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



FORM 10-K



(Mark One)ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended September 30, 2008ORo

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


Commission file number: 000-30863

GRAPHIC

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

Delaware

04-3064173(State or other jurisdiction of incorporation)

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

02021(Address of principal executive offices)

(Zip Code)


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

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

Title of Each Class

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

NASDAQ Global Market


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

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

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting
company. See definitions of "large accelerated filer", "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer o

Accelerated filer ý

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

Smaller reporting company o


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

The aggregate market value of the voting Common Stock held by nonaffiliates of the registrant on March 31, 2008 was approximately $60,164,000.

The
number of shares outstanding of the registrant's Common Stock as of December 10, 2008 was 43,183,595 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our proxy statement relating to the 2009 Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission no later than
120 days after the end of our fiscal year, are incorporated by reference into Part III of this Form 10-K.



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NETWORK ENGINES, INC.  ANNUAL REPORT ON FORM 10-K  For the Fiscal Year Ended September 30, 2008        TABLE OF CONTENTS



PART IITEM 1.

BUSINESS


1ITEM 1A.

RISK FACTORS


11ITEM 1B.

UNRESOLVED STAFF COMMENTS


23ITEM 2.

PROPERTIES


23ITEM 3.

LEGAL PROCEEDINGS


23ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS


24PART IIITEM 5.

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


25ITEM 6.

SELECTED FINANCIAL DATA


28ITEM 7.

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


29ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


45ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


46ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE


75ITEM 9A.

CONTROLS AND PROCEDURES


75ITEM 9B.

OTHER INFORMATION


76PART IIIITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE


76ITEM 11.

EXECUTIVE COMPENSATION


76ITEM 12.

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


76ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE


76ITEM 14.

PRINCIPAL ACCOUNTING FEES AND SERVICES


76PART IVITEM 15.

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES


77SIGNATURES


78


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

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

PART I

ITEM 1.    BUSINESS

Overview

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

We
develop and manufacture application platform solutions that enable leading original equipment manufacturers, or OEMs, independent software vendors, or ISVs, and service providers to
deliver their software applications in the form of a network-ready device. We offer our customers an extensive suite of services associated with the design, development, manufacturing, brand
fulfillment and post-sale support of these devices. We produce, brand and fulfill devices for our customers, and we derive our revenues primarily from the sale of value-added hardware
platforms to these customers. Our customers subsequently resell and support the platforms under their own brands to their customer bases. Our customers include, but are not limited to:
ArcSight, Inc., AVST, Inc., Bomgar, Inc., Bradford Networks, Juniper Networks, Inc., EMC Corporation, Nortel Networks Inc., Sophos, Plc., and
Tektronix, Inc.

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

On
October 11, 2007, we acquired privately-held Alliance Systems, Inc. ("Alliance Systems"), a leading provider of application platforms and related equipment
to global carrier
communications companies and enterprise communications service providers. This acquisition, which was valued at approximately $41 million, was funded through a combination of approximately
$34 million in cash and the issuance of 2.9 million shares of our common stock.

Based
in Plano, Texas, Alliance Systems provided application platforms and support services for wireless, voice over internet protocol ("VoIP"), contact center and enterprise
communications

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applications.
The majority of Alliance Systems' revenue was derived from sales to OEM customers. Through the acquisition of Alliance Systems, we have entered new vertical markets and are able to
leverage a broader range of capabilities to address market needs for converged solutions.

Headquartered
in Canton, Massachusetts, we were incorporated in 1989, and began developing custom server-based hardware platforms in 1997 for internet protocol-based organizations,
content infrastructure providers and larger enterprises. In 1999, we achieved an important milestone by introducing a 1U Intel-based server, representing a server only 1.75 inches in height. At that
time, we designed most of the hardware components that went into our servers and, as a result, we invested significant resources in the development of our products. In large part as a result of the
success of that product, we completed an initial public offering in July 2000. Subsequently, a significant number of companies entered the 1U server marketplace, much of the hardware components of
server-based appliances became commoditized and, at the same time, the demand of internet-based organizations declined precipitously. As a result, we restructured our operations in fiscal year 2001,
which among other things de-emphasized the use of proprietary components in server hardware platforms. In December 2002, we acquired TidalWire, Inc., which was a specialty
distributor of third-party data storage networking products. The acquisition enabled us to distribute third-party data storage networking connectivity products for the leading Fibre Channel host bus
adapter, or HBA, and storage switch manufacturers in the data storage industry to a customer base of value-added resellers, or VARs, and systems integrators. During the first quarter of fiscal year
2005, we decided to discontinue selling third-party data storage networking products. The TidalWire acquisition also provided us with the ability to partner with ISVs to develop, manufacture, and
distribute the ISVs' software applications in the form of server appliances. Throughout fiscal years 2003 and 2004, we established relationships with several ISV customers.

During
fiscal years 2005 and 2006 we also developed, manufactured, sold, marketed and supported our NS Series Security Appliances that were based on Microsoft's Internet Security and
Acceleration ("ISA") Server software. Because sales of our NS Series appliances were less than expected in fiscal years 2005 and 2006, we discontinued the sale and demand creation for these
appliances. In fiscal year 2008, we expanded into the carrier communications and enterprise communications markets through our acquisition of Alliance Systems. Today, we leverage our engineering and
manufacturing expertise to deliver application platform solutions to our OEM, ISV and service provider customers while seeking to establish relationships with new customers.

Industry Background

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

Over
time, much of the networking solutions market has evolved toward the development and manufacture of systems, built using commercially available standardized components and
standardized operating system software. The speed and processing power of standard processors has reached a level at which these processors can adequately meet the demands of many networking
applications. Popular operating system platforms, such as Windows and Linux, have also increased in capability and sophistication and can now be used as the 'embedded' operating system environment for
many of today's networking applications.

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This
evolution in the development and manufacturing of systems, or server appliances, built with commercially available standardized components has allowed networking equipment vendors
to refocus development efforts and resources on the application software and system integration aspects of their solutions. Vendors recognize that custom hardware development in many cases is no
longer critical in meeting their customers' performance requirements. Competing systems are being integrated and packaged on standardized hardware platforms and, therefore, hardware alone no longer
differentiates a system in the marketplace. Based on the fact that application platforms can be built using standard commodity hardware and operating systems components, vendors recognize that these
aspects of their solution do not represent competitive differentiation points and are hence candidates for outsourcing. As a result, we believe that many OEMs, ISVs and service providers that use
application platform solutions will continue to outsource components of solution design, integration control, evaluation, test, manufacturing and global logistics to partners like NEI that specialize
in these skills.

While
there are many markets in which an application platform may ultimately be used, early adoption of our core solution technologies is most prevalent in the data storage, network
security, enterprise communications and carrier telecommunications markets. These markets are significant in size and have exhibited continued growth in recent years. The security applications that we
believe are most
likely to benefit from an application platform solution include firewalls, authentication, anti-virus, anti-spam, instant messaging ("IM") security, web content filtering,
intrusion detection and prevention, device relationship management, digital rights management and web services security management. The storage applications that we believe are most likely to benefit
from deployment in the form of an application platform solution (as either physical or virtual deployments) include storage security, backup and recovery, virtual tape libraries, storage resource
management and data migration and archival systems. The enterprise communications markets that we believe are most likely to benefit from deployment in the form of an application platform include
unified communications applications, including VoIP, Internet protocol private branch exchange ("IP-PBX"), audio and web conferencing, unified messaging ("UM") and IM.

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

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

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

The NEI Solution

We develop and manufacture application platform solutions and provide services that enable our customers to deliver their applications
as purpose-built appliances and network-ready devices. We achieve this by delivering innovative platforms and high value-added services to our customers to enable more cost-efficient,
secure, predictable and managed solutions. We focus on developing

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affordable
platforms and services to meet the target performance and comprehensive solution requirements of our customers. Key elements of our value proposition include:

Solution Design.The core of our business is developing comprehensive application platform solutions and acting as partners (in conjunction with our OEM, ISV and
service provider customers) to bring successful products to market. We have developed a complete platform development and deployment process, which takes into account all major aspects of a
comprehensive solution design, from performance requirements to branding, packaging and quality assurance. We strive to engage with our customers at multiple levels of their organization, including
engineering and product management, to optimize the solution by focusing on the convergence of the hardware, operating system, utilities and application software. We make use of in-house
application platform designs as well as third-party technology partner solutions, depending on the customer's configuration, application and volume requirements. An element of our solution design
expertise includes our virtual appliance solution service that enables our ISV customers to meet the demand for virtual deployments that require the creation of virtual application platforms. A
virtual application platform is a pre-built software solution, comprised of one or more virtual machines that is packaged, maintained, updated, and managed as a unit. Our virtual appliance
solution service consists of the software 'image' development and delivery mechanisms, and the service component itself, which addresses the management, maintenance and updating virtual appliances
need to run properly from initial provisioning through end-of-life.

Integration Control.We have sophisticated manufacturing facilities at our locations in Canton and Plano. Both locations are ISO 9001:2000 certified, and
our Plano facility is TL 9000 certified. The advanced integration control processes, comprehensive systems, and manufacturing test suites that we develop with our customers are designed to ensure
quality and traceability at every key step of the manufacturing process. We believe our core strengths include our ability to react quickly to accommodate changes in customer demands, including
increasing order volumes, engineering changes to existing products and new product introductions. For certain high-volume products, we supplement our production capacity and make provision
to maintain continuity of supply through a relationship with a contract manufacturer.

Smart Services.We believe our expertise in developing customized hardware platforms using standard-based components is a significant competitive advantage with
respect to customers. However, today's customers also require high value-added, technology-enabling services. We couple our technical expertise with these Smart Services to simplify platform
management and enable remote and automatic health monitoring, update and patch deliveries and software image back-up. Smart Services also help software developers track their field units
for up-to-date licensing and certificate status. Our ACE Element Manager software subsystem helps our customers more easily manage, monitor and maintain their appliances. ACE
provides a choice of operating system for our customers who develop their applications using Linux or Microsoft software. ACE enables us to provide our customers with an automated update service that
maintains the operating system when and if updates become available.

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

Support and Maintenance.We operate in a technology environment in which platforms, operating systems, components and software applications are constantly
evolving. We proactively analyze these developments in order to maintain the operation of the software applications despite changes in the underlying technologies. We also adapt our application
platform solutions to meet emerging requirements and capabilities of new versions of our customers' software or changes in their service

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offerings.
To better enable our customers to meet these challenges, we offer customers a variety of standard maintenance, support and service programs to extend product lifespan and maximize uptime.
These programs help ensure high availability, rapid response, effective troubleshooting, fast parts replacement and 24-hour support. Recognizing that customers often have unique support
and service requirements, we also offer custom-tailored support and maintenance programs. Some of our customers use advanced server replacement services for fast substitution in the event of field
unit damage or malfunction. Our advanced parts replacement program extends the warranty on system parts, expedites system diagnosis and repair, and makes on-site technical assistance
available as needed. Other support and service programs, such as anytime on-site service, are designed to give customers even more comprehensive coverage and support when uptime and
availability are considered mission critical.

Business Strategy

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

Strengthen existing relationships and engage with new OEMs, ISVs and service providers to sell application platform solutions.We believe that offering customers a
comprehensive platform solution supported by an extensive suite of services, including solution design, integration control, Smart Services, global logistics and post-sales support and
maintenance plans, enables them to accelerate their deployment and improve the integration of their software while achieving a low total cost of ownership over the long term. We believe that our
lifecycle management expertise and high value-added software services provide us with a competitive advantage in the marketplace that we intend to leverage to attract new OEMs, ISVs and service
providers, as well as develop additional opportunities within our existing customer base. During fiscal year 2008 we achieved 46 design wins. A "design win" occurs when a customer or prospective
customer notifies us that we have been selected to integrate the customer's application. Some of these customers generated meaningful revenue for us during the year, while others are in various stages
of product and market development. Over the next year we will be focused on cultivating new customers and opportunities in order to generate revenues, winning competitive bids, and continuing to
engage with new customers on a more complete solution-based level. We currently target OEMs, ISVs and service providers whose technology aligns with the benefits of deployment in the form of an
application platform, and who have adequate sales and marketing resources to bring such platforms to market. Prior to fiscal year 2008, these customers were in the data storage and network security
markets, where early adoption of application platform solutions has been most prevalent. However, with our acquisition of Alliance Systems, we have expanded the reach of our products and services to
the carrier communications and enterprise communications markets.

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

Develop and integrate technologies that improve the functionality, security, manageability and deployment of application platforms.We intend to continue to
enhance our proprietary technologies and, where appropriate, integrate other third-party technologies and standard components that deliver the promise of highly managed application platform solutions.
Our ACE Element Manager technology enables the remote management of such platforms through a secure web-based management system. We believe ACE Element Manager will enhance our ability to
enable complete appliance lifecycle management. Historically ACE Element Manager was only deployed on specific platform solutions.

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However,
in support of our lifecycle management offering we have developed ACE Element Manager for deployment across all of our platform solutions, including those in which the operating system is
based on Linux.

Products and Services

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

Our
products and services are described in more detail below:



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



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



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

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

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

Our
virtual platform solution service enables our ISV customers to meet the demand from their enterprise customers for virtual instances. This service enables the creation of virtual
application platforms that allow enterprise customers to more effectively provision software applications, reduce hardware dependencies and make better use of hardware assets for
next-generation deployment scenarios. The virtual platform solution service consists of software image development and delivery, as well as the service component, which addresses the
management, maintenance and updating that virtual platforms need to run properly from initial provisioning through end-of-life.



With ISO 9001 and TL 9000 certification as our guide, we provide high-quality internal manufacturing and test
services for our customers. We operate multiple production lines for high-volume and low-volume manufacturing. Our high-volume manufacturing process involves
building the chassis, including the integration of the main logic board, memory, disk drive and PCI board into the chassis and testing of the final product. Our low-volume process involves
branding of third-party supplied servers, as well as memory, disk drive and PCI board integration and testing. We maintain separate low- and high-volume lines in order to
provide our customers with the appropriate type of manufacturing resources and skill sets needed to best meet the volume requirements of a particular product. In addition, our low-volume
line allows us to provide customers with rapid manufacturing turn around time, which provides a significant time to market advantage for new products. Our customers' products undergo a complete system
test and burn-in period prior to final inspection, racking, packaging and shipment.



We brand the application platform for our OEM, ISV and service provider customers. Branding is applied to the platform chassis or bezel
itself as well as to all accompanying documentation, including quick set-up guides, manuals, shipping cartons, shipping labels and paperwork. We provide in-house graphic arts
services to facilitate production of branding designs and we work with outside design and production agencies that are highly experienced in equipment packaging and strategic branding techniques. We
also employ full-time mechanical engineers who build customized bezels, LCD front panels, light-pipes, and other distinctive features to provide a custom look and feel for our customers'
application platforms. We provide our customers with global logistics support and order fulfillment by delivering the final product to either our customer or, at their request, directly to their end
user customers all over the world. In order to streamline the sharing of information related to these services, we provide customers with access to a secure, self-service web portal. The
portal allows customers to view product manufacturing, inventory and consignment status as well as other operational events. Customers can also request additional information and use a link to
automatically receive notification of shipments and inventory levels. The portal enhances customers' ability to view, manage and report their assets on a day-to-day basis.

Customers

Our primary customer focus has been targeted towards OEMs, ISVs and service providers that wish to sell application platform solutions
to their customers. During the most recent fiscal quarter, we sold products and/or services to over 200 customers, including: ArcSight, Inc., AVST, Inc., Bomgar, Inc.,

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Bradford
Networks, Juniper Networks, Inc., EMC Corporation, Nortel Networks, Sophos Plc., and Tektronix, Inc. EMC and Tektronix were our only customers that represented more than
10% of our revenues for the year ended September 30, 2008, during which our sales to those customers were $82 million and $25 million, respectively, representing 42% and 13%,
respectively, of total net revenues. EMC was our only customer that represented more than 10% of our revenues for the years ended September 30, 2007 and 2006, during which our sales to EMC were
$99 million, or 83% of total net revenues, and $97 million, or 81% of total net revenues, respectively.

Sales and Marketing



Our sales team is focused on developing relationships with OEMs, ISVs and service providers seeking to deploy their application as a
purpose-built platform. We have organized a sales organization and business development team tasked with identifying and qualifying prospective customers and projects. When an opportunity is
identified, sales and customer care program managers meet with the customer and begin to work on appropriate design and deployment strategies. We then involve other employees from hardware and
software engineering, quality and product management to analyze the prospective customer's requirements and develop a platform solution.



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

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

Warranty and Post-sales Support Services

We offer a variety of warranty services that support the products we sell. The standard warranty generally provides for us to repair or
replace any defective product within predetermined timeframes and generally spans a period of up to 36 months after initial product shipment, depending on the product and our contractual
relationships with certain customers. We offer a range of additional post-sales support services, including advanced replacement of defective units as well as warranty coverage for
extended periods.

Manufacturing

We provide manufacturing, test and fulfillment services for application platforms at our 22,500 square foot manufacturing facility
located at our headquarters in Canton, and at our 32,000 square foot manufacturing facility located in Plano. Our Canton location received initial ISO 9001:2000 certification in October 2003
and maintains that certification today. Our Plano location has ISO 9001:2000 and TL 9000 certifications. We operate separate manufacturing lines for high-volume and
low-volume manufacturing. We maintain two separate production facilities in order to provide our customers with the appropriate type of manufacturing resources, business continuities and
skill sets to best meet the volume, cost and quality requirements of a particular product. In addition, our low-volume lines allow

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us
to provide customers with rapid manufacturing turn around time, which provides a significant time to market advantage for new products.

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

Engineering

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

Employees

As of September 30, 2008, we had 235 employees, of whom 99 were engaged in manufacturing, 11 were engaged in customer support,
48 were engaged in sales and marketing, 37 were engaged in research and development and 40 were engaged in general and administrative functions. We also employ contract labor, predominately in our
manufacturing operations. As of September 30, 2008, we utilized 17 contract employees.

Backlog

Our backlog includes orders confirmed with a purchase order for products scheduled to be shipped within 180 days to customers
with approved credit status. Certain of our customers place large orders with us to be delivered over time. In addition, we have an inventory consignment agreement with our largest customer whereby
shipments of certain products to the customer are held at its locations until the customer requires the products for its production process. We do not recognize revenues from consignment shipments
until the consigned product is utilized. Also, certain of our customers, including our largest customer, have certain rights under our agreements with them to change the delivery timing of future
shipments to them. In addition, our agreement with our largest customer includes provisions that allow this customer to cancel orders within certain contractual time periods. As a result of these
factors, we do not consider our backlog to be firm nor do we believe that our backlog, as of any particular date, is necessarily indicative of actual net revenues for any future period.

Competition

Our markets are highly competitive, and we expect this competition to persist and intensify in the future. Our principal competitors
are general-purpose server manufacturers that provide solutions for network equipment providers, communications equipment manufacturers and ISVs and build servers for the OEM marketplace. These
competitors include Dell, Hewlett-Packard, IBM and Sun Microsystems. We also compete with major distributor integrators, such as Arrow Electronics, Inc. and Avnet, Inc. that offer
distribution as well as customized integration services to their customers. In

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addition,
we compete with smaller companies that specialize in building server products and providing some level of integration services, such as Patriot Technologies, MBX Systems, NCS
Technologies, Inc., and SteelCloud, Inc. We also may compete with certain providers of electronics manufacturing services ("EMS") in the event they expand their service offerings.

Intellectual Property

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

We
have five patents applied for and in process for our ACE Element Manager and Update Services technologies.

Despite
our efforts to protect our proprietary rights, our competitors might independently develop similar technology and unauthorized parties may attempt to copy or otherwise obtain and
use our technology. Monitoring unauthorized use of our proprietary technology is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology,
particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. Due to rapid technological changes in our market, we believe the various legal
protections available for our intellectual property are of limited value. In addition to such intellectual property, we seek to establish and maintain an extensive knowledge of leading technologies
and to incorporate these
technologies into our application platform solutions by leveraging the technological knowledge and creative skills of our personnel.

Financial Information About Geographic Areas

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

Access to Our Securities and Exchange Commission Reports and Other Information

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

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

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ITEM 1A.    RISK FACTORS

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

Risks of dependence on one strategic partner.

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

For the years ended September 30, 2008, 2007, and 2006, sales directly to EMC, our largest customer, totaled $82 million,
$99 million, and $97 million, respectively, accounting for 42%, 83%, and 81%, of our total net revenues, respectively. These sales are primarily attributable to one product pursuant to a
non-exclusive contract. Although this concentration has decreased as a result of our acquisition of Alliance Systems, we anticipate that our future operating results will continue to
depend heavily on sales to, and our relationship with, this customer. Accordingly, the success of our business will depend, in large part, on this customer's willingness to continue to utilize our
application platform solutions in its existing and future products. Further, our financial success is dependent upon the future success of the products we sell to this customer and the continued
growth of this customer, whose industry has a history of rapid technological change, short product lifecycles, consolidation and pricing and margin pressures. Advances in hard drive storage capacity
could also result in lower sales volumes to this customer. A significant reduction in sales to this customer, or significant pricing and additional margin pressures exerted on us by this customer,
would have a material adverse effect on our results of operations. In addition, if this customer delays or cancels purchases of our products, our operating results would be harmed and we may be unable
to accurately predict revenues, profitability and cash flows.

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

Risks related to business strategy.

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

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

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There
are multiple risks associated with this strategy including:



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

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

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

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

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



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

Risks related to the application platform markets.

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

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

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

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

The markets we serve are characterized by rapid technological change, frequent new product introductions and enhancements, potentially
short product lifecycles, changes in customer demands and evolving industry standards. In the application platform market, we attempt to mitigate these risks by utilizing standards-based hardware
platforms and by maintaining an adequate knowledge base of available technologies. However, the application platform solutions that we sell could be rendered

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obsolete
if products based on new technologies are introduced or new industry standards emerge and we are not able to incorporate these technological changes into our products. In addition, we depend
on third parties for the base hardware of our application platforms and we are at risk if these third parties do not integrate new technologies. Releasing new products and services prematurely may
result in quality problems, and delays may result in loss of customer confidence and market share. We may be unable to develop new products and services or achieve and maintain market acceptance of
them once they have come to market. Furthermore, when we do introduce new or enhanced products and services, we may be unable to manage the transition from the older products and services to minimize
disruption in customer ordering patterns, avoid excessive inventories of older products and deliver enough new products and services to meet customer demand.

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

Risks related to financial results.

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

In the past, we have incurred significant net losses and could incur net losses in the future. At September 30, 2008 and
September 30, 2007, our accumulated deficit was $138 million and $129 million, respectively. We believe that any future growth will require us to incur significant engineering,
selling and marketing and administrative expenses. As a result, we will need to generate significant revenues to achieve and sustain profitability. If we do not achieve and sustain profitability, the
market price for our common stock may decline. Even if we achieve sustained profitability there can be no guarantee that our stock price will increase.

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

In connection with our October 2007 acquisition of Alliance Systems, we entered into an agreement with Silicon Valley Bank to provide
for a line of credit. We view this line of credit as a source of available liquidity to fund fluctuations in our working capital requirements. This facility contains various conditions, covenants and
representations with which we must be in compliance in order to borrow funds. However, if we wish to borrow under this facility in the future, there can be no assurance that we will be in compliance
with these conditions, covenants and representations. In addition, this line of credit facility with Silicon Valley Bank expires on August 5, 2010. After that, we may need to secure new
financing to continue funding fluctuations in our working capital requirements. However, we may not be able to secure new financing, or financing on favorable terms, if we experience a significant
adverse change in our business. As of December 15, 2008, we had not drawn on this line of credit.

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

Our discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that

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affect
the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our consolidated financial
statements, including those related to:



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

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

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



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

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

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

At September 30, 2008, the carrying value of our intangible asset, which consists of customer relationships associated with our
acquisition of Alliance Systems, was approximately $9.9 million, net of accumulated amortization. Because we had determined that our goodwill was fully impaired as of September 30, 2008,
we considered this an indicator that the carrying value of our intangible asset might not be recoverable. We performed a test for recoverability, and determined that the carrying value of the
intangible asset was fully recoverable, and therefore no impairment charge was recorded. We will continue to incur non-cash charges relating to the amortization of our intangible asset
over its remaining useful life. Future determinations of significant write-offs of the intangible asset resulting from an impairment test or any accelerated amortization of the intangible
asset could have a significant impact on our operating results and affect our ability to achieve or maintain profitability. Although we do not believe that any impairment of the intangible asset
exists at this time, in the event that any indicators of possible impairment exist, we may record charges which could have a material adverse effect on our results of operations. Such indicators
include, but are not limited to, a worsening in customer attrition rates compared to historical attrition rates, or lower than initially anticipated cash flows associated with customer relationships.

Our
acquisition of Alliance Systems was structured to include a downward adjustment to the purchase price based on the net working capital of Alliance Systems as of October 11,
2007, as defined in the merger agreement, and therefore approximately $4.0 million of the cash paid is contingently returnable to us upon resolution of this provision. As a result, the amount
of contingently returnable consideration has been excluded from the allocation of the purchase price to the net assets acquired until such time that this amount is no longer contingently returnable.
When the contingencies are resolved, any portion of the $4.0 million which is not returned to us will be reclassified as additional goodwill. If additional goodwill is recorded in a future
period, it will then be subject to review for

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impairment
annually as of the fiscal year end date, and more frequently if certain indicators are present. If an impairment is recorded in the future, it would negatively impact our operating results.

Risks related to competition.

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

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

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

Risks related to marketing and sales efforts and customer service.

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

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

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

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

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

Risks related to product manufacturing.

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

We depend upon single source and limited source suppliers for our industry standard processors, main logic boards, telephony boards,
certain disk drives, hardware platforms and power supplies as well as certain of our chassis and sheet metal parts. Additionally, we depend on limited sources to supply certain other industry standard
and customized components. We have in the past experienced, and may in the future experience, shortages of or difficulties in acquiring components in the quantities and of the quality needed to
produce our application platform solutions. Shortages in supply or quality issues related to these key components for an extended time would cause delays in the production of our application platform
solutions, prevent us from satisfying our contractual obligations and meeting customer expectations, and result in lost sales and customers. If we are unable to buy components in the quantities and of
the quality that we need on a timely basis or at acceptable prices, we will not be able to manufacture and deliver our application platform solutions on a timely or cost effective basis to our
customers, and our competitive position, reputation, business, financial condition and results of operations could be seriously harmed. If we are able to secure other sources of supply for such
components, our costs to purchase such components could increase, which would negatively impact our gross margins. A significant portion of our components are purchased from suppliers located in
China. Recently, several factories in China have closed without notice. If a factory which supplies parts to us closes with little or no notice, we could experience shortages and difficulties in
locating alternative sources of supply.

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

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

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significant
repair or replacement costs or potential damage to our reputation, any of which could have a material adverse effect on our business, results of operations or financial condition.

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



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

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

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

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

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Other risks related to our business.

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

Substantial litigation regarding intellectual property rights exists in the technology industry. We expect that application platform
solutions may be subject to third-party infringement claims as the number of competitors in the industry segment grows and the functionality of products in different industry segments overlap. In the
past we have received claims from third parties that our application platform solutions infringed their intellectual property rights. We do not believe that our application platform solutions employ
technology that infringes the proprietary rights of any third parties. We are also not aware of any claims made against any of our customers related to their infringement of the proprietary rights of
other parties in relation to products that include our application platform solutions. Other parties may make claims against us that, with or without merit, could:



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

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

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

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

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

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

In December 2001, a class action lawsuit relating to our initial public offering was filed against us, our chairman, one of our
executive officers and the underwriters of our initial public offering. For more information on lawsuits, see "Part I, Item 3Legal Proceedings." We are currently attempting
to settle the lawsuit filed against us related to our initial public offering. We are unable to predict the effects on our financial condition or business of the lawsuit related to our initial public
offering or other lawsuits that may arise from time to time. While we maintain certain insurance coverage, there can be no assurance that claims against us will not result in substantial monetary
damages in excess of such insurance coverage. This class action lawsuit, or any future lawsuits, could cause our director and officer insurance premiums to increase and could affect our ability to
obtain director and officer insurance coverage, which would negatively affect our business. In addition, we have expended, and may in the future expend, significant resources to defend such claims.
This class action lawsuit, or other similar lawsuits that may arise from time to time, could negatively impact both our financial condition and the market price of our common stock and could result in
management devoting a substantial portion of their time to these lawsuits, which could adversely affect the operation of our business.

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

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

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

The market price of our common stock has been subject to significant fluctuations and may continue to fluctuate or decline. During the
year ended September 30, 2007, the closing price of our common stock ranged from a low of $1.73 to a high of $2.81, and in the year ended September 30, 2008, from a low of $0.55 to a
high of $2.12. The market for technology stocks has been extremely volatile and frequently reaches levels that bear no relationship to the past or present operating performance of those companies.
General economic conditions, such as recession or interest rate or currency rate fluctuations in the United States or abroad, could negatively affect the market price of our common stock. For example,
the recent uncertainty related to deteriorating global economic conditions has negatively impacted the market price of our common stock. In addition, our operating results may be below the
expectations of securities analysts and investors. If this were to occur, the market price of our common stock may decrease significantly. In the past, following periods of volatility in the market
price of a company's securities, securities class action litigation has often been instituted against such companies. Such litigation could result in substantial cost and a diversion of management's
attention and resources.

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

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

Subsequent to June 30, 2008, at certain times, the market price of our common stock has been less than $1.00 per share. If we
are unable to meet the stock price listing requirements of NASDAQ, our common stock could be de-listed from the NASDAQ Global Market. On September 29, 2008, we received notification
from NASDAQ that during the preceding 30 consecutive trading days, the closing bid price of our common stock was below the $1.00 minimum bid price per share required for continued listing on the
NASDAQ Global Market under NASDAQ Marketplace Rule 4450(a)(5). In accordance with NASDAQ Marketplace Rule 4450(e)(2), NASDAQ provides issuers 180 calendar days to regain compliance with
the minimum bid price requirement by maintaining a closing bid price of $1.00 per share or higher for a minimum of 10 consecutive trading days. On October 22, 2008, NASDAQ notified us that it
had suspended enforcement of the minimum bid price rule for three months. As a result, we will have until July 2, 2009 to regain compliance with the minimum bid price requirement. NASDAQ may,
in its discretion, require that our common stock maintain a bid price in excess of $1.00 for a period in excess of 10 business days, but generally no more than 20 business days, before determining
that we have demonstrated the ability to maintain long-term compliance. If we are unsuccessful in meeting the minimum bid price requirement during the compliance period ending
July 2, 2009, NASDAQ will provide notice to us that our common stock will be delisted from the NASDAQ Global Market. If we receive such a notice, we may appeal the staff determination to the
NASDAQ Listing Qualifications Panel. We may also apply to transfer our common stock to the NASDAQ Capital Market if we satisfy all criteria for initial listing on the NASDAQ Capital Market, other than
compliance with the minimum bid price requirement. If such application to the NASDAQ Capital Market is approved, then we will have an additional 180-day compliance period in order to
regain compliance with the minimum bid price requirement while listed on the NASDAQ Capital Market.

If
our common stock were de-listed from the NASDAQ Global Market, among other things, this could result in a number of negative implications, including reduced liquidity in
our common stock as a result of the loss of market efficiencies associated with NASDAQ and the loss of federal preemption of state securities laws, as well as the potential loss of confidence by
suppliers, customers and employees, the loss of institutional investor interest, fewer business development opportunities and greater difficulty in obtaining financing.

A general downturn in the economy could materially adversely affect our financial performance and other aspects of our business.

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

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

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

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

ITEM 1B.    UNRESOLVED STAFF COMMENTS

None.

ITEM 2.    PROPERTIES

Our principal business operations are conducted in our corporate headquarters in Canton, Massachusetts where we lease approximately
52,000 square feet of manufacturing and office space, and in our Plano, Texas location where we lease approximately 83,000 square feet of manufacturing and office space. We believe that our Canton and
Plano facilities will be adequate to meet our requirements for the foreseeable future.

ITEM 3.    LEGAL PROCEEDINGS

Initial Public Offering Lawsuit

On or about December 3, 2001, a putative class action lawsuit was filed in the United States District Court for the Southern
District of New York against us, Lawrence A. Genovesi (our former Chairman and Chief Executive Officer), Douglas G. Bryant (our Chief Financial Officer), and several underwriters of our initial public
offering. The suit alleges,inter alia, that the defendants violated the federal securities laws by issuing and selling securities pursuant to our
initial public offering in July 2000 ("IPO") without disclosing to investors that the underwriter defendants had solicited and received excessive and undisclosed commissions from certain investors.
The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between July 13, 2000 and December 6, 2000.

In
October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice. On December 5, 2006, the United States Court of Appeals for the Second
Circuit overturned the District Court's certification of a plaintiff class. On April 6, 2007, the Second Circuit denied plaintiffs' petition for rehearing, but clarified that the plaintiffs may
seek to certify a more limited class in the District Court. On September 27, 2007, plaintiffs filed a motion for class certification in certain designated "focus cases" in the District Court.
That motion has since been withdrawn. On November 13, 2007, the issuer defendants in certain designated "focus cases" filed a motion to dismiss the second consolidated amended class action
complaints that were filed in those cases. On March 26, 2008, the District Court issued an Opinion and Order denying, in large part, the motions to dismiss the amended complaints in the "focus
cases."

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We
are unable to predict the outcome of this suit and as a result, no amounts have been accrued as of September 30, 2008.

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

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 2008.

EXECUTIVE OFFICERS OF THE COMPANY

Name

Age

PositionGregory A. Shortell


64

President, Chief Executive Officer and DirectorDouglas G. Bryant


51

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


52

Senior Vice President of Sales and MarketingRichard P. Graber


48

Senior Vice President of Engineering and Operations


Gregory
A. Shortell

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

Douglas
G. Bryant

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

Charles
N. Cone, III

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

Richard
P. Graber

Richard
P. Graber joined the Company in October 2003 as Vice President of Engineering and Operations and became Senior Vice President in December 2008.
Prior to joining the Company, Mr. Graber was the Vice President of Engineering and Operations at Jedai Broadband Networks, Inc., a developer of access technology for broadband providers.
Prior to Jedai Broadband Networks, Mr. Graber was Vice President of Engineering for ViaGate Technologies, Inc. from November 2000 to August 2001. Prior to joining ViaGate Technologies,
Mr. Graber held senior engineering positions at Dialogic, an Intel company, from June 1988 to October 2000.

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PART II

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

(a)   Market Information

NEI's common stock began trading on the NASDAQ National Market on July 13, 2000 under the symbol "NENG". Prior to that time there had been no market for
our common stock. The following table sets forth the high and low closing sales prices per share for our common stock on the NASDAQ Global Market for the periods indicated:

2008

2007Fiscal Year Ended September 30:

High

Low

High

LowFirst Quarter

$
2.12

$
1.57

$
2.81

$
1.94Second Quarter


1.64


1.36


2.62


2.00Third Quarter


1.72


1.10


1.97


1.75Fourth Quarter


1.18


0.55


2.33


1.73


(b)   Holders of record

As of December 9, 2008, there were approximately 227 holders of record of our common stock. Because many of such shares are held by brokers and other
institutions on behalf of stockholders, the Company is unable to estimate the total number of stockholders represented by these record holders.

(c)   Dividends

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

(d)   Securities Authorized for Issuance under Equity Compensation Plans

The information required by this item is included under the caption "Equity Compensation Plan Information" in our Proxy Statement related to the 2009 Annual
Meeting of Shareholders to be filed with the Securities and Exchange Commission no later than 120 days after the end of our fiscal year and is incorporated herein by reference.

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(e)   Performance Graph

The following graph compares the cumulative total return to holders of our common stock for the period from September 30, 2003 through September 30,
2008 with the cumulative total return over such period of the NASDAQ Stock Market (U.S.) Index, and the RDG Technology Composite.

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

GRAPHIC



The
graph assumes the investment of $100 in our common stock and in each of such indices (and the reinvestment of all dividends). Measurement points are the last trading days of each of
the years ended September 30, 2003, 2004, 2005, 2006, 2007 and 2008. The performance shown is not necessarily indicative of future performance.

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

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(f)    Stock Repurchase Program

Following is a summary of stock repurchases for each month during the fourth quarter of the year ended September 30, 2008:

Month

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

Average Price
Paid Per Share

Maximum Dollar Value
that May Yet Be Used
for Purchases Under
the ProgramJuly 2008


249,500

$
1.09

$
4,555,602August 2008


262,500

$
1.01

$
4,291,696September 2008


256,301

$
0.88

$
4,066,816Total


768,301

$
0.99

$
4,066,816


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ITEM 6.    SELECTED FINANCIAL DATA

The following selected financial data are derived from the financial statements of Network Engines, Inc. The historical results
presented are not necessarily indicative of future results. The consolidated statements of operations data for the years ended September 30, 2008, 2007, and 2006 and the consolidated balance
sheet data as of September 30, 2008 and 2007 have been derived from our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K. The
selected consolidated statements of operations data for the years ended September 30, 2005 and 2004 and the selected consolidated balance sheet data as of September 30, 2006, 2005, and
2004 are derived from our audited consolidated financial statements not included in this Annual Report on Form 10-K. The selected consolidated financial data set forth below should
be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Financial Statements and Supplementary Data" and the related Notes included
elsewhere in this Annual Report on Form 10-K.

On
December 27, 2002, we completed our acquisition of TidalWire. The financial information for the year ended September 30, 2005 only includes three months of results
related to the TidalWire business,
since we exited that portion of the business during the first fiscal quarter of 2005. On October 11, 2007, we completed our acquisition of Alliance Systems, Inc. ("Alliance Systems").
The results for the year ended September 30, 2008 only include activity from this acquisition since October 12, 2007. As such, the presentation of historical financial information and
any discussion regarding the comparison of historical financial information to financial information for the year ended September 30, 2008, does not include any financial information for
Alliance Systems prior to October 12, 2007, unless otherwise indicated. Forward-looking statements made regarding our expected future operating results include the expected results of Network
Engines and Alliance Systems on a combined basis.

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

Year Ended September 30,2008

2007

2006

2005

2004Net revenues

$
197,495

$
119,627

$
118,696

$
98,071

$
136,755Gross profit


32,343


23,252


19,871


17,061


23,908Operating expenses(a)(b)


41,056


22,584


26,628


33,637


25,816(Loss) income from operations


(8,713
)

668


(6,757
)

(16,576
)

(1,908
)Net (loss) income


(8,477
)

2,502


(5,447
)

(15,583
)

(1,619
)Net (loss) income per common sharebasic and diluted

$
(0.19
)
$
0.06

$
(0.14
)
$
(0.42
)
$
(0.04
)Weighted average shares outstandingbasic


43,856


40,637


38,207


37,461


36,594Weighted average shares outstandingdiluted


43,856


41,256


38,207


37,461


36,594




September 30,Balance Sheet Data:

2008

2007

2006

2005

2004Cash, cash equivalents, short-term investments and restricted cash

$
10,050

$
44,650

$
32,865

$
37,409

$
39,635Working capital


40,960


55,384


47,891


48,484


55,108Total assets


78,065


74,822


61,061


59,804


78,021Long-term debt, less current portion








60


79


Total stockholders' equity


54,352


55,508


48,403


49,861


64,673


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

Overview

We develop and manufacture application platform solutions that enable leading original equipment manufacturers, or OEMs, independent
software vendors, or ISVs, and service providers to deliver their software applications in the form of a network-ready device. Application platforms are pre-configured network
infrastructure devices designed to optimally deliver specific software application functionality, ease deployment, improve integration and manageability, accelerate time to market and increase the
security of that software application in a customer's network. We offer application platform customers an extensive suite of services associated
with the design, development, manufacturing, brand fulfillment and post-sale support of these devices. We produce, brand and fulfill devices branded for our customers, and derive our
revenues primarily from the sale of value-added hardware platforms to these customers. Our customers subsequently resell and support the platforms under their own brands to their customer bases.

On
October 11, 2007, we acquired privately-held Alliance Systems, Inc. ("Alliance Systems"), a leading provider of application platforms and related equipment
to global carrier communications companies and enterprise communications service providers. Based in Plano, Texas, Alliance Systems provided application platforms and enhanced support services for
wireless, voice over internet protocol ("VoIP"), contact center and enterprise communications applications.

Critical Accounting Policies and Estimates

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



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

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

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

For
revenue arrangements that contain multiple elements, such as the sale of both product and post-sales support and/or extended warranty and related services element, in
which software is not incidental to the product as a whole, we determine fair value based upon vendor specific objective evidence, which is typically established through contractual
post-sales support renewal rates whereby the residual fair value is allocated to the application platform. For revenue arrangements that contain multiple elements in which software is not
included or is incidental to the product as a whole, we allocate revenue to the extended warranty and related services element based on separately priced contractual rates for those elements.

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

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



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



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

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

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Effective October 1, 2005, we adopted the provisions of Financial Accounting Standards Board ("FASB") Statement of Financial
Accounting Standard No. 123(R), "Share-Based Payment" ("FAS 123(R)"), which requires us to measure compensation cost at the grant date, based on the fair value of the award, and to
recognize that cost as an expense over the employee's requisite service period (generally the vesting period of the equity award).

Under
FAS 123(R), we determine the fair value of stock options on the grant date using an option pricing model. Such an option pricing model requires us to make judgments for
certain assumptions used, in particular, the expected term of the option and the expected volatility over that term. For stock options granted on or after January 1, 2008, we determined the
expected term based on analysis of our historical exercise and post-vesting cancellation behavior. For stock options granted prior to January 1, 2008, we determined the expected
term using the midpoint between the vesting date and the end of the contractual term of the options, also known as the "simplified method" described under Securities and Exchange Commission ("SEC")
Staff Accounting Bulletin No. 107 ("SAB 107"). We have determined the expected volatility based on a weighted average of the historical volatility of the market price of our common
stock. In determining the amount of expense to be recorded, judgment is also required to estimate forfeitures of the awards based on the probability of employees completing the required service
periods. Historical forfeitures are used as a starting point for developing our estimate of future forfeitures.



Goodwill represents the excess purchase price over the fair value of the net tangible and intangible assets acquired. We review
goodwill for impairment annually as of the fiscal year end date, and more frequently if certain indicators are present. When conducting our impairment evaluation, we compare the carrying value of the
reporting unit to the fair value of the reporting unit. We have determined that the reporting unit is the Company as a whole. If the carrying amount of the reporting unit exceeds its fair value, then
the carrying value of that reporting unit's goodwill is compared to the implied fair value of the goodwill and an impairment loss is recorded in an amount equal to that excess, if any. Fair value is
calculated using widely accepted valuation techniques, including the present value of estimated future cash flows using a risk-adjusted discount rate, and market multiple analyses. These
types of analyses require significant judgments by management.

Conditions
that could trigger a more frequent impairment assessment include, but are not limited to, a significant adverse change in certain agreements, an economic downturn in our
customers' industries, increased competition, or other information regarding our market value, such as a reduction in our stock price.

During
the quarter ended June 30, 2008, certain conditions existed that caused management to determine that a triggering event had occurred requiring an assessment of goodwill for
impairment. These indicators included a decline in the price of our common stock to a price that was below our carrying value for a period of time during the quarter, and revenues for the quarter
ended June 30, 2008 that were lower than our expectations, resulting in a net loss for the quarter ended June 30, 2008.

Our
assessment for impairment was conducted in accordance with FASB Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets" ("FAS 142"),
which required us to determine the fair value of the Company as a whole since it is considered the reporting unit to which all goodwill is allocated. We estimated the fair value of the reporting unit
utilizing industry accepted valuation techniques that included the present value of estimated future cash flows using a risk-adjusted discount rate, and a market multiple approach, which
considered our market capitalization adjusted for a control premium. These valuation techniques require significant judgments by management, including estimates and assumptions about our projected
future operating results,

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discount
rates, and long-term growth rates. Our forecasts of future revenue were based on expected future growth from new as well as existing customers, and historical trends. In addition,
we considered the expected gross margins attainable in the future and the required level of operating expenses needed to conduct our business.

Our
impairment assessment resulted in the fair value of the reporting unit exceeding the carrying value, and therefore goodwill was not impaired as of June 30, 2008. Our estimates
used in determining the fair value were based on available information at the time we performed the impairment assessment.

We
performed our annual impairment assessment as of September 30, 2008. Step one of this assessment resulted in the carrying value of the reporting unit exceeding the fair value.
In step two of the impairment analysis, the Company compared the implied fair value of goodwill to its carrying value. The implied fair value of goodwill was determined to be zero. Consequently, we
determined that goodwill was fully impaired, resulting in an impairment charge of $8.7 million for the year ended September 30, 2008. The primary reasons for the difference in
conclusions that goodwill was not impaired as of June 30, 2008, but was fully impaired as of September 30, 2008, were the continued decline in the price of our common stock during the
quarter ended September 30, 2008, forecasts of future revenues which were lower than the forecasts used in the impairment analysis performed as of June 30, 2008, and lower revenues in
the quarter ended September 30, 2008 as compared to the quarter ended June 30, 2008 and compared to our expectations for that quarter. The forecasted revenues used in our
September 30, 2008 analysis were lower than those used at June 30, 2008 as a result of the macroeconomic conditions and events that transpired in the global credit markets during
September and October of 2008.

We
review long-lived assets, including definite-lived intangible assets, to determine if any adverse conditions exist that would indicate impairment. FASB Statement of
Financial Accounting Standard No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144"), requires impairment losses to be recorded on
long-lived assets used in operations when indicators of impairment are present and the projected undiscounted cash flows estimated to be generated by those assets are less than the
long-lived assets' carrying value. We assess the recoverability of long-lived assets based on the projected undiscounted future cash flows over the asset's remaining life. The
amount of impairment, if any, is measured based on the excess of the carrying value over fair value. Fair value is generally calculated as the present value of estimated future cash flows using a
risk-adjusted discount rate,
which requires significant management judgment with respect to revenue and expense growth rates, and the selection and use of an appropriate discount rate. Factors that could lead to an impairment of
acquired customer relationships (recorded as a result of the Alliance Systems acquisition) include, but are not limited to, a worsening in customer attrition rates compared to historical attrition
rates, or lower than initially anticipated cash flows associated with customer relationships.

We
tested our intangible asset, which consists of customer relationships recorded as a result of the acquisition of Alliance Systems, for recoverability as of September 30, 2008.
We performed this assessment because we determined that the impairment of goodwill described above was an indicator that the carrying value of our intangible asset might not be recoverable. As a
result of this test, we determined that the carrying value of the intangible asset was recoverable, and therefore no impairment charge was recorded. We also reassessed the remaining estimated useful
life of the intangible asset, which is being amortized over its period of economic benefit of 17 years. We determined that no change to the estimated useful life was necessary.

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We record deferred tax assets and liabilities based on the net tax effects of tax credits, operating loss carryforwards and temporary
differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We then assess the likelihood that our deferred tax
assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. The valuation allowance is based on our estimate of
future taxable income and the period over which our deferred tax assets will be recoverable. At September 30, 2008, we believe that it is more likely than not that all of our deferred tax
assets will not be realized, and, accordingly, we have recorded a valuation allowance against all of our deferred tax assets. If results of operations in the future indicate that some or all of the
deferred tax assets will be recovered, the resulting reduction of the valuation allowance will be recorded as a tax benefit. To the extent that net operating losses, when realized, relate to stock
option deductions of approximately $6.8 million, the resulting benefits will be credited to additional paid-in capital.



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

Comparability of Financial Information

On October 11, 2007, we completed our acquisition of Alliance Systems. As a result, the three month period ended
March 31, 2008 was the first quarter that included the results of operations of Alliance Systems in our consolidated results for an entire quarter. Our financial results only include the
financial results of Alliance Systems for periods subsequent to October 11, 2007. As such, the presentation of historical financial information and any discussion regarding the comparison of
historical financial information does not include any financial information for Alliance Systems prior to October 12, 2007, unless otherwise indicated.

33

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Table of Contents

Results of Operations

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

Year Ended September 30,2008

2007

2006Dollars

% of Net
Revenues

Dollars

% of Net
Revenues

Dollars

% of Net
RevenuesNet revenues

$
197,495


100.0
%
$
119,627


100.0
%
$
118,696


100.0
%Gross profit(a)


32,343


16.4
%

23,252


19.4
%

19,871


16.7
%Operating expenses(b)(c)


41,056


20.8
%

22,584


18.9
%

26,628


22.4
%(Loss) income from operations


(8,713
)

(4.4
)%

668


0.5
%

(6,757
)

(5.7
)%Net (loss) income


(8,477
)

(4.3
)%

2,502


2.1
%

(5,447
)

(4.6
)%


---

Discussion of Fiscal Years 2008 and 2007



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

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



Gross profit represents net revenues recognized less the cost of revenues. Cost of revenues includes cost of materials, warranty costs,
inventory write-downs, shipping and handling costs, customer support costs and manufacturing costs. Manufacturing costs are primarily comprised of compensation, contract labor costs and, when
applicable, contract manufacturing costs.

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

Gross
profit is affected by customer and product mix, component material costs, pricing and the volume of orders. We expect gross profit to continue to be affected by these factors.

34

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

Year Ended September 30,2008

2007Increase (Decrease)% of Net
Revenues



% of Net
RevenuesDollars

Dollars

Dollars

PercentageOperating expenses:Research and development

$
8,643


4.4
%
$
8,723


7.3
%
$
(80
)

(0.9
)%Selling and marketing


11,099


5.6
%

6,265


5.2
%

4,834


77.2
%General and administrative


10,310


5.2
%

7,596


6.4
%

2,714


35.7
%Amortization of intangible asset


1,891


1.0
%







1,891


Restructuring charge


444


0.2
%







444


Impairment of goodwill


8,669


4.4
%







8,669


Total operating expenses

$
41,056


20.8
%
$
22,584


18.9
%
$
18,472


81.8
%




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

Year Ended September 30,2008

2007Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageResearch and development:Compensation and related expenses

$
5,521


63.9
%
$
5,229


59.9
%
$
292


5.6
%Stock-based compensation


725


8.4
%

1,169


13.4
%

(444
)

(38.0
)%Prototype


813


9.4
%

664


7.6
%

149


22.4
%Consulting and outside services


779


9.0
%

870


10.0
%

(91
)

(10.5
)%Other


805


9.3
%

791


9.1
%

14


1.8
%Total research and development

$
8,643


100
%
$
8,723


100
%
$
(80
)

(0.9
)%


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

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Table of Contents

Our application platform development strategy emphasizes the utilization of standard component technologies, which utilize off-the-shelf
components. However, we expect that in some cases, significant development efforts will be required to fulfill our current and potential customers' needs using customized platforms. We expect that
prototype and consulting costs will be variable and could fluctuate depending on the timing and magnitude of our development projects.



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

Year Ended September 30,2008

2007Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageSelling and marketing:Compensation and related expenses

$
8,006


72.1
%
$
4,291


68.5
%
$
3,715


86.6
%Stock-based compensation


323


2.9
%

304


4.9
%

19


6.3
%Marketing programs


758


6.8
%

640


10.2
%

118


18.4
%Travel


704


6.4
%

449


7.2
%

255


56.8
%Consulting


132


1.2
%

58


0.9
%

74


127.6
%Other


1,176


10.6
%

523


8.3
%

653


124.9
%Total selling and marketing

$
11,099


100
%
$
6,265


100
%
$
4,834


77.2
%


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



General and administrative expenses consist primarily of salaries and other related costs for executive, finance, information
technology and human resources personnel; professional services, which include legal, accounting, audit and tax fees; and director and officer insurance. The following table summarizes the most
significant components of general and administrative expense for the periods

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Table of Contents

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

Year Ended September 30,2008

2007Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageGeneral and administrative:Compensation and related expenses

$
4,936


47.9
%
$
3,343


44.0
%
$
1,593


47.7
%Stock-based compensation


715


6.9
%

801


10.5
%

(86
)

(10.7
)%Professional services


3,026


29.3
%

2,312


30.4
%

714


30.9
%Director and officer insurance


256


2.5
%

315


4.2
%

(59
)

18.7
%Other


1,377


13.4
%

825


10.9
%

552


66.9
%Total general and administrative

$
10,310


100
%
$
7,596


100
%
$
2,714


35.7
%


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



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



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



We performed our annual impairment assessment of goodwill as of September 30, 2008. Our assessment for impairment was conducted
in accordance with FAS 142, which required us to determine the fair value of the Company as a whole since it is considered the reporting unit to which all goodwill is allocated. We estimated
the fair value of the reporting unit utilizing industry accepted valuation techniques that included the present value of estimated future cash flows using a risk-adjusted discount rate,
and a market multiple approach, which considered our market capitalization adjusted for a control premium. These valuation techniques require significant judgments by management, including estimates
and assumptions about our projected future operating results, discount rates, and long-term growth rates. Our forecasts of future revenue were based on expected future growth from new as
well as

37

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Table of Contents

existing
customers, and historical trends. In addition, we considered the expected gross margins attainable in the future and the required level of operating expenses needed to conduct our business.

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



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



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

Discussion of Fiscal Years 2007 and 2006



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



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

38

---



Table of Contents



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

Year Ended September 30,2007

2006Increase (Decrease)% of Net
Revenues



% of Net
RevenuesDollars

Dollars

Dollars

PercentageOperating expenses:Research and development

$
8,723


7.3
%
$
8,377


7.0
%
$
346


4.1
%Selling and marketing


6,265


5.2
%

10,522


8.9
%

(4,257
)

(40.5
)%General and administrative


7,596


6.4
%

7,729


6.5
%

(133
)

(1.7
)%Total operating expenses

$
22,584


18.9
%
$
26,628


22.4
%
$
(4,044
)

(15.2
)%




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

Year Ended September 30,2007

2006Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageResearch and development:Compensation and related expenses

$
5,229


59.9
%
$
4,990


59.6
%
$
239


4.8
%Stock-based compensation


1,169


13.4
%

1,112


13.3
%

57


5.1
%Prototype


664


7.6
%

783


9.3
%

(119
)

(15.2
)%Consulting and outside services


870


10.0
%

607


7.2
%

263


43.3
%Other


791


9.1
%

885


10.6
%

(94
)

(10.6
)%Total research and development

$
8,723


100
%
$
8,377


100
%
$
346


4.1
%


Research
and development expenses increased slightly for the year ended September 30, 2007 as compared to the year ended September 30, 2006, primarily due to increased
compensation and related expenses and consulting and outside services. The increase in compensation and related expenses was primarily related to cost of living adjustments to salaries which occurred
during the year as well as the timing of new hires. The increase in consulting costs and the decrease in prototype costs were related to the timing of certain development projects.

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Table of Contents



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

Year Ended September 30,2007

2006Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageSelling and marketing:Compensation and related expenses

$
4,291


68.5
%
$
6,439


61.2
%
$
(2,148
)

(33.4
)%Stock-based compensation


304


4.9
%

770


7.3
%

(466
)

(60.5
)%Marketing programs


640


10.2
%

1,465


13.9
%

(825
)

(56.3
)%Travel


449


7.2
%

929


8.8
%

(480
)

(51.7
)%Consulting


58


0.9
%

435


4.2
%

(377
)

(86.7
)%Other


523


8.3
%

484


4.6
%

39


8.1
%Total selling and marketing

$
6,265


100
%
$
10,522


100
%
$
(4,257
)

(40.5
)%


Selling
and marketing expenses significantly decreased for the year ended September 30, 2007 as compared to the year ended September 30, 2006. This decrease was the result
of our strategic change to decrease demand creation sales and marketing activities related to our NS Series appliances and more fully leverage our customers' sales and marketing resources. In
particular, as a result of this strategic change, we decreased headcount from 31 at September 30, 2006 to 23 at September 30, 2007 resulting in the decreases in compensation and related
expenses and stock-based compensation. In addition, the reduction in marketing program expenses and travel was a result of reduced spending on end user lead generation programs for our NS Series
security appliances.



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

Year Ended September 30,2007

2006Increase (Decrease)% of
Expense
Category



% of
Expense
CategoryDollars

Dollars

Dollars

PercentageGeneral and administrative:Compensation and related expenses

$
3,343


44.0
%
$
3,075


39.8
%
$
268


8.7
%Stock-based compensation


801


10.5
%

744


9.6
%

57


7.7
%Professional services


2,312


30.4
%

2,216


28.7
%

96


4.3
%Director and officer insurance


315


4.2
%

806


10.4
%

(491
)

(60.9
)%Other


825


10.9
%

888


11.5
%

(63
)

(7.1
)%Total general and administrative

$
7,596


100
%
$
7,729


100
%
$
(133
)

(1.7
)%


General
and administrative expenses decreased slightly for the year ended September 30, 2007 as compared to the year ended September 30, 2006. Increases in compensation and
related expenses, which were related to changes in our senior management and professional services, were offset by larger decreases in the cost of director and officer insurance and other expenses.
The increase in

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Table of Contents

professional
services was due primarily to costs associated with the investigation of embezzlement by a former non-management employee which was detected during the fourth quarter of
fiscal year 2006 and was completed during the first quarter of fiscal year 2007.



Interest and other income, net increased to $2.0 million for the year ended September 30, 2007 from $1.4 million
for the year ended September 30, 2006. This increase was primarily due to higher interest rates and higher balances of our cash, cash equivalents, and short-term investments.

Liquidity and Capital Resources

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

Year Ended
September 30,2008

2007Net (loss) income

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


14,053


3,353Changes in working capital


(4,329
)

4,750Cash provided by operating activities


1,247


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


(34,986
)

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


(636
)

2,129Effect of exchange rate differences on cash


(25
)

(Decrease) increase in cash and cash equivalents


(34,400
)

36,389Cash and cash equivalents at beginning of year


44,403


8,014Cash and cash equivalents at end of year

$
10,003

$
44,403




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

Changes
in working capital were primarily driven by differences in the timing of cash receipts, cash disbursements, inventory receipts and invoicing to customers. The use of cash to
settle accounts payable and accrued expenses was related in part to the balances assumed in the acquisition of Alliance Systems, which we settled subsequent to the acquisition. The change in accounts
payable was also related to the fact that our last disbursement of cash prior to year end in fiscal year 2008 occurred closer to the year end date as compared to in fiscal year 2007. The change in
accrued expenses was also related in part to the fact that accrued compensation included two days worth of accrued payroll costs at September 30, 2008, compared to five days worth at
September 30, 2007. The change in accounts receivable was primarily related to collections of the receivable balances assumed in the acquisition of Alliance Systems, as well as the fact that
revenues trended downward in the fourth quarter of fiscal year 2008. The change in inventories was primarily related to a slowing of purchasing

41

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Table of Contents

in
the fourth quarter of fiscal year 2008, which was related to the downward trend in revenues and lowered forecasts of future revenues from some of our larger customers.

Changes
in working capital for the year ended September 30, 2007 included an increase in deferred revenue of $2.5 million, which was primarily related to the transfer of
certain support obligations from Microsoft.



Cash used in investing activities during the year ended September 30, 2008 primarily related to the use of approximately
$34 million of cash for the acquisition of Alliance Systems.



Cash used in financing activities during the year ended September 30, 2008 consisted primarily of $0.9 million of cash
used to repurchase shares of our common stock. Employee stock option exercises and purchases under the Employee Stock Purchase Plan provided $0.3 million of cash in fiscal 2008 as compared to
$2.1 million in fiscal 2007. We expect employee stock option exercises and purchases under the Employee Stock Purchase Plan to continue in fiscal 2009; however, we cannot predict the level of
cash inflows, given the volatility of our stock price.

On
June 12, 2008, our Board of Directors authorized the repurchase of up to $5 million of our common stock through a share repurchase program. As authorized by the program,
shares may be purchased in the open market or through privately negotiated transactions, in a manner consistent with applicable securities laws and regulations. This stock repurchase program does not
obligate us to acquire any specific number of shares and may be terminated at any time. To facilitate repurchases of shares under this program, we established a Rule 10b5-1 plan
intended to comply with the requirements of Rule 10b5-1 and Rule 10b-18 under the Securities Exchange Act of 1934. A Rule 10b5-1 plan permits
the repurchase of shares by a company at times when it otherwise might be prevented from doing so under insider trading laws or because of company blackout periods, provided that the plan is adopted
when the company is not aware of material non-public information. Pursuant to the plan, a broker designated by us has the authority to repurchase shares, in accordance with the terms of
the plan, without further direction from us. The amount and timing of specific repurchases are subject to the terms of the plan and market conditions. As of September 30, 2008, we had purchased
906,801 shares of our common stock under the repurchase program at an average price of $1.03 per share including transaction costs. Upon the expiration of the 10b5-1 plan on
November 7, 2008, we suspended repurchases of our common stock. We may resume repurchases under the program at any time at the discretion of management.



On October 11, 2007, we entered into a Loan and Security Agreement ("Loan Agreement") with Silicon Valley Bank (the "Bank"). The
term of this agreement was for one year, to end on October 9, 2008. The Loan Agreement provided the Company with a $15 million revolving loan facility. The interest rate on this line was
equal to one quarter of a point (0.25%) below the current prime rate with interest payable monthly.

On
August 5, 2008, we and the Bank entered into the First Loan Modification Agreement (the "Modification Agreement"). The Modification Agreement amended the Loan Agreement to
extend its term to August 5, 2010, and to change the amount of the revolving loan facility to $10 million. The Modification Agreement did not change the interest rate on the line. We
opted to lower the amount of the revolving loan facility from $15 million to $10 million in order to better reflect our potential borrowing needs and to reduce the fees we incur to
maintain the loan facility. As of December 15, 2008, we have not drawn on this line of credit.

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Table of Contents

Contractual Obligations and Commitments

The following table sets forth certain information concerning our obligations and commitments to make certain payments, as of
September 30, 2008 (in thousands):

Payments Due by PeriodLess than
1 Year

1-3 Years

4-5 Years

After
5 Years

TotalOperating leases

$
1,464

$
2,840

$
357

$


$
4,661Capital lease obligation


24


18








42Total

$
1,488

$
2,858

$
357

$


$
4,703


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



We
believe that our available cash resources and cash that we expect to generate from sales of our products will be sufficient to meet our operating and capital requirements through at
least the next twelve months. We also received, during the first quarter of fiscal year 2009, $1.9 million of the $2.6 million income tax receivable which was recorded on our balance
sheet as of September 30, 2008. Our future liquidity would also be positively impacted to the extent that we are able to recover all or part of the $4.0 million of contingently
returnable acquisition consideration which was recorded on our balance sheet as of September 30, 2008 in connection with the acquisition of Alliance Systems.

In
the event that our available cash resources and our Silicon Valley Bank line of credit are not sufficient, or if an event of default occurs, such as failure to achieve certain
financial covenants, that limits our ability to borrow under the line of credit, we may need to raise additional funds. We may in the future seek to raise additional funds through borrowings, public
or private equity financings or from other sources. There can be no assurance that additional financing will be available at all or, if available, will be on terms acceptable to us. Additional equity
financings could result in dilution to our shareholders. If additional financing is needed and is not available on acceptable terms, we may need to reduce our operating expenses and scale back our
operations.

Off-Balance Sheet Arrangements

We have not created, and are not party to, any special-purpose or off balance sheet entities for the purpose of raising capital,
incurring debt or operating parts of our business that are not consolidated into our financial statements. We have not entered into any transactions with unconsolidated entities whereby we have
subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable
interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to us.

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Related Party Transactions

Robert M. Wadsworth, one of our directors, is a managing director of the limited liability corporation that controls HarbourVest
Partners (and its affiliates), one of our significant stockholders.

Mr. Wadsworth
also serves as a director of Innoveer Solutions, Inc. ("Innoveer"), formerly Akibia Consulting. We previously engaged Innoveer to perform certain professional
services related to our customer resource management ("CRM") software system. During the years ended September 30, 2008, 2007, and 2006, we incurred approximately $0, $40,200, and $80,000,
respectively, related to these services. We had no amounts outstanding to Innoveer at September 30, 2008 or 2007.

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

Charles
A. Foley, one of our directors, also serves as the CEO of TimeSight Systems ("TimeSight", formerly known as Digital Ocular Networks). During the years ended September 30,
2008 and 2007, we recorded revenues of $38,000 and $6,000, respectively, related to sales of application platform solutions to TimeSight. We had $11,000 and $0 in accounts receivable outstanding from
TimeSight at September 30, 2008 and 2007, respectively.

Recent Accounting Pronouncements

In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, "Fair Value Measurements"
("FAS 157"). This statement addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under accounting
principles generally accepted in the United States. In February 2008, the FASB issued FASB Staff Position No. 157-1, "Application of FASB Statement
No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13" ("FSP
157-1"). FSP 157-1 amends FAS 157 to remove certain leasing transactions from its scope. In February 2008, the FASB issued FASB Staff Position
No. 157-2, "Effective Date of FASB Statement No. 157" ("FSP 157-2"). FSP 157-2 defers the effective date of FAS 157 for certain
non-financial assets and liabilities to the beginning of our fiscal year that begins after November 15, 2008. In October 2008, the FASB issued FASB Staff Position
No. 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active" ("FSP 157-3"). FSP 157-3 clarifies the application
of FAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is
not active. FAS 157 is effective for financial assets and liabilities as of the beginning of our fiscal year that begins after November 15, 2007. We are in the process of evaluating
whether the adoption of FAS 157 will have a material impact on our financial position, results of operations or cash flows.

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

In
December 2007, the FASB issued Statement of Financial Accounting Standard No. 141(R), "Business Combinations" ("FAS 141R"). This statement replaced Statement of
Financial Accounting

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Standard
No. 141 to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business
combination and its effects. FAS 141R establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the
liabilities assumed, and any noncontrolling interest in the acquiree, recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase and determines what
information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. FAS 141R is effective for business combinations on
a prospective basis for which the acquisition date is on or after the beginning of our fiscal year that begins after December 15, 2008.

In
April 2008, the FASB issued FASB Staff Position No. FAS 142-3, "Determination of the Useful Life of Intangible Assets" ("FSP 142-3"). FSP
142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FAS 142.
This change is intended to improve the consistency between the useful life of a recognized intangible asset under FAS 142 and the period of expected cash flows used to measure the fair value of
the asset under FAS 141R and other
generally accepted accounting principles. The requirement for determining useful lives must be applied prospectively to intangible assets acquired after the effective date and the disclosure
requirements must be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. FSP 142-3 is effective as of the beginning of our fiscal year
that begins after December 15, 2008. We are in the process of evaluating whether the adoption of FSP 142-3 will have a material impact on our financial position or results of
operations.

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We do not engage in any foreign currency hedging transactions and therefore, do not believe we are subject to material exchange rate
risk. We are exposed to market risk related to changes in interest rates. In the past, we have invested excess cash balances in cash equivalents and short-term investments, and if we were
to do so in the future, we believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows would
not be material. In addition, a hypothetical 10% increase or decrease in interest rates would not have a material adverse effect on our financial condition.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



PageREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

47CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2008 AND
2007

48CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30,
2008, 2007 AND 2006

49CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
FOR THE YEARS ENDED SEPTEMBER 30, 2008, 2007 AND 2006

50CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED SEPTEMBER 30,
2008, 2007 AND 2006

51NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

52


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Table of Contents

Report of Independent Registered Public Accounting Firm

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

In
our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Network
Engines, Inc. and its subsidiaries at September 30, 2008 and September 30, 2007, and the results of their operations and their cash flows for each of the three years in the period
ended September 30, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the
accompanying index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related
consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2008, based on
criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). The Company's management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting, included in Management's Annual Report on Internal Control Over Financial Reporting appearing under Item 9A. Our
responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company's internal control over financial reporting based on our integrated audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of
internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the
assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As
discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertain tax positions in fiscal 2008.

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

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

PricewaterhouseCoopers LLP
Boston, Massachusetts
December 15, 2008

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NETWORK ENGINES, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

September 30,2008

2007ASSETSCurrent assets:Cash and cash equivalents

$
10,003

$
44,403Restricted cash


47


247Accounts receivable, net of allowances of $122 and $32 at September 30, 2008 and 2007, respectively


26,403


17,511Income tax receivable


2,585


Inventories


21,380


10,175Prepaid expenses and other current assets


2,009


1,077Total current assets


62,427


73,413Property and equipment, net


1,549


1,128Intangible asset, net


9,884


Contingently returnable acquisition consideration


4,022


Other assets


183


281Total assets

$
78,065

$
74,822LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilities:Accounts payable

$
11,745

$
10,189Accrued compensation and other related benefits


1,327


1,773Accrued warranty


931


1,046Other accrued expenses


2,291


2,182Deferred revenue


5,173


2,839Total current liabilities


21,467


18,029Deferred revenue, net of current portion


2,246


1,285Total liabilities


23,713


19,314Commitments 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; 46,753,826 and 43,590,883 shares issued; 43,285,167 and 41,029,025 shares outstanding at
September 30, 2008 and 2007, respectively


468


436Additional paid-in capital


195,228


187,005Accumulated deficit


(137,572
)

(129,095
)Treasury stock, at cost, 3,468,659 and 2,561,858 shares at September 30, 2008 and 2007, respectively


(3,772
)

(2,838
)Total stockholders' equity


54,352


55,508Total liabilities and stockholders' equity

$
78,065

$
74,822


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 30,2008

2007

2006Net revenues

$
197,495

$
119,627

$
118,696Cost of revenues


165,152


96,375


98,825Gross profit


32,343


23,252


19,871Operating expenses:Research and development


8,643


8,723


8,377Selling and marketing


11,099


6,265


10,522General and administrative


10,310


7,596


7,729Amortization of intangible asset


1,891





Restructuring charge


444





Impairment of goodwill


8,669





Total operating expenses


41,056


22,584


26,628(Loss) income from operations


(8,713
)

668


(6,757
)Interest and other income, net


436


1,953


1,358(Loss) income before income taxes


(8,277
)

2,621


(5,399
)Provision for income taxes


200


119


48Net (loss) income

$
(8,477
)
$
2,502

$
(5,447
)Net (loss) income per sharebasic and diluted

$
(0.19
)
$
0.06

$
(0.14
)Shares used in computing basic net (loss) income per share


43,856


40,637


38,207Shares used in computing diluted net (loss) income per share


43,856


41,256


38,207


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

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NETWORK ENGINES, INC.

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

(in thousands, except share data)

Shares of
Common StockCommon
Stock
Par value

Additional
Paid-in
Capital

Accumulated
Deficit

Treasury
Stock

Total
Stockholders'
Equity

Comprehensive
(Loss) IncomeIssued

In TreasuryBalance, September 30, 2005


40,341,890


(2,561,858
)
$
403

$
178,446

$
(126,150
)
$
(2,838
)
$
49,861Issuance of common stock upon stock option exercises


1,152,424





12


870








882Issuance of common stock under employee stock purchase plan


256,990





3


290








293Stock compensation related to grants of stock options to non-employee











7








7Stock compensation related to grants of stock options to employees











2,807








2,807Net 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
)
$
48,403Issuance of common stock upon stock option exercises


1,732,789





17


1,948








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


106,790





1


183








184Stock compensation related to grants of stock options to employees











2,454








2,454Net income














2,502





2,502

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


43,590,883


(2,561,858
)
$
436

$
187,005

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


2,904,301





29


5,965








5,994Issuance of common stock upon stock option exercises


9,500








17








17Issuance of common stock under employee stock purchase plan


249,142





3


296








299Stock compensation related to grants of stock options to employees











1,945








1,945Purchase of treasury stock





(906,801
)










(934
)

(934
)Net loss














(8,477
)




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


46,753,826


(3,468,659
)
$
468

$
195,228

$
(137,572
)
$
(3,772
)
$
54,352


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

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Table of Contents

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

Year Ended September 30,2008

2007

2006Cash flows from operating activities:Net (loss) income

$
(8,477
)
$
2,502

$
(5,447
)Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities:Depreciation and amortization


3,311


846


1,004Stock compensation


1,946


2,446


2,807Provision for doubtful accounts


126


54


(28
)Impairment of goodwill


8,669





Loss on disposal of fixed assets


1


7


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


4,304


(387
)

(6,708
)Inventories


1,556


(1,722
)

789Prepaid expenses and other current assets


76


183


(555
)Accounts payable


(6,353
)

3,142


1,402Accrued warranty


(185
)

487


104Accrued expenses


(3,934
)

513


893Deferred revenue


207


2,534


334Net cash provided by (used in) operating activities


1,247


10,605


(5,405
)Cash flows from investing activities:Acquisition, net of cash assumed


(30,203
)




Contingently returnable acquisition payment


(4,022
)




Payment for disposition of subsidiary


(231
)




Purchases of property and equipment


(530
)

(888
)

(398
)Purchases of short-term investments





(17,500
)

(44,210
)Sales of short-term investments





42,304


47,300Changes in other assets





(261
)

102Net cash (used in) provided by investing activities


(34,986
)

23,655


2,794Cash flows from financing activities:Purchase of treasury stock


(934
)




Proceeds from issuance of common stock


316


2,149


1,175Payments on capital lease obligations


(18
)

(20
)

(18
)Net cash (used in) provided by financing activities


(636
)

2,129


1,157Effect of exchange rate differences on cash


(25
)




Net (decrease) increase in cash and cash equivalents


(34,400
)

36,389


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


44,403


8,014


9,468Cash and cash equivalents, end of year

$
10,003

$
44,403

$
8,014Supplemental cash flow information:Cash paid for income taxes

$
146

$


$
Supplemental disclosure of non-cash investing activities:Common stock issued for acquisition

$
5,994

$


$



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

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Nature of Business

Network Engines, Inc. ("Network Engines", "NEI" or the "Company") develops and manufactures application platform solutions that enable original equipment manufacturers, or OEMs,
independent software vendors, or ISVs, and service providers to deliver their software applications in the form of an application platform solution. Application platforms are
pre-configured network infrastructure devices designed to optimally deliver specific software application functionality and facilitate ease of deployment and support of a software
application in a customer's network. The Company offers its customers an extensive suite of services, including development, manufacturing, fulfillment and post-sale support, in addition
to certain software products, such as the Company's ACE Element Manager. The Company produces and fulfills devices branded for its
customers, and derives its revenues primarily from the sale of value-added hardware platforms to these customers. These customers subsequently resell and support the appliances under their own brands
to their customer bases.

On
October 11, 2007, the Company acquired privately-held Alliance Systems, Inc. ("Alliance Systems"), a leading provider of application platforms and related
equipment supporting carrier communications and enterprise communications solutions. This acquisition, which was valued at approximately $41 million, was funded through a combination of
approximately $34 million in cash and the issuance of 2.9 million shares of the Company's common stock.

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

2. Summary of Significant Accounting Policies



The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All
intercompany transactions and balances have been eliminated. Certain prior year amounts have been reclassified to conform to the current year's classification. The reclassifications had no impact on
net income (loss), total assets or total liabilities.



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



Cash equivalents consist principally of money market funds, commercial paper, and other marketable securities purchased with an
original maturity of three months or less. These investments are carried at cost, which approximates market value. The Company did not hold any short-term investments as of
September 30, 2008 or 2007. At September 30, 2008 and 2007, $47,000 and $247,000, respectively, of cash was restricted and pledged as collateral for a letter of credit related to the
lease of the Company's facilities and certain vendor purchases.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies (Continued)



Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash
equivalents and trade receivables. When
the Company opts to invest excess cash, it invests primarily in municipal bonds, money market funds of major financial institutions, and government agency securities. There are no significant
concentrations in any one issuer of securities. The Company provides credit to customers in the normal course of business and does not require collateral from its customers, but routinely assesses
their financial strength. The Company maintains reserves for potential credit losses, based on analysis of individual accounts receivable, historical bad debt write-offs, customer
concentrations, customer creditworthiness, current economic conditions, accounts receivable aging trends and the payment terms we extend to our customers. Such losses have been within management's
expectations.



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

Net Revenues for the
Year Ended
September 30,

Accounts
Receivable at
September 30,2008

2007

2006

2008

2007EMC Corporation


42
%

83
%

81
%

30
%

81
%Tektronix, Inc.(1)


13
%







17
%




---



Financial instruments, including cash equivalents, restricted cash, accounts receivable, and accounts payable, are carried in the
financial statements at amounts that approximate their fair value as of September 30, 2008 and 2007.



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



Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful
lives. Leasehold improvements are amortized over the shorter of the useful life of the improvement or the remaining term of the lease. Upon retirement or sale, the cost of the assets

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies (Continued)

disposed
of and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in the determination of net income or loss. Repairs and maintenance are
charged to expense as incurred.



Effective October 1, 2005, the Company adopted the provisions of Financial Accounting Standards Board ("FASB") Statement of
Financial Accounting Standard No. 123(R), "Share-Based Payment," ("FAS 123(R)"), which establishes accounting for equity instruments exchanged for employee services. Under the provisions
of FAS 123(R), stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee's requisite service period
(generally the vesting period of the equity award).



Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired. The
Company reviews goodwill for impairment annually as of the fiscal year end date, and more frequently if certain indicators are present, using a two-step process in accordance with FASB
Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets" ("FAS 142"). In the first step, an entity's net assets are
segregated into reporting units and compared to their fair values. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to
measure the amount of impairment loss, if any. The second step compares the implied fair value of a reporting unit's goodwill with the carrying amount of that goodwill. If the carrying amount of a
reporting unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The Company has one reporting unit and estimates the fair
value of the reporting unit using widely accepted valuation techniques, including the present value of estimated future cash flows using a risk-adjusted discount rate, and market multiple
analyses. These types of analyses require significant judgments by management. During the year ended September 30, 2008, the Company recorded a goodwill impairment charge of $8,669,000 (see
Note 4).

Long-lived
assets primarily consist of property and equipment and an intangible asset with a definite life. FASB Statement of Financial Accounting Standard No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144"), requires impairment losses to be recorded on long-lived assets used in operations when
indicators of impairment are present and the projected undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying value. The amount of impairment, if any, is
measured based on the excess of the carrying value over fair value. Fair value is generally calculated as the present value of estimated future cash flows using a risk-adjusted discount
rate, which requires significant management judgment with respect to revenue and expense growth rates, and the selection and use of an appropriate discount rate.

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

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies (Continued)



The functional currency for the Company's foreign subsidiary is the U.S. dollar. Net foreign currency losses included in the
determination of net income (loss) for the three years ended September 30, 2008, 2007 and 2006 were not significant.



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

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

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

For
revenue arrangements that contain multiple elements, such as the sale of both the product and post-sales support and/or extended warranty and related services element, in
which software is not incidental to the product as a whole, the Company determines fair value based upon vendor specific objective evidence, which is typically established through contractual
post-sales support renewal rates whereby the residual fair value is allocated to the application platform. For revenue arrangements that contain multiple elements, in which software is not
included or is incidental to the product as a whole, the Company allocates revenue to the extended warranty and related services element based on separately priced contractual rates for those
elements.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies (Continued)

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



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



Advertising costs are expensed as incurred. Advertising expenses for the years ended September 30, 2008, 2007, and 2006 were
$527,000, $358,000, and $868,000, respectively.



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



Deferred tax assets and liabilities are determined based on the difference between the financial statement and the tax bases of assets
and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. A valuation allowance against deferred tax assets is recorded if, based upon the weight
of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

The
Company adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" ("FIN 48"), as of October 1, 2007. FIN 48 prescribes a
recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and
penalties, accounting in interim periods, disclosure and transition issues. Because the Company has recorded a full valuation allowance against its deferred tax assets, the adoption of FIN 48
had no impact on the Company's retained earnings or reported liabilities.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Summary of Significant Accounting Policies (Continued)



Comprehensive income (loss) is comprised of two components: net income (loss) and other comprehensive income (loss). During the years
ended September 30, 2008, 2007 and 2006, comprehensive income (loss) was equal to net income (loss).



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

Year Ended September 30,2008

2007

2006Numerator:Net (loss) income

$
(8,477
)
$
2,502

$
(5,447
)Denominator:Shares used in computing basic net (loss) income per share


43,856


40,637


38,207Common stock equivalents from employee stock options





619


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


43,856


41,256


38,207Net (loss) income per share:Basic

$
(0.19
)
$
0.06

$
(0.14
)Diluted

$
(0.19
)
$
0.06

$
(0.14
)Anti-dilutive potential common stock equivalents excluded from the calculation of net (loss) income per share:Options to purchase common stock


7,469


3,884


3,722




In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, "Fair Value Measurements"
("FAS 157"). This statement addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under accounting
principles generally accepted in the United States. In February 2008, the FASB issued FASB Staff Position 157-1, "Application of FASB Statement No. 157 to FASB Statement
No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13" ("FSP 157-1").
FSP 157-1 amends FAS 157 to remove certain leasing transactions from its scope. In February 2008, the FASB issued FASB Staff Position 157-2, "Effective Date of
FASB Statement No. 157" ("FSP 157-2"). FSP 157-2 defers the effective date of FAS 157 for certain non-financial assets and liabilities
to the beginning of the Company's fiscal year that begins after November 15, 2008. In October 2008, the FASB issued FASB Staff Position No. 157-3, "Determining the Fair Value
of a Financial Asset When the Market for That Asset is Not Active" ("FSP 157-3"). FSP 157-3 clarifies the application of FAS 157 in a market that is

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2. Summary of Significant Accounting Policies (Continued)

not
active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FAS 157 is
effective for financial assets and liabilities as of the beginning of the Company's fiscal year that begins after November 15, 2007. The Company is in the process of evaluating whether the
adoption of FAS 157 will have a material impact on its financial position, results of operations or cash flows.

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

In
December 2007, the FASB issued Statement of Financial Accounting Standard No. 141(R), "Business Combinations" ("FAS 141R"). This Statement replaced Statement of
Financial Accounting Standard No. 141 to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports
about a business combination and its effects. FAS 141R establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase and
determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the business combination. FAS 141R is effective for business combinations on a prospective basis for which the acquisition
date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.

In
April 2008, the FASB issued FASB Staff Position No. FAS 142-3, "Determination of the Useful Life of Intangible Assets" ("FSP 142-3"). FSP
142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FAS 142.
This change is intended to improve the consistency between the useful life of a recognized intangible asset under FAS 142 and the period of expected cash flows used to measure the fair value of
the asset under FAS 141R and other generally accepted accounting principles. The requirement for determining useful lives must be applied prospectively to intangible assets acquired after the
effective date and the disclosure requirements must be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. FSP 142-3 is effective as of
the beginning of the Company's fiscal year that begins after December 15, 2008. The Company is in the process of evaluating whether the adoption of FSP 142-3 will have a material
impact on its financial position or results of operations.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. Business Combination

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

The
acquisition was structured to include a downward adjustment to the purchase price based on the net working capital of Alliance Systems as of October 11, 2007, as defined in
the merger agreement, and therefore approximately $4.0 million of the cash paid is contingently returnable to the Company upon resolution of this provision. As a result, the amount of
contingently returnable consideration has been excluded from the allocation of the purchase price to the net assets acquired until such time that this amount is no longer contingently returnable. When
the contingencies are resolved, any portion of the $4.0 million which is not returned to the Company will be reclassified as additional goodwill. If additional goodwill is recorded in a future
period, it will then be subject to review for impairment annually as of the fiscal year end date, and more frequently if certain indicators are present.

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

Net assets acquiredCash

$
362Accounts receivable


13,641Income tax receivable


2,585Inventory


12,799Prepaid and other current assets


923Property and equipment


1,347Deferred tax asset


5,170Intangible asset


11,775Goodwill


8,669Other assets


127Accounts payable


(7,836
)Income tax payable


(127
)Deferred tax liability


(5,170
)Other accrued expenses


(4,160
)Deferred revenue


(3,180
)Total net assets acquired

$
36,925


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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. Business Combination (Continued)

The
acquired intangible asset is customer relationships, which will be amortized over the period of economic benefit expected to be received, resulting in a weighted average amortization
period of 4.97 years. The transaction, which was nontaxable to the Company, resulted in the Company recording deferred tax liabilities of $5,170,000 related to the differences between the
financial statement and the tax bases of the acquired assets and liabilities. As a result of the recorded deferred tax liabilities, the Company determined it would more likely than not realize the tax
benefits from certain of its historical deferred tax assets, and therefore reduced its valuation allowance accordingly. The goodwill recorded will not be deductible for tax purposes. Additionally,
fees and expenses incurred by Alliance Systems that have not been included in the purchase price allocation may be deductible in the future, in the event that the Company sells the Alliance Systems
business.

During
the three month period ended December 31, 2007, the Company was in the process of executing certain restructuring activities with respect to portions of the acquired
business. These activities, which were accounted for in accordance with Emerging Issues Task Force ("EITF") Issue No. 95-3, "Recognition of Liabilities in Connection with a Purchase
Business Combination" ("EITF 95-3"), primarily consisted of $548,000 in severance costs for reductions in staffing levels and $446,000 in costs related to the disposition of
Alliance Systems' German subsidiary. In connection with these exit activities the Company recorded the estimated liabilities as part of the cost of the acquisition. The Company disposed of Alliance
Systems' German subsidiary on February 12, 2008. There were no amounts accrued at September 30, 2008 related to these exit activities.

The
Company has included, as a component of the net assets acquired, an estimated liability for approximately $123,000 for uncertain tax positions, as determined in accordance with
FIN 48. These uncertain tax positions related to state tax filing requirements. This liability, which included an estimate for interest and penalties, was based on the known facts at the time
of the purchase price allocation.

The
Company's consolidated financial statements include Alliance Systems' operating results from the date of acquisition. The following unaudited pro forma information presents a summary
of consolidated results of operations of the Company and Alliance Systems as if the acquisition had occurred at the beginning of each period presented, with pro forma adjustments to give effect to

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. Business Combination (Continued)

amortization
of the intangible asset, and certain other adjustments together with related tax effects (in thousands, except per share amounts):

Unaudited, pro formaYear Ended
September 30,2008

2007Net revenues

$
199,781

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

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

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

$
(0.19
)
$
0.05Diluted

$
(0.19
)
$
0.05






4. Goodwill and Intangible Assets

The Company recorded goodwill and an intangible asset as the result of its acquisition of Alliance Systems. The acquired intangible asset is customer relationships, which will be
amortized using an economic consumption method over 17 years, which is the estimated period of economic benefit expected to be received. The following table presents the intangible asset
balances as of September 30, 2008 (in thousands):

Gross Carrying
Amount

Accumulated
Amortization

Net Book
ValueCustomer relationships

$
11,775

$
1,891

$
9,884


Amortization
expense was $1,891,000 for the year ended September 30, 2008. The estimated future amortization expense for the intangible asset as of September 30, 2008 by
fiscal year is $1,765,000 for 2009, $1,554,000 for 2010, $1,330,000 for 2011, $1,119,000 for 2012, $866,000 for 2013 and $3,250,000 thereafter.

Because
the Company operates as a single reporting unit, the goodwill balance as of September 30, 2008 was allocated to the Company as a whole. The Company reviews goodwill and
long-lived assets, including definite-lived intangible assets, to determine if any adverse conditions exist that would indicate impairment. The Company reviews goodwill for impairment
annually as of the fiscal year end date, and more frequently if certain indicators are present.

During
the quarter ended June 30, 2008, certain conditions existed that caused management to determine that a triggering event had occurred requiring an assessment of goodwill for
impairment. These indicators included a decline in the price of the Company's common stock to a price that was below the reporting unit's carrying value for a period of time during the quarter, and
revenues for the

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4. Goodwill and Intangible Assets (Continued)

quarter
ended June 30, 2008 that were lower than the Company's expectations, resulting in a net loss for the quarter ended June 30, 2008.

The
Company's assessment for impairment was conducted in accordance with FAS 142, which required the Company to determine the fair value of the Company as a whole since it is
considered the reporting unit to which all goodwill is allocated. The Company estimated the fair value of the reporting unit utilizing industry accepted valuation techniques that included the present
value of estimated future cash flows using a risk-adjusted discount rate, and a market multiple approach, which considered the Company's market capitalization adjusted for a control
premium. These valuation techniques required significant judgments by management, including estimates and assumptions about the Company's projected future operating results, discount rates, and
long-term growth rates. The Company's forecasts of future revenue were based on expected future growth from new as well as existing customers, and historical trends. In addition, the
Company considered the expected gross margins attainable in the future and the required level of operating expenses needed to conduct its business.

The
Company's impairment assessment resulted in the fair value of the reporting unit exceeding the carrying value, and therefore goodwill was not impaired as of June 30, 2008. The
Company's estimates used in determining the fair value were based on available information at the time it performed the impairment assessment.

The
Company performed its annual goodwill impairment assessment as of September 30, 2008. Step one of this assessment resulted in the carrying value of the reporting unit
exceeding the fair value. In step
two of the impairment analysis, the Company compared the implied fair value of goodwill to its carrying value. The implied fair value of goodwill was determined to be zero. Consequently, the Company
determined that goodwill was fully impaired, resulting in an impairment charge of $8,669,000 during the quarter ended September 30, 2008. The primary reasons for the difference in conclusions
that goodwill was not impaired as of June 30, 2008, but was fully impaired as of September 30, 2008, were the continued decline in the price of the Company's common stock during the
quarter ended September 30, 2008, forecasts of future revenues which were lower than the forecasts used in the impairment analysis performed as of June 30, 2008, and lower revenues in
the quarter ended September 30, 2008 as compared to the quarter ended June 30, 2008 and compared to the Company's expectations for that quarter. The forecasted revenues used in the
September 30, 2008 analysis were lower than those used at June 30, 2008 as a result of the macroeconomic conditions and events that transpired in the global credit markets during
September and October of 2008.

The
Company also tested its intangible asset for recoverability as of September 30, 2008, because it determined that the impairment of goodwill described above was an indicator
that the carrying value of the intangible asset might not be recoverable. As a result of this test, the Company determined that the carrying value of the intangible asset was recoverable, and
therefore no impairment charge was recorded. The Company also reassessed the amortization method and remaining amortization period for the intangible asset, and determined that no changes to the
amortization period or method were necessary.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. Cash and Cash Equivalents

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

September 30,2008

2007Cash and cash equivalents:Cash

$
10,003

$
3,836Money market funds





37,941Commercial paper





2,626Total cash and cash equivalents

$
10,003

$
44,403


6. Inventories

Inventories consisted of the following (in thousands):

September 30,2008

2007Raw materials

$
13,402

$
5,764Work in process


1,442


445Finished goods


6,536


3,966Total inventories

$
21,380

$
10,175


7. Property and Equipment

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

September 30,Useful Life

2008

2007Office furniture and equipment


5 years

$
1,024

$
843Engineering and production equipment


3 years


1,795


1,661Computer equipment and software


3 years


4,916


3,991Leasehold improvements


Shorter of lease term or
useful life of asset


2,594


1,99710,329


8,492Less: accumulated depreciation and amortization





(8,780
)

(7,364
)$
1,549

$
1,128


Depreciation
and amortization expense related to property and equipment was approximately $1,420,000, $846,000, and $1,004,000 for the years ended September 30, 2008, 2007, and
2006, respectively.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

8. Stockholders' Equity



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



On June 12, 2008, the Board of Directors of the Company authorized the repurchase of up to $5 million of its common stock
through a share repurchase program. As authorized by the program, shares may be purchased in the open market or through privately negotiated transactions, in a manner consistent with applicable
securities laws and regulations. This stock repurchase program does not obligate the Company to acquire any specific number of shares, does not have an expiration date, and may be terminated at any
time by the Company's Board of Directors. To facilitate repurchases of shares under this program, the Company established a Rule 10b5-1 plan intended to comply with the requirements
of Rule 10b5-1 and Rule 10b-18 under the Securities Exchange Act of 1934. A Rule 10b5-1 plan permits the repurchase of shares by a company at
times when it otherwise might be prevented from doing so under insider trading laws or because of company blackout periods, provided that the plan is adopted when the company is not aware of material
non-public information. Pursuant to the plan, a broker designated by the Company has the authority to repurchase shares, in accordance with the terms of the plan, without further direction
from the Company. The amount and timing of specific repurchases are subject to the terms of the plan and market conditions. During the year ended September 30, 2008, the Company repurchased
906,801 shares of its common stock at an average price of $1.03 per share, all of which were held in treasury as of September 30, 2008. As of September 30, 2008, the maximum dollar value
that may yet be used for purchases under the program was $4,066,000. Upon the expiration of the 10b5-1 plan on November 7, 2008, the Company suspended repurchases of its common
stock. The Company may resume repurchases under the program at any time at the discretion of management.

9. Related Party Transactions

Robert M. Wadsworth, one of the Company's directors, is a managing director of the limited liability corporation that controls HarbourVest Partners (and its affiliates), one of the
Company's significant stockholders.

Mr. Wadsworth
also serves as a director of Innoveer Solutions, Inc. ("Innoveer"), formerly Akibia Consulting. The Company previously engaged Innoveer to perform certain
professional services related to its customer resource management ("CRM") software system. During the years ended September 30, 2008, 2007, and 2006, the Company incurred expenses of $0,
$40,200, and $80,000, respectively, related to these services. The Company had no amounts outstanding to Innoveer at September 30, 2008 or 2007.

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

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. Related Party Transactions (Continued)

Charles
A. Foley, one of the Company's directors, also serves as the CEO of TimeSight Systems ("TimeSight", formerly known as Digital Ocular Networks). During the years ended
September 30, 2008 and 2007, the Company recorded revenues of $38,000 and $6,000, respectively, related to sales of application platform solutions to TimeSight. The Company had $11,000 and $0
in accounts receivable outstanding from TimeSight at September 30, 2008 and 2007, respectively.

10. Stock Incentive Plans and Stock-Based Compensation

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

In
May 2000, the Company's shareholders approved an increase of 3,300,000 in the number of shares authorized under the 1999 Plan and an automatic annual increase in the number of shares
authorized under the 1999 Plan. The automatic annual increase is equal to the lesser of: 5% of the number of shares of common stock outstanding on the first day of each fiscal year; 4,000,000 shares;
or an amount determined by the Board of Directors, which is subject to a maximum of 20,047,902 authorized shares under the 1999 Plan. During the years ended September 30, 2008, 2007 and 2006,
the Company increased the number of shares available under the 1999 Plan by 2,051,450, 750,000 and 750,000 shares, respectively. As of September 30, 2008, the Company was authorized to grant
options, restricted stock or other awards of up to 16,608,723 shares of common stock under the 1999 Plan, and 3,474,648 shares were available for future grant.

In
May 2000, the Company's shareholders approved the 2000 Director Stock Option Plan (the "Director Plan"). Under the Director Plan, the Company may make formula grants of stock options
to non-employee directors of up to 500,000 shares of common stock. Each non-employee director receives an initial grant of 50,000 shares upon appointment to the Company's
board, which vests in equal annual installments over four years beginning on the first anniversary of the grant date. Subsequent annual grants of 15,000 shares to each non-employee
director vest 100% on the first anniversary of the grant date. In March 2004, the Company's shareholders approved an increase of an additional 325,000 shares of common stock authorized to be issued
under the Director Plan, resulting in a total of 825,000 options authorized to be issued. Under the Director Plan, options to purchase 795,000 shares have been granted, options to purchase 135,000
shares have been exercised and options to purchase 60,000 shares have been
cancelled through September 30, 2008. As of September 30, 2008, 90,000 shares were available for future grant.

In
May 2000, the Company's shareholders approved the 2000 Employee Stock Purchase Plan (the "Purchase Plan"). Under the Purchase Plan, the Company may issue up to an aggregate of 750,000
shares of common stock to eligible employees. In March 2004, March 2007, and March 2008, the Company's shareholders approved increases of 500,000, 250,000, and 350,000 additional shares, respectively,
of common stock authorized to be issued under the Purchase Plan, resulting in a total of 1,850,000 shares authorized to be issued. Eligible employees must be employed by the Company for

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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

more
than 20 hours per week and more than five months in a fiscal year. Under the Purchase Plan, the Company makes two offerings each fiscal year, at the end of which employees may purchase
shares of common stock using funds withheld through payroll deductions over the term of each offering. Offering periods begin on the 15th day of November and May each year. The
per share purchase price for offerings is equal to 85% of the closing price of the Company's common stock at the end of the offering period. During the years ended September 30, 2008, 2007, and
2006, 249,142, 106,790, and 256,990 shares of common stock were issued under the Purchase Plan, respectively. The Company had 365,178 shares available for issuance under its Purchase Plan as of
September 30, 2008.

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

Year Ended September 30,2008

2007

2006Cost of revenues

$
183

$
171

$
181Research and development


725


1,169


1,112Selling and marketing


323


305


770General and administrative


715


801


744Total stock-based compensation expense

$
1,946

$
2,446

$
2,807


The
Company estimates the fair value of stock options using the Black-Scholes valuation model. This valuation model takes into account the exercise price of the award, as well as various
significant assumptions, including the expected term, the expected volatility of the price of the Company's common stock over the expected term, the risk-free interest rate over the
expected term, and the Company's expected annual dividend yield. The Company believes that the valuation model and the approaches utilized to develop the underlying assumptions are appropriate in
calculating the fair values of the Company's stock options granted during the years ended September 30, 2008, 2007 and 2006. Estimates of fair value are not intended to predict the value
ultimately realized by persons who receive equity awards. In determining the amount of expense to be recorded, judgment is also required to estimate forfeitures of awards based on the probability of
employees completing the required service periods. Historical forfeitures are used as a starting point for developing estimates of future forfeitures.

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

Year Ended September 30,2008

2007

2006Expected term(1)


5.50 to 6.25 years


5.50 to 6.25 years


5.50 to 6.25 yearsExpected volatility factor(2)


54.89% to 59.05%


62.28% to 78.21%


77.49% to 79.65%Risk-free interest rate(3)


2.70% to 4.13%


4.15% to 4.70%


4.39% to 5.15%Expected annual dividend yield


%


%


%


---

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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



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

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

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

Number of
Shares

Weighted
Average
Exercise
Price

Weighted
Average
Remaining
Contractual
Term
(in years)Outstanding, September 30, 2007


6,091,355

$
2.51Granted


2,589,000


1.89Exercised


(9,500
)

1.73Forfeited


(951,214
)

2.04Expired


(236,599
)

2.66Outstanding, September 30, 2008


7,483,042

$
2.35


6.65Exercisable at September 30, 2008


4,338,754

$
2.73


5.48


All
options granted during the years ended September 30, 2008, 2007, and 2006 were granted with exercise prices equal to the fair market value of the Company's common stock on the
grant date and had weighted average fair values of $1.12, $1.44, and $1.12 per share, respectively, determined using the Black-Scholes option pricing model. As of September 30, 2008, 3,564,648
shares were available for future grants under the 1999 Plan and the Director Plan and the Company had reserved 7,483,042 shares of common stock for the exercise of outstanding stock options.

At
September 30, 2008, the aggregate intrinsic value of options outstanding and options exercisable was $9,000. The intrinsic value of a stock option is the amount by which the
market value of the underlying stock exceeds the exercise price of the option.

The
aggregate intrinsic value of options exercised during the years ended September 30, 2008, 2007 and 2006 was $2,000, $1,908,000, and $1,294,000, respectively.

67

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Table of Contents

NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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

The
following table summarizes the stock options outstanding at September 30, 2008:

Options OutstandingOptions ExercisableWeighted
Average
Exercise
Price

Weighted Average
Remaining
Contractual
Term (in years)Exercise Price Range

Number

Number

Weighted Average
Exercise Price$0.13 - $  1.27


728,785

$
0.93


3.90


711,641

$
0.92$1.36 - $  1.36


1,458,032

$
1.36


7.24


913,613

$
1.36$1.38 - $  1.55


610,769

$
1.44


7.08


356,230

$
1.44$1.59 - $  1.59


772,499

$
1.59


8.53


150,919

$
1.59$1.60 - $  2.11


752,753

$
1.86


5.83


521,373

$
1.90$2.12 - $  2.12


1,086,000

$
2.12


9.03


0


$2.18 - $  2.61


882,329

$
2.39


6.32


575,291

$
2.44$2.64 - $  6.00


770,500

$
3.68


5.01


688,312

$
3.77$8.00 - $  9.15


346,625

$
8.46


4.77


346,625

$
8.46$9.16 - $39.81


74,750

$
16.86


1.82


74,750

$
16.867,483,042

$
2.35


6.65


4,338,754

$
2.73


At
September 30, 2008, unrecognized compensation expense related to unvested stock options was $2,427,000, which is expected to be recognized over a weighted average period of
2.43 years.

During
each of the years ended September 30, 2008, 2007 and 2006, the Company granted 5,000 options to a non-employee. These options were accounted for at their fair
value resulting in immaterial amounts of compensation expense recorded during the years ended September 30, 2008, 2007 and 2006.

11. Commitments and Contingencies



The Company leases its office space under non-cancelable operating leases. During the year ended September 30, 2006,
the Company entered into an amendment of its headquarters office space lease. The amendment of this lease extended the lease term through March 2009 for 52,000 square feet of office and manufacturing
space. The lease amendment included a provision for free rent for one month in fiscal year 2007 and has rent escalation clauses in 2008 and 2009. Accordingly, rent expense is recognized on a
straight-line basis and any amounts paid which are greater than or less than the amount expensed are recorded as deferred rent liabilities. Additionally, the lease amendment provided the
Company with the option to renew the lease for an additional two year period at the then-current market rate. During the year ended September 30, 2008, the Company entered into
another amendment of its headquarters office space lease, which extended the lease term through March 2012 with an option to further extend through March 2014.

In
connection with its acquisition of Alliance Systems in October 2007, the Company assumed Alliance Systems' operating lease for 83,000 square feet of office and manufacturing space
located in Plano, Texas. The lease term continues through July 2011, and the lease includes options to extend the lease term for two additional five-year periods at
then-current market rates. The lease includes annual rent escalation clauses, and accordingly, rent expense is recognized on a straight-line basis, as described above.

68

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Table of Contents

NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. Commitments and Contingencies (Continued)

As
of September 30, 2008, the future minimum lease payments under the Company's non-cancelable operating leases were as follows (in thousands):

Year Ending September 30,2009

$
1,4642010


1,4792011


1,3612012


357Total

$
4,661


Rent
expense for the years ended September 30, 2008, 2007 and 2006 was $1,415,000, $713,000, and $654,000, respectively.



Acquisition-related indemnificationsWhen, as part of an acquisition, the Company acquires all the stock of a company, the
Company assumes liabilities for certain events or circumstances that took place prior to the date of acquisition. The maximum potential amount of future payments the Company could be required to make
for such obligations is undeterminable. As of September 30, 2008, the Company has received one claim related to the Alliance Systems acquisition, for which the Company has paid a settlement of
$88,000. While the provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim related to acquisitions other than Alliance Systems is
unlikely. As a result, the Company has no liabilities recorded for these indemnification clauses as of September 30, 2008 and 2007.

The
Company enters into standard indemnification agreements in the ordinary course of its business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to
reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its business partners or customers, in connection with any patent, copyright, trademark, trade
secret or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The Company has never
incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly,
the Company has no liabilities recorded for these indemnifications as of September 30, 2008 and 2007.



The Company offers and fulfills warranty services on certain of its application platform solutions. Warranty terms vary in duration
depending upon the product sold, but generally provide for the repair or replacement of any defective products for periods of up to 36 months after shipment. Based upon historical experience
and expectations of future conditions, the Company reserves for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. For warranties related to
third-party data storage networking products, the Company recorded warranty expense based on its agreement with its third-party warranty fulfillment provider, whose fees were determined based on fixed
periodic amounts as well as activity-based charges.

69

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Table of Contents

NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. Commitments and Contingencies (Continued)

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

Year Ended September 30,2008

2007Beginning balance

$
1,046

$
559Acquisitions


70


Accruals for warranties issued


2,010


1,892Fulfillment of warranties during the period


(2,195
)

(1,405
)Ending balance

$
931

$
1,046




On or about December 3, 2001, a putative class action lawsuit was filed in the United States District Court for the Southern
District of New York against the Company, Lawrence A. Genovesi (the Company's former Chairman and Chief Executive Officer), Douglas G. Bryant (the Company's Chief Financial Officer), and several
underwriters of the Company's initial public offering. The suit alleges,inter alia, that the defendants violated the federal securities laws by issuing
and selling securities pursuant to the Company's initial public offering in July 2000 ("IPO") without disclosing to investors that the underwriter defendants had solicited and received excessive and
undisclosed commissions from certain investors. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Company's common stock between
July 13, 2000 and December 6, 2000.

In
October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice. On December 5, 2006, the United States Court of Appeals for the Second
Circuit overturned the District Court's certification of the a plaintiff class. On April 6, 2007, the Second Circuit denied plaintiffs' petition for rehearing, but clarified that the plaintiffs
may seek to certify a more limited class in the District Court. On September 27, 2007, plaintiffs filed a motion for class certification in certain designated "focus cases" in the District
Court. That motion has since been withdrawn. On November 13, 2007, the issuer defendants in certain designated "focus cases" filed a motion to dismiss the second consolidated amended class
action complaints that were filed in those cases. On March 26, 2008, the District Court issued an Opinion and Order denying, in large part, the motions to dismiss the amended complaints in the
"focus cases."

The
Company is unable to predict the outcome of this suit and as a result, no amounts have been accrued as of September 30, 2008.

12. Income Taxes

For the years ended September 30, 2008 and 2007, the Company recorded provisions of $57,000 and $98,000, respectively, in alternative minimum tax expense in connection with the
federal limitation on alternative minimum tax net operating loss carryforwards. In addition, for the year ended September 30, 2008, the Company also recorded a provision for state income taxes
of $138,000 related to certain tax jurisdictions where the Company previously did not generate net operating losses which could be used to offset current taxes. In particular, these jurisdictions were
attributable to states in

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Table of Contents

NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. Income Taxes (Continued)

which
Alliance Systems historically had filed income tax returns. Due to the loss incurred during the year ended September 30, 2006, the Company did not record a provision for any federal or
state income taxes in that year. For the years ended September 30, 2008, 2007 and 2006, the Company recorded provisions of $5,000, $21,000 and $48,000, respectively, for foreign income taxes
owed by its subsidiary in the United Kingdom.

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

Year Ended September 30,2008

2007

2006At U.S. federal statutory rate

$
(2,814
)
$
855

$
(1,852
)State taxes, net of federal effect


256


231


(266
)Foreign taxes


5


21


48Non-deductible expenses and other items


3,354


457


556AMT Tax


57


98


Effect of change in valuation allowance


(658
)

(1,543
)

1,562Provision for income taxes

$
200

$
119

$
48


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

September 30,2008

2007Deferred tax assets:Net operating losses

$
29,702

$
30,408Tax credit carryforwards


2,318


2,486Capitalized research and engineering


1,154


1,897Temporary differences


7,856


5,068Total deferred tax assets


41,030


39,859Valuation allowance for deferred tax assets


(37,076
)

(39,859
)Net deferred tax assets


3,954


Deferred tax liabilities:Intangible asset


(3,954
)

Net deferred tax asset

$


$



A
valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized. Accordingly, as of September 30, 2008 and
2007, a valuation allowance was recorded for the full amount of the deferred tax asset due to the uncertainty of its realization. Approximately $6.8 million of the net operating loss
carryforwards relate to disqualifying dispositions of incentive stock options, the tax benefit from which, if realized, will be credited to additional paid-in capital.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. Income Taxes (Continued)

As
of September 30, 2008, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $84,766,000 and $14,155,000, respectively.
For federal income tax purposes these net operating loss carryforwards will expire as follows: $44,281,000 in 2021, $22,686,000 in 2022, $3,458,000 in 2023, $1,172,000 in 2024, $9,187,000 in 2025 and
$3,982,000 thereafter. For state income tax purposes these net operating loss carryforwards will expire as follows: $1,150,000 in 2009, $9,182,000 in 2010, and $3,823,000 in 2011.

The
Company also has available research and development credits for federal and state income tax purposes as of September 30, 2008 of approximately $1,583,000 and $588,000,
respectively, which expire at various dates from 2009 through 2024. An ownership change, as defined in the Internal Revenue Code, resulting from the issuance of additional stock may limit the amount
of net operating loss and tax credit carryforwards that can be utilized annually to offset future taxable income and tax liabilities. The amount of the annual limitation is determined based upon the
Company's value immediately prior to the ownership change. Subsequent significant changes in ownership could further affect the limitations in future years.

The
Company has an uncertain tax position of approximately $540,000 related to the validity of certain credits. Because the Company has significant operating loss carryforwards to offset
future taxable income, the Company does not expect to utilize any of these credits in the near term, and as a result, the Company does not expect that the uncertain tax position will change
significantly within the next twelve months.

The
Company files its tax returns as prescribed by the tax laws of the jurisdictions in which it operates. The Company's tax years from 2001 to 2007 are still subject to examination.
Various state and foreign jurisdiction tax years remain open to examination as well, although the Company believes any additional assessment will be immaterial to its consolidated financial
statements.

The
Company adopted FIN 48 effective October 1, 2007. Because the Company has recorded a full valuation allowance against its deferred tax assets, the adoption of
FIN 48 had no impact on the Company's retained earnings or reported liabilities. Under FIN 48, the Company classifies any penalties and interest as a component of the income tax
provision. As part of the accounting for the acquisition of Alliance Systems, the Company has included, as a component of the net assets acquired, an estimated liability for approximately $123,000 for
uncertain tax positions, as determined in accordance with FIN 48. These uncertain tax positions related to state tax filing requirements. This liability, which included an estimate of $31,000
for interest and penalties, was based on the known facts at the time of the purchase price allocation. As of October 1, 2007, the date of the Company's adoption of FIN 48, and as of
September 30, 2008, no other amounts were accrued for penalties or interest related to uncertain tax positions. No penalties or interest are included in the provision for income taxes for the
year ended September 30, 2008.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. Income Taxes (Continued)

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

2008Balance upon adoption, October 1, 2007

$
540Increase for prior years


Increase for current years


47Acquired uncertain tax positions


123Reductions related to settlements with tax authorities


Reductions related to expiration of statute of limitations


Balance at September 30, 2008

$
710


13. Employee Savings Plan

The Company sponsors a savings plan for its employees who meet certain eligibility requirements, which is designed to be a qualified plan under Section 401(k) of the Internal
Revenue Code. Eligible employees are permitted to contribute to the 401(k) plan through payroll deductions within statutory and plan limits. The Company may make discretionary contributions upon the
approval of the 401(k) plan trustees and the Company's Board of Directors. Through September 30, 2008, the Company had not made any contributions to this plan.

14. Restructuring Charge

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

15. Line of Credit

On October 11, 2007, the Company entered into a Loan and Security Agreement ("Loan Agreement") with Silicon Valley Bank (the "Bank"). The term of this agreement was for one year,
to end on October 9, 2008. The Loan Agreement provided the Company with a $15 million revolving loan facility. The interest rate on this line was equal to one quarter of a point (0.25%)
below the current prime rate with interest payable monthly.

On
August 5, 2008, the Company and the Bank entered into the First Loan Modification Agreement (the "Modification Agreement"). The Modification Agreement amended the Loan
Agreement to extend its term to August 5, 2010, and to change the amount of the revolving loan facility to $10 million.
The Modification Agreement did not change the interest rate on the line. The Company opted to lower the amount of the revolving loan facility from $15 million to $10 million in order to
better reflect its potential borrowing needs and to reduce the fees it incurs to maintain the loan facility. As of December 15, 2008, the Company had not drawn on this line of credit, and had
been in compliance with all covenants since entering into the Loan Agreement, as amended.

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NETWORK ENGINES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

16. Geographic Data

All of the Company's long-lived assets were located in the United States as of September 30, 2008 and 2007. The following table summarizes the Company's revenues by
geographic region, in thousands:

Year Ended September 30,2008

2007

2006United States

$
149,311

$
84,209

$
86,564Foreign countries


48,184


35,418


32,132Total net revenues

$
197,495

$
119,627

$
118,696


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

Year Ended September 30,2008

2007

2006Ireland

$
27,472

$
30,849

$
29,125Canada


3,760


1,469


1,499United Kingdom


3,486


2,943


1,456


17. Quarterly Financial Data (Unaudited)

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

Three Months EndedDecember 31,
2007

March 31,
2008

June 30,
2008

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

$
54,340

$
55,174

$
47,046

$
40,935Gross profit


9,740


8,899


7,650


6,054Net income (loss)


1,241


300


(283
)

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

$
0.03

$
0.01

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


43,656


44,009


44,090


43,672Diluted weighted average shares outstanding


44,021


44,306


44,090


43,672




Three Months EndedDecember 31,
2006

March 31,
2007

June 30,
2007

September 30,
2007(in thousands, except per share data)Net revenues

$
27,238

$
29,305

$
27,998

$
35,086Gross profit


5,233


6,090


5,315


6,613Net (loss) income


(114
)

365


416


1,834Basic and diluted net (loss) income per share

$


$
0.01

$
0.01

$
0.04Basic weighted average shares outstanding


39,947


40,735


40,871


40,990Diluted weighted average shares outstanding


39,947


41,438


41,270


41,418


Net
loss for the three months ended September 30, 2008 includes a goodwill impairment charge of $8,669,000 and a restructuring charge of $444,000.

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Table of Contents

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

None.

ITEM 9A.    CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of September 30, 2008. Based on this
evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2008, our disclosure controls and procedures were (1) effective in accumulating
and communicating information to the Company's management, as appropriate, to allow timely decisions regarding required disclosure, and (2) effective, in that they provide reasonable assurance
that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms.

Management's Annual Report on Internal Control Over Financial Reporting

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



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

Network
Engines' management assessed the effectiveness of the Company's internal control over financial reporting as of September 30, 2008. In making this assessment, it used the
criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on our assessment, we concluded that, as of
September 30, 2008, the Company's internal control over financial reporting was effective based on those criteria.

The
effectiveness of the Company's internal control over financial reporting as of September 30, 2008 has been audited by PricewaterhouseCoopers LLP, an independent
registered public accounting firm, as stated in their report which appears under Item 8.

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Table of Contents

Changes in Internal Control Over Financial Reporting

During the quarter ended September 30, 2008, no change in the Company's internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred that has materially affected, or is reasonably likely to materially affect, the Company's internal control
over financial reporting.

ITEM 9B.    OTHER INFORMATION

None.

PART III

ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this item relating to directors, code of ethics, audit committee, and audit committee financial expert of
the Company and Section 16(a) beneficial ownership reporting compliance is contained in our Proxy Statement related to the 2009 Annual Meeting of Shareholders to be filed with the Securities
and Exchange Commission no later than 120 days after the end of our fiscal year, under the sections captioned "Election of Directors", "Information About Directors" and "Section 16(a)
Beneficial Ownership Reporting Compliance", and is incorporated herein by reference in response to this item. The information regarding executive officers is included in Part I of this
Form 10-K under the section captioned "Executive Officers of the Company".

ITEM 11.    EXECUTIVE COMPENSATION

The information required by this item is included under the section captioned "Executive Compensation" in our Proxy Statement related
to the 2009 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission no later than 120 days after the end of our fiscal year and is incorporated herein by
reference.

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

The information required by this item relating to security ownership of certain beneficial owners and management, and securities
authorized for issuance under equity compensation plans, is included in our Proxy Statement related to the 2009 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission
no later than 120 days after the end of our fiscal year under the section captioned "Stock Ownership of Directors, Officers and Greater-Than-5%-Stockholders" and is
incorporated herein by reference.

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

The information required by this item relating to certain relationships and related transactions is included in our Proxy Statement
related to the 2009 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission no later than 120 days after the end of our fiscal year under the sections captioned
"Board and Committees" and "Certain Relationships and Related Party Transactions" and is incorporated herein by reference.

ITEM 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required by this item is included under the caption "Ratification of the Selection of Independent Registered Public
Accounting Firm" in our Proxy Statement related to the 2009 Annual

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Table of Contents

Meeting
of Shareholders to be filed with the Securities and Exchange Commission no later than 120 days after the end of our fiscal year and is incorporated herein by reference.

PART IV

ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



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



PageReport of Independent Registered Public Accounting Firm

47Consolidated Balance Sheets as of September 30, 2008 and
2007

48Consolidated Statements of Operations for the years ended September 30,
2008, 2007 and 2006

49Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss)
for the years ended September 30, 2008, 2007 and 2006

50Consolidated Statements of Cash Flows for the years ended September 30,
2008, 2007 and 2006

51Notes to Consolidated Financial Statements

52




Schedule IIValuation and Qualifying Accounts for each of the three fiscal years ended September 30, 2008.

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



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

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Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this
report to be signed on its behalf by the undersigned, thereunto duly authorized, on December 15, 2008.

NETWORK ENGINES, INC.By:

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


Pursuant
to the requirements of the Securities Exchange Act of 1934, the report has been signed as of December 15, 2008 below by the following persons on behalf of the registrant
and in the capacities indicated.

Name

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

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

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

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

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

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

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

Director/s/ ROBERT M. WADSWORTH Robert M. Wadsworth

Director


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SCHEDULE II

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

Fiscal Year

Description

Balance At
Beginning of
Period

Additions

Deductions

Balance At
End of
Period2006

Allowance For Doubtful Accounts

$
75

$
28

$
74

$
292007

Allowance For Doubtful Accounts

$
29

$
3

$


$
322008

Allowance For Doubtful Accounts

$
32

$
126

$
36

$
1222006

Allowance For Sales Returns

$


$


$


$
2007

Allowance For Sales Returns

$


$
51

$
20

$
312008

Allowance For Sales Returns

$
31

$
1,527

$
1,364

$
1942006

Deferred Tax Asset Valuation Allowance

$
40,915

$
1,562

$
177

$
42,3002007

Deferred Tax Asset Valuation Allowance

$
42,300

$
(898
)
$
1,543

$
39,8592008

Deferred Tax Asset Valuation Allowance

$
39,859

$
(2,125
)
$
658

$
37,076


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EXHIBIT INDEX

Exhibit No.

Exhibit2.1

Agreement and Plan of Merger, dated October 9, 2007, by and among Network Engines, Inc., Nautilus Acquisition Corp., a Texas corporation and a wholly-owned subsidiary of Network Engines, Alliance Systems,
 Inc., a Texas corporation, and Jonathan Shapiro, as Shareholder Representative (Filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated October 15, 2007 and incorporated by reference herein).3.1

Second Amended and Restated Certificate of Incorporation of the Company (filed as Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2000 and incorporated by
reference herein).3.2

Second Amended and Restated By-laws of the Company (filed as Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2000 and incorporated by reference
herein).3.3

Third Amended and Restated By-laws of the Company (filed as Exhibit 3.01 to the Company's Current Report on Form 8-K dated February 8, 2008 and incorporated by reference herein).4.1

Specimen common stock certificate (filed as Exhibit 4.1 to the Company's registration statement on Form S-1 (File No. 333-34286) and incorporated by reference herein).10.1

Investor Rights Agreement, dated December 20, 1999, among the Company and certain of our investors (filed as Exhibit 10.6 to the Company's registration statement on Form S-1 (File No. 333-34286) and
incorporated by reference herein).10.2*

The Company's 1999 Stock Incentive Plan (filed as Exhibit 10.2 to the Company's registration statement on Form S-1 (File No. 333-34286) and incorporated by reference herein).10.3*

Form of First Amendment to the Company's 1999 Stock Incentive Plan (filed as Exhibit 10.16 to the Company's registration statement on Form S-1 (File No. 333-34286) and incorporated by reference
herein).10.4*

Form of Incentive Stock Option Agreement under the Company's 1999 Stock Incentive Plan (filed as Exhibit 10.3 to the Company's registration statement on Form S-1 (File No. 333-34286) and incorporated by
reference herein).10.5*

The Company's 2000 Employee Stock Purchase Plan, as Amended (filed as Exhibit 10.4 to the Company's registration statement on Form S-1 (File No. 333-34286) and incorporated by reference herein).10.6*

The Company's 2000 Director Stock Option Plan, as Amended (filed as Exhibit 10.5 to the Company's registration statement on Form S-1 (File No. 333-34286) and incorporated by reference herein).10.7*

Form of option granted to each of Frank M. Polestra and Robert M. Wadsworth on March 16, 2000, under the Company's 1999 Stock Incentive Plan (filed as Exhibit 10.15 to the Company's registration statement on
Form S-1 (File No. 333-34286) and incorporated by reference herein).10.8*

Incentive Stock Option Agreement with John H. Curtis, dated March 21, 2001, under the Company's 1999 Stock Incentive Plan (filed as Exhibit 10.23 to the Company's Quarterly Report on Form 10-Q for the
fiscal quarter ended March 31, 2001 and incorporated by reference herein).


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Exhibit No.

Exhibit10.9*

Non-statutory Stock Option Agreement with John H. Curtis, dated March 21, 2001 (filed as Exhibit 10.24 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2001 and
incorporated by reference herein).10.10*

Employment Agreement, dated March 21, 2001, between the Company and John H. Curtis (filed as Exhibit 10.22 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2001 and
incorporated by reference herein).10.11*

Executive Retention Agreement, dated April 12, 2002, between the Company and John H. Curtis (filed as Exhibit 10.37 to the Company's Annual Report on Form 10-K for the fiscal year ended September 30,
2002 and incorporated by reference herein).10.12

Lease dated October 19, 1999 with New Boston Batterymarch, LP for 25 Dan Road, Canton, Massachusetts (filed as exhibit 10.1 to the Company's registration statement of Form S-1 (File No. 333-34286)
and incorporated by reference herein).10.13

First Amendment dated February 1, 2000 and Second Amendment dated June 1, 2000 to Lease for 25 Dan Road, Canton, Massachusetts (filed as Exhibit 10.18 to the Company's registration statement on
Form S-1 (File No. 333-34286) and incorporated by reference herein).10.14

Third Amendment dated September 14, 2000 and 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 Company10.20

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

Fifth Amendment dated July 20, 2006 to Lease for 25 Dan Road, Canton, Massachusetts10.22

Offer Letter dated February 16, 2007 between Network Engines, Inc. and Paul Butler (Filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated March 1, 2007 and incorporated by
reference herein).10.23

Severance Terms Agreement, dated February 26, 2007, between the Company and Paul Butler (Filed as Exhibit 10.2 to the Company's Current Report on Form 8-K dated March 1, 2007 and incorporated by
reference herein).10.24

Loan and Security Agreement, dated as of October 11, 2007, by and among Network Engines, Inc., Alliance Systems, Inc. and Silicon Valley Bank (Filed as Exhibit 10.1 to the Company's Current Report on
Form 8-K dated October 15, 2007 and incorporated by reference herein).


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Exhibit No.

Exhibit10.25*

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

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

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

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

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

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

Sixth Amendment dated August 6, 2008 to Lease for 25 Dan Road, Canton, Massachusetts10.32*

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

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