Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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**(MarkOne)**

 

**x****      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30, 2010**

 

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition periodfrom                      to                      **

 

**Commissionfile number: 000-30863**

 

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**NETWORKENGINES, INC.**

(Exact name of registrant as specified in itscharter)

 

| **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)                             |

 

**(781)332-1000**

(Registrant’stelephone number, including area code)

 

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

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T during the preceding 12 months (or for such shorter periodthat the registrant was required to submit and post such files).  Yes  o  No  o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company.  See the definitionsof “large accelerated filer,” “accelerated filer” and “smaller reportingcompany” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer o                      |   | Accelerated filer x         |
|------------------------------------------------|--------|-----------------------------|
|                                           |   |                        |
| Non-accelerated filer o                        |   | Smaller reporting company o |
| (Do not check if a smaller reporting  company) |   |                        |

 

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

 

As of August 5, 2010, there were 42,837,632shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

 

 

 

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Table of Contents

 

**NETWORK ENGINES, INC.**

 

**INDEX**

 
| ** **                                                                                          | ** ** | **PAGE  NUMBER** |
|-----------------------------------------------------------------------------------------------------|------------|------------------|
|                                                                                                |       |             |
| **PART I.  FINANCIAL INFORMATION**                                                             |       |             |
|                                                                                                |       |             |
| ITEM  1. FINANCIAL STATEMENTS (UNAUDITED)                                                           |       | 1                |
|                                                                                                |       |             |
| CONDENSED CONSOLIDATED  BALANCE SHEETS                                                              |       | 1                |
| CONDENSED CONSOLIDATED  STATEMENTS OF OPERATIONS                                                    |       | 2                |
| CONDENSED CONSOLIDATED  STATEMENTS OF CASH FLOWS                                                    |       | 3                |
| NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED  FINANCIAL STATEMENTS                                 |       | 4                |
|                                                                                                |       |             |
| ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS |       | 13               |
|                                                                                                |       |             |
| ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK                                   |       | 24               |
|                                                                                                |       |             |
| ITEM 4. CONTROLS AND PROCEDURES                                                                     |       | 25               |
|                                                                                                |       |             |
| **PART II.  OTHER INFORMATION**                                                                |       |             |
|                                                                                                |       |             |
| ITEM  1. LEGAL PROCEEDINGS                                                                          |       | 25               |
|                                                                                                |       |             |
| ITEM  1A. RISK FACTORS                                                                              |       | 26               |
|                                                                                                |       |             |
| ITEM 6. EXHIBITS                                                                                    |       | 37               |
|                                                                                                |       |             |
| SIGNATURES                                                                                          |       | 38               |

 

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Table of Contents

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

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

**(unaudited)**

 
| ** **                                                                                                                                                                                                             | ** ** | **June 30, 2010** | ** ** | **September 30,  2009** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                             |       |                   | ** ** |                         |       |
| **Current assets:**                                                                                                                                                                                                    | ** ** | ** **             | ** ** | ** **                   | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                             |       | $                      | 12,715     |                         | $          | 21,039 |   |
| Accounts receivable, net  of allowances of $65 and $117 at June 30, 2010 and September 30,  2009, respectively                                                                                               |       | 35,717                 |       | 27,479                       |       |
| Income tax receivable                                                                                                                                                                                                  |       | 142                    |       | 17                           |       |
| Refundable acquisition  consideration                                                                                                                                                                                  |       | —                 |       | 3,629                        |       |
| Inventories                                                                                                                                                                                                            |       | 23,981                 |       | 13,078                       |       |
| Prepaid expenses and  other current assets                                                                                                                                                                             |       | 1,706                  |       | 1,504                        |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total current assets                                                                                                                                                                                                   |       | 74,261                 |       | 66,746                       |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Property and equipment,  net                                                                                                                                                                                           |       | 1,601                  |       | 1,622                        |       |
| Intangible asset, net                                                                                                                                                                                                  |       | 6,962                  |       | 8,128                        |       |
| Other assets                                                                                                                                                                                                           |       | 245                    |       | 174                          |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total assets                                                                                                                                                                                                           |       | $                      | 83,069     |                         | $          | 76,670 |   |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                         | ** ** | ** **             | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                               | ** ** | ** **             | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                       |       | $                      | 16,021     |                         | $          | 14,200 |   |
| Accrued compensation and  other related benefits                                                                                                                                                                       |       | 1,935                  |       | 1,466                        |       |
| Accrued warranty                                                                                                                                                                                                       |       | 586                    |       | 641                          |       |
| Other accrued expenses                                                                                                                                                                                                 |       | 2,320                  |       | 2,043                        |       |
| Deferred revenue                                                                                                                                                                                                       |       | 4,691                  |       | 4,233                        |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total current  liabilities                                                                                                                                                                                             |       | 25,553                 |       | 22,583                       |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Deferred revenue, net of  current portion                                                                                                                                                                              |       | 3,103                  |       | 2,517                        |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total liabilities                                                                                                                                                                                                      |       | 28,656                 |       | 25,100                       |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Commitments and  contingencies (Note 9)                                                                                                                                                                                |       |                   |       |                         |       |
| ** **                                                                                                                                                                                                             | ** ** | ** **             | ** ** | ** **                   | ** ** |
| **Stockholders’ equity:**                                                                                                                                                                                         | ** ** | ** **             | ** ** | ** **                   | ** ** |
| Preferred stock, $0.01  par value, 5,000,000 authorized, and no shares issued and outstanding                                                                                                                          | ** ** | **—**             | ** ** | **—**                   | ** ** |
| Common stock, $0.01 par  value, 100,000,000 shares authorized; 47,940,692 and 47,132,540 shares  issued; 42,797,288 and 42,147,336 shares outstanding at June 30, 2010  and September 30, 2009, respectively |       | 479                    |       | 471                          |       |
| Additional paid-in  capital                                                                                                                                                                                            |       | 198,617                |       | 196,711                      |       |
| Accumulated deficit                                                                                                                                                                                                    |       | (139,664               | )          | (140,770                     | )          |
| Treasury stock, at cost,  5,143,404 and 4,985,204 shares at June 30, 2010 and September 30,  2009, respectively                                                                                              |       | (5,019                 | )          | (4,842                       | )          |
| Total stockholders’  equity                                                                                                                                                                                       |       | 54,413                 |       | 51,570                       |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                       |       | $                      | 83,069     |                         | $          | 76,670 |   |

 

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

 

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**NETWORK ENGINES, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

** **
| ** **                                                    | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **2010**                                        | ** ** | **2009**                                       | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net revenues                                                  |       | $                                               | 61,582     |                                           | $          | 33,329 |   | $ | 160,664 |   | $ | 108,025 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Cost of revenues                                              |       | 54,833                                          |       | 28,292                                         |       | 141,357 |   | 91,612 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Gross profit                                                  |       | 6,749                                           |       | 5,037                                          |       | 19,307 |   | 16,413 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Operating expenses:                                           |       |                                            |       |                                           |       |   |   |   |   |
| Research and development                                      |       | 1,745                                           |       | 1,644                                          |       | 5,012 |   | 4,739 |   |
| Selling and marketing                                         |       | 1,858                                           |       | 2,039                                          |       | 5,676 |   | 6,240 |   |
| General and administrative                                    |       | 2,145                                           |       | 2,222                                          |       | 6,365 |   | 6,572 |   |
| Amortization of intangible asset                              |       | 389                                             |       | 439                                            |       | 1,167 |   | 1,317 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Total operating expenses                                      |       | 6,137                                           |       | 6,344                                          |       | 18,220 |   | 18,868 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Income (loss) from operations                                 |       | 612                                             |       | (1,307                                         | )          | 1,087 |   | (2,455 | ) |
| Interest and other (expense) income, net                      |       | (36                                             | )          | 64                                             |       | (44 | ) | 76 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Income (loss) before income taxes                             |       | 576                                             |       | (1,243                                         | )          | 1,043 |   | (2,379 | ) |
| Provision for (benefit from) income taxes                     |       | (96                                             | )          | —                                         |       | (63 | ) | — |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net income (loss)                                             |       | $                                               | 672        |                                           | $          | (1,243 | ) | $ | 1,106 |   | $ | (2,379 | ) |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net income (loss) per share — basic                      |       | $                                               | 0.02       |                                           | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.06 | ) |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net income (loss) per share — diluted                    |       | $                                               | 0.01       |                                           | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.06 | ) |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Shares used in computing basic net income (loss)  per share   |       | 42,555                                          |       | 42,764                                         |       | 42,210 |   | 43,026 |   |
| Shares used in computing diluted net income (loss)  per share |       | 45,369                                          |       | 42,764                                         |       | 43,922 |   | 43,026 |   |

 

**The accompanying notes are an integral part of thecondensed consolidated financial statements**

 

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**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **Nine months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                          | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                                                                                          | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                              |       |                                 |       |   |   |
| Net income (loss)                                                                                   |       | $                                    | 1,106      |   | $ | (2,379 | ) |
| Adjustments to reconcile  net income (loss) to net cash (used in) provided by operating activities: |       |                                 |       |   |   |
| Depreciation and  amortization                                                                      |       | 1,864                                |       | 1,997 |   |
| (Gain) loss on disposal  of property and equipment                                                  |       | (9                                   | )          | 22 |   |
| Provision for doubtful  accounts                                                                    |       | (30                                  | )          | 143 |   |
| Stock-based compensation                                                                            |       | 837                                  |       | 999 |   |
| Changes in operating  assets and liabilities:                                                       |       |                                 |       |   |   |
| Accounts receivable                                                                                 |       | (8,208                               | )          | 4,114 |   |
| Income tax receivable                                                                               |       | (125                                 | )          | 2,541 |   |
| Inventories                                                                                         |       | (10,901                              | )          | 9,125 |   |
| Prepaid expenses and  other assets                                                                  |       | (235                                 | )          | 264 |   |
| Accounts payable                                                                                    |       | 1,821                                |       | (4,423 | ) |
| Accrued expenses                                                                                    |       | 722                                  |       | (518 | ) |
| Deferred revenue                                                                                    |       | 1,043                                |       | (660 | ) |
|                                                                                                |       |                                 |       |   |   |
| Net cash (used in)  provided by operating activities                                                |       | (12,115                              | )          | 11,225 |   |
|                                                                                                |       |                                 |       |   |   |
| Cash flows from  investing activities:                                                              |       |                                 |       |   |   |
| Receipt of refundable  acquisition consideration                                                    |       | 3,629                                |       | — |   |
| Purchases of property  and equipment                                                                |       | (685                                 | )          | (853 | ) |
|                                                                                                |       |                                 |       |   |   |
| Net cash provided by  (used in) investing activities                                                |       | 2,944                                |       | (853 | ) |
|                                                                                                |       |                                 |       |   |   |
| Cash flows from  financing activities:                                                              |       |                                 |       |   |   |
| Purchase of treasury  stock                                                                         |       | (177                                 | )          | (803 | ) |
| Proceeds from issuance  of common stock                                                             |       | 1,075                                |       | 168 |   |
| Payment of bank line of  credit fees                                                                |       | (38                                  | )          | — |   |
| Payments on capital  lease obligation                                                               |       | (13                                  | )          | (20 | ) |
|                                                                                                |       |                                 |       |   |   |
| Net cash provided by  (used in) financing activities                                                |       | 847                                  |       | (655 | ) |
|                                                                                                |       |                                 |       |   |   |
| Net (decrease) increase  in cash and cash equivalents                                               |       | (8,324                               | )          | 9,717 |   |
| Cash and cash  equivalents, beginning of period                                                     |       | 21,039                               |       | 10,003 |   |
|                                                                                                |       |                                 |       |   |   |
| Cash and cash  equivalents, end of period                                                           |       | $                                    | 12,715     |   | $ | 19,720 |   |

 

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

 

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**NETWORK ENGINES, INC.**

**NOTES TOTHE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.  Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements have been prepared byNetwork Engines, Inc. (“Network Engines” or the “Company”) in accordancewith accounting principles generally accepted in the United States of Americaand pursuant to the rules and regulations of the Securities and ExchangeCommission (the “SEC”).  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations.  The year-end condensed consolidated balancesheet data was derived from audited financial statements, but does not includeall year-end disclosures required by accounting principles generally acceptedin the United States of America.  Thesefinancial statements should be read in conjunction with the audited financialstatements and the accompanying notes included in the Company’s 2009 AnnualReport on Form 10-K (the “2009 Form 10-K”) filed by the Company withthe SEC.

 

Theinformation furnished reflects all adjustments, which, in the opinion ofmanagement, are of a normal recurring nature and are considered necessary for afair statement of results for the interim periods.  It should also be noted that results for theinterim periods are not necessarily indicative of the results expected for thefull year or any future period.

 

The preparation of these condensed consolidatedfinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosures of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  The most significant estimates reflected inthese financial statements include allowance for doubtful accounts, inventoryvaluation, valuation of deferred tax assets, valuation of intangible assets,warranty reserves and stock-based compensation. Actual results could differ from those estimates.

 

**2.  Significant Accounting Policies**

 

***Recently Adopted Accounting Pronouncements***

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedauthoritative guidance which defines fair value, establishes a framework for measuringfair value in accordance with generally accepted accounting principles andexpands disclosures about fair value measurements.  The Company adopted this guidance, as itapplies to its financial assets and liabilities which are recognized or disclosedat fair value on a recurring basis (at least annually), as of October 1,2008. The Company adopted this guidance, as it applies to its nonfinancialassets and liabilities, as of October 1, 2009.  The adoption of thisguidance did not have an impact on the Company’s financial position, results ofoperations, or cash flows.

 

InDecember 2007, the FASB issued authoritative guidance related to businesscombinations. This guidance establishes principles and requirements for how theacquirer recognizes and measures in its financial statements the identifiableassets acquired, the liabilities assumed, and any noncontrolling interest inthe acquiree, recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase and determines what informationto disclose to enable users of the financial statements to evaluate the natureand financial effects of the business combination. This guidance is effectivefor business combinations on a prospective basis for which the acquisition dateis on or after the beginning of the Company’s first annual reporting periodbeginning on or after December 15, 2008. The Company adopted this guidanceas of October 1, 2009 and the adoption did not have an impact on itsfinancial position, results of operations, or cash flows.

 

InApril 2008, the FASB issued authoritative guidance used to determine theuseful life of intangible assets. This guidance amends the factors that shouldbe considered in developing renewal or extension assumptions used to determinethe useful life of a recognized intangible asset. This change is intended toimprove the consistency between the useful life of a recognized intangibleasset and the period of expected cash flows used to measure the fair value ofthe asset. The requirement for determining useful lives must be appliedprospectively to intangible assets acquired after the effective date and thedisclosure requirements must be applied prospectively to all intangible assetsrecognized as of, and subsequent to, the effective date. The Company adoptedthis guidance as of October 1, 2009 and the adoption did not have animpact on its financial position, results of operations, or cash flows.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

InOctober 2009, the FASB issued authoritative guidance formultiple-deliverable revenue arrangements, which amends previously issuedguidance to require an entity to use its best estimate of selling price whenvendor-specific objective evidence or acceptable third party evidence ofselling price does not exist for any products or services included in a multipleelement arrangement. The arrangement consideration should be allocated amongthe products and services based upon their relative selling prices, thuseliminating the use of the residual method of allocation. This guidance alsorequires expanded qualitative and quantitative disclosures regardingsignificant judgments made and changes in applying this guidance. This guidanceis effective on a prospective basis for revenue arrangements entered into ormaterially modified in fiscal years beginning on or after June 15, 2010.Early adoption and retrospective application are also permitted. The Companyadopted this guidance during the quarter ended March 31, 2010 and appliedthe guidance back to October 1, 2009, the start of the Company’s fiscalyear ending September 30, 2010.  Theadoption of this guidance did not have a material impact on the Company’sfinancial position, results of operations, or cash flows, and does not changethe units of accounting for our revenue transactions.

 

InOctober 2009, the FASB issued authoritative guidance for certain revenuearrangements that include software elements. Under this guidance, tangibleproducts containing software elements that function together to deliver theproduct’s essential functionality are no longer within the scope of softwarerevenue guidance. Entities that sell joint hardware and software products thatmeet this scope exception will be required to follow the guidance formultiple-deliverable revenue arrangements outside of the scope of softwarerevenue guidance. This guidance is effective on a prospective basis for revenuearrangements entered into or materially modified in fiscal years beginning onor after June 15, 2010. Early adoption and retrospective application arealso permitted. The Company adopted this guidance during the quarter ended March 31,2010  and applied the guidance back to October 1,2009, the start of the Company’s fiscal year ending September 30,2010.  The adoption of this guidance didnot have a material impact on the Company’s financial position, results ofoperations, or cash flows.

 

InJanuary 2010, the FASB issued authoritative guidance requiring additionaldisclosure related to fair value measurements that are made on a recurring andnon-recurring basis.  This guidance updates the guidance previously issuedby the FASB related to fair value measurement disclosures.  Under thisguidance, entities will be required to provide disclosures for transfers in andout of Level 1 and Level 2 fair value inputs.  In addition, entities will berequired to provide disclosures for activity within the Level 3 fair valueinput tier, including purchases, sales, issuances, and settlements during thereporting period.  This guidance is effective for interim and annualreporting periods beginning after December 15, 2009, except for the Level3 disclosure requirements, which will be effective for fiscal years beginningafter December 15, 2010.  The Company adopted the guidance as itrelates to Level 1 and Level 2 fair value inputs as of January 1, 2010 andthe adoption did not have a material impact on its financial position, resultsof operations, or cash flows.  TheCompany does not expect the adoption of this guidance as it relates to Level 3inputs to have a material impact on its financial position, results ofoperations, or cash flows.

 

InOctober 2009, the FASB amended the authoritative guidance related torevenue recognition for arrangements with multiple deliverables andarrangements that include software elements. The Company elected to early adoptthis guidance on a prospective basis for applicable transactions originating ormaterially modified on or after January 1, 2010, the start of the secondfiscal quarter of the Company’s fiscal year 2010.

 

Underprevious authoritative guidance, for revenue arrangements that containedmultiple elements, such as the sale of both the product and post-sales supportand/or extended warranty and related services element, in which software wasnot incidental to the product as a whole, the Company was required to determinethe fair value of the undelivered elements based upon vendor-specific objectiveevidence (“VSOE”) of fair value. VSOE was established through contractualpost-sales support renewal rates.  TheCompany used the residual fair value method to allocate the arrangementconsideration to the product. For revenue arrangements that contained softwareelements that were not incidental to the product as a whole, and VSOE was notavailable for the undelivered elements, the Company deferred all revenue associatedwith the arrangement and recognized the revenue over the related serviceperiod.

 

Underthe amended authoritative guidance for arrangements with multiple deliverablesand arrangements that include software elements, the Company is required todetermine if the software elements function together with the tangible productto deliver the tangible product’s essential functionality.  The Company determined that its softwareelements provide additional functionality but are not necessary to deliver thetangible product’s essential functionality; as such, the Company is required toallocate the arrangement consideration to the hardware and software elementsbased upon the relative selling price of the hardware and softwaredeliverables.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

TheCompany’s software elements consist of software and software maintenance.  Revenue associated with the software isrecognized upon delivery, when VSOE is available for the undelivered softwaremaintenance.  Revenue associated with thesoftware maintenance is recognized over the term of the maintenance period,which is generally one year.  When VSOEis not available for the undelivered software maintenance, revenue associatedwith the software elements is deferred and recognized over the softwaremaintenance period.

 

TheCompany’s hardware elements generally consist of an application platform andpost-sales support and/or an extended warranty. Revenue associated with the application platform is recognized upondelivery.  The Company allocates revenueassociated with the post-sales support and/or extended warranty based uponseparately priced contractual rates for these elements.  Revenue associated with the post-salessupport and/or extended warranty is deferred and recognized over the supportperiod, generally one to three years.

 

Thefollowing table presents the effect that the adoption of the authoritativeguidance would have had on the Company’s Condensed Consolidated Statement ofOperations for the three months ended December 31, 2009, assuming theCompany had adopted the authoritative guidance on October 1, 2009:

 
| ** **                                             | ** ** | **Three months ended December 31, 2009** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                             | ** ** | **As Reported**                                         | ** ** | **Adjustments** | ** ** | **As Amended** | ** ** |
|                                                   |       |                                                    |       |   |   |   |   |
| Net revenues                                           |       | $                                                       | 43,878     |   | $ | 175 |   | $ | 44,053 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Cost of revenues                                       |       | 37,882                                                  |       | 116 |   | 37,998 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Gross profit                                           |       | 5,996                                                   |       | 59 |   | 6,055 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Operating expenses                                     |       | 5,851                                                   |       | — |   | 5,581 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Income from operations                                 |       | 145                                                     |       | 59 |   | 204 |   |
| Interest and other income, net                         |       | 18                                                      |       | — |   | 18 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Income before income taxes                             |       | 163                                                     |       | 59 |   | 222 |   |
| Provision for income taxes                             |       | 24                                                      |       | — |   | 24 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Net income                                             |       | $                                                       | 139        |   | $ | 59 |   | $ | 198 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Net income per share — basic and diluted          |       | $                                                       | 0.00       |   | $ | 0.00 |   | $ | 0.00 |   |
|                                                   |       |                                                    |       |   |   |   |   |
| Shares used in computing basic net income per  share   |       | 42,027                                                  |       | 42,027 |   | 42,027 |   |
| Shares used in computing diluted net income per  share |       | 42,833                                                  |       | 42,833 |   | 42,833 |   |

 

TheCompany’s Condensed Consolidated Statement of Operations for the nine monthsended June 30, 2010 includes the impact of the adjustments above.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

***Cash and CashEquivalents***

 

The Company held $12.7 million in cash as of June 30,2010.  The Company held cash and cashequivalents totaling $21.0 million as of September 30, 2009.  Cashequivalents consisted of a money market fund purchased with an originalmaturity of three months or less.  The following table presents balancesof cash and cash equivalents held as of June 30, 2010 and September 30,2009 (in thousands):

 
| ** **                          | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2010**          | ** ** | **2009**               | ** ** |
| **Cash**                            |       | $                 | 12,715     |                   | $          | 4,009 |   |
| **Cash equivalents:**               |       |              |       |                   |       |
| Money market funds                  |       | —            |       | 17,030                 |       |
|                                |       |              |       |                   |       |
| **Total cash and cash equivalents** |       | $                 | 12,715     |                   | $          | 21,039 |   |

 

***Comprehensive Income (Loss)***

 

During each period presented, comprehensive income(loss) was equal to net income (loss).

 

***Significant Customers***

 

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

 
| ** **           | ** ** | **Net Revenues**            | ** ** | ** **                      | ** ** | ** **                 | ** ** |
|----------------------|------------|----------------------------------|------------|---------------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Accounts Receivable at** | ** ** |
| ** **           | ** ** | **June 30,**                | ** ** | **June 30,**               | ** ** | **June 30,**          | ** ** | **September 30,** | ** ** |
| ** **           | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010**                   | ** ** | **2009** | ** ** | **2010** | ** ** | **2009** | ** ** |
| EMC Corporation      |       | 58                               | %          | 35                              | %          | 48                         | %          | 35 | % | 57 | % | 30 | % |
| Tektronix, Inc. |       | 20                               | %          | 11                              | %          | 22                         | %          | 11 | % | 20 | % | 17 | % |

 

**3. Business Combination**

 

OnOctober 11, 2007, the Company acquired all of the equity of AllianceSystems, Inc. (“Alliance Systems”), a privately held corporation locatedin Plano, Texas, which provided application platforms and related equipment supportingcarrier communications and enterprise communications solutions.  Forfurther information on the acquisition, refer to the Company’s Annual Report onForm 10-K for the year ended September 30, 2009.

 

Theacquisition of Alliance Systems was structured to include an adjustment todecrease the purchase price based on the net working capital of AllianceSystems as of October 11, 2007, as defined in the merger agreement, andtherefore approximately $4.0 million of the cash paid was contingentlyreturnable to the Company and was previously recorded as contingentlyreturnable acquisition consideration. The former Alliance Systems shareholdersdisputed the amounts claimed by the Company under this provision of the mergeragreement. In September 2009, the Company engaged in arbitration with theformer Alliance Systems shareholders to resolve the disputed claims as providedfor in the merger agreement. In October 2009, the arbitrator’s decisionwas rendered. As a result, approximately $3.6 million of the contingentlyreturnable consideration was returned to the Company from escrow funds onNovember 3, 2009. This amount was recorded as refundable acquisitionconsideration in the Company’s consolidated balance sheet as ofSeptember 30, 2009.  The $393,000not returned to the Company was recorded as settlement of acquisition disputein the statement of operations for the year ended September 30, 2009.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**4.  Stock-Based Compensation**

 

Stock-basedcompensation expense is measured at the grant date, based on the fair value ofthe award, and is recognized as an expense over the employee’s requisiteservice period (generally the vesting period of the equity award).

 

The following table presents stock-based employeecompensation expense included in the Company’s unaudited condensed consolidatedstatements of operations (in thousands):

 
| ** **                             | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **2010**                                        | ** ** | **2009**                                       | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                   |       |                                            |       |                                           |       |   |   |   |   |
| Cost of revenues                       |       | $                                               | 38         |                                           | $          | 34 |   | $ | 115 |   | $ | 109 |   |
| Research and development               |       | 40                                              |       | 58                                             |       | 129 |   | 200 |   |
| Selling and marketing                  |       | 78                                              |       | 75                                             |       | 247 |   | 213 |   |
| General and administrative             |       | 87                                              |       | 152                                            |       | 346 |   | 477 |   |
| Total stock-based compensation expense |       | $                                               | 243        |                                           | $          | 319 |   | $ | 837 |   | $ | 999 |   |

 

TheCompany estimates the fair value of stock options using the Black-Scholesvaluation model.  This valuation model takes into account the exerciseprice of the award, as well as a variety of significant assumptions. These assumptions include the expected term, the expected volatility of theCompany’s common stock over the expected term, the risk-free interest rate overthe expected term, and the Company’s expected annual dividend yield.  TheCompany believes that the valuation technique and the approach utilized todevelop the underlying assumptions are appropriate in calculating the fairvalues of the Company’s stock options granted during the three and nine monthperiods ended June 30, 2010 and 2009.  Estimates of fair value arenot intended to predict the value ultimately realized by persons who receiveequity awards.  In determining the amount of expense to be recorded, judgmentis also required to estimate forfeitures of the awards based on the probabilityof employees completing the required service period.  Historicalforfeitures are used as a starting point for developing the estimate of futureforfeitures.

 

Assumptions used to determine the fair value ofoptions granted during the three and nine months ended June 30, 2010 and2009, using the Black-Scholes valuation model, were:

 
| ** **                      | ** ** | **Three months ended June 30,** | ** ** | **Nine months ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                      | ** ** | **2010**                                            | ** ** | **2009**                                           | ** ** | **2010** | ** ** | **2009** | ** ** |
|                            |       |                                                |       |                                               |       |   |   |   |   |
| Expected  term (1)              |       | 3.75 years                                          |       | 3.50 years                                         |       | 3.75 to 6.50 years |   | 3.50 to 6.00 years |   |
| Expected  volatility factor (2) |       | 75.31%                                              |       | 79.74%                                             |       | 71.56% to 75.31% |   | 66.82% to 80.11% |   |
| Risk-free  interest rate (3)    |       | 1.58% to 1.86%                                      |       | 1.54%                                              |       | 1.45% to 2.97% |   | 1.28% to 2.21% |   |
| Expected  annual dividend yield |       | —                                              |       | —                                             |       | — |   | — |   |

 

----

(1)          Theexpected term for each grant was determined based on analysis of the Company’shistorical exercise and post-vesting cancellation activity.

 

(2)          Theexpected volatility for each grant was estimated based on a weighted average ofthe historical volatility of the Company’s common stock.

 

(3)          Therisk-free interest rate for each grant was based on the U.S. Treasury yieldcurve in effect at the time of grant for a period equal to the expected term ofthe stock option.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

A summary of the Company’s stock option activity forthe nine months ended June 30, 2010 is as follows:

 
| ** **                              | ** ** | **Nine months ended June 30, 2010** | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|
| ** **                              | ** ** | **Number of  Options**              | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average Remaining  Contractual  Term (in years)** | ** ** |
|                                    |       |                                     |       |   |   |   |   |
| Outstanding at  September 30, 2009 |       | 7,959,408                                |       | $ | 2.08 |   |   |   |
| Granted                                 |       | 523,500                                  |       | $ | 1.51 |   |   |   |
| Exercised                               |       | (808,152                                 | )          | $ | 1.33 |   |   |   |
| Forfeited                               |       | (40,208                                  | )          | $ | 1.55 |   |   |   |
| Expired                                 |       | (187,608                                 | )          | $ | 3.97 |   |   |   |
| Outstanding at  June 30, 2010      |       | 7,446,940                                |       | $ | 2.08 |   | 6.18 |   |
| Exercisable at June 30,  2010      |       | 5,527,094                                |       | $ | 2.35 |   | 5.47 |   |

 

All stock options granted during the nine monthsended June 30, 2010 were granted with exercise prices equal to the fairmarket value of the Company’s common stock on the grant date and had a weightedaverage grant date fair value of $0.94.

 

At June 30, 2010, unrecognized compensationexpense related to non-vested stock options was $1,238,000, which is expectedto be recognized over a weighted average vesting period of 2.05 years.

 

**5.  Net Income (Loss) Per Share**

 

Basicnet income (loss) per share is computed by dividing the net income (loss) forthe period by the weighted average number of shares of common stock outstandingduring the period.  Diluted net income (loss) per share is computed bydividing the net income (loss) for the period by the weighted average number ofshares of common stock and potential common stock, if dilutive, outstandingduring the period.  Potential common stock includes incremental shares ofcommon stock issuable upon the exercise of stock options, calculated using thetreasury stock method.  For periods in which the Company incurs a netloss, diluted net loss per share is the same as basic net loss per sharebecause the inclusion of these common stock equivalents would be anti-dilutive.

 

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

 
| ** **                                                                                                              | ** ** | **Three months  ended June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2010**                              | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Numerator:                                                                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss)                                                                                                       |       | $                                     | 672        |                                 | $          | (1,243 | ) | $ | 1,106 |   | $ | (2,379 | ) |
|                                                                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Denominator:                                                                                                            |       |                                  |       |                                 |       |   |   |   |   |
| Shares used in computing  basic net income (loss) per share                                                             |       | 42,555                                |       | 42,764                               |       | 42,210 |   | 43,026 |   |
| Common stock equivalents  from employee stock options                                                                   |       | 2,814                                 |       | —                               |       | 1,712 |   | — |   |
|                                                                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Shares used in computing  diluted net income (loss) per share                                                           |       | 45,369                                |       | 42,764                               |       | 43,922 |   | 43,026 |   |
|                                                                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss) per  share:                                                                                           |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                                                                   |       | $                                     | 0.02       |                                 | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.06 | ) |
| Diluted                                                                                                                 |       | $                                     | 0.01       |                                 | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.06 | ) |
|                                                                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Anti-dilutive potential  common stock equivalents excludedfrom the calculation of  diluted net income (loss) per share: |       |                                  |       |                                 |       |   |   |   |   |
| Options to purchase  common stock                                                                                       |       | 974                                   |       | 6,830                                |       | 3,822 |   | 7,834 |   |

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**6.  Intangible Asset**

 

The Company recorded an intangible asset as the resultof its acquisition of Alliance Systems (see Note 3 above).  The acquired intangibleasset is customer relationships, which is being amortized over 17 years, whichis the estimated period of economic benefit expected to be received, resultingin a weighted average amortization period of 4.97 years.  The following table presents the intangibleasset balances as of June 30, 2010 and September 30, 2009 (in thousands):

 
| ** **             | ** ** | **June 30, 2010**      | ** ** | **September 30, 2009**   | ** ** |
|------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
| ** **             | ** ** | ** **                  | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer relationships |       | $                           | 11,775     |                          | $          | 4,813 |   | $ | 6,962 |   | $ | 11,775 |   | $ | 3,647 |   | $ | 8,128 |   |
|                        |            |                             |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Amortizationexpense for the three and nine months ended June 30, 2010 was $389,000 and$1,167,000, respectively.  The estimatedfuture amortization expense for the intangible asset as of June 30, 2010by fiscal year is $389,000 for the remainder of 2010, $1,330,000 for 2011,$1,119,000 for 2012, $868,000 for 2013, $678,000 for 2014 and $2,578,000thereafter.

 

TheCompany reviews long-lived assets, including definite-lived intangible assets,to determine if any adverse conditions exist that would indicateimpairment.  Factors that could lead to an impairment of acquired customerrelationships include a worsening in customer attrition rates compared tohistorical attrition rates, or lower than initially anticipated cash flowsassociated with customer relationships.  The Company assesses therecoverability of long-lived assets based on the projected undiscounted futurecash flows estimated to be generated over the asset’s remaining life.  Theamount of impairment, if any, is measured based on the excess of the carryingvalue over fair value.  Fair value is generally calculated as the presentvalue of estimated future cash flows using a risk-adjusted discount rate, whichrequires significant management judgment with respect to revenue and expensegrowth rates, and the selection and use of an appropriate discount rate.

 

**7.  Inventories**

 

Inventoriesconsisted of the following (in thousands): 

 
| ** **      | ** ** | **June 30,  2010** | ** ** | **September 30, 2009** | ** ** |
|-----------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **      | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Raw materials   |       | $                       | 9,871      |                        | $          | 8,246 |   |
| Work in process |       | 2,911                   |       | 1,063                       |       |
| Finished goods  |       | 11,199                  |       | 3,769                       |       |
|            |       |                    |       |                        |       |
| Total           |       | $                       | 23,981     |                        | $          | 13,078 |   |

 

**8.  Equity**

 

OnJune 12, 2008, the Board of Directors of the Company authorized therepurchase of up to $5 million of its common stock through a share repurchaseprogram.  As authorized by the program, shares may be purchased in theopen market or through privately negotiated transactions, in a mannerconsistent with applicable securities laws and regulations.  This stockrepurchase program does not obligate the Company to acquire any specific numberof shares, does not have an expiration date, and may be terminated at any timeby the Company’s Board of Directors.  All repurchases are expected to befunded from the Company’s current cash balances or from cash generated fromoperations.  To facilitate repurchases of shares under this program, theCompany has established Rule 10b5-1 plans intended to comply with therequirements of Rule 10b5-1 and Rule 10b-18 under the SecuritiesExchange Act of 1934.  A Rule 10b5-1 plan permits the repurchaseof shares by a company at times when it otherwise might be prevented from doingso under insider trading laws or because of company blackout periods, providedthat the plan is adopted when the company is not aware of material non-publicinformation.  Pursuant to the plan, a broker designated by the Company hasthe authority to repurchase shares, in accordance with the terms of the plan,without

 

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Table of Contents

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

furtherdirection from the Company.  The amount and timing of specificrepurchases are subject to the terms of the plan and market conditions. Upon the expiration of the first 10b5-1 plan on November 7, 2008, theCompany suspended repurchases of its common stock.  The Company resumedthe stock repurchase program on March 16, 2009 under a new 10b5-1 plan, asauthorized by the Board of Directors.  During the three months ended June 30,2010, the Company did not repurchase any shares of its common stock.  During the nine months ended June 30,2010, the Company repurchased 158,200 shares of its common stock at an averagecost of $1.12 per share.  From the inception of the share repurchaseprogram through June 30, 2010, the Company had repurchased 2,581,546shares of its common stock at an average cost of $0.84 per share.  As of June 30,2010, the maximum dollar value that may yet be used for purchases under theprogram was $2,820,000.

 

**9.  Commitments andContingencies**

 

***Guarantees and Indemnifications***

 

Acquisition-relatedindemnifications — When, as part of an acquisition, the Company acquires allthe stock of a company, the Company assumes liabilities for certain events orcircumstances that took place prior to the date of acquisition.  Themaximum potential amount of future payments the Company could be required tomake for such obligations is undeterminable.  Although certain provisionsof the agreements remain in effect indefinitely, the Company believes that theprobability of receiving a claim related to acquisitions other than AllianceSystems is unlikely.  As a result, the Company had not recorded anyliabilities for such indemnification clauses as of June 30, 2010.  Asof June 30, 2010, the Company had received two claims related to theAlliance Systems acquisition.  For one of the claims, the Company paid asettlement of $88,000 during the fiscal year ended September 30,2008.  The second claim was brought in January 2009 by CordsenEngineering GmbH (“Cordsen”), a former customer of Alliance Systems, allegingthat certain products that Cordsen purchased from Alliance Systems (prior tothe Company’s acquisition of Alliance Systems) were defective and did not meetCordsen’s desired specifications.  Cordsen alleges that by virtue of theCompany’s acquisition of Alliance Systems in October 2007, the Companybecame the assignee of Alliance Systems’ agreement with Cordsen.  In April 2010,a settlement was reached with Cordsen, whereby the former Alliance Systemsshareholders agreed to pay a settlement of $100,000 and the Company’s insureragreed to pay a settlement of $300,000 to Cordsen.   Payment of the settlement was made on May 12,2010.  The Company has also received aclaim relating to a sales and use tax audit of Alliance Systems by the state ofTexas. The Company is indemnified by the former shareholders of AllianceSystems, as provided under the terms of the merger agreement, for any resultingliabilities related to the period prior to the date that the Company acquired AllianceSystems.

 

TheCompany enters into standard indemnification agreements in the ordinary courseof its business.  Pursuant to these agreements, the Company indemnifies,holds harmless, and agrees to reimburse the indemnified party for lossessuffered or incurred by the indemnified party, generally its business partnersor customers, in connection with any patent, copyright, trademark, trade secretor other intellectual property infringement claim by any third party withrespect to its products.  The term of these indemnification agreements isgenerally perpetual.  The Company has never incurred costs to defendlawsuits or settle claims related to these indemnification agreements.  Asa result, the Company believes the estimated fair value of these agreements isminimal.  Accordingly, the Company has no liabilities recorded for theseindemnifications as of June 30, 2010.

 

Productwarranties — The Company offers and fulfills standard warranty services on itsapplication platform solutions.  Warranty terms vary in duration dependingupon the product sold, but generally provide for the repair or replacement ofany defective products for periods of up to 36 months after shipment. Based upon historical experience and expectation of future conditions, the Companyreserves for the estimated costs to fulfill customer warranty obligations uponthe recognition of the related revenue.  The following table presentschanges in the Company’s product warranty liability for the three and ninemonths ended June 30, 2010 and 2009 (in thousands):

 
| ** **                                   | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                   | ** ** | **2010**                              | ** ** | **2009**                             | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                         |       |                                  |       |                                 |       |   |   |   |   |
| Beginning balance                            |       | $                                     | 593        |                                 | $          | 796 |   | $ | 641 |   | $ | 931 |   |
| Accruals for warranties  issued              |       | 459                                   |       | 159                                  |       | 1,246 |   | 741 |   |
| Fulfillment of  warranties during the period |       | (466                                  | )          | (293                                 | )          | (1,301 | ) | (1,010 | ) |
| Ending balance                               |       | $                                     | 586        |                                 | $          | 662 |   | $ | 586 |   | $ | 662 |   |

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

Onor about December 3, 2001, a putative class action lawsuit was filed inthe United States District Court for the Southern District of New York againstthe Company, Lawrence A. Genovesi (the Company’s former Chairman and ChiefExecutive Officer), Douglas G. Bryant (the Company’s Chief Financial Officer),and several underwriters of the Company’s initial public offering. The suitalleges, *inter alia*, that thedefendants violated the federal securities laws by issuing and sellingsecurities pursuant to the Company’s initial public offering in July 2000(“IPO”) without disclosing to investors that the underwriter defendants hadsolicited and received excessive and undisclosed commissions from certaininvestors. The suit seeks damages and certification of a plaintiff classconsisting of all persons who acquired shares of the Company’s common stockbetween July 13, 2000 and December 6, 2000.

 

InOctober 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissedfrom this case without prejudice. On December 5, 2006, the United StatesCourt of Appeals for the Second Circuit overturned the District Court’scertification of a plaintiff class. On April 6, 2007, the Second Circuitdenied plaintiffs’ petition for rehearing, but clarified that the plaintiffsmay seek to certify a more limited class in the District Court. OnSeptember 27, 2007, plaintiffs filed a motion for class certification incertain designated “focus cases” in the District Court. That motion has sincebeen withdrawn. On November 13, 2007, the issuer defendants in certaindesignated “focus cases” filed a motion to dismiss the second consolidatedamended class action complaints that were filed in those cases. OnMarch 26, 2008, the District Court issued an Opinion and Order denying, inlarge part, the motions to dismiss the amended complaints in the “focus cases.”On April 2, 2009, the plaintiffs filed a motion for preliminary approvalof a new proposed settlement between plaintiffs, the underwriter defendants,the issuer defendants and the insurers for the issuer defendants. OnJune 10, 2009, the Court issued an opinion preliminarily approving theproposed settlement, and scheduling a settlement fairness hearing for September10, 2009. On October 5, 2009, the Court issued an opinion grantingplaintiffs’ motion for final approval of the settlement, approval of the planof distribution of the settlement fund, and certification of the settlementclasses. An Order and Final Judgment was entered on December 30,2009.  Various notices of appeal of the District Court’s October 5,2009 order have been filed. The Company is unable to predict the outcome ofthis suit and as a result, no amounts have been accrued as of June 30,2010.

 

**10.Line of Credit**

 

OnOctober 11, 2007, the Company entered into a Loan and Security Agreement(the “Loan Agreement”) with Silicon Valley Bank (the “Bank”). On August 5,2008, the Company and the Bank entered into the First Loan ModificationAgreement (the “First Modification “). The First Modification amended the LoanAgreement to extend its term to August 5, 2010, and to change the amountof the revolving loan facility to $10 million.

 

OnFebruary 5, 2010, the Company and the Bank entered into an Amended andRestated Loan and Security Agreement.  This agreement amended the LoanAgreement to extend its term to February 4, 2012, and to change theinterest rate on the line to one half of a point (0.50%) above the Prime Ratewith interest payable monthly.  The PrimeRate is the rate announced from time to time by the Bank.  The Company isalso required to comply with certain financial covenants relating to liquidityand minimum operating cash flows per quarter. As of August 9, 2010, the Company had not drawn on this line ofcredit.

 

**11.  IncomeTaxes**

 

The Companyrecorded a net benefit from income taxes of $96,000 and $63,000 for the threeand nine months ended June 30, 2010, respectively.  The benefit was attributable to the Company’sability to carry back its net operating loss (“NOL”) from fiscal year 2009 tooffset alternative minimum tax (“AMT”) paid in prior years.  For the three months ended June 30,2010, the benefit of approximately $125,000 was offset by $29,000 for theprovision of income taxes in certain states where the Company does not have NOLcarryforwards to offset taxable income. For the nine months ended June 30, 2010, the benefit ofapproximately $125,000 was offset by $62,000 for the provision of income taxesin certain states where the Company does not have NOL carryforwards to offsettaxable income.

 

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Special Note Regarding Forward-Looking Statements**

 

This Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, that involve risks anduncertainties.  All statements other thanstatements of historical information provided herein are forward-lookingstatements and may contain projections related to financial results, economicconditions, trends and known uncertainties. Our actual results could differ materially from those discussed in theforward-looking statements as a result of a number of factors, which includethose discussed in this section and in Part II, Item 1A, RiskFactors, of this report and the risks discussed in our other filings with theSecurities and Exchange Commission (the “SEC”). Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s analysis, judgment,belief or expectation only as of the date hereof.  We undertake no obligation to publiclyreissue these forward-looking statements to reflect events or circumstancesthat arise after the date hereof.

 

The following discussion andanalysis should be read in conjunction with the condensed consolidatedfinancial statements and the notes thereto included in Item 1 in this QuarterlyReport on Form 10-Q and our Annual Report on Form 10-K for the fiscalyear ended September 30, 2009 filed by us with the SEC.

 

**Overview**

 

We design and manufacture applicationplatform solutions that enable original equipment manufacturers, or OEMs, andindependent software vendors, or ISVs, that then deliver their softwareapplications in the form of a network-ready device. Application platforms arepre-configured server-based network infrastructure devices, engineered todeliver specific software application functionality, ease deploymentchallenges, improve integration and manageability, accelerate time-to-marketand increase the security of that software application in an end user’snetwork. We offer our customers an extensive suite of services includingsolution design, integration control, global logistics, Smart Services, andsupport and maintenance. We produce and fulfill devices branded for ourcustomers, and derive our revenues primarily from the sale of value-addedhardware platforms to these customers. Our customers subsequently resell andsupport these platforms under their own brands to their customer bases.

 

**CriticalAccounting Policies and Estimates**

 

Our discussion and analysis of financial conditionand results of operations are based upon our condensed consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America.  In preparing these financial statements, wehave made estimates and judgments in determining certain amounts included inthe financial statements.  We base ourestimates and judgments on historical experience and other assumptions that webelieve to be reasonable under the circumstances.  Actual results may differ from theseestimates under different assumptions or conditions.

 

OnJanuary 1, 2010, we adopted the authoritative guidance issued by theFinancial Accounting Standards Board (“FASB”) related to revenue arrangementswith multiple deliverables and revenue arrangements which include softwareelements.  Under the amendedauthoritative guidance for arrangements with multiple deliverables and arrangementsthat include software elements, we are required to determine if the softwareelements function together with the tangible product to deliver the tangibleproduct’s essential functionality.  Wedetermined that our software elements provide additional functionality but arenot necessary to deliver the tangible product’s essential functionality; assuch, we are required to allocate the arrangement consideration to the hardwareand software elements based upon the relative selling price of the hardware andsoftware deliverables.  Our softwareelements consist of software and software maintenance.  Revenue associated with the software isrecognized upon delivery, when VSOE is available for the undelivered softwaremaintenance.  Revenue associated with thesoftware maintenance is recognized over the term of the maintenance period,which is generally one year.  When VSOEis not available for the undelivered software maintenance, revenue associatedwith the software elements is deferred and recognized over the software maintenanceperiod.  Our hardware elements generallyconsist of an application platform and post-sales support and/or an extendedwarranty.  Revenue associated with theapplication platform is recognized upon delivery.  We allocate revenue associated with the post-salessupport and/or extended warranty based upon separately priced contractual ratesfor these elements.  Revenue associatedwith the post-sales support and/or extended warranty is deferred and recognizedover the support period, generally one to three years.  With the exception of the adoption of theauthoritative guidance related to revenue arrangements with multipledeliverables and revenue arrangements which include software elements, therehave been no changes to our critical accounting policies since September 30,2009.

 

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**Resultsof Operations**

 

**Threemonths ended June 30, 2010 compared to the three months ended June 30,2009**

 

The following table summarizes financial data forthe periods indicated, in thousands and as a percentage of net revenues, andprovides the changes in thousands and percentages:

 
| ** **                     | ** ** | **Three months ended June 30,** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **2010**                             | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                     | ** ** | **Dollars**                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                   |       | $                                    | 61,582     |   | 100.0 | % | $ | 33,329 |   | 100.0 | % | $ | 28,253 |   | 84.8 | % |
| Gross profit                   |       | 6,749                                |       | 11.0 | % | 5,037 |   | 15.1 | % | 1,712 |   | 34.0 | % |
| Operating expenses             |       | 6,137                                |       | 10.0 | % | 6,344 |   | 19.0 | % | (207 | ) | (3.3 | )% |
| Income (loss) from  operations |       | 612                                  |       | 1.0 | % | (1,307 | ) | (3.9 | )% | 1,919 |   | — |   |
| Net income (loss)              |       | 672                                  |       | 1.1 | % | (1,243 | ) | (3.7 | )% | 1,915 |   | — |   |
|                                |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

 

Ourrevenues are derived primarily from sales of application platform solutions toour OEM and ISV customers.  The increase in net revenues during the threemonths ended June 30, 2010 as compared to the three months ended June 30,2009 was primarily the result of increased sales volume to some of our largercustomers, in particular a design win achieved in the fourth quarter of fiscalyear 2009 with our largest customer, combined with lower overall sales volumesin the three months ended June 30, 2009 due to the global economicdownturn.  The increases in revenues were partially offset by a decreasein net revenues related to our transition away from some of our non-strategic,transactional revenues to projects that are more in line with our businessmodel.

 

***Gross Profit***

 

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

 

Grossprofit increased in the three months ended June 30, 2010 as compared tothe three months ended June 30, 2009, primarily due to increased salesvolumes with our largest customer.  Grossprofit as a percentage of net revenues decreased for the three months ended June 30,2010, as compared to the three months ended June 30, 2009. This decreasefrom the prior year was primarily due to the high volume design win achieved inthe fourth quarter of fiscal year 2009 with our largest customer, which hasgross margins that are lower than historical levels.  The first shipmentsof product related to some of this business occurred (and the related revenueswere recognized) during the three months ended December 31, 2009 and continuedto ramp up in the three month periods ended March 31, 2010 and June 30,2010.  We have pursued such opportunities in order to increase revenuesand leverage those revenues over our existing infrastructure to improveoperating margins.  In addition, certain planned price decreases with ourlargest customer on certain legacy products were in effect during the threemonths ended June 30, 2010 compared to the three months ended June 30,2009.

 

Grossprofit as a percentage of net revenues is affected by customer and product mix,component material costs, pricing and the volume of orders as well as by themix of product manufactured internally compared to product manufactured by acontract manufacturer, which carries higher manufacturing costs. There could bevariability with regard to our gross profit percentage in future periods as itwill be highly dependent on how much of our revenue is derived from our highvolume, lower gross margin business.  We may also continue to seek highervolume revenue opportunities which have gross profit percentages that are lowerthan historical levels.

 

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***Operating Expenses***

 

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

 
| ** **                        | ** ** | **Three months ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2010**                             | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating expenses:               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Research and development          |       | $                                    | 1,745      |   | 2.8 | % | $ | 1,644 |   | 4.9 | % | $ | 101 |   | 6.1 | % |
| Selling and marketing             |       | 1,858                                |       | 3.0 | % | 2,039 |   | 6.1 | % | (181 | ) | (8.9 | )% |
| General and administrative        |       | 2,145                                |       | 3.5 | % | 2,222 |   | 6.7 | % | (77 | ) | (3.5 | )% |
| Amortization of  intangible asset |       | 389                                  |       | 0.7 | % | 439 |   | 1.3 | % | (50 | ) | (11.4 | )% |
|                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                                    | 6,137      |   | 10.0 | % | $ | 6,344 |   | 19.0 | % | $ | (207 | ) | (3.3 | )% |

 

***Research and Development***

 

Researchand development expenses consist primarily of salaries and related expenses forpersonnel engaged in research and development, material costs for prototype andtest units, fees paid to consultants and outside service providers, and otherexpenses related to the design, development, testing and enhancements of ourapplication platform solutions.  Weexpense all of our research and development costs as they are incurred.  The following table summarizes the mostsignificant components of research and development expense for the periodsindicated, in thousands and as a percentage of total research and developmentexpense, and provides the changes in thousands and percentages:

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2010**                             | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related  expenses    |       | $                                    | 1,175      |   | 67.3 | % | $ | 1,052 |   | 64.0 | % | $ | 123 |   | 11.7 | % |
| Stock-based compensation              |       | 40                                   |       | 2.3 | % | 58 |   | 3.5 | % | (18 | ) | (31.0 | )% |
| Prototype                             |       | 338                                  |       | 19.4 | % | 247 |   | 15.0 | % | 91 |   | 36.8 | % |
| Consulting and  professional services |       | 89                                   |       | 5.1 | % | 147 |   | 9.0 | % | (58 | ) | (39.5 | )% |
| Other                                 |       | 103                                  |       | 5.9 | % | 140 |   | 8.5 | % | (37 | ) | (26.4 | )% |
|                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total research and  development       |       | $                                    | 1,745      |   | 100.0 | % | $ | 1,644 |   | 100 | % | $ | 101 |   | 6.1 | % |

 

Researchand development expenses increased in the three months ended June 30,2010, as compared to the three months ended June 30, 2009, primarily dueto increases in compensation and related expenses and prototype expenses,partially offset by a decrease in consulting and professional servicesexpenses.  The increase in compensationand related expenses was primarily due to an increase in headcount from 36 at June 30,2009 to 41 at June 30, 2010 and an increase in variable compensation,which was directly related to the results of operations.   Prototype and consulting and professionalservices expenses tend to fluctuate based on the status of our developmentprojects which are in process at any given time.  Although our applicationplatform development strategy emphasizes the utilization of standard componenttechnologies, which utilize off-the-shelf components, some of our designsrequire customized platforms which require additional prototype and consultingand professional services.  As such, we expect that prototype andconsulting and professional services costs will continue to be variable andcould fluctuate depending on the timing and magnitude of our developmentprojects.

 

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***Selling and Marketing***

 

Sellingand marketing expenses consist primarily of salaries and commissions forpersonnel engaged in sales and marketing, and costs associated with ourmarketing programs, which include costs associated with our attendance at tradeshows, public relations, product literature costs, web site enhancements, andtravel.  The following table summarizesthe most significant components of selling and marketing expense for theperiods indicated, in thousands and as a percentage of total selling andmarketing expense, and provides the changes in thousands and percentages:

 
| ** **                         | ** ** | **Three months ended June 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2010**                             | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:             |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related  expenses |       | $                                    | 1,356      |   | 73.0 | % | $ | 1,506 |   | 73.9 | % | $ | (150 | ) | (10.0 | )% |
| Stock-based compensation           |       | 78                                   |       | 4.2 | % | 75 |   | 3.7 | % | 3 |   | 4.0 | % |
| Marketing programs                 |       | 114                                  |       | 6.1 | % | 195 |   | 9.5 | % | (81 | ) | (41.5 | )% |
| Travel                             |       | 96                                   |       | 5.2 | % | 83 |   | 4.1 | % | 13 |   | 15.7 | % |
| Other                              |       | 214                                  |       | 11.5 | % | 180 |   | 8.8 | % | 34 |   | 18.9 | % |
|                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and  marketing       |       | $                                    | 1,858      |   | 100.0 | % | $ | 2,039 |   | 100 | % | $ | (181 | ) | (8.9 | )% |

 

Selling and marketing expenses decreased in the three months ended June 30,2010, as compared to the three months ended June 30, 2009, primarily dueto decreases in compensation and related expenses and marketing programexpenses.  The decrease in compensationand related expenses was primarily attributed to a decrease in headcount from42 at June 30, 2009 to 39 at June 30, 2010, as well as a decrease incommission expense.  The decrease incommission expense was primarily due to changes in the metrics and targets weuse to determine commission payouts.  Thedecrease in marketing programs was primarily attributed to lower expensesassociated with industry trade shows during the three months ended June 30,2010.  Historically, we have attended amajor trade show during the third quarter of our fiscal year; however, thattrade show occurred during the three months ended March 31, 2010 insteadof the third quarter of fiscal year 2010.

 

***General and Administrative***

 

Generaland administrative expenses consist primarily of salaries and other relatedcosts for executive, finance, information technology and human resourcespersonnel; consulting and professional services, which include legal,accounting, audit and tax fees; and director and officer insurance.  The following table summarizes the mostsignificant components of general and administrative expense for the periodsindicated, in thousands and as a percentage of total general and administrativeexpense, and provides the changes in thousands and percentages:

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2010**                             | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related  expenses    |       | $                                    | 1,163      |   | 54.2 | % | $ | 1,103 |   | 49.6 | % | $ | 60 |   | 5.4 | % |
| Stock-based compensation              |       | 87                                   |       | 4.1 | % | 152 |   | 6.9 | % | (65 | ) | (42.8 | )% |
| Consulting and  professional services |       | 528                                  |       | 24.6 | % | 504 |   | 22.7 | % | 24 |   | 4.8 | % |
| Director and officer  insurance       |       | 38                                   |       | 1.8 | % | 56 |   | 2.5 | % | (18 | ) | (32.1 | )% |
| Other                                 |       | 329                                  |       | 15.3 | % | 407 |   | 18.3 | % | (78 | ) | (19.2 | )% |
|                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total general and  administrative     |       | $                                    | 2,145      |   | 100.0 | % | $ | 2,222 |   | 100 | % | $ | (77 | ) | (3.5 | )% |

 

Generaland administrative expenses decreased in the three months ended June 30,2010, as compared to the three months ended June 30, 2009, primarily dueto decreases in stock-based compensation and other expenses, partially offsetby an increase in compensation and related expenses.  The decrease in stock-based compensation was

 

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primarilydue to the fact that certain stock options granted in prior periods havereached the end of their vesting periods. The decrease in other expenses was primarily attributed to a decrease inbad debt expense during the three months ended June 30, 2010 as comparedto the three months ended June 30, 2009. Compensation and related expensesincreased primarily due to an increase in variable compensation, which wasdirectly related to the results of operations.

 

***Amortization of Intangible Asset***

 

Amortizationof the intangible asset decreased by $50,000 in the three months ended June 30,2010, as compared to the three months ended June 30, 2009.  Amortization expense for the intangible assetdecreases annually over its life of 17 years, to reflect the fact that theestimated economic benefit expected to be received from the intangible assetdeclines over time.

 

***Interest andOther Income (Expense), net***

 

Interestand other income (expense), net, totaled $(36,000) of expense for the threemonths ended June 30, 2010, compared to $64,000 of income for the threemonths ended June 30, 2009.  Thischange was primarily due to foreign currency exchange losses of $28,000recorded during the three months ended June 30, 2010 as compared toforeign currency exchange gains of $23,000 recorded during the three monthsended June 30, 2009.  These losses relate primarily to value-addedtax (“VAT”) refunds receivable.  The refundable VAT amounts, which we payon products and services purchased from our contract manufacturer located inIreland, are denominated in Euros.  Additionally, interest incomedecreased by $53,000 during the three months ended June 30, 2010, ascompared to the three months ended June 30, 2009.  This decrease was primarily attributable tolower cash balances as well as lower interest rates on the cash balances heldby us during the three months ended June 30, 2010 as compared to the threemonths ended June 30, 2009.

 

***Provision for (benefit from) IncomeTaxes***

 

Thebenefit from income taxes recorded for the three months ended June 30,2010 of $(96,000) was primarily related to estimated tax refunds associatedwith federal alternative minimum tax (“AMT”) payments made in previous fiscalyears.  This benefit was partially offset by a provision for income taxesrecorded for the three months ended June 30, 2010 for estimated stateincome tax liabilities.  There was noprovision for income taxes during the three months ended June 30,2009.  Although we have significant net operating loss carryforwards whichcan be used to offset taxable income, we may be subject to federal AMT. In addition, we will be subject to state taxes in various jurisdictions wherewe do not have net operating loss carryforwards or where states have suspendedthe use of net operating loss carryforwards to offset taxable income.

 

**Nine months ended June 30, 2010 compared to the ninemonths ended June 30, 2009**

 

Thefollowing table summarizes financial data for the periods indicated, in thousandsand as a percentage of net revenues, and provides the changes in thousands andpercentages:

 
| ** **                     | ** ** | **Nine Months ended June 30,** | ** ** |
|--------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2010**                            | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                     | ** ** | **Dollars**                         | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                   |       | $                                   | 160,664    |   | 100.0 | % | $ | 108,025 |   | 100.0 | % | $ | 52,639 |   | 48.7 | % |
| Gross profit                   |       | 19,307                              |       | 12.0 | % | 16,413 |   | 15.2 | % | 2,894 |   | 17.6 | % |
| Operating expenses             |       | 18,220                              |       | 11.3 | % | 18,868 |   | 17.5 | % | (648 | ) | (3.4 | )% |
| Income (loss) from  operations |       | 1,087                               |       | 0.7 | % | (2,455 | ) | (2.3 | )% | 3,542 |   | — |   |
| Net income (loss)              |       | 1,106                               |       | 0.7 | % | (2,379 | ) | (2.2 | )% | 3,485 |   | — |   |
|                                |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Net Revenues***

 

Theincrease in net revenues during the nine months ended June 30, 2010 ascompared to the nine months ended June 30, 2009 was primarily the resultof increased sales volume to some of our larger customers, in particular adesign win achieved in the fourth quarter of fiscal year 2009 with our largestcustomer, combined with lower overall sales volumes in the nine months ended June 30,2009 due to the global economic downturn.  The increase in revenues waspartially offset by a decrease in net revenues related to our transition awayfrom some of our non-strategic, transactional revenues to projects that aremore in line with our business model.

 

***Gross Profit***

 

Grossprofit increased in the nine months ended June 30, 2010 as compared to thenine months ended June 30, 2009, primarily due to increased sales volumesto our largest customer.

 

Grossprofit as a percentage of net revenues decreased for the nine months ended June 30,2010, as compared to the nine months ended June 30, 2009. The decreasefrom the prior year was primarily due to changes in customer and product mix,which were impacted by a high volume design win achieved in the fourth quarterof fiscal year 2009 with our largest customer, which has gross margins that arelower than historical levels.  The first shipments of product related tosome of this business occurred (and the related revenues were recognized)during the three months ended December 31, 2009 and continued to ramp upin the three month periods ended March 31, 2010 and June 30,2010.  We have pursued such opportunities in order to increase revenuesand leverage those revenues over our existing infrastructure to improveoperating margins.  In addition, certain planned price decreases with ourlargest customer on certain legacy products took effect during the nine monthsended June 30, 2010 in connection with the design win achieved in thefourth quarter of fiscal year 2009.

 

***Operating Expenses***

 

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

 
| ** **                        | ** ** | **Nine months ended June 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **2010**                            | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                         | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating expenses:               |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Research and development          |       | $                                   | 5,012      |   | 3.1 | % | $ | 4,739 |   | 4.4 | % | $ | 273 |   | 5.8 | % |
| Selling and marketing             |       | 5,676                               |       | 3.5 | % | 6,240 |   | 5.8 | % | (564 | ) | (9.0 | )% |
| General and  administrative       |       | 6,365                               |       | 4.0 | % | 6,572 |   | 6.1 | % | (207 | ) | (3.1 | )% |
| Amortization of  intangible asset |       | 1,167                               |       | 0.7 | % | 1,317 |   | 1.2 | % | (150 | ) | (11.4 | )% |
|                              |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                                   | 18,220     |   | 11.3 | % | $ | 18,868 |   | 17.5 | % | $ | (648 | ) | (3.4 | )% |

 

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***Research and Development***

 

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

 
| ** **                            | ** ** | **Nine months ended June 30,** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|
| ** **                            | ** ** | **2010**                            | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                         | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related  expenses    |       | $                                   | 3,417      |   | 68.2 | % | $ | 3,057 |   | 64.5 | % | $ | 360 |   | 11.8 | % |
| Stock-based compensation              |       | 129                                 |       | 2.6 | % | 200 |   | 4.2 | % | (71 | ) | (35.5 | )% |
| Prototype                             |       | 852                                 |       | 17.0 | % | 631 |   | 13.3 | % | 221 |   | 35.0 | % |
| Consulting and  professional services |       | 303                                 |       | 6.0 | % | 436 |   | 9.2 | % | (133 | ) | (30.5 | )% |
| Other                                 |       | 311                                 |       | 6.2 | % | 415 |   | 8.8 | % | (104 | ) | (25.1 | )% |
|                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total research and  development       |       | $                                   | 5,012      |   | 100.0 | % | $ | 4,739 |   | 100 | % | $ | 273 |   | 5.8 | % |

 

Research and development expenses increased in thenine months ended June 30, 2010, as compared to the nine months ended June 30,2009, primarily due to increases in compensation and related expenses andprototype expenses, partially offset by decreases in consulting andprofessional services and other expenses. Compensation and related expenses increased primarily due to an increasein headcount from 36 at June 30, 2009 to 41 at June 30, 2010 and anincrease in variable compensation, which was directly related to the results ofoperations.  Our prototype and consulting and professional servicesexpenses are project driven, as such, the timing of these expenditures canvary.

 

***Selling and Marketing***

 

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

 
| ** **                         | ** ** | **Nine months ended June 30,** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2010**                            | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                         | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:             |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related  expenses |       | $                                   | 4,234      |   | 74.6 | % | $ | 4,641 |   | 74.4 | % | $ | (407 | ) | (8.8 | )% |
| Stock-based compensation           |       | 247                                 |       | 4.4 | % | 213 |   | 3.4 | % | 34 |   | 15.9 | % |
| Marketing programs                 |       | 318                                 |       | 5.6 | % | 482 |   | 7.7 | % | (164 | ) | (34.0 | )% |
| Travel                             |       | 265                                 |       | 4.6 | % | 268 |   | 4.3 | % | (3 | ) | (1.1 | )% |
| Other                              |       | 612                                 |       | 10.8 | % | 636 |   | 10.2 | % | (24 | ) | (3.8 | )% |
|                               |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and  marketing       |       | $                                   | 5,676      |   | 100.0 | % | $ | 6,240 |   | 100 | % | $ | (564 | ) | (9.0 | )% |

 

Selling and marketing expenses decreased in the nine months ended June 30,2010, as compared to the nine months ended June 30, 2009, primarily due todecreases in compensation and related expenses and marketing programexpenses.  The decrease in compensationand related expenses was primarily attributed to a decrease in commissionexpense, as well as a decrease in headcount from 42 at June 30, 2009 to 39at June 30, 2010.  The decrease incommission expense was primarily due to changes in the metrics and targets weuse to determine commission payouts.  Thedecrease in marketing programs was primarily attributed to decreases in marketresearch, public relations, and trade show related expenses incurred during thenine months ended June 30, 2010 as compared to the nine months ended June 30,2009, in an effort to manage operating expenses.

 

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***General and Administrative***

 

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

 
| ** **                            | ** ** | **Nine months ended June 30,** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|
| ** **                            | ** ** | **2010**                            | ** ** | **2009** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                         | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:          |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related  expenses    |       | $                                   | 3,544      |   | 55.7 | % | $ | 3,261 |   | 49.6 | % | $ | 283 |   | 8.7 | % |
| Stock-based compensation              |       | 346                                 |       | 5.4 | % | 477 |   | 7.3 | % | (131 | ) | (27.5 | )% |
| Consulting and  professional services |       | 1,458                               |       | 22.9 | % | 1,629 |   | 24.8 | % | (171 | ) | (10.5 | )% |
| Director and officer  insurance       |       | 114                                 |       | 1.8 | % | 167 |   | 2.5 | % | (53 | ) | (31.7 | )% |
| Other                                 |       | 903                                 |       | 14.2 | % | 1,038 |   | 15.8 | % | (135 | ) | (13.0 | )% |
|                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total general and  administrative     |       | $                                   | 6,365      |   | 100.0 | % | $ | 6,572 |   | 100 | % | $ | (207 | ) | (3.1 | )% |

 

Generaland administrative expenses decreased in the nine months ended June 30,2010, as compared to the nine months ended June 30, 2009, primarily due todecreases in consulting and professional services, stock-based compensationexpenses and other expenses, partially offset by an increase in compensationand related expenses.  The decrease inconsulting and professional services was primarily attributed to a decrease inlegal expenses incurred during the nine months ended June 30, 2010 ascompared to the nine months ended June 30, 2009.  The decrease in stock-based compensation wasprimarily due to the fact that certain stock options granted in prior periodsreached the end of their vesting periods during the nine months ended June 30,2010.  The decrease in other expenses wasprimarily due to a decrease in bad debt expense during the nine months ended June 30,2010 as compared to the nine months ended June 30, 2009.  Compensation and related expenses increasedprimarily due to an increase in variable compensation, which was directlyrelated to the results of operations.

 

***Amortization of Intangible Asset***

 

Amortizationof the intangible asset decreased by $150,000 in the nine months ended June 30,2010, as compared to the nine months ended June 30, 2009.  Amortization expense for the intangible assetdecreases annually over its life of 17 years, to reflect the fact that theestimated economic benefit expected to be received from the intangible assetdeclines over time.

 

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

 

Interestand other income (expense), net, totaled $(44,000) of expense for the ninemonths ended June 30, 2010, as compared to $76,000 of income for the ninemonths ended June 30, 2009.  Thechange was primarily due to a decrease of $139,000 in interest income,primarily attributable to lower cash balances and lower interest rates on thecash balances held by us during the nine months ended June 30, 2010 ascompared to the nine months ended June 30, 2009.

 

***Provision for (benefit from) IncomeTaxes***

 

Thebenefit from income taxes recorded for the nine months ended June 30, 2010of $(63,000) was primarily related to estimated tax refunds associated withfederal alternative minimum tax (“AMT”) payments made in previous fiscalyears.  This benefit was partially offset by a provision for income taxesrecorded for the nine months ended June 30, 2010 for estimated stateincome tax liabilities.  There was noprovision for income taxes during the nine months ended June 30,2009.  Although we have significant net operating loss carryforwards whichcan be used to offset taxable income, we may be subject to federal AMT. In addition, we will be subject to state taxes in various jurisdictions wherewe do not have net operating loss carryforwards or where states have suspendedthe use of net operating loss carryforwards to offset taxable income.

 

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**Liquidity and Capital Resources**

 

Thefollowing table summarizes cash flow activities, in thousands, for the periods indicated:

 
| ** **                                            | ** ** | **Nine months ended  June 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
|                                                  | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                                            | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Net income (loss)                                     |       | $                                    | 1,106      |   | $ | (2,379 | ) |
| Non-cash adjustments to  net income (loss)            |       | 2,662                                |       | 3,161 |   |
| Changes in working  capital                           |       | (15,883                              | )          | 10,443 |   |
|                                                  |       |                                 |       |   |   |
| Net cash (used in)  provided by operating activities  |       | (12,115                              | )          | 11,225 |   |
|                                                  |       |                                 |       |   |   |
| Net cash provided by  (used in) investing activities  |       | 2,944                                |       | (853 | ) |
| Net cash provided by  (used in) financing activities  |       | 847                                  |       | (655 | ) |
|                                                  |       |                                 |       |   |   |
| Net (decrease) increase  in cash and cash equivalents |       | (8,324                               | )          | 9,717 |   |
| Beginning cash and cash  equivalents                  |       | 21,039                               |       | 10,003 |   |
|                                                  |       |                                 |       |   |   |
| Ending cash and cash  equivalents                     |       | $                                    | 12,715     |   | $ | 19,720 |   |

 

***Operating Activities***

 

Cashused in operating activities of $12.1 million during the nine months ended June 30,2010 was primarily the result of net cash used in changes in working capital, partiallyoffset by net income and the impact of non-cash adjustments to net income.  The changes in working capital were partiallythe result of an increase in accounts receivable, which was primarily relatedto higher net revenues.  The changes in working capital were alsopartially the result of an increase in inventories, which was primarily due toincreased purchasing to meet expected future customer demand, in particular asa result of the ramping up of new business relating to our fiscal year 2009 designwins.

 

Cashprovided by operating activities of $11.2 million during the nine months endedJune 30, 2009 was primarily the result of net cash provided by changes inworking capital and the impact of non-cash adjustments to net loss, partiallyoffset by the net loss for the period.  The change in accounts receivablewas related to collections of payments from customers, as well as a decrease innet revenues.  The change in inventories was related to the depletion ofinventories on hand and lower purchases during the nine months endedJune 30, 2009, which was related to the downward trend in revenues andefforts we undertook to minimize inventory quantities on hand.  Changes inworking capital during the nine months ended June 30, 2009 also includedthe receipt of $2.5 million of income tax refunds related to taxes paid byAlliance Systems in prior years.

 

***Investing Activities***

 

Cashprovided by investing activities during the nine months ended June 30,2010 was primarily the result of the receipt of the $3.6 million in refundableacquisition consideration, which was a return of cash we originally paid inconnection with our acquisition of Alliance Systems (see Note 3 in thenotes to the condensed consolidated financial statements for details regardingthe acquisition).  This increase in cash was partially offset by the useof $685,000 of cash for purchases of property and equipment.

 

Cashused in investing activities during the nine months ended June 30, 2009consisted of the use of approximately $853,000 of cash for purchases ofproperty and equipment.

 

***Financing Activities***

 

Cashprovided by financing activities during the nine months ended June 30,2010 consisted primarily of the receipt of $1.1 million as the result ofemployee stock option exercises, partially offset by $177,000 used torepurchase shares of our common stock and $38,000 used to pay fees associatedwith our bank line of credit (see Note 10 in the notes to the condensedconsolidated financial statements for details regarding the line of credit).Cash

 

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usedin financing activities during the nine months ended June 30, 2009consisted primarily of $803,000 used to repurchase shares of our common stock,partially offset by the receipt of $168,000 as the result of purchases underthe Employee Stock Purchase Plan.

 

OnJune 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 bepurchased in the open market or through privately negotiated transactions, in amanner consistent with applicable securities laws and regulations.  This stock repurchase program does notobligate us to acquire any specific number of shares, does not have anexpiration date, and may be terminated at any time by our Board ofDirectors.  All repurchases are expectedto be funded from our current cash balances or from cash generated fromoperations.  To facilitate repurchases of shares under this program, we haveestablished Rule 10b5-1 plans intended to comply with the requirements of Rule 10b5-1and Rule 10b-18 under the Securities Exchange Act of 1934.  A Rule 10b5-1plan permits the repurchase of shares by a company at times when it otherwisemight be prevented from doing so under insider trading laws or because ofcompany blackout periods, provided that the plan is adopted when the company isnot aware of material non-public information.  Pursuant to the plan, abroker designated by us has the authority to repurchase shares, in accordancewith the terms of the plan, without further direction from us.  Theamount and timing of specific repurchases are subject to the terms of the planand market conditions.  During thethree months ended June 30, 2010, we did not repurchase any shares of ourcommon stock.  During the nine monthsended June 30, 2010, we repurchased 158,200 shares of our common stock atan average cost of $1.12 per share.  Fromthe inception of the share repurchase program through June 30, 2010, wehad repurchased 2,581,546 shares of our common stock at an average cost of$0.84 per share.  Upon the expiration ofthe first 10b5-1 plan on November 7, 2008, we suspended repurchases of ourcommon stock.  We resumed the stockrepurchase program on March 16, 2009 under a new 10b5-1 plan, asauthorized by the Board of Directors.  Asof June 30, 2010, the maximum dollar value that may yet be used forpurchases under the program was $2,820,000.

 

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

 

·                  the timing and size of orders from ourcustomers;

 

·                  the timeliness of receipts of payments fromour customers;

 

·                  the timing and size of our purchases ofinventories;

 

·                  our ability to enter into partnerships withOEMs and ISVs;

 

·                  the level of success of our customers inselling systems that include our application platform solutions;

 

·                  the costs and timing of product engineeringefforts and the success of these efforts; and

 

·                  market developments.

 

Webelieve that our available cash resources, cash that we expect to generate fromsales of our products and services, and cash available through the SiliconValley Bank line of credit will be sufficient to meet our operating and capitalrequirements through at least the next twelve months.

 

In the event that our available cash resources and the Silicon ValleyBank line of credit are not sufficient, or if an event of default occurs, suchas failure to achieve certain financial covenants, that limits our ability toborrow under the line of credit, we may need to raise additional funds.  We may in the future seek to raise additionalfunds through borrowings, public or private equity financings or from othersources.  On April 28, 2010, wefiled a shelf registration statement on Form S-3 (the “shelf registrationstatement”), pursuant to which we may sell, from time to time, any combinationof securities under the prospectus included in the shelf registrationstatement, for an aggregate offering price of up to $40,000,000.  Under the shelf registration statement, wemay offer, from time to time, common stock, preferred stock, debt securities,depository shares, purchase contracts, purchase units, warrants, or anycombination of the above offerings.

 

Therecan be no assurance that additional financing will be available at all or, ifavailable, will be on terms acceptable to us. Additional equity financings could result in dilution to our shareholders.  If additional financing is

 

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neededand is not available on acceptable terms, we may need to reduce our operatingexpenses and scale back our operations.

 

***Contractual Obligations andCommitments***

 

OnJune 30, 2010, we entered into a Lease Agreement (the “Lease”) with RainerAsset Management Company, LLC (the “Lessor”) that replaces and extends ourprevious lease for 83,000 square feet of manufacturing and office space locatedat 3501 East Plano Parkway, Plano, Texas 75074.

 

TheLease has an initial term of 90 months, with two available extension options ofthree years, each at our election.  The cumulative base rent under theinitial term of the Lease totals $4,332,000, with rent payable monthly. Under the terms of the Lease, we are responsible for the payment of additionalrent items, which include property taxes, utilities, insurance premiums, commonarea costs, and maintenance costs.

 

Withthe exception of the Lease executed on June 30, 2010, there were no othermaterial changes to our contractual obligations and commitments during the ninemonths ended June 30, 2010 as disclosed in our Annual Report on Form 10-Kfor the year ended September 30, 2009.

 

Thefollowing table sets forth certain information concerning our obligations andcommitments to make certain payments, as of June 30, 2010 (in thousands):

 
| ** **               | ** ** | **Payments Due by Period**  | ** ** |
|--------------------------|------------|-----------------------------|------------|
| ** **               | ** ** | **Less than********1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **After******** 5 Years** | ** ** | **Total** | ** ** |
|                     |       |                        |       |   |   |   |   |   |   |   |   |
| Operating leases         |       | $                           | 900        |   | $ | 2,349 |   | $ | 2,021 |   | $ | 58 |   | $ | 5,328 |   |
| Capital lease obligation |       | 20                          |       | 34 |   | — |   | — |   | 54 |   |
|                     |       |                        |       |   |   |   |   |   |   |   |   |
| Total                    |       | $                           | 920        |   | $ | 2,383 |   | $ | 2,021 |   | $ | 58 |   | $ | 5,382 |   |

 

**Off-Balance Sheet Arrangements**

 

Wehave not created, and are not party to, any special-purpose or off-balancesheet entities for the purpose of raising capital, incurring debt or operatingparts of our business that are not consolidated into our financial statements.  We have not entered into any transactionswith unconsolidated entities whereby the Company has subordinated retainedinterests, derivative instruments or other contingent arrangements that exposethe Company to material continuing risks, contingent liabilities, or any otherobligation under a variable interest in an unconsolidated entity that providesfinancing, liquidity, market risk or credit risk support to the Company.

 

**Recent Accounting Pronouncements**

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedauthoritative guidance which defines fair value, establishes a framework formeasuring fair value in accordance with generally accepted accountingprinciples, and expands disclosures about fair value measurements. We adoptedthis guidance, as it applies to our financial assets and liabilities which arerecognized or disclosed at fair value on a recurring basis (at least annually),as of October 1, 2008. We adopted this guidance, as it applies to ournonfinancial assets and liabilities, as of October 1, 2009.  Theadoption of this guidance did not have an impact on our financial position,results of operations, or cash flows.

 

InDecember 2007, the FASB issued authoritative guidance related to businesscombinations. This guidance establishes principles and requirements for how theacquirer recognizes and measures in its financial statements the identifiableassets acquired, the liabilities assumed, and any noncontrolling interest inthe acquiree, recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase and determines what informationto disclose to enable users of the financial statements to evaluate the natureand financial effects of the business combination. This guidance is effectivefor business combinations on a prospective basis for which the acquisition dateis on or after the beginning of our first annual reporting period beginning onor

 

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afterDecember 15, 2008. We adopted this guidance on October 1, 2009 andthe adoption did not have a material impact on our financial position, resultsof operations, or cash flows.

 

InApril 2008, the FASB issued authoritative guidance used to determine theuseful life of intangible assets. This guidance amends the factors that shouldbe considered in developing renewal or extension assumptions used to determinethe useful life of a recognized intangible asset. This change is intended toimprove the consistency between the useful life of a recognized intangibleasset and the period of expected cash flows used to measure the fair value ofthe asset. The requirement for determining useful lives must be appliedprospectively to intangible assets acquired after the effective date and thedisclosure requirements must be applied prospectively to all intangible assetsrecognized as of, and subsequent to, the effective date. This guidance iseffective as of the beginning of our fiscal year that begins afterDecember 15, 2008. We adopted this guidance on October 1, 2009 andthe adoption did not have a material impact on our financial position, resultsof operations, or cash flows.

 

InOctober 2009, the FASB issued authoritative guidance formultiple-deliverable revenue arrangements, which amends previously issuedguidance to require an entity to use its best estimate of selling price whenvendor-specific objective evidence or acceptable third party evidence ofselling price does not exist for any products or services included in amultiple element arrangement. The arrangement consideration should be allocatedamong the products and services based upon their relative selling prices, thuseliminating the use of the residual method of allocation. This standard alsorequires expanded qualitative and quantitative disclosures regardingsignificant judgments made and changes in applying this guidance. This standardis effective on a prospective basis for revenue arrangements entered into ormaterially modified in fiscal years beginning on or after June 15, 2010.Early adoption and retrospective application are also permitted. We adoptedthis authoritative guidance during the quarter ended March 31, 2010  and applied the guidance back to October 1,2009, the beginning of our fiscal year ending September 30, 2010.  The adoption of this guidance did not have amaterial impact on our financial position, results of operations, or cashflows, and does not change the units of accounting for our revenuetransactions.

 

InOctober 2009, the FASB issued authoritative guidance for certain revenuearrangements that include software elements. Under this guidance, tangibleproducts containing software elements that function together to deliver theproduct’s essential functionality are no longer within the scope of softwarerevenue guidance. Entities that sell joint hardware and software products thatmeet this scope exception will be required to follow the guidance formultiple-deliverable revenue arrangements. This standard is effective on aprospective basis for revenue arrangements entered into or materially modifiedin fiscal years beginning on or after June 15, 2010. Early adoption andretrospective application are also permitted. We adopted this authoritativeguidance during the quarter ended March 31, 2010  and applied the guidance back to October 1,2009, the beginning of our fiscal year ending September 30, 2010.  The adoption of this guidance did not have amaterial impact on our financial position, results of operations, or cashflows.

 

InJanuary 2010, the FASB issued authoritative guidance requiring additionaldisclosure related to fair value measurements that are made on a recurring andnon-recurring basis.  This guidance updates the guidance previously issuedby the FASB related to fair value measurement disclosures.  Under thisguidance, entities will be required to provide disclosures for transfers in andout of Level 1 and Level 2 fair value inputs.  In addition, entities willbe required to provide disclosures for activity within the Level 3 fair valueinput tier, including purchases, sales, issuances, and settlements during thereporting period.  This guidance is effective for interim and annualreporting periods beginning after December 15, 2009, except for the Level3 disclosure requirements, which will be effective for fiscal years beginningafter December 15, 2010.  We adopted the guidance as it relates toLevel 1 and Level 2 fair value inputs as of January 1, 2010 and theadoption did not have a material impact on our financial position, results ofoperations, or cash flows.  We do notexpect the adoption of this guidance as it relates to Level 3 inputs to have amaterial impact on our financial position, results of operations, or cashflows.

 

**ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

Weengage in certain transactions which are denominated in currencies other thanthe U.S. dollar (primarily the Euro). These transactions may subject us toexchange rate risk based on fluctuations in currency exchange rates, whichoccur between the time such a transaction is recognized in our financialstatements and the time that the transaction is settled. However, based on thehistorical magnitudes and timing of such transactions, we do not believe we aresubject to material exchange rate risk. We do not engage in any foreigncurrency hedging transactions. We are exposed to market risk related to changesin interest rates. In the past, we have invested excess cash balances in cashequivalents 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 ininterest rates on our financial position, results of

 

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operationsand cash flows would not be material. In addition, we believe that ahypothetical 10% increase or decrease in interest rates would not have amaterial adverse effect on our financial condition.

 

**ITEM 4.    CONTROLS AND PROCEDURES**

 

Ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, evaluated the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act) as of June 30, 2010.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of June 30, 2010,our disclosure controls and procedures (1) were designed to effectivelyaccumulate and communicate information to the Company’s management, asappropriate, to allow timely decisions regarding required disclosure and(2) were effective, in that they provide reasonable assurance thatinformation required to be disclosed by the Company in the reports that itfiles or submits under the Securities Exchange Act is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms.

 

During the three months ended June 30,2010, no change in our internal controlover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) occurred that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II—OTHER INFORMATION**

 

**ITEM 1.     LEGAL PROCEEDINGS**

 

*Initial Public Offering Lawsuit*

 

Onor about December 3, 2001, a putative class action lawsuit was filed inthe United States District Court for the Southern District of New York againstus, Lawrence A. Genovesi (our former Chairman and Chief Executive Officer),Douglas G. Bryant (our Chief Financial Officer), and several underwriters ofour initial public offering. The suit alleges, *interalia*, that the defendants violated the federal securities laws byissuing and selling securities pursuant to our initial public offering inJuly 2000 (“IPO”) without disclosing to investors that the underwriterdefendants had solicited and received excessive and undisclosed commissionsfrom certain investors. The suit seeks damages and certification of a plaintiffclass consisting of all persons who acquired shares of our common stock betweenJuly 13, 2000 and December 6, 2000.

 

InOctober 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissedfrom this case without prejudice. On December 5, 2006, the United StatesCourt of Appeals for the Second Circuit overturned the District Court’scertification of a plaintiff class. On April 6, 2007, the Second Circuitdenied plaintiffs’ petition for rehearing, but clarified that the plaintiffsmay seek to certify a more limited class in the District Court. OnSeptember 27, 2007, plaintiffs filed a motion for class certification incertain designated “focus cases” in the District Court. That motion has sincebeen withdrawn. On November 13, 2007, the issuer defendants in certaindesignated “focus cases” filed a motion to dismiss the second consolidatedamended class action complaints that were filed in those cases. OnMarch 26, 2008, the District Court issued an Opinion and Order denying, inlarge part, the motions to dismiss the amended complaints in the “focus cases.”On April 2, 2009, the plaintiffs filed a motion for preliminary approvalof a new proposed settlement between plaintiffs, the underwriter defendants,the issuer defendants and the insurers for the issuer defendants. OnJune 10, 2009, the District Court issued an opinion preliminarilyapproving the proposed settlement, and scheduling a settlement fairness hearingfor September 10, 2009. On October 5, 2009, the District Court issuedan opinion granting plaintiffs’ motion for final approval of the settlement,approval of the plan of distribution of the settlement fund, and certificationof the settlement classes. An Order and Final Judgment was filed onDecember 30, 2009.  Various notices of appeal of the District Court’sOctober 5, 2009 order have now been filed. We are unable to predict theoutcome of this suit and as a result, no amounts have been accrued as of June 30,2010.

 

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*Customer Claim*

 

OnJanuary 20, 2009, a lawsuit was filed in the United States District Courtfor the Eastern District of Texas against us and several other co-defendants.The suit, filed by Cordsen Engineering GmbH (“Cordsen”), a former customerof Alliance Systems, alleges breach of contract and other claims with regard tocertain products that Cordsen purchased from Alliance Systems (prior to ouracquisition of Alliance Systems) and which Cordsen alleges did not meet itsdesired specifications. (See Note 3 in the notes to the consolidatedfinancial statements for details regarding the acquisition.) Cordsen allegesthat by virtue of our acquisition of Alliance Systems in October 2007, webecame the assignee of Alliance Systems’ agreement with Cordsen. In April 2010,a settlement was reached with Cordsen, whereby the former Alliance Systemsshareholders agreed to pay a settlement of $100,000 and our insurer agreed topay a settlement of $300,000 to Cordsen.  Payment of the settlement was made on May 12, 2010.

 

**ITEM 1A. RISK FACTORS**

 

The risks and uncertainties described below are notthe only ones we are faced with. Additional risks and uncertainties not presently known to us, or thatare 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 adverselyaffected.  Subsequent to the previousdisclosure of risk factors in Item 1A of Part I of our most recent AnnualReport on Form 10-K for the fiscal year ended September 30, 2009,there have been no significant changes in our risk factors except for theaddition of the risk associated with our contract manufacturer, included belowunder the caption, “Risks related to product manufacturing”.

 

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

 

**We derive a significant portion of our revenues from sales ofapplication platform solutions directly to EMC and our revenues may declinesignificantly if this customer reduces, cancels or delays purchases of ourproducts, terminates its relationship with us or exercises certain of itscontractual rights.**

 

Forthe three months ended June 30, 2010 and 2009, sales directly to EMC, ourlargest customer, accounted for 58% and 35%, of our total net revenues,respectively.  For the nine months ended June 30, 2010 and 2009,sales directly to EMC accounted for 48% and 35%, of our total net revenues,respectively.  These sales are primarily attributable to a limited numberof products pursuant to non-exclusive contracts. We anticipate that our futureoperating results will continue to depend heavily on sales to, and ourrelationship with, this customer. Accordingly, the success of our business willdepend, in large part, on this customer’s willingness to continue to utilizeour application platform solutions in its existing and future products. In thefourth quarter of fiscal year 2009, we won new business to provide additionalproducts to this customer.   Grossmargins as a percentage of net revenues associated with this customer decreasedduring the nine months ended June 30, 2010 as this new business rampedup.  To the extent that our salesassociated with our largest customer increase as a percentage of our total netrevenues, our overall gross margin percentage may decrease.

 

Ourfinancial success is dependent upon the future success of the products we sellto this customer and the continued growth of this customer, whose industry hasa history of rapid technological change, short product lifecycles,consolidation and pricing and margin pressures. As we have experienced in recentperiods, advances in hard drive storage capacity could also result in lowersales volumes to this customer. A significant reduction in sales to thiscustomer, or significant pricing and additional margin pressures exerted on usby this customer, would have a material adverse effect on our results ofoperations. In addition, if this customer delays or cancels purchases of ourproducts, our operating results would be harmed and we may be unable toaccurately predict revenues, profitability and cash flows.

 

Underthe terms of our non-exclusive contracts, this customer has the right to enterinto agreements with third parties for similar products, is not obligated topurchase any minimum quantity of products from us and may choose to stoppurchasing from us at any time, with or without cause. In addition, thiscustomer may terminate the agreements in the event that we attempt to assignour rights under the agreements to another party without this customer’s priorapproval. Furthermore, in the event that we default on certain portions of theagreement, this customer has the right to manufacture certain products inexchange for a mutually agreeable royalty fee. If any of these events were tooccur, or if this customer were to delay or discontinue purchases of ourproducts as a result of dissatisfaction or otherwise, our revenues andoperating results would be materially adversely affected, our

 

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reputationin the industry might suffer, and we may be unable to accurately predictrevenues, profitability and cash flows.

 

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

 

**Ourfuture success is dependent upon our ability to generate significant revenuesfrom application platform development relationships.**

 

Webelieve we must diversify our revenues and a major component of our businessstrategy is to form application platform design relationships with newOEMs and ISVs. Under this strategy, we work with our customers to designan application platform branded with their name. The customers then perform allof the selling and marketing efforts related to sales of their brandedappliance.

 

Thereare multiple risks associated with this strategy including:

 

·                  the expenditureof significant product design and engineering costs, which if not recoveredthrough application platform sales could negatively affect our operatingresults;

 

·                  a significantreliance on our customers’ application software products, which could betechnologically inferior to competitive products and result in limitations onour application platform sales, causing our revenues and operating results tosuffer;

 

·                  our customerswill most likely continue selling their software products as separate productsin addition to selling them in the form of an application platform, which willrequire us to effectively communicate the benefits of delivering their softwarein the form of an application platform;

 

·                  our reliance onour customers to perform all of the selling and marketing efforts associatedwith further sales of the application platform solution we develop with them;

 

·                  continuedconsolidation within the data storage, network security, carrier communicationsand enterprise communications industries that results in existing customersbeing acquired by other companies;

 

·                  our ability toleverage strategic relationships to obtain new sales leads;

 

·                  our ability toprovide our customers with high quality application platform solutions atcompetitive prices; and

 

·                  there is noguarantee that design wins will result in actual orders or sales. A “design win”occurs when a new customer or a separate division within an existing customernotifies us that we have been selected to integrate the customer’s application.There can be delays of several months or more between the design win and when acustomer initiates actual orders. The design win may never result in actualorders or sales. Further, if the customer’s plans change, we may commitsignificant resources to design wins that do not result in actual orders.

 

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

 

Wehave begun to pursue (and in some cases we have won) larger opportunities whichwe expect to have a more significant impact on our net revenues. We expect thatthese opportunities will have gross margins as a percentage of revenues whichare lower than historical levels, but we believe that such opportunities can beleveraged over our existing infrastructure without requiring us to incursignificant additional operating costs. However, if we cannot meet customerdemand utilizing our existing infrastructure, we may need to increase ourinfrastructure and associated operating costs, which would negatively impactour operating results. Also, our revenue growth may be lower than expected ifwe are unsuccessful in winning large opportunities, which would lead us topursue smaller opportunities in order to grow revenues.

 

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**Wemay not be able to effectively commercialize our application platformsolutions or may be at a competitive disadvantage if we cannot license orintegrate third-party applications that are essential for the functionality ofcertain platforms.**

 

Webelieve our success will depend on our ability to license or integrate certainapplications from third-parties that would be incorporated in certain of ourapplication platform solutions. Because we do not currently know with certaintywhich of these prospective technologies will be desired in the marketplace, wemay incorrectly invest in development or prioritize our efforts to integratethese technologies in our application platforms. Additionally, even if wecorrectly focus our efforts, there can be no assurance that we will select thepreferred provider of these technologies, the third-party provider will becommitted to the relationship and integration of their technology, or that theywill license their technology to us without obtaining significant certificationor training, which could be costly and time consuming. If we are unable tosuccessfully integrate the correct third-party technologies in a timely manner,our application platform solutions may be inferior to other competitiveproducts in the marketplace, which may adversely affect the results of ouroperations and our ability to grow our business. We believe that our servicesare a key competitive differentiation point and an important element of thetotal solution we offer. If our current and prospective customers do not findthe services we offer to be of value to them or their end users, they maydecide to perform these services in-house or we may lose their business tocompetitors. If this were to occur, our revenues and operating results would beadversely impacted.

 

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

 

Aspart of our strategy, we review opportunities to incorporate products andtechnologies that could be required in order to add new customers, retainexisting customers, expand the breadth of product offerings or enhance ourtechnical capabilities. Investing in new technologies presents numerous risks,including:

 

·                  we mayexperience difficulties integrating new technologies into our current or futureproducts;

 

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

 

·                  we mayincorporate technologies that do not result in the desired improvements to ourcurrent and/or future application platform products;

 

·                  we mayincorporate new technologies that either may not be desired by our customers ormay not be compatible with our customers’ existing technology;

 

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

 

·                  we could findthat the new products and/or technologies that we choose to incorporate intoour products are technologically inferior to those utilized by our competitors.

 

Ifwe are unable to adequately integrate new technologies into our applicationplatform products or if we invest in technologies that do not result in thedesired effects on our current and/or future product offerings, our businesscould be harmed and operating results could suffer.

 

***Risks related to the application platform markets.***

 

**Ifapplication platforms are not increasingly adopted as a solution to meet asignificant portion of companies’ software application needs, the market forapplication platform solutions may not grow, which could negatively impactour revenues.**

 

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

 

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Ourexpectations for the growth of the application platform market may not befulfilled if customers continue to use general-purpose servers or proprietaryplatforms. The role of our products could, for example, be limited ifgeneral-purpose servers out-perform application platforms, provide morecapabilities and/or flexibility than application platforms or are offered at alower cost. This could force us to lower the prices of our application platformsolutions or could result in fewer sales of these products, which wouldnegatively impact our revenues and decrease our gross profits.

 

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

 

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

 

Themarkets we serve are characterized by rapid technological change, frequent newproduct introductions and enhancements, potentially short product lifecycles,changes in customer demands and evolving industry standards. In the applicationplatform market, we attempt to mitigate these risks by utilizingstandards-based hardware platforms and by maintaining an adequate knowledgebase of available technologies. However, the application platform solutionsthat we sell could be rendered obsolete if products based on new technologiesare introduced or new industry standards emerge and we are not able toincorporate these technological changes into our products. In addition, wedepend on third parties for the base hardware of our application platforms andwe 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 maybe unable to design new products and services or achieve and maintain marketacceptance of them once they have come to market. Furthermore, when we dorelease new or enhanced products and services, we may be unable to manage thetransition from the older products and services to minimize disruption incustomer ordering patterns, avoid excessive inventories of older products anddeliver enough new products and services to meet customer demand.

 

Toremain competitive in the application platform market, we must successfullyidentify new product opportunities and partners and develop and bring newproducts to market in a timely and cost-effective manner. Our failure to selectthe appropriate partners and keep pace with rapid industry, technology ormarket changes could have a material adverse effect on our business, results ofoperations or financial condition.

 

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

 

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

 

Inthe past, we have incurred significant net losses and could incur net losses inthe future. At June 30, 2010 and September 30, 2009, our accumulateddeficit was $140 million and $141 million, respectively. If we are successfulin winning large opportunities in future periods but cannot meet our customerrequirements utilizing our existing infrastructure and production capabilities,we may need to increase our infrastructure. This would increase operatingexpenses and negatively impact our operating results. Also, our revenue growthmay be lower than expected if we are unsuccessful in winning largeopportunities, which would lead us to pursue smaller opportunities in order togrow revenues. As a result, we will need to generate significant revenues toachieve and sustain profitability. If we do not achieve and sustainprofitability, the market price for our common stock may decline. Even if weachieve sustained profitability there can be no guarantee that our stock price willincrease.

 

**We may not be able to borrow funds under our credit facilityor secure future financing if there is a material adverse change in ourbusiness.**

 

InOctober 2007, we entered into an agreement with Silicon Valley Bank toprovide for a line of credit. We view this line of credit as a source ofavailable liquidity to fund fluctuations in our working capital requirements.This facility contains various conditions, covenants and representations withwhich we must be in compliance in 

 

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orderto borrow funds. However, if we wish to borrow under this facility in thefuture, there can be no assurance that we will be in compliance with theseconditions, covenants and representations. In addition, this line of creditfacility with Silicon Valley Bank expires on February 4, 2012. After that,we may need to secure new financing to continue funding fluctuations in ourworking capital requirements. However, we may not be able to secure newfinancing, or financing on favorable terms, if we experience an adverse changein our business. If we experience an increase in order activity from ourcustomers, our cash balance may decrease due to the need to purchaseinventories to fulfill those orders. If this occurs, we may have to draw onthis facility, or secure other financing, in order to maintain our liquidity.As of August 9, 2010, we have not borrowed on this line of credit.

 

**If ourestimates or judgments relating to our critical accounting policies are basedon assumptions that change or prove to be incorrect, our operating resultscould fall below expectations of securities analysts and investors, resultingin a decline in our stock price.**

 

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

 

·      revenuerecognition;

 

·      collectibilityof accounts receivable;

 

·      inventorywrite-downs;

 

·      stock-basedcompensation;

 

·      valuationof intangible assets;

 

·      warrantyreserves; and

 

·      realizationof deferred tax assets.

 

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

 

**Ourquarterly revenues and operating results may also fluctuate for variousreasons, which could cause our operating results to fall below expectations andthus impact the market price of our common stock.**

 

Ourquarterly revenues and operating results are difficult to predict and mayfluctuate significantly from quarter to quarter.  We base our expected quarterly revenues onforecasts received from our customers, however, none of our customers areobligated to purchase any quantity of our products in the future nor are theyobligated to meet forecasts of their product needs. Our operating expenselevels are based in part on expectations of future revenues and gross profits,which are partially dependent on our customers’ ability to accurately forecastand communicate their future product needs. If revenues or gross profits in aparticular quarter do not meet expectations, operating results could suffer andthe market price of our common stock could decline. Factors affecting quarterlyoperating results include:

 

·                  the degree towhich our customers are successful in reselling application platform solutionsto their end customers;

 

·                  our customers’consumption of their existing inventories of our products;

 

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·                  the variability of orders we receive fromcustomers who have project-based businesses, especially in thetelecommunications market;

 

·                  the loss of key suppliers or customers;

 

·                  the product mixof our sales;

 

·                  the timing ofnew product introductions by our customers;

 

·                  theavailability and/or price of products from suppliers;

 

·                  pricecompetition;

 

·                  costsassociated with our introduction of new application platform solutions and themarket acceptance of those products; and

 

·                  the mix of product manufactured internally and by our contractmanufacturer.

 

**If theproducts and services that we sell become more commoditized and competition inthe data storage, network security, carrier communications and enterprisecommunications markets continues to increase, then our gross profit as apercentage of net revenues may decrease and our operating resultsmay suffer.**

 

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

 

**Anintangible asset represents a significant portion of our assets, and any impairmentof the intangible asset would adversely impact our operating results.**

 

AtJune 30, 2010, the carrying value of our intangible asset, which consistsof customer relationships associated with our acquisition of AllianceSystems, Inc. (“Alliance Systems”), was approximately $7.0 million,net of accumulated amortization. We will continue to incur non-cash chargesrelating to the amortization of our intangible asset over its remaining usefullife. Future determinations of significant write-offs of the intangible assetresulting from an impairment test or any accelerated amortization of theintangible asset could have a significant impact on our operating results andaffect our ability to achieve or maintain profitability. Although we do notbelieve that any impairment of the intangible asset exists at this time, in theevent that any indicators of possible impairment exist, we may record chargeswhich could have a material adverse effect on our results of operations. Suchindicators include, but are not limited to, a worsening in customer attritionrates compared to historical attrition rates, or lower than initiallyanticipated cash flows associated with customer relationships.

 

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***Risks related to competition.***

 

**Competitionin the application platform market is significant and if we fail to competeeffectively, our financial results will suffer.**

 

Inthe application platform market, we face significant competition from a numberof different types of companies. Our competitors include companies who marketgeneral-purpose servers, server virtualization software, specific-purposeservers and application platforms as well as companies that sell customintegration services utilizing hardware produced by other companies. Many ofthese companies are larger than we are and have greater financial resources andname recognition than we do, as well as significant distribution capabilitiesand 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 ofsupport on a more cost-effective basis than we can. We expect competition inthe application platform market to increase significantly as more companiesenter the market and as our existing competitors continue to improve theperformance of their current products and to introduce new products andtechnologies. Such increased competition could adversely affect sales of ourcurrent and future products. In addition, competing companies may be able to undertakemore extensive promotional activities, adopt more aggressive pricing policiesand offer more attractive terms to their customers than we can. If ourcompetitors provide lower cost products with greater functionality or supportthan our application platform solutions, or if some of their products arecomparable to ours and are offered as part of a range of products that isbroader than ours, our application platform solutions could become undesirable.

 

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

 

***Risks related to marketing and sales efforts and customerservice.***

 

**We needto effectively manage our sales and marketing operations to increase marketawareness and sales of our products and to promote our brand recognition.  If we fail to do so, our growth will belimited.**

 

Althoughwe currently have a relatively small sales and marketing organization, we mustcontinue to increase market awareness and sales of our products and servicesand promote our brand in the marketplace. We believe that to competesuccessfully we will need OEMs and ISVs to recognize us as a top-tierprovider of application platform solutions and services. If we are unable toincrease market awareness and promote ourselves as a leading provider ofapplication platform solutions with our available resources, we may be unableto develop new customer relationships or expand our product and serviceofferings at existing customers.

 

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

 

We need to effectively manage our customer supportoperations to ensure that we maintain good relationships with our customers. Webelieve that providing a level of high quality customer support will be a keydifferentiator for our product offerings and may require more technicallyqualified staff which could be more costly. If we are unable to provide thishigher level of service we may be unable to successfully attract and retaincustomers.

 

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

 

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***Risks related to product manufacturing.***

 

**Ourdependence on sole source and limited source suppliers for key applicationplatform components makes us susceptible to supply shortages and potentialquality issues that could prevent us from shipping customer orders on time, orat all, and could result in lost sales and customers.**

 

Wedepend upon single source and limited source suppliers for our industrystandard processors, main logic boards, telephony boards, certain disk drives,hardware platforms and power supplies as well as certain of our chassis andsheet metal parts. Additionally, we depend on limited sources to supply certainother industry standard and customized components. We have in the pastexperienced, and may in the future experience, shortages of or difficulties inacquiring components in the quantities and of the quality needed to produce ourapplication platform solutions. Shortages in supply or quality issues relatedto these key components for an extended time would cause delays in theproduction of our application platform solutions, prevent us from satisfyingour contractual obligations and meeting customer expectations, and result inlost sales and customers. If we are unable to buy components in the quantitiesand of the quality that we need on a timely basis or at acceptable prices, wewill not be able to manufacture and deliver our application platform solutionson a timely or cost effective basis to our customers, and our competitiveposition, reputation, business, financial condition and results of operationscould be seriously harmed. If we are able to secure other sources of supply forsuch components, our costs to purchase such components could increase, whichwould negatively impact our gross margins. A significant portion of ourcomponents are purchased from suppliers located in China. During the past year,several factories in China have closed without notice. If a factory whichsupplies parts to us closes with little or no notice, we could experienceshortages and difficulties in locating alternative sources of supply.

 

**Tighter management of inventories across global supply chainsmay lead to longer lead times for our purchases of certain inventorycomponents. If we are unable to manage our supply chain and maintain sufficientinventories to meet customer demand, this could result in lost sales andcustomers.**

 

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

 

**Our useof a contract manufacturer for the production of key application platformsmakes us susceptible to production shortages in the event that our contractmanufacturer closes with little or no advance notice, experiences productionproblems or delays, or a business interruption.**

 

Wedepend on a contract manufacturer to provide additional manufacturing capacityfor certain application platforms, as well as certain repair and logisticsservices for our customers.  If ourcontract manufacturer closes with little or no advance notice, experiencesproduction problems or delays, or a business interruption, we could experienceshortages in our manufacturing capacity. If we are unable to secure additional manufacturing capacity, we may notbe able to manufacture and deliver our application platform solutions on atimely basis to our customers and our competitive position, reputation andfinancial condition could be harmed.

 

**If ourapplication platform solutions fail to perform properly andconform to specifications, our customers may demand refunds, assertclaims for damages or terminate existing relationships with us, and ourreputation and operating results may suffer materially.**

 

Asapplication platform solutions are complex, they may contain errors that can bedetected 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, wecould experience a rate of failure in our products that could result insubstantial repair, replacement or service costs and potential damage to ourreputation. In addition, because our solutions are combined with products fromother vendors, should problems occur, it might be difficult to identify thesource of the problem. 

 

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Continuedimprovement in manufacturing capabilities, control of material andmanufacturing quality and costs, and product testing are critical factors inour future growth. There can be no assurance that our efforts to monitor,develop, modify and implement appropriate test and manufacturing processes forour products will be sufficient to permit us to avoid a rate of failure in ourproducts that results in substantial delays in shipment, significant repair orreplacement costs or potential damage to our reputation, any of which couldhave a material adverse effect on our business, results of operations orfinancial condition.

 

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

 

·                  the loss of ordelay in market acceptance and sales of our application platform solutions;

 

·                  diversion ofengineering resources;

 

·                  increasedmanufacturing costs;

 

·                  the loss ofcustomers;

 

·                  injury to ourreputation and other customer relations problems; and

 

·                  increasedmaintenance and warranty costs.

 

Anyof these problems could harm our business and future operating results. Producterrors or delays could be material, including any product errors or delaysassociated with the introduction of new products or versions of existingproducts. If our application platform solutions fail to conform to warrantedspecifications, customers could demand a refund for the purchase price andassert claims for damages.

 

Moreover,because our application platform solutions may be used in connection withcritical computing systems services, including providing security to protectvaluable information, we may receive significant liability claims if they donot work properly. While our agreements with customers typically containprovisions intended to limit our exposure to liability claims, theselimitations do not preclude all potential claims. Liability claims could exceedour insurance coverage and require us to spend significant time and money inlitigation or to pay significant damages. Any claims for damages, even ifunsuccessful, could seriously damage our reputation and business.

 

**If wedo not accurately forecast our application platform materials requirements, ourbusiness and operating results could be adversely affected.**

 

Weuse rolling forecasts based on anticipated product orders to determine ourapplication platform component requirements. Lead times for materials andcomponents that we order may change significantly depending on variables suchas specific supplier requirements, contract terms and current market demand forthose components. In addition, a variety of factors, including the timing ofproduct releases, potential delays or cancellations of orders, the timing oflarge orders and the unproven acceptance of new products in the market make itdifficult to predict product orders. As a result, our materials requirementforecasts may not be accurate. If we overestimate our materials requirements,we may have excess inventory, which would increase costs and negatively impactour cash position. Our agreements with certain customers provide us withprotections related to inventory purchased in accordance with the terms ofthese agreements; however, these protections may not be sufficient to preventcertain losses as a result of excess or obsolete inventory. If we underestimateour materials requirements, we may have inadequate inventory which couldinterrupt our manufacturing and delay delivery of our application platformsolutions to customers, resulting in a loss of sales or customers. Any of theseoccurrences would negatively impact our business and operating results.

 

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

 

**Ouroperating results would suffer if we, our customers, or other third-partysoftware providers from whom we license technology, were subject to aninfringement claim that resulted in protracted litigation, the award ofsignificant damages against us or the payment of substantial ongoing royalties.**

 

Substantiallitigation regarding intellectual property rights exists in the technologyindustry. We expect that application platform solutions may be subject tothird-party infringement claims as the number of competitors in the industrysegment grows and the functionality of products in different industry segmentsoverlap. In the past we have received claims from third parties that ourapplication platform solutions infringed their intellectual property rights. Wedo not believe that our application platform solutions employ technology thatinfringes the proprietary rights of any third parties. We are also not aware ofany claims made against any of our customers related to their infringement ofthe proprietary rights of other parties in relation to products that include ourapplication platform solutions. Other parties may make claims against us or ourcustomers that, with or without merit, could:

 

·                  be timeconsuming for us to address;

 

·                  require us toenter into royalty or licensing agreements;

 

·                  result incostly litigation, including potential liability for damages;

 

·                  divert ourmanagement’s attention and resources; and

 

·                  cause productshipment delays.

 

Inaddition, other parties may make claims against our customers related toproducts that are incorporated into our application platform solutions. Ourbusiness could be adversely affected if such claims resulted in the inabilityof our customers to continue producing the infringing product.

 

**If wefail to retain and attract appropriate levels of qualified employees andmembers of senior management, we may not be able to successfully executeour business strategy.**

 

Oursuccess depends in large part on our ability to retain and attract highlyskilled engineering, sales, marketing, customer service and managerialpersonnel. If we are unable to attract a sufficient number of qualifiedpersonnel, we may not be able to meet key objectives such as developing,upgrading, or enhancing our products in a timely manner, which could negativelyimpact our business and could hinder any future growth.

 

**If wefail to maintain an effective system of internal controls, we may not beable to accurately report our financial results.  As a result, current and potentialstockholders could lose confidence in our financial reporting, which could havea negative market reaction.**

 

Section 404 of the Sarbanes-Oxley Act of 2002requires our management to report on, and our independent registered publicaccounting firm to attest to, the effectiveness of our internal control overfinancial reporting.  We have an ongoingprogram to perform the system and process evaluation and testing necessaryto comply with these requirements.  As aresult, we have incurred expenses and have devoted additional managementresources to Section 404 compliance. Effective internal controls are necessary for us to provide reliablefinancial reports.  If we cannot providereliable financial reports, our business and operating results could be harmed.

 

**Ifeither of the sites of our manufacturing operations were to experience asignificant disruption in its operations, it would have a material adverseeffect on our financial condition and results of our operations.**

 

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

 

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**Themarket price for our common stock may be particularly volatile, and ourstockholders may be unable to resell their shares at a profit.**

 

Themarket price of our common stock has been subject to significant fluctuationsand may continue to fluctuate or decline. During the fiscal year endedSeptember 30, 2009, the closing price of our common stock ranged from alow of $0.29 to a high of $1.32, and during the nine months ended June 30,2010, from a low of $1.07 to a high of $3.61.  The market for technologyand micro-cap stocks has been extremely volatile and frequently reaches levelsthat bear no relationship to the past or present operating performance of thosecompanies. General economic conditions, such as recession or interest rate orcurrency rate fluctuations in the United States or abroad, could negativelyaffect the market price of our common stock. In addition, our operating resultsmay be below the expectations of securities analysts and investors. If thiswere 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’ssecurities, securities class action litigation has often been institutedagainst such companies. Such litigation could result in substantial cost and adiversion of management’s attention and resources.

 

Anydecline in the market price of our common stock or negative market conditionscould adversely affect our ability to raise additional capital, to completefuture acquisitions of or investments in other businesses and to attract andretain qualified technical and sales and marketing personnel.

 

**If themarket price o**f**our common stock is notquoted on a national exchange, our ability to raise future capital may behindered and the market price of our common stock may be negatively impacted.**

 

Atcertain times in the past, the market price of our common stock has been lessthan $1.00 per share. If we are unable to meet the stock price listingrequirements of NASDAQ, our common stock could be de-listed from the NASDAQGlobal Market. If our common stock were de-listed from the NASDAQ GlobalMarket, 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 ofmarket efficiencies associated with NASDAQ and the loss of federal preemptionof state securities laws, as well as the potential loss of confidence bysuppliers, customers and employees, the loss of institutional investorinterest, fewer business development opportunities and greater difficulty inobtaining financing. As of August 9, 2010, we were in compliance with allapplicable requirements for continued listing on the NASDAQ Global Market.

 

**A continued or prolonged downturn in the economy could have amaterial adverse effect on our financial performance and other aspects of ourbusiness.**

 

Thecurrent downturn in the economy, and any further slowdown in future periods, couldadversely affect our business in ways that we are unable to fully anticipate.Tightened credit markets may negatively impact operations by affecting solvencyof customers, suppliers and other business partners, or the ability of ourcustomers to obtain credit to finance purchases of our products and services,which in turn could lead to increased difficulty in collecting accountsreceivable. Tightened credit markets may also negatively impact our ability toborrow funds, if needed, either under our line of credit with Silicon ValleyBank or from other sources. In addition, government responses to thedisruptions in the financial markets may not stabilize the markets or increaseliquidity or the availability of credit for us or our customers. A widespreadreduction of global business activity could cause customers to reduce capitalexpenditures, put increased pricing pressure on our products and services, andsubject us, our suppliers and our customers to interest rate risks and taxchanges that could impact our financial strength. These and other economicfactors could have a material adverse effect on our financial condition,operating results and liquidity.

 

**We haveanti-takeover defenses that could delay or prevent an acquisition and couldadversely affect the market price of our common stock.**

 

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

 

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In addition, provisions of our second amended andrestated certificate of incorporation and our second amended and restatedby-laws may deter an unsolicited offer to purchase us.  These provisions, coupled with the provisionsof 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, onlyone of which is elected at each annual meeting. These factors may further delay or prevent a change of control ofour business.

 

**Class actionlawsuits have been filed against us, our board of directors, our formerchairman and certain of our executive officers and other lawsuits may beinstituted against us from time to time.**

 

In December 2001, a class action lawsuitrelating to our initial public offering was filed against us, our chairman, oneof our executive officers and the underwriters of our initial publicoffering.  For more information onlawsuits, see “Part II, Item 1 — Legal Proceedings.”  We are currently attempting to settle thelawsuit filed against us related to our initial public offering.  We are unable to predict the effects on ourfinancial condition or business of the lawsuit related to our initial publicoffering 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 substantialmonetary damages in excess of such insurance coverage.  This class action lawsuit, or any futurelawsuits, could cause our director and officer insurance premiums to increaseand could affect our ability to obtain director and officer insurance coverage,which would negatively affect our business. In addition, we have expended, and may in the future expend,significant resources to defend such claims. This class action lawsuit, or other similar lawsuits thatmay arise from time to time, could negatively impact both our financialcondition and the market price of our common stock and could result inmanagement devoting a substantial portion of their time to these lawsuits,which could adversely affect the operation of our business.

 

**ITEM 6.     EXHIBITS**

 

(a)    Exhibits

 

Theexhibits which are filed with this report or which are incorporated byreference are set forth in the Exhibit Index hereto.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                       | **NETWORK ENGINES, INC.** |
|----------------------------|--------------------------------|
|                       | ** **                     |
|                       | ** **                     |
| Date:  August 9, 2010 |                           | /s/ Gregory A. Shortell |
|                       |                           |   |
|                       |                           | Gregory A. Shortell |
|                       |                           | President  and Chief Executive Officer |
|                       |                           | (Principal  Executive Officer) |
|                       |                           |   |
|                       |                           | /s/ Douglas G. Bryant |
|                       |                           |   |
|                       |                           | Douglas  G. Bryant |
|                       |                           | Chief  Financial Officer, Treasurer and Secretary |
|                       |                           | (Principal  Financial Officer and Principal Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                         |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                |
| 10.2                 |       | Lease  Agreement, dated June 30, 2010, between Network Engines, Inc. and  Rainer Asset Management Company, LLC                            |
|                 |       |                                                                                                                                                |
| 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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