations amounting to $101,000 at September 30, 2006. Accumulatedamortization totals $27,000 at September 30, 2006. Amortization of suchequipment is included in depreciation and amortization expense.

At September 30,2006, the minimal annual rental commitments, under this capital lease agreementare as follows (in thousands):

| 2007                                              |   | $  | 24     |   |
|---------------------------------------------------|--------|----|--------|--------|
| 2008                                              |   | 24 |   |
| 2009                                              |   | 24 |   |
| 2010                                              |   | 18 |   |
| Total minimum  lease payments                     |   | 90 |   |
| Less amount representing interest                 |   | 11 |   |
| Present value of minimum lease payments           |   | 79 |   |
| Less current portion                              |   | 19 |   |
| Capital lease  obligation, net of current portion |   | $  | 60     |   |

 

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

**8. STOCKHOLDERS’ EQUITY**

*Preferred Stock*

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

**9. RELATED PARTYTRANSACTIONS**

Robert M. Wadsworth, one of the Company’s directors,is a managing director of the limited liability corporation that controlsHarbourVest Partners (and its affiliates), one of the Company’s significantstockholders. Mr. Wadsworth, is also a director of PSI Holding Group, Inc.(“PSI”), the parent company of Akibia, Inc. (“Akibia”). During the yearsended September 30, 2006 and 2005, HarbourVest owned greater than 5% ofthe outstanding stock of the Company and greater than 5% of the outstandingstock of PSI. While the Company was selling third-party data storage networkingproducts it engaged Akibia to provide certain customer support and warrantyfulfillment services related to the Company’s sales of HBAs. The Company’sagreement with Akibia expired in March 2005 as scheduled. However, theterms of the agreement required Akibia to fulfill the warranty services for theentire warranty period. Akibia charged the Company a quarterly fixed fee of$83,000 and a variable fee based upon the Company’s sales of HBAs which ended December 2004.For the years ended September 30, 2006, 2005 and 2004 the Company recognized$0, $201,000 and $1,070,000, respectively, of expense as a result of its HBAcustomer support and warranty fulfillment services agreements with Akibia. Inconnection with this customer support and warranty fulfillment servicesagreement, the Company also sold HBA’s to Akibia to allow Akibia to fulfill theCompany’s warranty obligations for these products. For the years ended September 30,2006, 2005 and 2004 the Company recorded revenues of $0, $40,000 and $143,000,respectively, from sales of HBAs to Akibia. There were no amounts receivablefrom or payable to Akibia at September 30, 2006 or 2005. In November 2005,Mr. John A. Blaeser, one of the Company’s directors, also joined the boardof directors of Akibia.

Mr. Wadsworth, also serves as a director ofInnoveer Solutions, Inc. (“Innoveer”), formerly Akibia Consulting, asubsidiary of Akibia. The Company previously engaged Innoveer to performcertain professional services related to an upgrade of its customer resourcemanagement (“CRM”) software system that was completed during fiscal year 2004.The Company incurred approximately $243,000 related to this upgrade project inthe year ended September 30, 2004. The Company also engages Innoveer toprovide professional services related to modifications of its CRM softwaresystem. During the years ended September 30, 2006 and 2005, the Companyincurred approximately $80,000 and $14,300, respectively, related to theseservices. The Company had $7,000 outstanding to Innoveer at September 30,2006 and no amounts outstanding to Innoveer at September 30, 2005.

Through fiscal 2005, Mr. Polestra, a formerdirector of the Company, was also a managing director of Ascent VenturePartners. Both Mr. Polestra and Mr. Blaeser are limited partners inone of Ascent Venture Partner’s funds, which owned greater than 5% of theoutstanding capital stock of Network Intelligence Corporation prior to itsacquisition by EMC Corporation on September 18, 2006. Network IntelligenceCorporation has a contract with the Company to purchase certain of its products.For the years ended September 30, 2005 and 2004, revenues from sales toNetwork Intelligence Corporation were 

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

**9. RELATEDPARTY TRANSACTIONS (Continued)**

approximately $4,040,000,and $3,200,000, respectively. At September 30, 2005, the Company had$871,000 of receivables from Network Intelligence Corporation.

Additionally, in September 2005,the Company engaged the consulting services of Mapleworks Technologies (“Mapleworks”),a software development services provider. Both Mr. Blaeser and Mr. Wadsworthare investors in Mapleworks and are members of its board of advisors. In theyears ended September 30, 2006 and 2005 the Company incurred $82,000 and$18,000, respectively, in fees for these consulting services. The Company hadno amounts outstanding to Mapleworks at September 30, 2006 or 2005.

**10. STOCK INCENTIVE PLANSAND STOCK-BASED COMPENSATION**

Effective October 1, 2005, the Company adoptedthe provisions of Statement of Financial Accounting Standards 123(R), *“Share-Based Payment,”* (“SFAS 123(R)”),**which establishes accounting for equityinstruments exchanged for employee services. Under the provisions ofSFAS 123(R), stock-based compensation cost is measured at the grant date,based on the fair value of the award, and is recognized as an expense over theemployee’s requisite service period (generally the vesting period of the equityaward). Prior to October 1, 2005, the Company accounted for share-basedcompensation to employees in accordance with Accounting Principles BoardOpinion No. 25,*“Accounting for StockIssued to Employees,”* (“APB 25”) and related interpretations. TheCompany also followed the disclosure requirements of Statement of FinancialAccounting Standards No. 123,*“Accountingfor Stock-Based Compensation”* (“SFAS 123”). The Company electedto adopt the modified prospective transition method as provided bySFAS 123(R) and, accordingly, financial statement amounts for theprior periods presented have not been retroactively adjusted to reflect thefair value method of expensing stock-based compensation.

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

In May 2000, the Company’s shareholders approvedan increase of 3,300,000 in the number of shares authorized under the 1999 Planand an automatic annual increase in the number of shares authorized under the1999 Plan. The automatic annual increase is equal to the lesser of: 5% of theoutstanding shares on the first day of each fiscal year; 4,000,000 shares; oran amount determined by the board of directors, which is subject to a maximumof 20,047,902 authorized shares under the plan. As of September 30, 2006,the Company is authorized to grant options, restricted stock or other awards ofup to 13,807,273 shares of common stock.

In May 2000, the Company’s shareholders approvedthe 2000 Director Option Plan (the “Director Plan”). Under the Director Plan,the Company may make formula grants of stock options to non-employee directorsof up to 500,000 shares of common stock. New directors to the Company’s boardare granted an initial grant of 50,000 shares, which vest 25% on the firstanniversary of the grant date and thereafter in equal quarterly installmentsover the next three years. Subsequent annual grants of 15,000 shares to 

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

**10. STOCKINCENTIVE PLANS AND STOCK-BASED COMPENSATION (Continued)**

directors vest 100% uponthe first anniversary of the grant date. In March 2004, the Company’sshareholders approved an increase of an additional 325,000 shares of commonstock authorized to be issued under this plan, resulting in a total of 825,000options authorized to be issued. Under the Director Plan, options to purchase595,000 shares have been granted, options to purchase 90,000 shares have beenexercised and options to purchase 45,000 shares have been cancelled through September 30,2006.

In May 2000, the Company’s shareholders approvedthe 2000 Employee Stock Purchase Plan (the “Purchase Plan”). Under the PurchasePlan, the Company may issue up to an aggregate of 750,000 shares of commonstock to eligible employees. In March 2004, the Company’s shareholdersapproved an increase of an additional 500,000 shares of common stock authorizedto be issued under the Purchase Plan, resulting in a total of 1,250,000 sharesauthorized to be issued. Eligible employees must be employed by the Company formore than 20 hours per week and more than five months in a fiscal year. Underthe Purchase Plan, the Company makes two offerings each fiscal year, at the endof which employees may purchase shares of common stock through payroll deductionsmade over the term of each offering. Offering periods begin on the 15th day of November and May each year.The per-share purchase price for offerings prior to May 15, 2005, wasequal to the lesser of 85% of the closing price of the common stock at the beginningor end of the offering period. During the year ended September 30, 2005,the board of directors amended the Purchase Plan to limit the per-sharepurchase price for offerings to 85% of the closing price at the end of theoffering period, beginning with the offering period ended May 15, 2005.During the year ended September 30, 2006, 257,000 shares of common stockwere issued under the Purchase Plan. The Company had 121,000 shares availablefor issuance under its Purchase Plan as of September 30, 2006.

Thefollowing table presents stock-based employee compensation expenses included inthe Company’s consolidated statements of operations (in thousands):

| ** **                              | ** ** | **Year Ended**              | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **September 30, 2006** | ** ** |
| Cost of revenues                        |       |                             | $          | 181 |   |   |
| Research and  development               |       |                             | 1,112      |   |   |
| Selling and  marketing                  |       |                             | 770        |   |   |
| General and  administrative             |       |                             | 744        |   |   |
| Total stock-based  compensation expense |       |                             | $          | 2,807 |   |   |

 

As a result of adopting SFAS 123(R), the Company’sloss before income taxes and net loss for the year ended September 30,2006 is $2,807,000 greater than if it had continued to account for stock-basedcompensation under APB 25. Basic and diluted net loss per share for theyear ended September 30, 2006 were also greater by $0.07 due to theadoption of SFAS 123(R). The amount of stock-based employee compensationcapitalized in inventory at September 30, 2006 was not significant.

The Company estimates the fair value of stock optionsusing the Black-Scholes valuation model. This valuation model takes intoaccount the exercise price of the award, as well as a variety of significantassumptions. The assumptions used to estimate the fair value of stock optionsinclude the expected term, the expected volatility of the Company’s stock overthe expected term, the risk-free interest rate over the expected term, and theCompany’s expected annual dividend yield. The Company believes that thevaluation technique and the approach utilized to develop the underlyingassumptions are appropriate in calculating the fair values of the Company’sstock options granted in the year ended September 30, 2006. 

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

**10. STOCKINCENTIVE PLANS AND STOCK-BASED COMPENSATION (Continued)**

Estimates of fair valueare not intended to predict the value ultimately realized by persons whoreceive equity awards. In determining the amount of expense to be recorded,judgment is also required to estimate forfeitures of the awards based on theprobability of employees completing the required service period.  Historical forfeitures are used as a startingpoint for developing our estimate of future forfeitures.

Assumptionsused to determine the fair value of options granted during the year ended September 30,2006, using the Black-Scholes valuation model were:

| ** **                      | ** ** | **Year Ended**              | ** ** |
|---------------------------------|------------|----------------------------------|------------|
| ** **                      | ** ** | **September 30, 2006** | ** ** |
| Expected term(1)                |       | 5.5 to 6.25 years                |       |
| Expected  volatility factor(2)  |       | 77.49% to 79.65%                 |       |
| Risk-free  interest rate(3)     |       | 4.39 to 5.15%                    |       |
| Expected annual dividend  yield |       | —%                          |       |

----

(1)          Expected term for eachgrant was determined as the midpoint between the vesting date and the end ofthe contractual term, also known as the “simplified method” for estimatingexpected term described by Staff Accounting Bulletin No. 107 (“SAB 107”).

(2)          The expected volatilityfor each grant is estimated based on a weighted average of historicalvolatility.

(3)          The risk-free interestrate for each grant is based on the U.S. Treasury yield curve in effect at thetime of grant for a period equal to the expected term of the stock option.

Stock-based compensation expense related to theCompany’s Employee Stock Purchase Plan was determined based on the discount of15% from the per share market price on the close of the purchase period.

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

**10. STOCKINCENTIVE PLANS AND STOCK-BASED COMPENSATION (Continued)**

Prior to October 1,2005, the Company accounted for stock-based compensation to employees inaccordance with APB 25. The Company also had previously adopted the provisionsof SFAS 123, which required disclosure only of stock-based compensationand its impact on net loss and net loss per share. The following tableillustrates the effects on net loss and net loss per share for the years ended September 30,2005 and 2004 as if the Company had applied the fair value recognitionprovisions of SFAS 123 to stock-based employee awards.

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

 

In prior years the Company recorded deferred stockcompensation related to certain of its acquisitions and the issuance of stockoptions granted at prices deemed to be below fair market value. The Companyrecognized stock compensation expense of approximately $14,000, and $431,000,for the years ended September 30, 2005, and 2004, respectively. TheCompany had no deferred stock compensation remaining at September 30,2005.

The Company issues common stock from previouslyauthorized but unissued shares to satisfy option exercises and purchases underthe Company’s Purchase Plan.

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

**10. STOCKINCENTIVE PLANS AND STOCK-BASED COMPENSATION (Continued)**

A summary of stock optionactivity follows:  

| ** **                              | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------|------------|
| Outstanding,  September 30, 2005   |       | 6,701,268                  |       |                                   | 2.41       |                                                                 |       |   |   |   |   |
| Granted                                 |       | 2,837,782                  |       |                                   | 1.58       |                                                                 |       |   |   |   |   |
| Exercised                               |       | (1,152,424                 | )          |                                   | 0.76       |                                                                 |       |   |   |   |   |
| Cancelled                               |       | (1,019,662                 | )          |                                   | 2.81       |                                                                 |       |   |   |   |   |
| Outstanding,  September 30, 2006   |       | 7,366,964                  |       |                                   | $          | 2.29                                                                 |       |   |   | 7.43 |   |   |
| Exercisable at  September 30, 2006 |       | 3,925,886                  |       |                                   | $          | 2.52                                                                 |       |   |   | 6.11 |   |   |

 

All options granted during the years ended September 30,2006, 2005, and 2004 were granted with exercise prices equal to the fair marketvalue of the Company’s common stock on the grant date and had weighted averagefair values of $1.12, $1.92, and $4.47 per share, respectively determined usingthe Black-Scholes option pricing model. As of September 30, 2006,2,621,565 shares were available for future grants under the Plans and theCompany had reserved 7,366,964 shares of common stock for the exercise ofoutstanding stock options.

At September 30, 2006, the aggregate intrinsicvalue of options outstanding and options exercisable was $4,350,000 and$2,657,000, respectively. The intrinsic value of a stock option is the amountby which the market value of the underlying stock exceeds the exercise price ofthe option.

The aggregate intrinsic value of options exercisedduring the years ended September 30, 2006, 2005 and 2004 was $1,294,000,$425,000 and $3,314,000, respectively.

Thefollowing table summarizes the stock options outstanding at September 30,2006:

| ** **                         | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Exercise Price Range** | ** ** | ** **                   | ** ** | **Number**                   | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual  Life (in years)** | ** ** | **Number** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $0.07–$  0.98       |       | 1,091,011                    |       |                         | $          | 0.89 |   |   |   | 5.87 |   |   | 1,056,155 |   |   | $ | 0.89 |   |   |
| $1.00–$  1.19       |       | 1,118,904                    |       |                         | $          | 1.14 | ** ** |   |   | 4.97 | ** ** |   | 1,104,654 |   |   | $ | 1.14 | ** ** |   |
| $1.20–$  1.35       |       | 49,364                       |       |                         | $          | 1.26 | ** ** |   |   | 7.11 | ** ** |   | 25,738 |   |   | $ | 1.24 | ** ** |   |
| $1.36–$  1.36       |       | 1,469,282                    |       |                         | $          | 1.36 | ** ** |   |   | 9.27 | ** ** |   | — |   |   | $ | 0.00 | ** ** |   |
| $1.38–$  1.53       |       | 739,143                      |       |                         | $          | 1.44 | ** ** |   |   | 8.86 | ** ** |   | 195,817 |   |   | $ | 1.43 | ** ** |   |
| $1.59–$  2.04       |       | 819,641                      |       |                         | $          | 1.81 | ** ** |   |   | 7.87 | ** ** |   | 365,840 |   |   | $ | 1.79 | ** ** |   |
| $2.11–$  2.76       |       | 811,464                      |       |                         | $          | 2.57 | ** ** |   |   | 8.25 | ** ** |   | 342,857 |   |   | $ | 2.61 | ** ** |   |
| $2.85–$  4.40       |       | 755,780                      |       |                         | $          | 3.92 | ** ** |   |   | 7.89 | ** ** |   | 436,670 |   |   | $ | 4.23 | ** ** |   |
| $4.66–$  8.62       |       | 391,000                      |       |                         | $          | 8.09 | ** ** |   |   | 6.58 | ** ** |   | 288,343 |   |   | $ | 8.02 | ** ** |   |
| $8.90–$39.81                  |       | 121,375                      |       |                         | $          | 14.76 | ** ** |   |   | 4.80 | ** ** |   | 109,812 |   |   | $ | 15.37 | ** ** |   |
|                               |       | 7,366,964                    |       |                         | $          | 2.29 | ** ** |   |   | 7.43 | ** ** |   | 3,925,886 |   |   | $ | 2.52 | ** ** |   |
|                                    |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

**10. STOCKINCENTIVE PLANS AND STOCK-BASED COMPENSATION (Continued)**

At September 30, 2006, unrecognized compensationexpense related to non-vested stock options was $3,990,000, which is expectedto be recognized over a weighted average period of 2.9 years.

During each of the yearsended September 30, 2006, 2005 and 2004 the Company granted 5,000 optionsto a non-employee. These options were accounted for at their fair valueresulting in an immaterial amount of compensation expense recorded during theyears ended September 30, 2006, 2005 and 2004.

**11. COMMITMENTS ANDCONTINGENCIES**

*Operating Leases*

TheCompany leases its office space under non-cancelable operating leases. Duringthe year ended September 30, 2006, the Company entered into an amendmentof its office space lease. The amendment of this lease extended the lease termthrough March 2009 for 52,000 square feet of office and manufacturingspace. The lease amendment includes a provision for free rent for one month infiscal year 2007 and has rent escalation clauses in 2008 and 2009. Accordingly,rent expense is being recognized on a straight-line basis and any amounts paidwhich are greater than or less than the amount expensed will be recorded on thebalance sheet as deferred rent. Additionally, the lease amendment provides theCompany with the option to renew the lease for an additional two year period atthe then current market rate. As of September 30, 2006, the future minimumlease payments under the Company’s non-cancelable operating leases were asfollows (in thousands): 

| **Year Ending**   | ** ** | ** ** | ** ** |
|------------------------|------------|------------|------------|
| **September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 2007                   |       | $          | 592        |   |
| 2008                   |       | 688        |       |
| 2009                   |       | 357        |       |
| Total                  |       | $          | 1,637      |   |
|                        |            |            |            |  |  |  |

 

Rent expense for the years ended September 30,2006, 2005 and 2004 was $654,000, $637,000 and $581,000, respectively.

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

**11. COMMITMENTS ANDCONTINGENCIES  (Continued)**

*Guarantees and Indemnifications*

Acquisition-related indemnifications—When, as part ofan acquisition, the Company acquires all the stock of a company, the Companyassumes liabilities for certain events or circumstances that took place priorto the date of acquisition. The maximum potential amount of future payments theCompany could be required to make for such obligations is undeterminable. Whilethe provisions of the agreements remain in effect indefinitely, the Companybelieves that the probability of receiving a claim is unlikely. As a result,the Company has not recorded a liability for these indemnification clauses asof September 30, 2006 and 2005.

The Company enters intostandard indemnification agreements in the ordinary course of its business.Pursuant to these agreements, the Company indemnifies, holds harmless, andagrees to reimburse the indemnified party for losses suffered or incurred bythe indemnified party, generally its business partners or customers, inconnection with any patent, copyright, trademark, trade secret or otherintellectual property infringement claim by any third party with respect to itsproducts. The term of these indemnification agreements is generally perpetual.The Company has never incurred costs to defend lawsuits or settle claimsrelated to these indemnification agreements. As a result, the Company believesthe estimated fair value of these agreements is minimal. Accordingly, theCompany has no liabilities recorded for these indemnifications as of September 30,2006 and 2005.

*Product warranties*

The Company offers and fulfills warranty services oncertain of its server appliances. In addition, while the Company was sellingthird-party data storage networking products it contracted with a third partyto provide warranty services for these products. The Company’s agreement withthis third-party warranty provider expired in March 2005 as scheduled. However,the terms of the agreement require the third-party warranty provider to servicethese products for the entire warranty period. Warranty terms vary in durationdepending upon the product sold but generally provide for the repair orreplacement of any defective products for periods of up to 36 months aftershipment. Based upon historical experience and expectation of futureconditions, the Company reserves for the estimated costs to fulfill customerwarranty obligations upon the recognition of the related revenue. Forwarranties related to third-party data storage networking products, the Companyrecorded warranty expense based on its agreement with its third-party warrantyfulfillment provider, whose fees were determined based on fixed periodicamounts as well as activity-based charges.

Thefollowing table presents changes in the Company’s product warranty liabilityfor the years ended September 30 (in thousands):

| ** **                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Beginning balance                            |       | $        | 455        |     | $          | 433 |   |
| Accruals for  warranties issued              |       | 1,109    |       | 1,170    |       |
| Fulfillment of  warranties during the period |       | (1,005   | )          | (1,148   | )          |
| Ending balance                               |       | $        | 559        |     | $          | 455 |   |

 

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

**11. COMMITMENTSAND CONTINGENCIES  (Continued)**

*Contingencies*

*TidalWireAcquisition Lawsuit*

A purported class actionand derivative lawsuit was filed on January 7, 2003 in the Court ofChancery in the State of Delaware against the Company, and certain members ofits Board of Directors relating to the acquisition of TidalWire Inc. Theplaintiffs in the complaint alleged that the Company and the named directors ofits Board of Directors breached their fiduciary duties by, among other things,paying an excessive amount in the acquisition of TidalWire Inc. and purportedlyfailing to disclose material facts in the Company’s Joint ProxyStatement/Information Statement distributed to stockholders for approval of theissuance of shares of the Company’s Common Stock in the merger. The plaintiffssought damages, rescission of the merger and other relief. On October 30,2003, the court approved a settlement of the action negotiated by the parties,and that settlement became final on December 1, 2003. Under thesettlement, all claims against the Company and its individual board memberswere dismissed with prejudice, and (a) the defendants in the lawsuit paid$600,000 to the Company, (b) plaintiff’s attorney fees of $185,000 werepaid out of that $600,000 amount and (c) in the disclosure for the Company’snext annual meeting, the Company was required to detail certain informationconcerning relationships among its board members, which the Company has compliedwith. Payments to the Company under this settlement, net of payments ofplaintiff’s attorney fees, were recorded as an increase of $415,000 toadditional paid-in capital during the year ended September 30, 2004.

*Announcement TimingLawsuit*

On March 17, 2004, the United States DistrictCourt for the District of Massachusetts (the “Court”) consolidated a number ofpurported class action lawsuits filed against Network Engines, Inc. andcertain individual Network Engines defendants (collectively the “Defendants”). Thesesuits generally concern the timing of the announcement of an amendment toNetwork Engines’ agreement with EMC Corporation regarding the resale ofEMC-approved Fibre Channel HBAs. The Plaintiffs filed an amended consolidatedcomplaint on June 4, 2004. The Defendants on August 13, 2004 filed amotion to dismiss the amended consolidated complaint. The Plaintiffs on October 12,2004 filed an opposition to the Defendants’ motion to dismiss and theDefendants filed a reply to the Plaintiff’s opposition on November 12,2004. The Court on November 22, 2004 denied the Defendant’s motion todismiss the amended consolidated complaint. On December 9, 2004, theDefendants filed an answer to the amended consolidated complaint.

Since that time theparties engaged in some informal discovery, exchanged formal discoveryrequests, and then pursued active settlement discussions. On March 31,2006, the parties filed a motion for preliminary approval of a class actionsettlement. On April 4, 2006, the Court entered an Order preliminarilyapproving the settlement and scheduled deadlines for the settlement approvalprocess. The settlement was subject to a notice and comment period, duringwhich class members could object, opt out of the settlement, or file claims underthe settlement. No class members objected to the settlement or opted out of theclass. On July 25, 2006, the Court approved the settlement. The Courtentered an Order and Final Judgment approving the terms of the settlement inits entirety. The terms of the settlement required the Company’s insuranceprovider to pay $2,875,000 in full settlement of the claims asserted by theclass.

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

**11. COMMITMENTSAND CONTINGENCIES  (Continued)**

*Initial PublicOffering Lawsuit*

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

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

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

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

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

**11. COMMITMENTSAND CONTINGENCIES  (Continued)**

publichearing on its fairness, which took place on April 24, 2006. The Court’sfinal approval of the settlement remains pending. The Company is unable topredict the outcome of this suit and as a result, no amounts have been accruedas of September 30, 2006.

**12. INCOME TAXES**

Due to the losses incurred during fiscal years 2006and 2005, the Company did not record a provision for any federal or stateincome taxes in those years.  For theyear ended September 30, 2004, the Company incurred $44,000 in alternativeminimum tax expense in connection with the federal limitation on alternativetax net operating loss carryforwards. For the year ended September 30,2006, the Company recorded a provision of $48,000 for foreign income taxes owedby its subsidiary in the United Kingdom.

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

| ** **                                       | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| At U.S. federal  statutory rate                  |       | $        | (1,852     | )        | $          | (5,298   | )          | $ | (536 | ) |
| State taxes, net  of federal effect              |       | (266     | )          | (415     | )          | (67      | )          |
| Foreign taxes                                    |       | 48       |       | —   |       | —   |       |
| Research and  development credits                |       | —   |       | (460     | )          | (219     | )          |
| Non-deductible  stock option compensation charge |       | —   |       | —   |       | 135      |       |
| Non-deductible  expenses and other items         |       | 556      |       | 2,664    |       | 23       |       |
| Effect of change  in valuation allowance         |       | 1,562    |       | 3,509    |       | 708      |       |
| Provision for  income taxes                      |       | $        | 48         |     | $          | —   |       | $ | 44 |   |

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andincome tax purposes using enacted tax rates in effect for the year in which thedifferences are expected to reverse. As of September 30, 2006 and 2005,net deferred tax assets consisted of the following (in thousands):

| ** **                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Net operating  losses                 |       | $        | 33,488     |     | $          | 32,220 |   |
| Tax credit  carryforwards             |       | 1,968    |       | 2,550    |       |
| Capitalized  research and engineering |       | 2,641    |       | 3,384    |       |
| Temporary  differences                |       | 4,203    |       | 2,761    |       |
| Total deferred tax asset              |       | 42,300   |       | 40,915   |       |
| Valuation  allowance                  |       | (42,300  | )          | (40,915  | )          |
| Net deferred tax  asset               |       | $        | —     |     | $          | — |   |

 

A valuation allowance is established if it is morelikely than not that all or a portion of the deferred tax asset will not berealized. Accordingly, as of September 30, 2006 and 2005, a valuationallowance was recorded for the full amount of the deferred tax asset due to theuncertainty of their realization.  

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

**12. INCOMETAXES (Continued)**

Approximately $6.8 millionof the net operating loss carryforwards relate to disqualifying dispositions ofincentive stock options, the tax benefit from which, if realized, will becredited to additional paid-in capital.

As of September 30, 2006, the Company had netoperating loss carryforwards for federal and state income tax purposes ofapproximately $82,942,000 and $88,135,000, respectively. For federal income taxpurposes these net operating loss carryforwards will expire as follows:$44,404,000 in 2021, $22,686,000 in 2022, $3,458,000 in 2023, $1,172,000 in2024, $9,187,000 in 2025 and $2,392,000 in 2026. For state income tax purposesthese net operating loss carryforwards will expire beginning in 2006.

The Company also hasavailable research and development credits for federal and state income taxpurposes of approximately $1,584,000 and $384,000, respectively, which expireat various dates from 2006 through 2023. An ownership change, as defined in theInternal Revenue Code, resulting from the issuance of additional stock maylimit the amount of net operating loss and tax credit carryforwards that can beutilized annually to offset future taxable income and tax liabilities. Theamount of the annual limitation is determined based upon the Company’s valueimmediately prior to the ownership change. Subsequent significant changes inownership could further affect the limitations in future years.

**13. EMPLOYEE SAVINGS PLAN**

The Company sponsors asavings plan for its employees, who meet certain eligibility requirements,which is designed to be a qualified plan under section 401(k) of theInternal Revenue Code. Eligible employees are permitted to contribute to the401(k) plan through payroll deductions within statutory and plan limits.The Company may make discretionary contributions upon the approval of the 401(k) plantrustees and the Company’s board of directors. Through September 30, 2006,the Company has not made any contributions to the plan.

**14. RESTRUCTURING ANDOTHER CHARGES**

During the year ended September 30, 2003, theCompany recorded a charge to operations of $507,000. This charge was comprisedentirely of future lease and lease-related payments and resulted from thecontinued vacancy of certain leased facilities and the expected future vacancyof certain leased facilities occupied by a sub-tenant. When the Companyrestructured its operations during fiscal 2001, a portion of the charges thatwere recorded were based on the curtailment of a planned expansion into leasedfacilities of approximately 24,000 square feet as well as vacatingapproximately 17,000 square feet of leased space. In December 2002, basedon the real estate market in the area of these facilities, the lack of interestin the spaces that the Company had been actively marketing to sublease and thedeteriorating financial condition of the sub-tenant, the Company revised itsestimates as to the duration of an expected sublease of these facilities andthe estimated sublease income.

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

During the year ended September 30, 2005, theCompany discontinued sales of third-party data storage networking productsbased on a review of that portion of the business and its prospects. An amendment to a key distributionagreement, the commoditization of Fibre Channel HBA technology and 

74

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

**14. RESTRUCTURINGAND OTHER CHARGES (Continued)**

increasing competition inthe market resulted in the Company experiencing declining gross profits relatedto its distribution of HBAs. As a result, the Company recorded a restructuringcharge of $366,000 during the quarter ended December 31, 2004. Approximately$283,000 of the charge related to one-time termination benefits associated withterminating eleven employees in this portion of the business during thequarter. The Company also incurred $83,000 for a fixed payment related to itswarranty fulfillment contract with an external service provider. The Companycompleted its sales of its remaining third-party data storage networkingproducts during the quarter ended December 31, 2004. The Company completedits payments under this restructuring obligation during the quarter ended March 31,2005.

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

| ** **                                                                       | ** ** | **Employee  Related** | ** ** | **Facility  Related** | ** ** | **Other** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------|------------|-----------|------------|
| **Restructuring  and other charges accrual balance at September 30, 2003**  |       |                  | —     | ** **            |       |      | 262        |      |       |   | 15 |   |   | 277 |   |
| Reversal of excess restructuring                                                 |       |                  |       |                  |       |      | (107       | )         |       |   |   |   |   | (107 | ) |
| Cash payments                                                                    |       |                  |       |                  |       |      | (155       | )         |       |   | (15 | ) |   | (170 | ) |
| Restructuring and other charges accrual balance at  September 30, 2004 |       |                  | —     |                  |       |      | —     |      |       |   | — |   |   | — |   |
| **Restructuring charge**                                                         |       |                  | 283        |                  |       |      | —     |      |       |   | 83 |   |   | 366 |   |
| **Cash payments**                                                                |       |                  | (283       | )                     |       |      | —     |      |       |   | (83 | ) |   | (366 | ) |
| Restructuring  charge accrual balance at September 30, 2005                 |       |                  | $          | —                |       |      |       | $         | —     |   |   |   | $ | — |   |   | $ | — |   |
|                                                                                  |            |                       |            |                       |            |           |            |           |            |  |  |  |  |  |  |  |  |  |  |

 

**15. SEGMENT AND GEOGRAPHICDATA**

The Company was organized into two reportablesegments: OEM Appliance and Distribution. Sales of server appliances to theCompany’s network equipment and ISV customers are included in the Company’s OEMAppliance segment. Sales of server appliances and data storage products to VARsand systems integrators were included in the Company’s Distribution segment.The accounting policies of these segments are the same as those described inNote 2:  “Summary of SignificantAccounting Policies.” The Company evaluated its segments’ performance based onnet revenues, gross profit and segment operating income (loss), and theCompany’s management regularly evaluates the Company’s segments in deciding howto allocate resources and assess performance. There were no inter-segment salesor transfers. Management does not review assets as part of the assessment ofsegment performance.

 

75

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

**15. SEGMENT AND GEOGRAPHICDATA (Continued)**

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

| ** **                       | ** ** | **OEM** | ** ** | **Distribution** | ** ** | **Total** | ** ** |
|----------------------------------|------------|---------|------------|------------------|------------|-----------|------------|
| **September 30, 2006**      |       |    |       |             |       |      |       |   |   |
| Net revenues                     |       | $       | 117,302    |             |       | $         | 1,394      |   |   | $ | 118,696 |   |
| Segment operating income  (loss) |       | $       | 15,413     |             |       | $         | (12,378    | ) |   | $ | 3,035 |   |
| **September 30, 2005**      |       |    |       |             |       |      |       |   |   |
| Net revenues                     |       | $       | 92,877     |             |       | $         | 5,194      |   |   | $ | 98,071 |   |
| Segment operating income  (loss) |       | $       | 10,279     |             |       | $         | (19,003    | )(a) |   | $ | (8,724 | ) |
| **September 30, 2004**      |       |    |       |             |       |      |       |   |   |
| Net revenues                     |       | $       | 80,321     |             |       | $         | 56,434     |   |   | $ | 136,755 |   |
| Segment operating income  (loss) |       | $       | 8,583      |             |       | $         | (3,778     | )(b) |   | $ | 4,805 |   |

----

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

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

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

| ** **                                                             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Total segment  operating income (loss)                                 |       | $        | 3,035      |     | $          | (8,724   | )          | $ | 4,805 |   |
| General and administrative                                             |       | 7,729    |       | 7,845    |       | 6,430    |       |
| Stock-based  compensation (not included in general and administrative) |       | 2,063    |       | 7        |       | 390      |       |
| Restructuring and  other charges (credits)                             |       | —   |       | —   |       | (107     | )          |
| Loss from  operations                                                  |       | $        | (6,757     | )        | $          | (16,576  | )          | $ | (1,908 | ) |

 

76

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

**15. SEGMENTAND GEOGRAPHIC DATA (Continued)**

All of the Company’slong-lived assets were located in the United States as of September 30,2006 and 2005. The following summarizes the Company’s revenues by geographicregion, in thousands:

| ** **          | ** ** | **Years ended September 30,** | ** ** |
|---------------------|------------|----------------------------------------------|------------|
| ** **          | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States       |       | $                                            | 86,564     |   | $ | 73,082 |   | $ | 113,457 |   |
| Foreign countries   |       | 32,132                                       |       | 24,989 |   | 23,298 |   |
| Total net  revenues |       | $                                            | 118,696    |   | $ | 98,071 |   | $ | 136,755 |   |

 

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

| ** **     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|----------|------------|
| Ireland        |       | $        | 29,125     |     | $          | 23,646   |       | $ | 17,625 |   |
| Canada         |       | 1,499    |       | 1,014    |       | 2,930    |       |
| United Kingdom |       | 1,456    |       | 71       |       | —   |       |
|                |            |          |            |          |            |          |            |  |  |  |

 

**16. QUARTERLY FINANCIALDATA (UNAUDITED)**

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

| ** **                                             | ** ** | **Three Months Ended**                                   | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **December 31,  2005**                                        | ** ** | **March 31,  2006** | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** |
| ** **                                             | ** ** | **(in thousands, except per share data)** | ** ** |
| Net Revenues                                           |       |                                                               | $          | 27,269 |   |   |   | $ | 28,036 |   |   | $ | 32,048 |   |   | $ | 31,343 |   |   |
| Gross profit                                           |       |                                                               | 4,661      |   |   |   | 4,331 |   |   | 5,384 |   |   | 5,495 |   |   |
| Net loss                                               |       |                                                               | (1,624     | ) |   |   | (2,460 | ) |   | (1,105 | ) |   | (258 | ) |   |
| Basic and diluted net loss per share                   |       |                                                               | $          | (0.04 | ) |   |   | $ | (0.06 | ) |   | $ | (0.03 | ) |   | $ | (0.01 | ) |   |
| Basic and diluted  weighted average shares outstanding |       |                                                               | 37,867     |   |   |   | 37,987 |   |   | 38,218 |   |   | 38,666 |   |   |

 

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

 

77

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

**16. QUARTERLYFINANCIAL DATA (UNAUDITED) (Continued)**

During the fourth quarter of fiscal 2005, the Companyrecorded goodwill and long-lived asset impairment charges of $7,769,000 and$273,000, respectively.

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**ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING ANDFINANCIAL DISCLOSURE**

None.

**ITEM 9A. CONTROLSAND PROCEDURES**

**Disclosure Controlsand Procedures**

Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act) as of September 30, 2006. Based on thisevaluation, our chief executive officer and chief financial officer concludedthat, as of September 30, 2006, our disclosure controls and procedureswere (1) effective in accumulating and communicating information to the Company’smanagement, as appropriate, to allow timely decisions regarding requireddisclosure (2) effective, in that they provide reasonable assurance thatinformation required to be disclosed by the Company in the reports that itfiles or submits under the Securities Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms.

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

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

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

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

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

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

Network Engines’ management assessed the effectivenessof the Company’s internal control over financial reporting as of September 30,2006. In making this assessment, it used the criteria set forth in InternalControl-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Based on our assessment, weconcluded that, as of September 30, 2006, the Company’s internal controlover financial reporting is effective based on those criteria.

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PricewaterhouseCoopers,LLP, Network Engines’ Independent Registered Public Accounting Firm, auditedour assessment of the effectiveness of the Company’s internal control overfinancial reporting as of September 30, 2006, as stated in their reportappearing under Item 8.

**Changes in InternalControl Over Financial Reporting**

No change in the Company’sinternal control over financial reporting occurred during the fiscal year endedSeptember 30, 2006 that has materially affected, or is reasonably likelyto materially affect, the Company’s internal control over financial reporting.

**ITEM 9B. OTHERINFORMATION**

None.

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**PART III**

**ITEM 10. DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

The information requiredby this item relating to directors, code of ethics, audit committee, and auditcommittee financial expert of the Company and Section 16(a) beneficialownership reporting compliance is contained in our Proxy Statement related tothe 2007 Annual Meeting of Shareholders to be filed with the Securities andExchange Commission no later than 120 days after the end of our fiscal year, underthe sections captioned “Election of Directors”, “Additional Information AboutDirectors” and “Section 16(a) Beneficial Ownership ReportingCompliance”, and is incorporated herein by reference in response to this item. Theinformation regarding executive officers is included in Part I of this Form 10-Kunder the section captioned “Executive Officers of the Company”.

**ITEM 11. EXECUTIVECOMPENSATION**

The information requiredby this item is included under the section captioned “Executive Compensation”in our Proxy Statement related to the 2007 Annual Meeting of Shareholders to befiled with the Securities and Exchange Commission no later than 120 days afterthe end of our fiscal year and is incorporated herein by reference.

**ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT ANDRELATED STOCKHOLDER MATTERS**

The information requiredby this item relating to security ownership of certain beneficial owners andmanagement, and securities authorized for issuance under equity compensationplans, is included in our Proxy Statement related to the 2007 Annual Meeting ofShareholders to be filed with the Securities and Exchange Commission no laterthan 120 days after the end of our fiscal year under the section captioned “StockOwnership of Directors, Officers and Greater-Than-5%-Stockholders” and isincorporated herein by reference.

**ITEM 13. CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

The information requiredby this item relating to certain relationships and related transactions isincluded in our Proxy Statement related to the 2007 Annual Meeting ofShareholders to be filed with the Securities and Exchange Commission no laterthan 120 days after the end of our fiscal year under the section captioned “CertainRelationships and Related Transactions” and is incorporated herein byreference.

**ITEM 14. PRINCIPALACCOUNTANT FEES AND SERVICES**

The information requiredby this item is included under the captions “Ratification of IndependentRegistered Public Accounting Firm—Principal Accountant Fees and Services” and “Policyon Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services ofIndependent Registered Public Accounting Firm” in our Proxy Statement relatedto the 2007 Annual Meeting of Shareholders to be filed with the Securities andExchange Commission no later than 120 days after the end of our fiscal year andis incorporated herein by reference.

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**PART IV**

**ITEM 15. EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

**(a) (1) FinancialStatements**

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

|                                                                                                                                         | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                                                                                |       | 47       |   |
| Consolidated Balance Sheets as of September 30,  2006 and 2005                                                                     |       | 49       |   |
| Consolidated Statements of Operations for the years  ended September 30, 2006, 2005 and 2004                                       |       | 50       |   |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Loss for the years ended September 30, 2006, 2005 and 2004 |       | 51       |   |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2006, 2005 and 2004                                       |       | 53       |   |
| Notes to Consolidated Financial Statements                                                                                              |       | 54       |   |

 

**(a) (2) List ofSchedules**

Schedule II—Valuation and Qualifying Accounts for eachof the three fiscal years ended September 30, 2006.

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

**(a) (3) List ofExhibits**

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

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**SIGNATURES**

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the Registrant has dulycaused this Report to be signed on its behalf by the undersigned, thereuntoduly authorized, on December 14, 2006.

|        | **NETWORK ENGINES, INC** |
|--------|--------------------------|
|   | By:                      | /s/ GREGORY A. SHORTELL |
|   |                     | Gregory A. Shortell |
|   |                     | President and Chief Executive Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Report has beensigned as of December 14, 2006 below by the following persons on behalf ofthe Registrant and in the capacities indicated.

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

 

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**SCHEDULEII**

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

| **Fiscal  Year** | ** ** | ** **                              | ** ** | **Description** | ** ** | **Balance At  Beginning  of Period** | ** ** | **Additions** | ** ** | **Deductions** | ** ** | **Balance  At End  of Period** | ** ** |
|------------------|------------|-----------------------------------------|------------|-----------------|------------|------------------------------------------------|------------|---------------|------------|----------------|------------|------------------------------------------|------------|
| 2004             |       | Allowance For Doubtful  Accounts        |       |            | $          | 389                                            |       |          |       | $              | 31         |                                     |       |   | $ | 230 |   |   | $ | 190 |   |
| 2005             |       | Allowance For Doubtful  Accounts        |       |            | $          | 190                                            |       |          |       | $              | (4         | )                                        |       |   | $ | 111 |   |   | $ | 75 |   |
| 2006             |       | Allowance For Doubtful  Accounts        |       |            | $          | 75                                             |       |          |       | $              | 28         |                                     |       |   | $ | 74 |   |   | $ | 29 |   |
| 2004             |       | Allowance For  Sales Returns            |       |            | $          | 245                                            |       |          |       | $              | 228        |                                     |       |   | $ | 221 |   |   | $ | 252 |   |
| 2005             |       | Allowance For Sales  Returns            |       |            | $          | 252                                            |       |          |       | $              | —     |                                     |       |   | $ | 252 |   |   | $ | — |   |
| 2006             |       | Allowance For Sales  Returns            |       |            | $          | —                                         |       |          |       | $              | —     |                                     |       |   | $ | — |   |   | $ | — |   |
| 2004             |       | Deferred Tax  Asset Valuation Allowance |       |            | $          | 36,316                                         |       |          |       | $              | 708        |                                     |       |   | $ | 490 |   |   | $ | 36,534 |   |
| 2005             |       | Deferred Tax Asset  Valuation Allowance |       |            | $          | 36,534                                         |       |          |       | $              | 3,509      |                                     |       |   | $ | (872 | ) |   | $ | 40,915 |   |
| 2006             |       | Deferred Tax Asset Valuation Allowance  |       |            | $          | 40,915                                         |       |          |       | $              | 1,562      |                                     |       |   | $ | 177 |   |   | $ | 42,300 |   |

 

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**EXHIBITINDEX**
| Exhibit No. | ** ** | **Exhibit**                                                                                                                                                                                                                                                                                                                 |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Second Amended and Restated Certificate of  Incorporation of the Company (filed as Exhibit 3.1 to the Company’s  Annual Report on Form 10-K for the fiscal year ended September 30,  2000 and incorporated by reference herein).                                                                        |
| 3.2              |       | Second Amended and  Restated By-laws of the Company (filed as Exhibit 3.2 to the Company’s  Annual Report on Form 10-K for the fiscal year ended  September 30, 2000 and incorporated by reference herein).                                                                                             |
| 4.1              |       | Specimen common stock  certificate (filed as Exhibit 4.1 to the Company’s registration  statement on Form S-1 (File No. 333-34286) and  incorporated by reference herein).                                                                                                                              |
| 10.1             |       | Investor Rights  Agreement, dated December 20, 1999, among the Company and certain of our  investors (filed as Exhibit 10.6 to the Company’s registration statement  on Form S-1 (File No. 333-34286) and incorporated by  reference herein).                                                      |
| 10.2*            |       | The Company’s 1999 Stock  Incentive Plan (filed as Exhibit 10.2 to the Company’s registration  statement on Form S-1 (File No. 333-34286) and  incorporated by reference herein).                                                                                                                  |
| 10.3*            |       | Form of First  Amendment to the Company’s 1999 Stock Incentive Plan (filed as  Exhibit 10.16 to the Company’s registration statement on Form S-1  (File No. 333-34286) and incorporated by reference herein).                                                                                 |
| 10.4*            |       | Form of Incentive  Stock Option Agreement under the Company’s 1999 Stock Incentive Plan(filed as  Exhibit 10.3 to the Company’s registration statement on Form S-1  (File No. 333-34286) and incorporated by reference herein).                                                               |
| 10.5*            |       | The Company’s 2000  Employee Stock Purchase Plan, as Amended (filed as Exhibit 10.4 to the  Company’s registration statement on Form S-1 (File No. 333-34286)  and incorporated by reference herein).                                                                                              |
| 10.6*            |       | The Company’s 2000 Director  Stock Option Plan, as Amended (filed as Exhibit 10.5 to the Company’s  registration statement on Form S-1 (File No. 333-34286)  and incorporated by reference herein).                                                                                                |
| 10.7*            |       | Form of option  granted to each of Frank M. Polestra and Robert M. Wadsworth on March 16,  2000, under the Company’s 1999 Stock Incentive Plan (filed as  Exhibit 10.15 to the Company’s registration statement on Form S-1  (File No. 333-34286) and incorporated by reference herein). |
| 10.8*            |       | Incentive Stock Option  Agreement with John H. Curtis, dated March 21, 2001, under the Company’s  1999 Stock Incentive Plan (filed as Exhibit 10.23 to the Company’s  Quarterly Report on Form 10-Q for the fiscal quarter ended  March 31, 2001 and incorporated by reference herein).       |
| 10.9*            |       | Non-statutory Stock Option  Agreement with John H. Curtis, dated March 21, 2001 (filed as  Exhibit 10.24 to the Company’s Quarterly Report on Form 10-Q  for the fiscal quarter ended March 31, 2001 and incorporated by  reference herein).                                                       |
| 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).                                            |

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| 10.12  |   | Lease dated  October 19, 1999 with New Boston Batterymarch, LP for 25 Dan Road,  Canton, Massachusetts (filed as exhibit 10.1 to the Company’s registration  statement of Form S-1 (File No. 333-34286) and  incorporated by reference herein).                                                           |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13  |   | First Amendment dated  February 1, 2000 and Second Amendment dated June 1, 2000 to Lease  for 25 Dan Road, Canton, Massachusetts (filed as Exhibit 10.18 to the  Company’s registration statement on Form S-1 (File No. 333-34286)  and incorporated by reference herein).                      |
| 10.14  |   | Third Amendment dated  September 14, 2000 and Forth Amendment dated October 14, 2003 to  Lease for 25 Dan Road, Canton, Massachusetts (filed as Exhibit 10.24 to  the Company’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2003 and incorporated by reference herein). |
| 10.15# |   | Purchase Agreement for  product between the Company and EMC Corporation, dated February 5, 2002  (filed as Exhibit 10.36 to the Company’s Quarterly Report on  Form 10-Q for the fiscal quarter ended March 31, 2002 and  incorporated by reference herein).                                         |
| 10.16  |   | Severance Terms  Agreement, dated January 9, 2006, between the Company and Gregory A.  Shortell (Filed as Exhibit 10.1 to the Company’s Quarterly Report on  Form 10-Q for the quarter ended December 31, 2005 and  incorporated by reference herein).                                               |
| 10.17  |   | Letter Agreement, dated  January 6, 2006, between the Company and Gregory A. Shortell (Filed as  Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q  for the quarter ended December 31, 2005 and incorporated by reference  herein).                                                        |
| 10.18  |   | Offer Letter dated  March 7, 2006 between Network Engines, Inc. and Kevin Murphy (Filed  as Exhibit 10.1 to the Company’s Current Report on Form 8-K  dated April 6, 2006 and incorporated by reference herein).                                                                                |
| 10.19  |   | Base Salaries of  Executive Officers of the Company                                                                                                                                                                                                                                                                           |
| 10.20  |   | Summary of the Company’s  Non-Employee Director Compensation                                                                                                                                                                                                                                                             |
| 10.21  |   | Fifth Amendment dated  July 20, 2006 to Lease for 25 Dan Road, Canton, Massachusetts                                                                                                                                                                                                                                     |
| 14.1   |   | Code of Business Conduct  and Ethics of the Company (filed as Exhibit 14 to the Company’s Current  Report on form 8-K dated February 3, 2004 and incorporated by  reference herein).                                                                                                                           |
| 21.1   |   | Subsidiaries of the  Company.                                                                                                                                                                                                                                                                                                 |
| 23.1   |   | Consent of  PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                                                                       |
| 31.1   |   | Certification of Gregory  A. Shortell, the Chief Executive Officer of the Company, pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                           |
| 31.2   |   | Certification of Douglas  G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                             |
| 32.1   |   | Certification of Gregory  A. Shortell, the Chief Executive Officer of the Company, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                           |
| 32.2   |   | Certification of Douglas  G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                             |

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*                    Indicatesmanagement contract or compensatory plan or arrangement.

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

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