Table of Contents

 

 

 

##### **UNITED STATES**

##### **SECURITIES ANDEXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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##### **FORM 10-Q**

 

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**(Mark One)**

 

| **x**                                                      | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                                 | ** ** | ** **                                                                                              |
| **For the quarterly period ended  December 31, 2008** |
| ** **                                                 | ** ** |                                                                                                    |
| **OR**                                                     |
| ** **                                                 | ** ** | ** **                                                                                              |
| **o**                                                      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from                      to**

 

###### **Commission file number: 000-30863**

 

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**NETWORK ENGINES, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**(781) 332-1000**

(Registrant’s telephone number, including area code)

 

Indicate bycheck mark whether the registrant: (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes  x** **No  o

 

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

 

Largeaccelerated filer  o  Accelerated filer  x  Non-accelerated filer  o  Smaller reporting company  o

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act)              Yes o  No x

 

As of February 5,2009, there were 43,183,595 shares of the registrant’s Common Stock, par value$.01 per share, outstanding.

 

 

 

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**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 UNAUDITED CONDENSED CONSOLIDATED FINANCIAL  STATEMENTS                                     |       | 4                |
|                                                                                                |       |             |
| ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS |       | 12               |
|                                                                                                |       |             |
| ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                 |       | 20               |
|                                                                                                |       |             |
| ITEM 4. CONTROLS AND PROCEDURES                                                                     |       | 20               |
|                                                                                                |       |             |
| **PART II.  OTHER INFORMATION**                                                                | ** ** | ** **       |
|                                                                                                |       |             |
| ITEM  1. LEGAL PROCEEDINGS                                                                          |       | 21               |
|                                                                                                |       |             |
| ITEM  1A. RISK FACTORS                                                                              |       | 21               |
|                                                                                                |       |             |
| ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND  USE OF PROCEEDS                                |       | 33               |
|                                                                                                |       |             |
| ITEM 6.  EXHIBITS                                                                                   |       | 33               |
|                                                                                                |       |             |
| SIGNATURES                                                                                          |       | 34               |

 

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Table of Contents

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

**(unaudited)**

 
| ** **                                                                                                                                                                                                                 | ** ** | **December 31,  2008** | ** ** | **September 30,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                 |       |                        |       |                         |       |
| **Current assets:**                                                                                                                                                                                                        | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Cash                                                                                                                                                                                                                       |       | $                           | 13,160     |                         | $          | 10,003 |   |
| Restricted cash                                                                                                                                                                                                            |       | 47                          |       | 47                           |       |
| Accounts receivable, net of allowances of  $130 and $122 at December 31, 2008 and September 30, 2008,  respectively                                                                                              |       | 24,481                      |       | 26,403                       |       |
| Income tax receivable                                                                                                                                                                                                      |       | 729                         |       | 2,585                        |       |
| Inventories                                                                                                                                                                                                                |       | 18,047                      |       | 21,380                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                                  |       | 2,768                       |       | 2,009                        |       |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| Total current assets                                                                                                                                                                                                       |       | 59,232                      |       | 62,427                       |       |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| Property and equipment, net                                                                                                                                                                                                |       | 1,495                       |       | 1,549                        |       |
| Intangible asset, net                                                                                                                                                                                                      |       | 9,445                       |       | 9,884                        |       |
| Contingently returnable acquisition  consideration                                                                                                                                                                         |       | 4,022                       |       | 4,022                        |       |
| Other assets                                                                                                                                                                                                               |       | 193                         |       | 183                          |       |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| Total assets                                                                                                                                                                                                               |       | $                           | 74,387     |                         | $          | 78,065 |   |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                              | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                                   | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                           |       | $                           | 8,252      |                         | $          | 11,745 |   |
| Accrued compensation and other related  benefits                                                                                                                                                                           |       | 1,526                       |       | 1,327                        |       |
| Other accrued expenses                                                                                                                                                                                                     |       | 2,656                       |       | 3,222                        |       |
| Deferred revenue                                                                                                                                                                                                           |       | 5,220                       |       | 5,173                        |       |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| Total current liabilities                                                                                                                                                                                                  |       | 17,654                      |       | 21,467                       |       |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| Deferred revenue, net of current portion                                                                                                                                                                                   |       | 2,586                       |       | 2,246                        |       |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| Total liabilities                                                                                                                                                                                                          |       | 20,240                      |       | 23,713                       |       |
|                                                                                                                                                                                                                       |       |                        |       |                         |       |
| 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; 47,002,254 and 46,753,826 shares issued; 43,183,595 and  43,285,167 shares outstanding at December 31, 2008 and  September 30, 2008, respectively |       | 470                         |       | 468                          |       |
| Additional paid-in capital                                                                                                                                                                                                 |       | 195,653                     |       | 195,228                      |       |
| Accumulated deficit                                                                                                                                                                                                        |       | (138,038                    | )          | (137,572                     | )          |
| Treasury stock, at cost, 3,818,659 and  3,468,659 shares at December 31, 2008 and September 30, 2008,  respectively                                                                                              |       | (3,938                      | )          | (3,772                       | )          |
| Total stockholders’ equity                                                                                                                                                                                            |       | 54,147                      |       | 54,352                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                            |       | $                           | 74,387     |                         | $          | 78,065 |   |

 

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

 

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**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

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

**(unaudited)**

** **
| ** **                                                    | ** ** | **Three months ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                    | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
|                                                          |       |                                                |       |   |   |
| Net revenues                                                  |       | $                                                   | 37,235     |   | $ | 54,340 |   |
|                                                          |       |                                                |       |   |   |
| Cost of revenues                                              |       | 31,627                                              |       | 44,600 |   |
|                                                          |       |                                                |       |   |   |
| Gross profit                                                  |       | 5,608                                               |       | 9,740 |   |
|                                                          |       |                                                |       |   |   |
| Operating expenses:                                           |       |                                                |       |   |   |
| Research and development                                      |       | 1,442                                               |       | 2,370 |   |
| Selling and marketing                                         |       | 2,177                                               |       | 3,117 |   |
| General and administrative                                    |       | 2,075                                               |       | 2,645 |   |
| Amortization of intangible asset                              |       | 439                                                 |       | 420 |   |
|                                                          |       |                                                |       |   |   |
| Total operating expenses                                      |       | 6,133                                               |       | 8,552 |   |
|                                                          |       |                                                |       |   |   |
| (Loss) income from operations                                 |       | (525                                                | )          | 1,188 |   |
| Interest and other income, net                                |       | 59                                                  |       | 124 |   |
|                                                          |       |                                                |       |   |   |
| (Loss) income before income taxes                             |       | (466                                                | )          | 1,312 |   |
| Provision for income taxes                                    |       | —                                              |       | 71 |   |
|                                                          |       |                                                |       |   |   |
| Net (loss) income                                             |       | $                                                   | (466       | ) | $ | 1,241 |   |
|                                                          |       |                                                |       |   |   |
| Net (loss) income per share – basic and  diluted         |       | $                                                   | (0.01      | ) | $ | 0.03 |   |
|                                                          |       |                                                |       |   |   |
| Shares used in computing basic net (loss)  income per share   |       | 43,137                                              |       | 43,656 |   |
| Shares used in computing diluted net (loss)  income per share |       | 43,137                                              |       | 44,021 |   |

 

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

 

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **Three months ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| ** **                                                                                          | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                               |       |                                                |       |   |   |
| Net (loss) income                                                                                   |       | $                                                   | (466       | ) | $ | 1,241 |   |
| Adjustments to reconcile net (loss) income  to net cash provided by (used in) operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                                       |       | 672                                                 |       | 773 |   |
| Provision for doubtful accounts                                                                     |       | 25                                                  |       | 89 |   |
| Stock-based compensation                                                                            |       | 339                                                 |       | 587 |   |
| Changes in operating assets and liabilities,  net of effects of acquisition:                        |       |                                                |       |   |   |
| Accounts receivable                                                                                 |       | 1,896                                               |       | 540 |   |
| Income tax receivable                                                                               |       | 1,856                                               |       | — |   |
| Inventories                                                                                         |       | 3,332                                               |       | (2,563 | ) |
| Prepaid expenses and other assets                                                                   |       | (769                                                | )          | (644 | ) |
| Accounts payable                                                                                    |       | (3,493                                              | )          | (1,079 | ) |
| Accrued expenses                                                                                    |       | (359                                                | )          | (2,567 | ) |
| Deferred revenue                                                                                    |       | 387                                                 |       | 880 |   |
|                                                                                                |       |                                                |       |   |   |
| Net cash provided by (used in) operating  activities                                                |       | 3,420                                               |       | (2,743 | ) |
|                                                                                                |       |                                                |       |   |   |
| Cash flows from investing activities:                                                               |       |                                                |       |   |   |
| Acquisition and related costs, net of cash  assumed                                                 |       | —                                              |       | (29,413 | ) |
| Contingently returnable acquisition payment                                                         |       | —                                              |       | (4,220 | ) |
| Purchases of property and equipment                                                                 |       | (178                                                | )          | (62 | ) |
| Changes in other assets                                                                             |       | —                                              |       | 140 |   |
|                                                                                                |       |                                                |       |   |   |
| Net cash used in investing activities                                                               |       | (178                                                | )          | (33,555 | ) |
|                                                                                                |       |                                                |       |   |   |
| Cash flows from financing activities:                                                               |       |                                                |       |   |   |
| Purchase of treasury stock                                                                          |       | (166                                                | )          | — |   |
| Proceeds from issuance of common stock                                                              |       | 89                                                  |       | 115 |   |
| Payments on capital lease obligation                                                                |       | (8                                                  | )          | (5 | ) |
|                                                                                                |       |                                                |       |   |   |
| Net cash (used in) provided by financing  activities                                                |       | (85                                                 | )          | 110 |   |
|                                                                                                |       |                                                |       |   |   |
| Effect of exchange rate differences on cash                                                         |       | —                                              |       | (29 | ) |
| Net increase (decrease) in cash and cash  equivalents                                               |       | 3,157                                               |       | (36,217 | ) |
| Cash and cash equivalents, beginning of  period                                                     |       | 10,003                                              |       | 44,403 |   |
|                                                                                                |       |                                                |       |   |   |
| Cash and cash equivalents, end of period                                                            |       | $                                                   | 13,160     |   | $ | 8,186 |   |

 

**Theaccompanying notes are an integral part of the condensed consolidated financialstatements.**

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**1.  Basis of Presentation**

 

The accompanyingcondensed consolidated financial statements have been prepared by NetworkEngines, Inc. (“Network Engines” or the “Company”) in accordance withaccounting principles generally accepted in the United States of America andpursuant 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 2008 AnnualReport on Form 10-K (the “2008 Form 10-K”) filed by the Company withthe SEC.

 

The information furnishedreflects all adjustments, which, in the opinion of management, are of a normalrecurring nature and are considered necessary for a fair statement of resultsfor the interim periods.  It should alsobe noted that results for the interim periods are not necessarily indicative ofthe results expected for the full year or any future period.

 

Thepreparation of these condensed consolidated financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Themost significant estimates reflected in these financial statements includeallowance for doubtful accounts, inventory valuation, valuation of deferred taxassets, valuation of intangible assets, warranty reserves and stock-basedcompensation.  Actual results coulddiffer from those estimates.

 

**2.  Significant Accounting Policies**

 

***RecentAccounting Pronouncements***

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard No. 157,“Fair Value Measurements” (“FAS 157”).  This statement addresses howcompanies should measure fair value when they are required to use a fair valuemeasure for recognition or disclosure purposes under accounting principlesgenerally accepted in the United States of America.  In February 2008, the FASB issued FASB Staff Position No. 157-1,“Application of FASB Statement No. 157 to FASB Statement No. 13 andOther Accounting Pronouncements That Address Fair Value Measurements forPurposes of Lease Classification or Measurement under Statement 13” (“FSP 157-1”).  FSP 157-1 amends FAS 157 to remove certainleasing transactions from its scope. In February 2008, the FASB issued FASB Staff Position No. 157-2,“Effective Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2 defers the effective date of FAS157 for non-financial assets and liabilities which are recognized or disclosedat fair value on a non-recurring basis to the beginning of the Company’s fiscal yearthat begins after November 15, 2008. In October 2008, theFASB issued FASB Staff Position No. 157-3, “Determining the Fair Value ofa Financial Asset When the Market for That Asset is Not Active” (“FSP 157-3”).  FSP 157-3 clarifies the application ofFAS 157 in a market that is not active and provides an example toillustrate key considerations in determining the fair value of a financialasset when the market for that financial asset is not active.

 

FAS 157 defines fairvalue as the price that would be received to sell an asset or paid to transfera liability (“exit price”) in an orderly transaction between marketparticipants at the measurement date. FAS 157 requires disclosures that categorize assets and liabilitieswhich are recognized or disclosed at fair value into one of three differentlevels depending on the assumptions (“inputs”) used in the valuation.  In the fair value hierarchy, Level 1 providesthe most reliable measure of fair value, while Level 3 generally requiressignificant management judgment. Financial assets and liabilities are classified in their entirety basedon the lowest level of input significant to the fair value measurement.  The FAS 157 fair value hierarchy is definedas follows:

 

·                  Level 1 – Valuations are based on unadjusted quoted prices in activemarkets that are accessible at the measurement date for identical assets orliabilities.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

·                  Level 2 – Valuations are based on quoted prices forsimilar assets or liabilities in active markets, or quoted prices for identicalor similar assets or liabilities in markets that are not active for whichsignificant inputs are observable, either directly or indirectly.

·                  Level 3 – Valuations are based on prices or valuationtechniques that require inputs that are both unobservable and significant tothe overall fair value measurement. Inputs reflect management’s best estimates regarding the assumptionsthat market participants would use in valuing the asset or liability at themeasurement date.

 

The Company adopted FAS 157, as it applies tofinancial assets and liabilities and nonfinancial assets and liabilities whichare recognized or disclosed at fair value on a recurring basis (at leastannually), as of October 1, 2008, and this adoption did not have anyimpact on the Company’s financial position, results of operations or cashflows.  The Company had no assets orliabilities recorded at fair value based on Level 1, Level 2 or Level 3 inputsas of the adoption date, October 1, 2008, or at any time during the threemonth period ended December 31, 2008. However, the Company may acquire assets or incur liabilities in futureperiods for which fair value measurement under FAS 157 may be required.  The Company is in the process of evaluatingwhether the adoption of FSP 157-2 (as it relates to the effective date of FAS 157 for non-financialassets and liabilities which are recognized or disclosed at fair value on anon-recurring basis) will have a material impact on its financial position, results ofoperations or cash flows.

 

The Company adopted FASB Statement of FinancialAccounting Standard No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities — Including an amendment of FASB Statement No. 115”(“FAS 159”) as of October 1, 2008.  This statement permits entitiesto choose to measure many financial instruments and certain other items at fairvalue at specified election dates. Subsequent unrealized gains and losses on items for which the fair valueoption has been elected will be reported in earnings.  The adoption of FAS 159 did not have anyimpact on the Company’s financial position, results of operations or cashflows, as the Company did not elect to measure any items at fair value as ofthe adoption date.

 

In December 2007, theFASB issued Statement of Financial Accounting Standard No. 141(R), “BusinessCombinations” (“FAS 141R”).  ThisStatement replaced Statement of Financial Accounting Standard No. 141 to improve therelevance, representational faithfulness, and comparability of the informationthat a reporting entity provides in its financial reports about a businesscombination and its effects.  FAS 141Restablishes principles and requirements for how the acquirer recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree,recognizes and measures the goodwill acquired in the business combination or again from a bargain purchase and determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination.  FAS141R is effective for business combinations on a prospective basis for whichthe acquisition date is on orafter the beginning of the Company’s first annual reporting period beginning onor after December 15, 2008.

 

InApril 2008, the FASB issued FASB Staff Position No. FAS 142-3, “Determinationof the Useful Life of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under Statement of Financial AccountingStandard No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”).  This change is intended to improve theconsistency between the useful life of a recognized intangible asset under FAS142 and the period of expected cash flows used to measure the fair value of theasset under FAS 141R and other generally accepted accounting principles.  The requirement for determining useful livesmust be applied prospectively to intangible assets acquired after the effectivedate and the disclosure requirements must be applied prospectively to allintangible assets recognized as of, and subsequent to, the effective date.  FSP 142-3 is effective as of the beginning ofthe Company’s fiscal year that begins after December 15, 2008.  The Company is in the process of evaluating whether the adoption of FSP142-3 will have a material impact on its financial position or results ofoperations.

 

***Cash, Cash Equivalents, Short-Term Investments and Restricted Cash***

 

TheCompany did not hold any cash equivalents or short-term investments as of December 31or September 30, 2008.  At December 31,2008 and September 30, 2008, $47,000 of cash was restricted and pledged ascollateral for a letter of credit related to the lease of one of the Company’soffice facilities.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

***Comprehensive Income (Loss)***

 

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

 

***Significant Customers***

 

The followingtable summarizes those customers which accounted for greater than 10% of theCompany’s net revenues or accounts receivable:

 
| ** **           | ** ** | **Net Revenues for the three** | ** ** | **Accounts Receivable at** | ** ** |
|----------------------|------------|----------------------------------------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **months ended December 31,**       | ** ** | **December 31,**                | ** ** | **September 30,** | ** ** |
| ** **           | ** ** | **2008**                                           | ** ** | **2007**                             | ** ** | **2008** | ** ** | **2008** | ** ** |
| EMC Corporation      |       | 33                                                 | %          | 38                                   | %          | 23 | % | 30 | % |
| Tektronix, Inc. |       | 14                                                 | %          | 13                                   | %          | 17 | % | 17 | % |

 

**3. BusinessCombination**

 

On October 11, 2007, in order toincrease the Company’s presence in the application platform marketplace, theCompany acquired all of the equity of Alliance Systems, Inc. (“AllianceSystems”), a privately held corporation located in Plano, Texas, which providedapplication platforms and related equipment supporting carrier communicationsand enterprise communications solutions. For further information on the acquisition, refer to the Company’sAnnual Report on Form 10-K for the year ended September 30, 2008.

 

The acquisition was structured toinclude a downward adjustment to the purchase price based on the net workingcapital of Alliance Systems as of October 11, 2007, as defined in themerger agreement, and therefore approximately $4.0 million of the cash paid iscontingently returnable to the Company upon resolution of this provision.  As a result, the amount of contingentlyreturnable consideration has been excluded from the allocation of the purchaseprice to the net assets acquired until such time that this amount is no longercontingently returnable.  When thecontingencies are resolved, any portion of the $4.0 million which is notreturned to the Company will be reclassified as additional goodwill.  If additional goodwill is recorded in afuture period, it will then be subject to review for impairment annually as ofthe fiscal year end date, and more frequently if certain indicators arepresent.

 

**4.  Stock-Based Compensation**

 

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

 

Thefollowing table presents stock-based employee compensation expense included inthe Company’s unaudited condensed consolidated statements of operations (inthousands):

 
| ** **                             | ** ** | **Three months ended  December 31,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
|                                   |       |                                                |       |   |   |
| Cost of revenues                       |       | $                                                   | 35         |   | $ | 54 |   |
| Research and development               |       | 84                                                  |       | 250 |   |
| Selling and marketing                  |       | 61                                                  |       | 95 |   |
| General and administrative             |       | 159                                                 |       | 188 |   |
| Total stock-based compensation expense |       | $                                                   | 339        |   | $ | 587 |   |

 

TheCompany estimates the fair value of stock options using the Black-Scholesvaluation model.  This valuation modeltakes into account the exercise price of the award, as well as a variety ofsignificant assumptions.  Theseassumptions include the expected term, the expected volatility of the Company’scommon stock over the expected term, the risk-free interest rate over theexpected term, and the Company’s expected annual dividend yield.

 

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**NETWORKENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

The Company believes that the valuationtechnique and the approach utilized to develop the underlying assumptions areappropriate in calculating the fair values of the Company’s stock optionsgranted during the three months ended December 31, 2008 and 2007.  Estimates of fair value are not intended topredict the value ultimately realized by persons who receive equityawards.  In determining the amount ofexpense to be recorded, judgment is also required to estimate forfeitures ofthe awards based on the probability of employees completing the requiredservice period.  Historical forfeitures are used as a starting point fordeveloping the estimate of future forfeitures.

 

Assumptions used to determine the fair value of options granted duringthe three months ended December 31, 2008 and 2007, using the Black-Scholesvaluation model, were:

 
| ** **                     | ** ** | **Three months ended December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
|                           |       |                                                    |       |   |   |
| Expected term (1)              |       | 4.75 to 5.50 years                                      |       | 6.06 to 6.25 years |   |
| Expected volatility factor (2) |       | 66.82% to 69.73%                                        |       | 59.05% |   |
| Risk-free interest rate (3)    |       | 1.55% to 1.72%                                          |       | 4.13% |   |
| Expected annual dividend yield |       | —                                                  |       | — |   |

 

----

| (1)    | For grants  issued prior to January 1, 2008, expected term was determined as  the midpoint between the vesting date and the end of the contractual term,  also known as the “simplified method” for estimating expected term described  by Staff Accounting Bulletin No. 107 (“SAB 107”). For grants  issued on or after January 1, 2008, expected term was determined based  on analysis of the Company’s historical exercise and post-vesting cancellation  activity. |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| (2)    | The expected  volatility for each grant was estimated based on a weighted average of the  historical volatility of the Company’s common stock.                                                                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| (3)    | The risk-free  interest rate for each grant was based on the U.S. Treasury yield curve in  effect at the time of grant for a period equal to the expected term of the  stock option.                                                                                                                                                                                                                                                                                                                                 |

 

Stock-basedcompensation expense related to the Company’s Employee Stock Purchase Plan isdetermined based on the discount of 15% from the per share market price on theclose of the purchase period.

 

Asummary of the Company’s stock option activity for the three months ended December 31,2008 is as follows:

 
| ** **                             | ** ** | **Three months ended December 31, 2008** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                             | ** ** | **Number of  Options**                                       | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average Remaining  Contractual  Term (in years)** | ** ** |
|                                   |       |                                                              |       |   |   |   |   |
| Outstanding at September 30, 2008 |       | 7,483,042                                                         |       | $ | 2.35 |   |   |   |
| Granted                                |       | 1,047,500                                                         |       | $ | 0.39 |   |   |   |
| Exercised                              |       | —                                                            |       | $ | — |   |   |   |
| Forfeited                              |       | (136,784                                                          | )          | $ | 2.11 |   |   |   |
| Expired                                |       | (157,152                                                          | )          | $ | 2.02 |   |   |   |
| Outstanding at December 31, 2008  |       | 8,236,606                                                         |       | $ | 2.11 |   | 7.08 |   |
| Exercisable at December 31, 2008  |       | 4,696,193                                                         |       | $ | 2.66 |   | 5.80 |   |

 

Allstock options granted during the three months ended December 31, 2008 weregranted with exercise prices equal to the fair market value of the Company’scommon stock on the grant date and had a weighted average grant date fair valueof $0.23.

 

At December 31, 2008, unrecognized compensationexpense related to non-vested stock options was $2,254,000, which is expectedto be recognized over a weighted average period of 2.68 years.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

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

 

Basic net(loss) income per share is computed by dividing the net (loss) income for theperiod by the weighted average number of shares of common stock outstandingduring the period.  Diluted net (loss)income per share is computed by dividing the net (loss) income for the periodby the weighted average number of shares of common stock and potential commonstock, if dilutive, outstanding during the period.  Potential common stock includes incrementalshares of common stock issuable upon the exercise of stock options, calculatedusing the treasury stock method.  Forperiods in which the Company incurs a net loss, diluted net loss per share isthe same as basic net loss per share because the inclusion of these commonstock equivalents would be anti-dilutive.

 

The followingtable sets forth the computation of basic and diluted net (loss) incomeper share as well as the weighted average potential common stock excluded fromthe calculation of net (loss) incomeper share because their inclusion would be anti-dilutive (in thousands, exceptper share data):

 
| ** **                                                                                                       | ** ** | **Three months ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Numerator:                                                                                                       |       |                                                |       |   |   |
| Net (loss) income                                                                                                |       | $                                                   | (466       | ) | $ | 1,241 |   |
|                                                                                                             |       |                                                |       |   |   |
| Denominator:                                                                                                     |       |                                                |       |   |   |
| Shares used in computing basic net (loss)  income per share                                                      |       | 43,137                                              |       | 43,656 |   |
| Common stock equivalents from employee stock  options                                                            |       | —                                              |       | 365 |   |
|                                                                                                             |       |                                                |       |   |   |
| Shares used in computing diluted net (loss)  income per share                                                    |       | 43,137                                              |       | 44,021 |   |
|                                                                                                             |       |                                                |       |   |   |
| Net (loss) income per share:                                                                                     |       |                                                |       |   |   |
| Basic                                                                                                            |       | $                                                   | (0.01      | ) | $ | 0.03 |   |
| Diluted                                                                                                          |       | $                                                   | (0.01      | ) | $ | 0.03 |   |
|                                                                                                             |       |                                                |       |   |   |
| Anti-dilutive potential common stock  equivalents excluded from the calculation of net (loss) income per  share: |       |                                                |       |   |   |
| Options to purchase common stock                                                                                 |       | 7,524                                               |       | 6,547 |   |

 

**6.  Intangible Asset**

 

The Companyrecorded an intangible asset as the result of its acquisition of AllianceSystems (see Note 3 above).  The acquiredintangible asset is customer relationships, which is being amortized over 17years, which is the estimated period of economic benefit expected to bereceived.  The following table presentsthe intangible asset balances as of December 31, 2008 and September 30,2008 (in thousands):

 
| ** **             | ** ** | **December 31, 2008** | ** ** | **September 30, 2008** | ** ** |
|------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **             | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization**    | ** ** | **Net Book  Value** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
| ** **             | ** ** | ** **                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer relationships |       | $                               | 11,775     |                             | $          | 2,330 |   | $ | 9,445 |   | $ | 11,775 |   | $ | 1,891 |   | $ | 9,884 |   |
|                        |            |                                 |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Amortizationexpense for the three months ended December 31, 2008 was $439,000.  The estimated future amortization expense forthe intangible asset as of December 31, 2008 by fiscal year is $1,317,000for the remainder of 2009, $1,554,000 for 2010, $1,330,000 for 2011, $1,119,000for 2012, $868,000 for 2013 and $3,257,000 thereafter.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

The Company reviewslong-lived assets, including definite-lived intangible assets, to determine ifany adverse conditions exist that would indicate impairment.  Factors that could lead to an impairment ofacquired customer relationships include a worsening in customer attrition ratescompared to historical attrition rates, or lower than initially anticipatedcash flows associated with customer relationships.  The Company assesses the recoverability oflong-lived assets based on the projected undiscounted future cash flows estimatedto be generated over the asset’s remaining life.  The amount of impairment, if any, is measuredbased on the excess of the carrying value over fair value.  Fair value is generally calculated as thepresent value of estimated future cash flows using a risk-adjusted discountrate, which requires significant management judgment with respect to revenueand expense growth rates, and the selection and use of an appropriate discountrate.

 

**7.  Inventories**

 

Inventories consisted ofthe following (in thousands):

 
| ** **      | ** ** | **December 31, 2008** | ** ** | **September 30, 2008** | ** ** |
|-----------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **      | ** ** | ** **                      | ** ** | ** **                       | ** ** |
| Raw materials   |       | $                               | 11,547     |                             | $          | 13,402 |   |
| Work in process |       | 1,496                           |       | 1,442                            |       |
| Finished goods  |       | 5,004                           |       | 6,536                            |       |
|            |       |                            |       |                             |       |
| Total           |       | $                               | 18,047     |                             | $          | 21,380 |   |

 

**8.  Equity**

 

On June 12, 2008, the Board of Directors of the Company authorizedthe repurchase of up to $5 million of its common stock through a sharerepurchase program.  As authorized by theprogram, shares may be purchased in the open market or through privately negotiatedtransactions, in a manner consistent with applicable securities laws andregulations.  This stock repurchaseprogram does not obligate the Company to acquire any specific number of shares,does not have an expiration date, and may be terminated at any time by theCompany’s Board of Directors.  Allrepurchases are expected to be funded from the Company’s current cash balancesor from cash generated from operations. To facilitate repurchases of shares under this program, the Companyestablished a Rule 10b5-1 plan intended to comply with the requirements ofRule 10b5-1 and Rule 10b-18 under the Securities Exchange Act of1934.  A Rule 10b5-1 plan permits the repurchase of shares by acompany at times when it otherwise might be prevented from doing so underinsider trading laws or because of company blackout periods, provided that theplan 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 further direction from the Company.  The amount and timing ofspecific repurchases are subject to the terms of the plan and marketconditions.  During the three monthsended December 31, 2008, the Company repurchased 350,000 shares of itscommon stock at an average cost of $0.47 per share.  From the inception of the share repurchaseprogram through December 31, 2008, the Company had repurchased 1,256,801shares of its common stock at an average cost of $0.88 per share.  Upon the expiration of the 10b5-1 plan on November 7,2008, the Company suspended repurchases of its common stock.  The Company may resume repurchases under theprogram at any time at the discretion of management.  As of December 31, 2008, the maximumdollar value that may yet be used for purchases under the program was$3,900,000.

 

**9.  Commitments and Contingencies**

 

***  Guarantees and Indemnifications***

 

Acquisition-related indemnifications – When, as part of an acquisition,the Company acquires all the stock of a company, the Company assumesliabilities for certain events or circumstances that took place prior to thedate of acquisition.  The maximumpotential amount of future payments the Company could be required to make forsuch obligations is undeterminable.  Althoughcertain provisions of the agreements remain in effect indefinitely, the Companybelieves that the probability of receiving a claim related to acquisitionsother than Alliance Systems is unlikely. As a result, the Company had not recorded any liabilities for suchindemnification clauses as of December 31, 2008.  As of December 31, 2008, the Company hadreceived one claim related to the Alliance Systems acquisition, for which 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

the Company paid a settlement of$88,000 during the fiscal year ended September 30, 2008.  A second claim was brought in January 2009by Cordsen Engineering GmbH (“Cordsen”), a former customer of Alliance Systems,alleging that certain products that Cordsen purchased from Alliance Systems(prior to the Company’s acquisition of Alliance Systems) were defective and didnot meet Cordsen’s desired specifications. Cordsen alleges that by virtue ofthe Company’s acquisition of Alliance Systems in October 2007, the Companybecame the assignee of Alliance Systems’ agreement with Cordsen.  The Alliance Systems selling stockholdershave agreed with the Company to undertake the defense of the action insofar asit relates to activities that occurred principally before the Company acquiredAlliance Systems, and have agreed to bear any costs associated with thisaction.  The Company believes this claimis without merit.  The Company is unableto predict the ultimate outcome of this claim and is unable to estimate theamount of any potential loss it might incur as a result of this claim, andtherefore no amounts have been accrued relating to this claim as of December 31,2008.  With regard to any claims whichthe Company has received or may receive in the future related to the AllianceSystems acquisition, the Company intends to pursue reimbursement from theformer shareholders of Alliance Systems for any losses incurred by the Companyas a result of such claims, pursuant to the terms of the Alliance Systemsmerger agreement.

 

The Company enters into standard indemnification agreements in theordinary course of its business.  Pursuantto these agreements, the Company indemnifies, holds harmless, and agrees toreimburse the indemnified party for losses suffered or incurred by theindemnified party, generally its business partners or customers, in connectionwith any patent, copyright, trademark, trade secret or other intellectualproperty infringement claim by any third party with respect to itsproducts.  The term of theseindemnification agreements is generally perpetual.  The Company has never incurred costs todefend lawsuits or settle claims related to these indemnificationagreements.  As a result, the Companybelieves the estimated fair value of these agreements is minimal.  Accordingly, the Company has no liabilitiesrecorded for these indemnifications as of December 31, 2008.

 

Productwarranties – TheCompany offers and fulfills standard warranty services on its applicationplatform solutions.  Warranty terms varyin duration depending upon the product sold, but generally provide for therepair or replacement of any defective products for periods of up to 36 monthsafter shipment.  Based upon historicalexperience and expectation of future conditions, the Company reserves for theestimated costs to fulfill customer warranty obligations upon the recognitionof the related revenue.  The followingtable presents changes in the Company’s product warranty liability for thethree months ended December 31, 2008 and 2007 (in thousands):

 
| ** **                                  | ** ** | **Three months ended  December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                  | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
|                                        |       |                                                |       |   |   |
| Beginning balance                           |       | $                                                   | 931        |   | $ | 1,046 |   |
| Acquisitions                                |       | —                                              |       | 70 |   |
| Accruals for warranties issued              |       | 334                                                 |       | 520 |   |
| Fulfillment of warranties during the period |       | (388                                                | )          | (619 | ) |
| Ending balance                              |       | $                                                   | 877        |   | $ | 1,017 |   |

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

On or about December 3, 2001, a putativeclass action lawsuit was filed in the United States District Court for theSouthern District of New York against the Company, Lawrence A. Genovesi (theCompany’s former Chairman and Chief Executive Officer), Douglas G. Bryant (theCompany’s Chief Financial Officer), and several underwriters of the Company’sinitial public offering.  The suitalleges, *inter alia*, that the defendants violatedthe federal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosingto investors that the underwriter defendants had solicited and receivedexcessive and undisclosed commissions from certain investors.  The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of the Company’scommon stock between July 13, 2000 and December 6, 2000.

 

In October 2002, Lawrence A. Genovesi andDouglas G. Bryant were dismissed from 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 Circuit denied plaintiffs’ petition for rehearing, butclarified that the plaintiffs may seek to certify a more limited class in theDistrict Court.  On September 27,2007, plaintiffs filed a motion for class certification in certain designated “focuscases” in the District 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

Court.  That motion has since beenwithdrawn.  On November 13,2007, the issuer defendants in certain designated “focus cases” filed a motionto dismiss the second consolidated amended class action complaints that werefiled in those cases.  On March 26, 2008, the DistrictCourt issued an Opinion and Order denying, in large part, the motions todismiss the amended complaints in the “focus cases.”  The Company is unable to predict the outcome ofthis suit and as a result, no amounts have been accrued as of December 31,2008.

 

**10. Line of Credit**

 

On October 11, 2007,the Company entered into a Loan and Security Agreement with Silicon Valley Bank(the “Bank”).  The term of this agreementwas for one year, ending on October 9, 2008.  The Loan Agreement provided the Company witha $15 million revolving loan facility. The interest rate on this line was equal to one quarter of a point(.25%) below the current prime rate with interest payable monthly.

 

On August 5, 2008,the Company and the Bank entered into the First Loan Modification Agreement(the “Modification Agreement”).  TheModification Agreement amended the Loan Agreement to extend its term to August 5,2010, and to change the amount of the revolving loan facility to $10million.  The Modification Agreement didnot change the interest rate on the line. The Company opted to lower the amount of the revolving loan facilityfrom $15 million to $10 million in order to better reflect itspotential borrowing needs and to reduce the fees it incurs to maintain the loanfacility.  As of February 9, 2009,the Company had not drawn on this line of credit.

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL 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 than statements ofhistorical information provided herein are forward-looking statements and maycontain projections related to financial results, economic conditions, trendsand known uncertainties.  Our actualresults could differ materially from those discussed in the forward-lookingstatements as a result of a number of factors, which include those discussed inthis section and in Part II, Item 1A, Risk Factors, of this report and therisks discussed in our other filings with the Securities and ExchangeCommission (the “SEC”).  Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s analysis, judgment, belief or expectation only as ofthe date hereof.  We undertake noobligation to publicly reissue these forward-looking statements to reflectevents or circumstances that arise after the date hereof.

 

The followingdiscussion and analysis should be read in conjunction with the condensedconsolidated financial statements and the notes thereto included in Item 1 inthis Quarterly Report on Form 10-Q and our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2008 filed by us with the SEC.

 

**Overview**

** **

We develop and manufacture application platformsolutions that enable leading original equipment manufacturers, or OEMs,independent software vendors, or ISVs, and service providers to deliver theirsoftware applications in the form of a network-ready device.  Application platforms are pre-configurednetwork infrastructure devices designed to optimally deliver specific softwareapplication functionality, ease deployment, improve integration andmanageability, accelerate time to market and increase the security of thatsoftware application in a customer’s network. We offer application platform customers an extensive suite of servicesassociated with the design, development, manufacturing, brand fulfillment andpost-sale support of these devices.  Weproduce, brand and fulfill devices branded for our customers, and derive ourrevenues primarily from the sale of value-added hardware platforms to thesecustomers. Our customers subsequently resell and support the platforms undertheir own brands to their customer bases.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of financial condition and results ofoperations are based upon our condensed consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. In preparing these financial statements, we have made estimates andjudgments in determining certain amounts included in the financialstatements.  We base our estimates andjudgments on historical experience and other assumptions that we believe to bereasonable under the circumstances. Actual results may differ from these estimates under differentassumptions or conditions.  There havebeen no changes to our critical accounting policies since September 30,2008.

 

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**Results of Operations**

 

**Three months ended December 31, 2008 compared to the three monthsended December 31, 2007**

 

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

 
| ** **                    | ** ** | **Three months ended December 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|
| ** **                    | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                    | ** ** | **Dollars**                                             | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                  |       | $                                                       | 37,235     |   | 100.0 | % | $ | 54,340 |   | 100.0 | % | $ | (17,105 | ) | (31.5 | )% |
| Gross profit                  |       | 5,608                                                   |       | 15.1 | % | 9,740 |   | 17.9 | % | (4,132 | ) | (42.4 | )% |
| Operating expenses            |       | 6,133                                                   |       | 16.5 | % | 8,552 |   | 15.7 | % | (2,419 | ) | (28.3 | )% |
| (Loss) income from operations |       | (525                                                    | )          | (1.4 | )% | 1,188 |   | 2.2 | % | (1,713 | ) | — |   |
| Net (loss) income             |       | $                                                       | (466       | ) | (1.3 | )% | $ | 1,241 |   | 2.3 | % | $ | (1,707 | ) | — |   |

 

***Net Revenues***

 

Our revenues are derived primarily from sales ofapplication platform solutions and related maintenance services to our OEM, ISVand service provider customers.

 

Our net revenues decreased for the three months ended December 31,2008, as compared to the three months ended December 31, 2007, primarilydue to decreases in sales volumes, which were significantly impacted bynegative global economic conditions.  Inaddition, two customers who have reduced or ceased their purchases from us, onebecause it was acquired by a larger company and one because it changed itsbusiness model, accounted for approximately $3.7 million of the decrease in netrevenues.  Also contributing to thedecrease was the fact that the three month period ended December 31, 2007included the results of operations of the former German subsidiary of AllianceSystems, which we sold in February 2008. Furthermore, we ceased sales of military and government products duringthe three month period ended June 30, 2008.  Net revenues from the German subsidiary andfrom sales of military and government products totaled approximately $1.9million during the three month period ended December 31, 2007.

 

***Gross Profit***

 

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

 

Gross profit as a percentage of net revenue decreased for the threemonths ended December 31, 2008, as compared to the three months ended December 31,2007.  The decrease from the prior yearwas primarily due to an increase in inventory write-downs, and the fact thatmanufacturing costs remained relatively constant from the prior year relativeto the decrease in net revenues.  Thesefactors were partially offset by decreases in cost of materials and warrantycosts as a percentage of net revenues.

 

Gross profit is affected by customer and product mix, component materialcosts, pricing and the volume of orders as well as by the mix of productmanufactured internally compared to product manufactured by a contractmanufacturer, which carries higher manufacturing costs.

 

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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 December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                       | ** ** | **Dollars**                                             | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating expenses:              |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Research and development         |       | $                                                       | 1,442      |   | 3.9 | % | $ | 2,370 |   | 4.3 | % | $ | (928 | ) | (39.2 | )% |
| Selling and marketing            |       | 2,177                                                   |       | 5.8 | % | 3,117 |   | 5.7 | % | (940 | ) | (30.2 | )% |
| General and administrative       |       | 2,075                                                   |       | 5.6 | % | 2,645 |   | 4.9 | % | (570 | ) | (21.6 | )% |
| Amortization of intangible asset |       | 439                                                     |       | 1.2 | % | 420 |   | 0.8 | % | 19 |   | 4.5 | % |
|                             |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses         |       | $                                                       | 6,133      |   | 16.5 | % | $ | 8,552 |   | 15.7 | % | $ | (2,419 | ) | (28.3 | )% |

 

***Research and Development***

 

Research and development expenses consist primarily ofsalaries and related expenses for personnel engaged in research anddevelopment, fees paid to consultants and outside service providers, materialcosts for prototype and test units and other expenses related to the design,development, testing and enhancements of our application platformsolutions.  We expense all of ourresearch and development costs as they are incurred.  The following table summarizes the most significantcomponents of research and development expense for the periods indicated, inthousands and as a percentage of total research and development expense, andprovides the changes in thousands and percentages:

 
| ** **                           | ** ** | **Three months ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                             | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development:            |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                       | 970        |   | 67.3 | % | $ | 1,521 |   | 64.2 | % | $ | (551 | ) | (36.2 | )% |
| Stock-based compensation             |       | 84                                                      |       | 5.8 | % | 250 |   | 10.6 | % | (166 | ) | (66.4 | )% |
| Prototype                            |       | 140                                                     |       | 9.7 | % | 122 |   | 5.1 | % | 18 |   | 14.8 | % |
| Consulting and professional services |       | 92                                                      |       | 6.4 | % | 265 |   | 11.2 | % | (173 | ) | (65.3 | )% |
| Other                                |       | 156                                                     |       | 10.8 | % | 212 |   | 8.9 | % | (56 | ) | (26.4 | )% |
|                                 |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development       |       | $                                                       | 1,442      |   | 100 | % | $ | 2,370 |   | 100 | % | $ | (928 | ) | (39.2 | )% |

 

Research and development expenses decreased in thethree months ended December 31, 2008, as compared to the three monthsended December 31, 2007, primarily due to decreases in compensation andrelated expenses, stock-based compensation and consulting and professionalservices expenses.  Compensation andrelated expenses and stock-based compensation expenses decreased primarily dueto a decrease in research and development headcount from 45 at December 31,2007 to 34 at December 31, 2008. Because our consulting and professional services expenses relating toresearch and development are project driven, the timing of these expenditurescan vary.

 

Our application platform development strategyemphasizes the utilization of standard component technologies, which utilizeoff-the-shelf components.  However, weexpect that in some cases, significant development efforts will be required tofulfill our current and potential customers’ needs using customizedplatforms.  We expect that prototype andconsulting and professional services costs will be variable and could fluctuatedepending on the timing and magnitude of our development projects.

 

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***Selling and Marketing***

 

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing, andcosts associated with our marketing programs, which include costs associatedwith our attendance at trade shows, public relations, product literature costs,web site enhancements, and travel.  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:

 
| ** **                           | ** ** | **Three months ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                             | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:               |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                       | 1,565      |   | 71.9 | % | $ | 2,336 |   | 74.9 | % | $ | (771 | ) | (33.0 | )% |
| Stock-based compensation             |       | 61                                                      |       | 2.8 | % | 95 |   | 3.1 | % | (34 | ) | (35.8 | )% |
| Marketing programs                   |       | 171                                                     |       | 7.8 | % | 112 |   | 3.6 | % | 59 |   | 52.7 | % |
| Travel                               |       | 109                                                     |       | 5.0 | % | 197 |   | 6.3 | % | (88 | ) | (44.7 | )% |
| Consulting and professional services |       | 34                                                      |       | 1.6 | % | 68 |   | 2.2 | % | (34 | ) | (50.0 | )% |
| Other                                |       | 237                                                     |       | 10.9 | % | 309 |   | 9.9 | % | (72 | ) | (23.3 | )% |
|                                 |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing          |       | $                                                       | 2,177      |   | 100 | % | $ | 3,117 |   | 100 | % | $ | (940 | ) | (30.2 | )% |

 

Selling and marketingexpenses decreased in the three months ended December 31, 2008, ascompared to the three months ended December 31, 2007, primarily due todecreases in compensation and related expenses. Compensation and related expenses decreased primarily due to a decreasein selling and marketing headcount from 62 as of December 31, 2007, to 46as of December 31, 2008, and due to lower variable compensation, which wasdirectly related to the decreases in net revenues and net income (loss).

 

We believe that we must target our selling andmarketing efforts on OEMs, ISVs and service providers in order to enhance ourposition as a leading provider of application platform solutions.

 

***General and Administrative***

 

General and administrative expenses consist primarilyof salaries and other related costs for executive, finance, informationtechnology and human resources personnel; professional services, which includelegal, 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 December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                             | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative:          |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                       | 1,062      |   | 51.2 | % | $ | 1,319 |   | 49.9 | % | $ | (257 | ) | (19.5 | )% |
| Stock-based compensation             |       | 159                                                     |       | 7.7 | % | 188 |   | 7.1 | % | (29 | ) | (15.4 | )% |
| Consulting and professional services |       | 465                                                     |       | 22.4 | % | 655 |   | 24.8 | % | (190 | ) | (29.0 | )% |
| Director and officer insurance       |       | 55                                                      |       | 2.6 | % | 64 |   | 2.4 | % | (9 | ) | (14.1 | )% |
| Other                                |       | 334                                                     |       | 16.1 | % | 419 |   | 15.8 | % | (85 | ) | (20.3 | )% |
|                                 |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                                                       | 2,075      |   | 100 | % | $ | 2,645 |   | 100 | % | $ | (570 | ) | (21.6 | )% |

 

General and administrative expenses decreased in thethree months ended December 31, 2008, as compared to the three monthsended December 31, 2007, primarily due to decreases in compensation andrelated expenses and consulting and professional services expenses.  Compensation and related expenses decreasedprimarily due to a decrease in general and administrative headcount from 44 asof December 31, 2007, to 39 as of December 31, 2008, 

 

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and due to lower variable compensation, which wasdirectly related to the decreases in net revenues and net income (loss).  The decrease in consulting and professionalservices expenses was primarily due to costs related to the acquisition andintegration of Alliance Systems incurred during the three months ended December 31,2007, which did not recur during the three months ended December 31, 2008.

 

***Amortization of Intangible Asset***

 

Amortization of the intangible asset increased by$19,000 for the three months ended December 31, 2008, as compared to thethree months ended December 31, 2007. The increase was primarily due to the fact that amortization of theintangible asset, which was recorded as the result of the acquisition ofAlliance Systems on October 11, 2007, began during the quarter ended December 31,2007, while the three month period ended December 31, 2008 included onefull quarter of amortization expense.

 

***Interest and Other Income, net***

* *

Interest and other income, net, decreased to $59,000for the three months ended December 31, 2008 from $124,000 for the three months ended December 31, 2007.  This decrease was primarily due to lowerinterest income, attributable to lower interest rates on the cash balances heldby us during the three months ended December 31, 2008, as compared to thethree months ended December 31, 2007.

 

**Liquidityand Capital Resources**

 

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

 
| ** **                                        | ** ** | **Three months ended  December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| ** **                                        | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net (loss) income                                 |       | $                                                   | (466       | ) | $ | 1,241 |   |
| Non-cash adjustments to net (loss) income         |       | 1,036                                               |       | 1,449 |   |
| Changes in working capital                        |       | 2,850                                               |       | (5,433 | ) |
|                                              |       |                                                |       |   |   |
| Cash provided by (used in) operating  activities  |       | 3,420                                               |       | (2,743 | ) |
|                                              |       |                                                |       |   |   |
| Cash used in investing activities                 |       | (178                                                | )          | (33,555 | ) |
| Cash (used in) provided by financing  activities  |       | (85                                                 | )          | 110 |   |
| Effect of exchange rate differences on cash       |       | —                                              |       | (29 | ) |
|                                              |       |                                                |       |   |   |
| Increase (decrease) in cash and cash  equivalents |       | 3,157                                               |       | (36,217 | ) |
| Beginning cash and cash equivalents               |       | 10,003                                              |       | 44,403 |   |
|                                              |       |                                                |       |   |   |
| Ending cash and cash equivalents                  |       | $                                                   | 13,160     |   | $ | 8,186 |   |

 

***Operating Activities***

 

Cash provided by operating activities during the threemonths ended December 31, 2008 was primarily the result of net cashprovided by changes in working capital and the impact of non-cash adjustmentsto net loss, partially offset by the net loss for the period.  Changes in working capital were primarilydriven by differences in the timing and magnitude of cash receipts, cashdisbursements, inventory receipts and invoicing to customers.  The change in accounts receivable was alsorelated to collections of payments from customers, as well as the fact thatrevenues for the three months ended December 31, 2008 were lower thanrevenues for the three months ended September 30, 2008.  The change in inventories was also related tothe depletion of inventories on hand and lower purchases during the threemonths ended December 31, 2008 compared to the three months ended September 30,2008, which was also related to the downward trend in revenues.  Changes in working capital during the threemonths ended December 31, 2008 also included the receipt of $1.9 millionof income tax refunds related to taxes paid by Alliance Systems in prior years.

 

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Cash used in operating activities of $2.7 million forthe three months ended December 31, 2007 was the result of net cash usedby changes in working capital, primarily related to increased purchases ofinventory and the use of cash to settle accounts payable and accrued expenses,partially offset by the impact of net income and non-cash adjustments to netincome.

 

***Investing Activities***

 

Cash used in investing activities during the threemonths ended December 31, 2008 related to the use of approximately$178,000 of cash for purchases of property and equipment.  Cash used in investing activities during thethree months ended December 31, 2007 primarily related to the use of $33.6million of cash for the acquisition of Alliance Systems.

 

***Financing Activities***

 

Cash used in financing activities during the threemonths ended December 31, 2008 consisted primarily of $166,000 used torepurchase shares of our common stock, partially offset by the receipt of$89,000 as the result of purchases under the Employee Stock Purchase Plan.  Cash provided by financing activities duringthe three months ended December 31, 2007 consisted primarily of thereceipt of $115,000 as the result of stock option exercises and purchases underthe Employee Stock Purchase Plan.

 

Cash inflows from purchases under the Employee StockPurchase Plan and from stock option exercises may also occur in the remainderof fiscal year 2009; however, we cannot predict the magnitude of the cashinflows, given the volatility of capital markets.

 

On June 12,2008, our Board of Directors authorized the repurchase of up to $5 million ofour 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 and may be terminated atany time.  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 established a Rule 10b5-1plan intended to comply with the requirements of Rule 10b5-1 and Rule 10b-18under the Securities Exchange Act of 1934.  A Rule 10b5-1 planpermits the repurchase of shares by a company at times when it otherwise mightbe prevented from doing so under insider trading laws or because of companyblackout periods, provided that the plan is adopted when the company is notaware of material non-public information.  Pursuant to the plan, a brokerdesignated by us has the authority to repurchase shares, in accordance with theterms of the plan, without further direction from us.  The amount andtiming of specific repurchases are subject to the terms of the plan and market conditions.  During the three months ended December 31,2008, we repurchased 350,000 shares of our common stock at an average cost of$0.47 per share.  From the inception ofthe share repurchase program through December 31, 2008, we had repurchased1,256,801 shares of our common stock at an average cost of $0.88 pershare.  Upon the expiration of the 10b5-1plan on November 7, 2008, we suspended repurchases of our commonstock.  We may resume repurchases underthe program at any time at the discretion of management.  As of December 31, 2008, the maximumdollar value that may yet be used for purchases under the program was$3,900,000.

 

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

 

·                  the timing and size of orders from our customers;

 

·                  the timeliness of receipts of payments from ourcustomers;

 

·                  our ability to enter into partnerships with OEMs, ISVsand service providers;

 

·                  the level of success of our customers in sellingsystems that include our application platform solutions;

 

·                  the costs and timing of product engineering effortsand the success of these efforts; and

 

·                  market developments.

 

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We believe that our available cash resources and cashthat we expect to generate from sales of our products and services will besufficient to meet our operating and capital requirements through at least thenext twelve months.

 

In the event that our available cash resources and theSilicon Valley Bank line of credit are not sufficient, or if an event ofdefault occurs, such as failure to achieve certain financial covenants, thatlimits our ability to borrow under the line of credit, we may need to raiseadditional funds.  We may in the futureseek to raise additional funds through borrowings, public or private equityfinancings or from other sources.  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 ourshareholders.  If additional financing isneeded and is not available on acceptable terms, we may need to reduce ouroperating expenses and scale back our operations.

 

***Contractual Obligations and Commitments***

 

During the three months ended December 31, 2008,there were no material changes to our contractual obligations and commitmentsas disclosed in our annual report on Form 10-K for the year ended September 30,2008.

 

**Off-Balance Sheet Arrangements**

 

We have not created, and are not party to, anyspecial-purpose or off-balance sheet entities for the purpose of raisingcapital, incurring debt or operating parts of our business that are notconsolidated into our financial statements. We have not entered into any transactions with unconsolidated entitieswhereby the Company has subordinated retained interests, derivative instrumentsor other contingent arrangements that expose the Company to material continuingrisks, contingent liabilities, or any other obligation under a variableinterest in an unconsolidated entity that provides financing, liquidity, marketrisk or credit risk support to the Company.

 

**Recent Accounting Pronouncements**

** **

In September 2006, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandard No. 157, “Fair Value Measurements” (“FAS 157”).  Thisstatement addresses how companies should measure fair value when they arerequired to use a fair value measure for recognition or disclosure purposesunder accounting principles generally accepted in the United States ofAmerica.  In February 2008, the FASB issued FASBStaff Position No. 157-1, “Application of FASB Statement No. 157 toFASB Statement No. 13 and Other Accounting Pronouncements That AddressFair Value Measurements for Purposes of Lease Classification or Measurementunder Statement 13” (“FSP 157-1”).  FSP157-1 amends FAS 157 to remove certain leasing transactions from its scope. In February 2008, the FASB issued FASBStaff Position No. 157-2, “Effective Date of FASB Statement No. 157”(“FSP 157-2”).  FSP 157-2 defers theeffective date of FAS 157 for non-financial assets and liabilities which arerecognized or disclosed at fair value on a non-recurring basis to the beginning ofour fiscal year that begins after November 15, 2008.  InOctober 2008, the FASB issued FASB Staff Position No. 157-3, “Determiningthe Fair Value of a Financial Asset When the Market for That Asset is NotActive” (“FSP 157-3”).  FSP 157-3clarifies the application of FAS 157 in a market that is not active andprovides an example to illustrate key considerations in determining the fairvalue of a financial asset when the market for that financial asset is notactive.

 

FAS157 defines fair value as the price that would be received to sell an asset orpaid to transfer a liability (“exit price”) in an orderly transaction betweenmarket participants at the measurement date. FAS 157 requires disclosures that categorize assets and liabilitieswhich are recognized or disclosed at fair value into one of three differentlevels depending on the assumptions (“inputs”) used in the valuation.  In the fair value hierarchy, Level 1 providesthe most reliable measure of fair value, while Level 3 generally requiressignificant management judgment. Financial assets and liabilities are classified in their entirety basedon the lowest level of input significant to the fair value measurement.  The FAS 157 fair value hierarchy is definedas follows:

 

·                  Level 1 – Valuations are based on unadjusted quotedprices in active markets that are accessible at the measurement date foridentical assets or liabilities.

·                  Level 2 – Valuations are based on quotedprices for similar assets or liabilities in active markets, or quoted pricesfor identical or similar assets or liabilities in markets that are not activefor which significant inputs are observable, either directly or indirectly.

 

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·                  Level 3 – Valuations are based on pricesor valuation techniques that require inputs that are both unobservable andsignificant to the overall fair value measurement.  Inputs reflect management’s best estimatesregarding the assumptions that market participants would use in valuing theasset or liability at the measurement date.

 

We adopted FAS 157, as it applies tofinancial assets and liabilities and nonfinancial assets and liabilities whichare recognized or disclosed at fair value on a recurring basis (at leastannually), as of October 1, 2008, and this adoption did not have anyimpact on our financial position, results of operations or cash flows.  We had no assets or liabilities recorded atfair value based on Level 1, Level 2 or Level 3 inputs as of the adoption date,October 1, 2008, or at any time during the three month period ended December 31,2008.  However, we may acquire assets orincur liabilities in future periods for which fair value measurement under FAS157 may be required.  We are in theprocess of evaluating whether the adoption of FSP 157-2 (as it relates to the effective date of FAS 157 for non-financialassets and liabilities which are recognized or disclosed at fair value on anon-recurring basis) will have a material impact on our financial position, results ofoperations or cash flows.

 

We adopted FASB Statement of FinancialAccounting Standard No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities — Including an amendment of FASB Statement No. 115”(“FAS 159”) as of October 1, 2008.  This statement permits entitiesto choose to measure many financial instruments and certain other items at fairvalue at specified election dates. Subsequent unrealized gains and losses on items for which the fair valueoption has been elected will be reported in earnings.  The adoption of FAS 159 did not have anyimpact on our financial position, results of operations or cash flows, as wedid not elect to measure any items at fair value as of the adoption date.

 

In December 2007, theFASB issued Statement of Financial Accounting Standard No. 141(R), “BusinessCombinations” (“FAS 141R”).  ThisStatement replaced Statement of Financial Accounting Standard No. 141 to improve therelevance, representational faithfulness, and comparability of the informationthat a reporting entity provides in its financial reports about a businesscombination and its effects.  FAS 141Restablishes principles and requirements for how the acquirer recognizes and measuresin its financial statements the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquiree, recognizes andmeasures the goodwill acquired in the business combination or a gain from abargain purchase and determines what information to disclose to enable users ofthe financial statements to evaluate the nature and financial effects of thebusiness combination.  FAS 141R iseffective for business combinations on a prospective basis for which theacquisition date is on or afterthe beginning of our first annual reporting period beginning on or after December 15,2008.

 

InApril 2008, the FASB issued FASB Staff Position No. FAS 142-3, “Determinationof the Useful Life of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under Statement of FinancialAccounting Standard No. 142, “Goodwill and Other Intangible Assets” (“FAS142”).  This change is intended toimprove the consistency between the useful life of a recognized intangibleasset under FAS 142 and the period of expected cash flows used to measure thefair value of the asset under FAS 141R and other generally accepted accountingprinciples.  The requirement fordetermining useful lives must be applied prospectively to intangible assetsacquired after the effective date and the disclosure requirements must be appliedprospectively to all intangible assets recognized as of, and subsequent to, theeffective date.  FSP 142-3 is effectiveas of the beginning of our fiscal year that begins after December 15,2008.  We are in the process of evaluating whetherthe adoption of FSP 142-3 will have a material impact on our financial positionor results of operations.

 

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**ITEM 3.    QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We do not engage in anyforeign currency hedging transactions and therefore do not believe we aresubject to material exchange rate risk. We are not currently exposed to market risk related to changes ininterest rates.  In the past, we haveinvested excess cash balances in cash equivalents and short-term investments,and if we were to do so in the future, we believe that the effect, if any, ofreasonably possible near-term changes in interest rates on our financialposition, results of operations and cash flows would not be material.  In addition, a hypothetical 10% increase ordecrease in interest rates would not have a material adverse effect on ourfinancial condition.

 

**ITEM 4.    CONTROLS AND PROCEDURES**

 

Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act) as of December 31, 2008. Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that, as of December 31, 2008, our disclosurecontrols and procedures (1) were designed to effectively accumulate andcommunicate information to the Company’s management, as appropriate, to allowtimely decisions regarding required disclosure and (2) were effective, inthat they provide reasonable assurance that information required to bedisclosed by the Company in the reports that it files or submits under theSecurities Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the Securities and Exchange Commission’s rules andforms.

 

During the three months ended December 31, 2008, no change in our internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)occurred that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II—OTHERINFORMATION**

 

**ITEM 1.     LEGAL PROCEEDINGS**

 

*InitialPublic Offering Lawsuit*

 

On or about December 3, 2001, a putativeclass action lawsuit was filed in the United States District Court for theSouthern District of New York against us, Lawrence A. Genovesi (our formerChairman and Chief Executive Officer), Douglas G. Bryant (our Chief FinancialOfficer), and several underwriters of our initial public offering.  The suit alleges, *inter alia*,that the defendants violated the federal securities laws by issuing and sellingsecurities pursuant to our initial public offering in July 2000 (“IPO”)without disclosing to investors that the underwriter defendants had solicitedand received excessive and undisclosed commissions from certain investors.  The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of our commonstock between July 13, 2000 and December 6, 2000.

 

In October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case withoutprejudice.  On December 5, 2006, theUnited States Court of Appeals for the Second Circuit overturned the DistrictCourt’s certification of a plaintiff class. On April 6, 2007, the Second Circuit denied plaintiffs’ petitionfor rehearing, but clarified that the plaintiffs may seek to certify a morelimited class in the District Court.  On September 27,2007, plaintiffs filed a motion for class certification in certain designated “focuscases” in the District Court.  Thatmotion has since been withdrawn.  On November 13,2007, the issuer defendants in certain designated “focus cases” filed a motionto dismiss the second consolidated amended class action complaints that werefiled in those cases.  On March 26,2008, the District Court issued an Opinion and Order denying, in large part,the motions to dismiss the amended complaints in the “focus cases.”  We are unable to predict the outcome of thissuit and as a result, no amounts have been accrued as of December 31,2008.

 

*CustomerClaim*

 

On January 20, 2009, a lawsuit was filed inthe United States District Court for the Eastern District of Texas against usand several other co-defendants.  Thesuit, filed by Cordsen Engineering GmbH (“Cordsen”), a former customer ofAlliance Systems, alleges breach of contract and other claims with regard tocertain products that Cordsen purchased from Alliance Systems (prior toour acquisition of Alliance Systems) and which Cordsen alleges did not meet itsdesired specifications. Cordsen alleges that by virtue of our acquisition ofAlliance Systems in October 2007, we became the assignee of Alliance Systems’agreement with Cordsen.  The AllianceSystems selling stockholders have agreed with us to undertake the defense ofthe action insofar as it relates to activities that occurred principally beforewe acquired Alliance Systems, and have agreed to bear any costs associated withthis action.  We believe this claim iswithout merit.  We are unable to predictthe ultimate outcome of this claim and are unable to estimate the amount of anypotential loss we might incur as a result of this claim, and therefore noamounts have been accrued relating to this claim as of December 31,2008.  With regard to this claim, theCompany intends to pursue reimbursement from the former shareholders ofAlliance Systems for any losses incurred by the Company, pursuant to the termsof the Alliance Systems merger agreement.

 

**ITEM 1A. RISK FACTORS**

 

The risks and uncertainties described below are not the only ones we arefaced with.  Additional risks anduncertainties not presently known to us, or that are currently deemedimmaterial, 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, 2008,there have been no significant changes in our risk factors.

 

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

 

**We derive a significant portion of our revenues from sales ofapplication platform solutions directly to EMC and our revenuesmay decline significantly if this customer reduces, cancels or delayspurchases of our products, terminates its relationship with us or exercisescertain of its contractual rights.**

 

For the three months ended December 31, 2008 and2007, sales directly to EMC, our largest customer, accounted for 33% and 38%,of our total net revenues, respectively. These sales are primarily attributable to one product pursuant to anon-exclusive contract.  Although thisconcentration has decreased as a result of our acquisition of Alliance Systems,we anticipate that our future operating results will continue to depend heavilyon sales to, and our relationship with, this customer.  Accordingly, the success of our business willdepend, in large 

 

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part, on this customer’s willingness to continue to utilize ourapplication platform solutions in its existing and future products.  Further, our financial success is dependentupon the future success of the products we sell to this customer and thecontinued growth of this customer, whose industry has a history of rapidtechnological change, short product lifecycles, consolidation and pricing andmargin pressures.  Advances inhard drive storage capacity could also result in lower sales volumes to thiscustomer.  A significant reductionin sales to this customer, or significant pricing and additional marginpressures exerted on us by this customer, would have a material adverse effecton our results of operations.  In addition,if this customer delays or cancels purchases of our products, our operatingresults would be harmed and we may be unable to accurately predict revenues,profitability and cash flows.

 

Under the terms of our non-exclusive contract, this customer has theright to enter into agreements with third parties for similar products, is notobligated to purchase any minimum quantity of products from us andmay choose to stop purchasing from us at any time, with or withoutcause.  In addition, this customermay terminate the agreement in the event that we attempt to assign ourrights under the agreement to another party without this customer’s priorapproval.  Furthermore, in the event thatwe default on certain portions of the agreement, this customer has the right tomanufacture certain products in exchange for a mutually agreeable royaltyfee.  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 reputation in theindustry might suffer, and we may be unable to accurately predict revenues,profitability and cash flows.

 

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

 

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

 

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

 

There are multiple risks associated with this strategy including:

 

·                  the expenditureof significant product development costs, which if not recovered throughapplication platform sales could negatively affect our operating results;

 

·                  a significantreliance on our customers’ application software products, which could be technologicallyinferior to competitive products and result in limitations on our applicationplatform sales, causing our revenues and operating results to suffer;

 

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

 

·                  our reliance onour customers to perform all of the selling and marketing effortsassociated with further sales of the application platform solution we developwith 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 become actual orders and sales.  A “design win’’ occurs when a customer orprospective customer notifies us that we have been selected to integrate thecustomer’s application.  There can bedelays of several months or more between the design win and 

 

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when a customer initiates actual orders.  The design win may never become an actualorder or sale.  Further, if the customer’splans change, we may commit significant resources to design wins that do notresult in actual orders.

 

Additionally, our future success will depend on our ability to establishrelationships with new customers while expanding sales of application platformsolutions to our existing customers.  Ifthese customers are unsuccessful in their marketing and sales efforts, or if weare unable to expand our sales to existing customers and develop relationshipswith new customers, our revenues and operating results could suffer.

 

**We may not be able to effectively commercialize our applicationplatform solutions or may be at a competitive disadvantage if we cannot licenseor integrate third-party applications that are essential for the functionalityof certain platforms.**

 

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

 

**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.**

 

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

 

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

 

·                  our new productsmay be delayed because selected new technologies themselves are delayed orhave defects and/or performance limitations;

 

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

 

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

 

·                  new technologiesare unproven and could contain latent defects, which could result in highproduct failures; 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.

 

If we are unable to adequately integrate new technologies into ourapplication platform products or if we invest in technologies that do notresult in the desired effects on our current and/or future product offerings,our business could be harmed and operating results could suffer.

 

***Risks related to the application platformmarkets.***

 

**If application platforms are not increasingly adopted as a solution tomeet a significant portion of companies’ software application needs, the marketfor application platform solutions may not grow, which could negativelyimpact our revenues.**

 

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

 

Our expectations for the growth of the application platform market may notbe fulfilled if customers continue to use general-purpose servers orproprietary platforms.  The role of ourproducts could, for example, be limited if general-purpose serversout-perform application platforms, provide more capabilities and/or flexibilitythan application platforms or are offered at a lower cost.  This could force us to lower the prices ofour application platform solutions or could result in fewer sales of theseproducts, which would negatively impact our revenues and decrease our grossprofits.

 

**The products that we sell are subject to rapid technological change andour sales will suffer if these products are rendered obsolete by newtechnologies.**

 

The markets we serve are characterized by rapid technological change,frequent new product introductions and enhancements, potentially short productlifecycles, changes in customer demands and evolving industry standards.  In the application platform market, weattempt to mitigate these risks by utilizing standards-based hardware platformsand by maintaining an adequate knowledge base 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, we depend on third parties forthe base hardware of our application platforms and we are at risk if thesethird parties do not integrate new technologies.  Releasing new products and servicesprematurely may result in quality problems, and delays may result in loss ofcustomer confidence and market share.  Wemay be unable to develop new products and services or achieve and maintain marketacceptance of them once they have come to market.  Furthermore, when we do introduce new orenhanced products and services, we may be unable to manage the transition fromthe older products and services to minimize disruption in customer ordering patterns,avoid excessive inventories of older products and deliver enough new productsand 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 select the appropriatepartners and keep pace with rapid industry, technology or market changes couldhave a material adverse effect on our business, results of operations orfinancial condition.

 

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

 

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

 

In the past, we have incurred significant net losses and could incur netlosses in the future.  At December 31,2008 and September 30, 2008, our accumulated deficit was $138million.  We believe that any futuregrowth will require us to incur significant engineering, selling and marketingand administrative expenses.  As a result,we will need to generate significant revenues to achieve and sustainprofitability.  If we do not achieve andsustain profitability, the market price for our common stock may decline.  Even if we achieve sustained profitabilitythere can be no guarantee that our stock price will increase.

 

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

 

Inconnection with our October 2007 acquisition of Alliance Systems, we enteredinto an agreement with Silicon Valley Bank to provide for a line ofcredit.  We view this line of credit as asource of available liquidity to fund fluctuations in our working capitalrequirements.  This facility containsvarious conditions, covenants and representations with which we must be incompliance in order to borrow funds. However, if we wish to borrow under this facility in the future, therecan be no assurance that we will be in compliance with these conditions,covenants and representations.  Inaddition, this line of credit facility with Silicon Valley Bank expires on August 5,2010.  After that, we may need to securenew financing to continue funding fluctuations in our working capitalrequirements.  However, we may not beable to secure new financing, or financing on favorable terms, if we 

 

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experiencea significant adverse change in our business. As of February 9, 2009, we had not drawn on this line of credit.

 

**If our estimates or judgments relating to our critical accountingpolicies are based on assumptions that change or prove to be incorrect, ouroperating results could fall below expectations of securities analysts andinvestors, resulting in a decline in our stock price.**

 

Our discussion and analysis of financialcondition and results of operations is based on our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America.  The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the amounts reported in theconsolidated financial statements and accompanying notes.  On an ongoing basis, we evaluate significantestimates used in preparing our consolidated financial statements, includingthose related to:

 

·                  revenuerecognition;

 

·                  collectibilityof accounts receivable;

 

·                  inventorywrite-downs;

 

·                  stock-basedcompensation;

 

·                  valuation ofintangible assets;

 

·                  warrantyreserves; and

 

·                  realization ofdeferred tax assets.

 

We base our estimates on historical experienceand on 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.

 

**Our quarterly revenues and operating results may also fluctuate forvarious reasons, which could cause our operating results to fall belowexpectations and thus impact the market price of our common stock.**

 

Our quarterly revenues and operating resultsare difficult to predict and may fluctuate significantly from quarter toquarter.  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 expense levels are based inpart on expectations of future revenues and gross profits, which arepartially dependent on our customers’ ability to accurately forecast andcommunicate their future product needs. If revenues or gross profits in a particular quarter do not meetexpectations, operating results could suffer and the market price of our commonstock could decline.  Factors affectingquarterly operating 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;

 

·                  the variabilityof orders we receive from customers who do not provide us with sales forecasts;

 

·                  the product mixof our sales;

 

·                  the timing ofnew product introductions by our customers;

 

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·                  the availabilityand/or price of products from suppliers;

 

·                  the loss of keysuppliers or customers;

 

·                  pricecompetition;

 

·                  costs associatedwith our introduction of new application platform solutions and the marketacceptance of those products; and

 

·                  the mix ofproduct manufactured internally and by our contract manufacturer.

 

**If the products and services that we sell become more commoditized andcompetition in the data storage, network security, carrier communications andenterprise communications markets continues to increase, then our gross profitas a percentage of net revenues may decrease and our operating resultsmay suffer.**

 

Products and services in the data storage,network security, carrier communications and enterprise communications marketsmay be subject to further commoditization as these industries continue tomature and other businesses introduce additional competing products andservices.  Our gross profit as apercentage of revenues for our products may decrease in response tochanges in our product mix, competitive pricing pressures, or new productintroductions into these markets.  If weare unable to offset decreases in our gross profits as a percentage of revenuesby increasing our sales volumes, or by decreasing our product costs, ouroperating results will decline.  Changesin 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 futurequarters.  To maintain our gross profits,we also must continue to reduce the manufacturing cost of our applicationplatform 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 manufacturerto produce a portion of our customer requirements for certain applicationplatform solutions may not allow us to reduce 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.  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 willsuffer.

 

**An intangible asset represents a significant portion of our assets, andany impairment of the intangible asset would adversely impact our operatingresults.**

 

At December 31, 2008, the carrying valueof our intangible asset, which consists of customer relationships associatedwith our acquisition of Alliance Systems, was approximately $9.4 million,net of accumulated amortization.  We willcontinue to incur non-cash charges relating to the amortization of ourintangible asset over its remaining useful life.  Future determinations of significantwrite-offs of the intangible asset resulting from an impairment test or anyaccelerated amortization of the intangible asset could have a significantimpact on our operating results and affect our ability to achieve or maintain profitability.  Although we do not believe that anyimpairment of the intangible asset exists at this time, in the event that anyindicators of possible impairment exist, we may record charges which could havea material adverse effect on our results of operations.  Such indicators include, but are not limitedto, a worsening in customer attrition rates compared to historical attritionrates, or lower than initially anticipated cash flows associated with customerrelationships.

 

Our acquisition of Alliance Systems wasstructured to include a downward adjustment to the purchase price based on thenet working capital of Alliance Systems as of October 11, 2007, as definedin the merger agreement, and therefore approximately $4.0 million of thecash paid is contingently returnable to us upon resolution of thisprovision.  As a result, the amount ofcontingently returnable consideration has been excluded from the allocation ofthe purchase price to the net assets acquired until such time that this amountis no longer contingently returnable. When the contingencies are resolved, any portion of the$4.0 million which is not returned to us will be reclassified asadditional goodwill.  If additionalgoodwill is recorded in a future period, it will then be subject to review forimpairment annually as of the fiscal year end date, and more frequently ifcertain indicators are present.  If animpairment charge is recorded in the future, it would negatively impact ouroperating results.

 

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***Risks related tocompetition.***

 

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

 

In the application platform market, we facesignificant competition from a number of different types of companies.  Our competitors include companies who marketgeneral-purpose servers, server virtualization software, specific-purpose serversand application platforms as well as companies that sell custom integrationservices utilizing hardware produced by other companies.  Many of these companies are larger than weare and have greater financial resources and name recognition than we do, aswell as significant distribution capabilities and larger, more establishedservice organizations to support their products.  Our larger competitors may be able toleverage their existing resources, including their extensive distribution capabilitiesand service organizations, to provide a wider offering of products and servicesand higher levels of support on a more cost-effective basis than we can.  We expect competition in the applicationplatform market to increase significantly as more companies enter the marketand as our existing competitors continue to improve the performance of theircurrent products and to introduce new products and technologies.  Such increased competition could adverselyaffect sales of our current and future products.  In addition, competing companies may beable to undertake more extensive promotional activities, adopt more aggressivepricing policies and offer more attractive terms to their customers than wecan.  If our competitors provide lowercost products with greater functionality or support than our applicationplatform solutions, or if some of their products are comparable to ours and areoffered as part of a range of products that is broader than ours, ourapplication platform solutions could become undesirable.

 

Even if the functionality of competingproducts is equivalent to ours, we face a risk that a significant number ofcustomers would elect to pay a premium for similar functionality from a largervendor rather than purchase products from us. 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 to effectively differentiateourselves from our competition, we may be forced to offer price reductionsto maintain relationships with certain customers.  As a result, our revenues may notincrease and may decline, and our gross margins may decline.  Furthermore, increased competition could leadto higher selling expenses which would negatively affect our business andfuture operating results.

 

***Risks related to marketing and sales effortsand customer service.***

 

**We need to effectively manage our sales and marketing operations toincrease market awareness and sales of our products and to promote our brandrecognition.  If we fail to do so, ourgrowth will be limited.**

 

Although we currently have a relatively smallsales and marketing organization, we must continue to increase market awarenessand sales of our products and promote our brand in the marketplace.  We believe that to compete successfully wewill need OEMs, ISVs and service providers to recognize us as a top-tierprovider of application platform solutions and services.  If we are unable to increase market awarenessand promote ourselves as a leading provider of application platform solutionswith our available resources, we may be unable to develop new customerrelationships or expand our product and service offerings with existingcustomers.

 

**If we are unable to effectively manage our customer service and supportactivities, we may not be able to retain our existing customers or attractnew customers.**

 

We need to effectively manage our customersupport operations to ensure that we maintain good relationships with ourcustomers.  We believe that providing alevel of high quality customer support will be a key differentiator for ourproduct offerings and may require more technically qualified staff which couldbe more costly.  If we are unable toprovide this higher level of service we may be unable to successfullyattract and retain customers.

 

If our customer support organization isunsuccessful in maintaining good customer relationships, we may losecustomers to our competitors and our reputation in the market could bedamaged.  As a result, we may loserevenues and our business could suffer. Furthermore, the costs of providing this service could be higher than weexpect, which could adversely affect our operating results.

 

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

 

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

 

We depend upon single source and limitedsource suppliers for our industry standard processors, main logic boards,telephony boards, certain disk drives, hardware platforms and power supplies aswell as certain of our chassis and sheet metal parts.  Additionally, we depend on limited sources tosupply certain other industry standard and customized components.  We have in the past experienced, andmay in the future experience, shortages of or difficulties in acquiringcomponents in the quantities and of the quality needed to produce ourapplication platform solutions.  Shortagesin supply or quality issues related to these key components for an extendedtime would cause delays in the production of our application platformsolutions, prevent us from satisfying our contractual obligations and meetingcustomer expectations, and result in lost sales and customers.  If we are unable to buy components in thequantities and of the quality that we need on a timely basis or at acceptableprices, we will not be able to manufacture and deliver our application platformsolutions on a timely or cost effective basis to our customers, and ourcompetitive position, reputation, business, financial condition and results ofoperations could be seriously harmed.  Ifwe are able to secure other sources of supply for such components, our costs topurchase such components could increase, which would negatively impact ourgross margins.  A significant portion ofour components are purchased from suppliers located in China.  Recently, several factories in China haveclosed 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.

 

**If our application 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.**

 

Because application platform solutions arecomplex, they could contain errors that can be detected at any point in aproduct’s lifecycle.  If flaws in design,production, assembly or testing of our products (by us or our suppliers) wereto occur, we could experience a rate of failure in our products that couldresult in substantial repair, replacement or service costs and potential damageto our reputation.  In addition, because our solutions are combined withproducts from other vendors, should problems occur, it might be difficult toidentify the source of the problem. Continued improvement in manufacturing capabilities, control of materialand manufacturing quality and costs, and product testing are critical factorsin our future growth.  There can be noassurance that our efforts to monitor, develop, modify and implementappropriate test and manufacturing processes for our products will besufficient to permit us to avoid a rate of failure in our products that resultsin substantial delays in shipment, significant repair or replacement costs orpotential damage to our reputation, any of which could have a material adverseeffect on our business, results of operations or financial condition.

 

In the past, we have discovered errors in someof our application platform solutions and have experienced delays in theshipment of our products during the period required to correct these errors orwe have had to replace defective products that were already shipped.  Errors in our application platform solutionsmay be found in the future and any of these errors could besignificant.  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.

 

Any of these problems could harm our business and future operatingresults.  Product errors or delays couldbe material, including any product errors or delays associated with theintroduction of new products or versions of 

 

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existing products.  If ourapplication platform solutions fail to conform to warrantedspecifications, customers could demand a refund for the purchase price andassert claims for damages.

 

Moreover, because our application platformsolutions may be used in connection with critical computing systems services,including providing security to protect valuable information, wemay receive significant liability claims if they do not workproperly.  While our agreements withcustomers typically contain provisions intended to limit our exposure toliability claims, these limitations do not preclude all potential claims.  Liability claims could exceed our insurancecoverage and require us to spend significant time and money in litigation or topay significant damages.  Any claims fordamages, even if unsuccessful, could seriously damage our reputation andbusiness.

 

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

 

We use rolling forecasts based on anticipatedproduct orders to determine our application platform componentrequirements.  Lead times for materialsand components that we order vary significantly depending on variables such asspecific supplier requirements, contract terms and current market demand forthose components.  In addition, a varietyof factors, including the timing of product releases, potential delays orcancellations of orders, the timing of large orders and the unproven acceptanceof new products in the market make it difficult to predict product orders.  As a result, our materials requirementforecasts may not be accurate.  Ifwe overestimate our materials requirements, we may have excess inventory,which would increase costs and negatively impact our cash position.  Our agreements with certain customers provideus with protections related to inventory purchased in accordance with the termsof these agreements; however, these protections may not be sufficient toprevent certain losses as a result of excess or obsolete inventory.  If we underestimate our materialsrequirements, we may have inadequate inventory, which could interrupt ourmanufacturing and delay delivery of our application platform solutions tocustomers, resulting in a loss of sales or customers.  Any of these occurrences would negativelyimpact our business and operating results.

 

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

 

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

 

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

 

·                  be timeconsuming for us to address;

 

·                  require us toenter into royalty or licensing agreements;

 

·                  result in costlylitigation, including potential liability for damages;

 

·                  divert ourmanagement’s attention and resources; and

 

·                  cause productshipment delays.

 

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

 

**If we fail to retain and attract appropriate levels of qualifiedemployees and members of senior management, we may not be able tosuccessfully execute our business strategy.**

 

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

 

**If we fail to maintain an effective system of internal controls, wemay not be able 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 of2002 requires our management to report on, and our independent registeredpublic accounting firm to attest to, the effectiveness of our internal controlover financial reporting.  We have anongoing program to perform the system and process evaluation and testingnecessary to comply with these requirements. As a result, we have incurred expenses and have devoted additionalmanagement resources to Section 404 compliance.  Effective internal controls are necessary forus to provide reliable financial reports. If we cannot provide reliable financial reports, our business andoperating results could be harmed.

 

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

 

In December 2001, a class actionlawsuit relating to our initial public offering was filed against us, ourchairman, one of our executive officers and the underwriters of our initialpublic offering.  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.

 

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

 

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

 

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

 

The market price of our common stock has beensubject to significant fluctuations and may continue to fluctuate ordecline.  During the fiscal year ended September 30,2008, the closing price of our common stock ranged from a low of $0.55 to ahigh of $2.12, and during the three months ended December 31, 2008, from alow of $0.29 to a high of $0.57.  Themarket for technology stocks has been extremely volatile and frequently reacheslevels that bear no relationship to the past or present operating performanceof those companies.  General economicconditions, such as recession or interest rate or currency rate fluctuations inthe United States or abroad, could negatively affect the market price of ourcommon stock.  For example, therecent uncertainty related to deteriorating global economic conditions hasnegatively impacted the market price of our common stock.  In addition, our operating resultsmay be below the expectations of securities analysts and investors.  If this were to occur, the market price ofour common stock may decrease significantly.  In the past, following periods of volatilityin the market price of a company’s securities, securities class actionlitigation has often been instituted against such companies.  Such litigation could result in substantialcost and a diversion of management’s attention and resources.

 

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Any decline in the market price of our commonstock or negative market conditions could adversely affect our ability to raiseadditional capital, to complete future acquisitions of or investments in otherbusinesses and to attract and retain qualified technical and sales andmarketing personnel.

 

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

 

Subsequent to June 30, 2008, at certain times, the market price ofour common stock has been less than $1.00 per share.  If we are unable to meet the stock pricelisting requirements of NASDAQ, our common stock could be de-listed from theNASDAQ Global Market.  On September 29,2008, we received notification from NASDAQ that during the preceding 30consecutive trading days, the closing bid price of our common stock was belowthe $1.00 minimum bid price per share required for continued listing on theNASDAQ Global Market under NASDAQ Marketplace Rule 4450(a)(5).  In accordance with NASDAQ Marketplace Rule 4450(e)(2),NASDAQ provides issuers 180 calendar days to regain compliance with the minimumbid price requirement by maintaining a closing bid price of $1.00 per share orhigher for a minimum of 10 consecutive trading days.  On October 22, 2008, NASDAQ notified usthat it had suspended enforcement of the minimum bid price rule for threemonths.  On December 23, 2008,NASDAQ notified us that it had further suspended enforcement of the minimum bidprice rule and that this rule was scheduled to be reinstated on April 20,2009.  As a result, we will have untilapproximately October 2, 2009 (subject to the determination of NASDAQ) toregain compliance with the minimum bid price requirement.  NASDAQ may, in its discretion, require thatour common stock maintain a bid price in excess of $1.00 for a period in excessof 10 business days, but generally no more than 20 business days, beforedetermining that we have demonstrated the ability to maintain long-termcompliance.  If we are unsuccessful inmeeting the minimum bid price requirement during the compliance period, NASDAQwill provide notice to us that our common stock will be delisted from theNASDAQ Global Market.  If we receive sucha notice, we may appeal the staff determination to the NASDAQ ListingQualifications Panel.  We may also applyto transfer our common stock to the NASDAQ Capital Market if we satisfy allcriteria for initial listing on the NASDAQ Capital Market, other thancompliance with the minimum bid price requirement.  If such application to the NASDAQ CapitalMarket is approved, then we will have an additional 180-day compliance periodin order to regain compliance with the minimum bid price requirement whilelisted on the NASDAQ Capital Market.

 

Ifour common stock were de-listed from the NASDAQ Global Market, among otherthings, this could result in a number of negative implications, includingreduced liquidity in our common stock as a result of the loss of marketefficiencies associated with NASDAQ and the loss of federal preemption of statesecurities laws, as well as the potential loss of confidence by suppliers, customersand employees, the loss of institutional investor interest, fewer businessdevelopment opportunities and greater difficulty in obtaining financing.

 

**Acontinued or prolonged downturn in the economy could have a material adverseeffect on our financial performance and other aspects of our business.**

 

Thecurrent downturn in the economy, and any further slowdown in future periods,could adversely affect our business in ways that we are unable to fullyanticipate.  Tightening credit marketsmay negatively impact operations by affecting solvency of customers, suppliersand other business partners, or the ability of our customers to obtain creditto finance purchases of our products and services, which in turn could lead toincreased difficulty in collecting accounts receivable.  Tightening credit markets may also negativelyimpact our ability to borrow funds, if needed, either under our line of creditwith Silicon Valley Bank or from other sources. In addition, government responses to the disruptions in the financialmarkets may not stabilize the markets or increase liquidity or the availabilityof credit for us or our customers.  Awidespread reduction of global business activity could cause customers toreduce capital expenditures, put increased pricing pressure on our products andservices, and subject us, our suppliers and our customers to interest raterisks and tax changes that could impact our financial strength.  These and other economic factors could have amaterial adverse effect on our financial condition, operating results andliquidity.

 

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

 

Our Board of Directors has the authority to issue up to 5,000,000 sharesof preferred stock and, without any further vote or action on the part ofthe stockholders, to determine the price, rights, preferences, privileges andrestrictions of the preferred stock. This preferred stock, if issued, might have preference over the rightsof the holders of common stock and could adversely affect the market price ofour common stock.  The issuance of this 

 

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preferred stock may make itmore difficult for a third party to acquire us or to acquire a majority of ouroutstanding voting stock.  We currentlyhave no plans to issue preferred stock.

 

In addition, provisions of our second amended and restated certificateof incorporation and our second amended and restated by-laws may deter anunsolicited offer to purchase us.  Theseprovisions, coupled with the provisions of the Delaware General CorporationLaw, may delay or impede a merger, tender offer or proxy contest involvingus.  For example, our Board of Directorsis divided into three classes, only one of which is elected at each annualmeeting.  These factors may furtherdelay or prevent a change of control of our business.

 

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**ITEM 2.     UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

The following table presents information regarding the Company’srepurchases of its common stock during the quarter ended December 31,2008.

 

Issuer Purchases of Equity Securities

 
| **Month**          | ** ** | **Number of   Shares   Purchased ****as   Part of Publicly   Announced   Program (1)** | ** ** | **Average   Price Paid   Per Share** | ** ** | **Maximum Dollar Value   that May Yet Be Used   for Purchases Under the   Program** | ** ** |
|--------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 2008  |       | 287,500                                                                                                                                  |       | $                                                        | 0.48       |                                                                                                                                            | $          | 3,930,000 |   |
| November 2008 |       | 62,500                                                                                                                                   |       | $                                                        | 0.46       |                                                                                                                                            | $          | 3,900,000 |   |
| December 2008 |       | —                                                                                                                                   |       | —                                                   |       | —                                                                                                                                          |       |
| Total              |       | 350,000                                                                                                                                  |       | $                                                        | 0.47       |                                                                                                                                            | $          | 3,900,000 |   |

 

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(1)          All of the shares of commonstock set forth in this column were purchased pursuant to a publicly announcedprogram as described in footnote 2 below.

(2)          On June 12, 2008,the Company announced that its Board of Directors had authorized the repurchaseof up to $5 million of its common stock through a share repurchaseprogram.  The program does not have anexpiration date.  All repurchasesdescribed in the table above were effectedpursuant to a written Rule 10b5-1 trading plan.  Fromthe program’s inception through December 31, 2008, the Company hadrepurchased 1,256,801 shares at an average cost of $0.88 per share.  Upon the expiration of the 10b5-1 plan on November 7,2008, the Company suspended repurchases of its common stock.  The Company may resume repurchases under theprogram at any time at the discretion of management.

 

**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: February 9,  2009 |                       | /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**                                                                                                                                         |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                |
| 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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